<PAGE>
 
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                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
 
                                   FORM 10-K
 
(Mark One)
                 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
  [X]               OF THE SECURITIES EXCHANGE ACT OF 1934
                  For the fiscal year ended December 31, 1998
 
                                      OR
 
  [_]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
                     For the transition period from  to
                          Commission File No. 0-18490
 
                                 K-SWISS INC.
            (Exact name of Registrant as specified in its charter)
 
               Delaware                              95-4265988
    (State or other jurisdiction of               (I.R.S. Employer
    incorporation or organization)             Identification Number)
 
    31248 Oak Crest Drive, Westlake                     91361
          Village, California                        (Zip Code)
    (Address of principal executive
               offices)
 
      Registrant's telephone number, including area code: (818) 706-5100
 
          Securities registered pursuant to Section 12(b) of the Act:
 
<TABLE>
<CAPTION>
                                                           Name of each exchange
             Title of each Class                            on which registered
             -------------------                           ---------------------
<S>                                            <C>
                    None                                            None
</TABLE>
 
          Securities registered pursuant to Section 12(g) of the Act:
                             Class A Common Stock,
                           par value $.01 per share
                               (Title of class)
 
  Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes  X  No
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.                                              [X]
 
  The aggregate market value of the Class A Common Stock of the Registrant
held by non-affiliates of the Registrant on February 1, 1999 based on the
closing price of the Class A Common Stock on the NASDAQ National Market System
on such date was $125,382,379.
 
  The number of shares of the Registrant's Class A Common Stock outstanding at
February 1, 1999 was 7,313,796 shares. The number of shares of the
Registrant's Class B Common Stock outstanding at February 1, 1999 was
3,426,556 shares.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Portions of the proxy statement for the Registrant's 1999 Annual
Stockholders Meeting are incorporated by reference into Part III.
 
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<PAGE>
 
                                  K-SWISS INC.
 
                      INDEX TO ANNUAL REPORT ON FORM 10-K
 
                  For the Fiscal Year Ended December 31, 1998
 
<TABLE>
<CAPTION>
            Caption                                                          Page
            -------                                                          ----
PART I
 <C>        <S>                                                              <C>
 Item 1.    Business.....................................................      3
 Item 2.    Properties...................................................      9
 Item 3.    Legal Proceedings............................................     10
 Item 4.    Submission of Matters to a Vote of Security Holders..........     10
 Item 4(a). Executive Officers of the Registrant.........................     10
 
PART II
 Item 5.    Market for Registrant's Common Equity and Related 
            Stockholder Matters..........................................     12
 Item 6.    Selected Financial Data......................................     13
 Item 7.    Management's Discussion and Analysis of Financial Condition
            and Results of Operations....................................     14
 Item 8.    Financial Statements and Supplementary Data..................     21
 Item 9.    Changes in and Disagreements with Accountants on Accounting
            and Financial Disclosure.....................................     41
 
PART III
 Item 10.   Directors and Executive Officers of the Registrant...........     41
 Item 11.   Executive Compensation.......................................     41
 Item 12.   Security Ownership of Certain Beneficial Owners and
            Management...................................................     41
 Item 13.   Certain Relationships and Related Transactions...............     41
 
PART IV
 Item 14.   Exhibits, Financial Statement Schedules, and Reports on Form
            8-K..........................................................     41
</TABLE>
 
                                       2
<PAGE>
 
                                    PART I
 
Item 1. Business
 
Company History and General Strategy
 
  K-Swiss Inc. designs, develops and markets a growing array of athletic
footwear for high performance sports use, fitness activities and casual wear.
The Company was founded in 1966 by two Swiss brothers, who introduced one of
the first leather tennis shoes in the United States. The shoe, the K-Swiss
"Classic", has remained relatively unchanged from its original design, and
accounts for a significant portion of the Company's sales. The Classic has
evolved from a high-performance shoe into a casual, lifestyle shoe. Since its
inception, the Company has emphasized in its marketing the Swiss heritage of
the Company, including the commitment to produce products of high quality and
enduring style. The Company plans to continue to emphasize the high quality
and classic design of its products as it introduces new models of athletic
footwear.
 
  On December 30, 1986, the Company was purchased by an investment group led
by the Company's current President. The Company thereafter recruited
experienced management and reduced manufacturing costs by increasing offshore
production and entering into new, lower cost purchasing arrangements. The
Company's products are manufactured to its specifications by overseas
suppliers predominately in China. In June 1991 and September 1992, K-Swiss
International Ltd. and K-Swiss B.V. (located in the Netherlands),
respectively, commenced operations to broaden the Company's distribution on a
global scale. In addition, in August 1992, K-Swiss Inc. completed the
acquisition of K-Swiss Europe Limited (renamed to K-Swiss (UK) Ltd.) which
handles distribution in the United Kingdom.
 
  The Company's product strategy is two pronged. The first combines classic
styling with high quality components and technical features designed to meet
performance requirements of specific sports. The Company endeavors to use
classic styling to reduce the impact of changes in consumer preferences and
believes that this strategy leads to longer product life cycles than are
typical of the products of certain of its competitors. Management believes
that long product life cycles reduce total markdowns over the life of the
products, thereby enhancing their attractiveness to retailers. This strategy
also enables the Company to maintain inventory with less risk of obsolescence
than is typical of more fashion-oriented products. The second product strategy
uses fashion oriented footwear sold principally on a futures only basis
usually with little or no planned inventory position taken on these products.
This strategy allows the Company to take advantage of trends in the
marketplace that it identifies while attempting to minimize the risk generally
associated with this type of product.
 
  The Company sells its products in the United States through independent
sales representatives primarily to specialty athletic footwear stores, pro
shops, sporting good stores and department stores. The Company also sells its
products to a number of foreign distributors. The Company now has sales
offices or distributors throughout the world. During 1992, the Company
established sales offices and now has appointed exclusive distributors in much
of Europe. The Company believes that its overseas sales offices and foreign
distributors provide an opportunity for future growth.
 
  The Company was organized under the laws of the State of Delaware on April
16, 1990. The Company is successor in interest to K-Swiss Inc., a
Massachusetts corporation, which in turn was successor in interest to K-Swiss
Inc., a California corporation. The Company's principal executive offices are
located at 31248 Oak Crest Drive, Westlake Village, California 91361, and its
telephone number is (818) 706-5100. Unless the context otherwise requires, the
term the "Company" as used herein refers to K-Swiss Inc. and its consolidated
subsidiaries.
 
 
                                       3
<PAGE>
 
Products
 
  The following table summarizes the K-Swiss product lines and sets forth the
approximate contribution to revenues (in dollars and as a percentage of
revenues) attributable to each footwear category for the periods indicated.
All footwear categories come in both men's (approximately 38% of 1998
revenues) and women's (approximately 36% of 1998 revenues). Most styles within
each footwear category are offered in men's, women's and children's.
 
<TABLE>
<CAPTION>
                                                    Revenues (1)
                                       ----------------------------------------
                                              Year Ended December 31,
                                       ----------------------------------------
                                           1998          1997          1996
                                       ------------  ------------  ------------
Product Category                          $      %      $      %      $      %
----------------                       -------- ---  -------- ---  -------- ---
                                           (Dollar amounts in thousands)
<S>                                    <C>      <C>  <C>      <C>  <C>      <C>
Classic............................... $ 98,312  61% $ 67,163  58% $ 50,573  48%
Tennis/Court..........................   20,146  13    20,505  18    25,511  24
Children's............................   36,491  22    21,288  19    18,693  18
Other (2).............................    5,972   4     6,169   5    10,733  10
                                       -------- ---  -------- ---  -------- ---
Total................................. $160,921 100% $115,125 100% $105,510 100%
                                       ======== ===  ======== ===  ======== ===
Domestic (3).......................... $144,891  90% $ 91,040  79% $ 75,945  72%
                                       ======== ===  ======== ===  ======== ===
</TABLE>
--------
(1) For purposes of this table, revenues do not include other domestic income
    and fees earned by the Company on sales by foreign licensees and
    distributors.
 
(2) Other consists of outdoor shoes, apparel, accessories, sport sandals and
    blemished shoes.
 
(3) Included in totals on previous line.
 
 Footwear
 
  The Company's product line through 1987 consisted primarily of the Classic.
The Classic was originally developed in 1966 as a high-performance tennis
shoe. Since that time, the Classic has become a popular casual shoe, while
realizing strong sales as the Original Classic shoe. The upper of the Classic
includes only three separate pieces of leather, which allows for a relatively
simple manufacturing process and yields a product with few seams. This simple
construction improves the shoe's comfort, fit and durability. The Company has
from time to time incorporated certain technical advances in materials and
construction, but the Classic has remained relatively unchanged in style since
1966. The Classic continues to be the Company's single most important product.
 
  The Classic, through product development, has evolved also into a category
of shoes denoted as the Classic category. The Classic category is comprised of
three components, the Classic as described above, the K-S Collection and the
Limited Edition series.
 
  The Classic component contains shoes that the Company intends to carry in
its product assortment for many years. They generally have shoe
characteristics such as d-rings and five stripes, and, because they are long-
duration shoes, the Company maintains significant inventory positions of this
component. Significant inventory positions allow for effective EDI programs
with our retailers which fits into the Company's strategy of attempting to
become the retailers most profitable vendor. The K-S Collection comprises
shoes offered for three to five seasons and they generally do not contain d-
rings and have diffused or no stripes. Sometimes inventory is maintained on
these products. The Limited Edition series is generally meant for a one-season
offering. They are generally fashionable type shoes that are purchased from
factories only to fulfill futures orders received from retailers.
 
  Presently, the Company competes in the Classic category (casual), tennis and
children's footwear. Each product category has certain styles designated as
core products. The Company's core products
 
                                       4
<PAGE>
 
offer style continuity and often include on-going improvement. The Company
believes its core product program is a critical factor in attempting to
achieve the Company's goal of becoming the "retailers' most profitable
vendor". The core program tends to minimize retailers' markdowns and maximizes
the effectiveness of marketing expenditures because of longer product life
cycles.
 
 Apparel and Accessories
 
  The Company markets a line of K-Swiss branded apparel and accessories. The
products are designed with the same classic strategies used in the footwear
line. Classic styling allows the Company to appeal to a variety of new markets
from an urban distribution to an upscale suburban consumer. The products
represent high quality with an exceptional value. Products consist of tennis
apparel (skirts, shorts, polo's, and warm-up suits) worn by the number one
Men's Doubles Team in the World, to oversized mesh jersey's, fleece
sweatshirts and pants, windwear, denim shorts, tee shirts, caps, and socks for
the casual athletic consumer.
 
  The apparel line is distributed through the large chain sporting goods
stores as well as independent shoe and sporting goods dealers nationwide.
 
  The apparel products offer the company the ability to dress the consumer
from head to toe. It also offers the Company visible promotional
opportunities.
 
 Sales
 
  Financial information relating to international and domestic operations is
presented as part of Item 8 of this report. See Note M to the Company's
Consolidated Financial Statements.
 
Marketing
 
 Advertising and Promotion
 
  Management believes that its strategy of designing products with longer life
cycles and introducing fewer new models relative to its competition enhances
the effectiveness of its advertising and promotions.
 
  In 1998, K-Swiss launched its largest ever television campaign. The campaign
titled "Club K-Swiss" was run primarily on network and cable television, and
was supported by several general interest/fashion magazines, as well as select
tennis magazines.
 
  As the Company's heritage has been rooted in performance tennis, the launch
in 1997 of a new high-end performance tennis line, termed, the 7.0 System
(after the NTRP rating system), was well received by retailers and consumers.
This launch was supported by an extensive print campaign in tennis enthusiast
magazines. Along with this, the Company signed the # 1 Doubles Team in the
World, "The Woodies", as endorsers of the new line. These marketing efforts
were in addition to the existing grassroot's efforts already in place, which
include; club teaching professionals, local tennis tournaments, along with
sponsorship of individual junior players.
 
  Advertising and promotion efforts in foreign markets are directed by local
distributors. The Company's agreements with foreign distributors generally
require such distributors to spend a certain percentage of their sales of the
Company's products on advertising and promotion. The Company controls the
nature and content of these promotions.
 
 Domestic Marketing
 
  The Company's current marketing strategy emphasizes distribution to
retailers whose marketing strategies are consistent with the Company's
reputation for quality and service.
 
                                       5
<PAGE>
 
  The Company's footwear products are sold domestically through approximately
45 independent regional sales representatives and three Company-employed
senior sales managers. The independent sales representatives are paid on a
commission basis, and are prohibited by contract from representing other
brands of athletic footwear and related products. These representatives sold
to approximately 3,100, 3,100 and 3,300 separate accounts as of December 31,
1998, 1997 and 1996, respectively. The Company's strategy is to increase its
account base of upscale retail outlets in a controlled manner.
 
  During 1998, the Foot Locker group of stores and affiliates accounted for
approximately 26% of total revenues. See Note L to the Company's Consolidated
Financial Statements. No other domestic customer accounted for more than 10%
of total revenues during this period.
 
  The Company offers a "futures" program, under which retailers are offered
discounts on orders scheduled for delivery more than five months after the
order is made. There is no guarantee that such orders will not be canceled
prior to acceptance by the customer. This program is similar to programs
offered by other athletic shoe companies. Because of the positive effect of
the futures program on inventory costs, planning and production scheduling,
the Company has expanded the program. See "Distribution". In addition, the
Company engages in certain marketing programs from time to time that provide
for extended terms on initial domestic orders of new styles.
 
  The Company maintains a customer service department consisting of 15 persons
at its Westlake Village, California facility. The customer service department
accepts telephone orders for the Company's products, handles inquiries and
notifies retailers of the status of their orders. The Company has made a
substantial investment in computer equipment for general customer support and
service, as well as for distribution. See "Distribution".
 
 International Marketing
 
  In 1991, the Company established a sales management team in Asia. The
Company has exclusive distributors in certain Pacific Rim countries. Exclusive
distributors of the Company's products are generally contractually obligated
to spend specific amounts on advertising and promotion of the Company's
products. The Company has also established exclusive distributors in other
international markets.
 
  To expand the marketing of its products into Europe, the Company opened its
own office in Amsterdam, the Netherlands in 1992.
 
  By the end of 1998, K-Swiss was working through 4 international subsidiaries
and 28 distributors to market K-Swiss products in potentially 54 countries.
 
Distribution
 
  During December 1997, the Company relocated its distribution facility. The
Company now maintains 309,000 square feet of warehouse space at a leased
facility in Mira Loma, California. Approximately 90,000 square feet of this
facility is subleased to a tenant. The Company owned a 56,000 square foot
warehouse in Pacoima, California which was leased to a tenant. This warehouse
was sold and escrow closed in January 1998. See "Item 2. Properties".
 
  The Company purchases footwear from independent manufacturers located
predominantly in China. The time required to fill new orders placed by the
Company with its manufacturers is approximately five months. Such footwear is
generally shipped in ocean containers and delivered to the Company's facility
in California. In some cases, large customers of the Company may receive
containers of footwear directly from the manufacturer. Distribution to
European and certain other
 
                                       6
<PAGE>
 
distributors is based out of the Netherlands office public distribution
facility. The Company generally arranges shipment of other international
orders directly from its independent manufacturers.
 
  The Company maintains an open-stock inventory on certain products which
permits it to ship to retailers on an "at once" basis in response to orders
placed by mail or toll-free telephone call. The Company has made a significant
investment in computer equipment that provides on-line capability to determine
open-stock availability for shipment. Additionally, products can be ordered
under the Company's "futures" program. See "Marketing--Domestic Marketing".
The Company ships by package express or truck from California, depending upon
size of order, customer location and availability of inventory.
 
Product Design and Development
 
  The Company maintains offices in Westlake Village, California and Taiwan
that include a staff of individuals responsible for the design and development
of new styles for all global regions. This staff receives guidance from the
Company's management team in California, who meet regularly to review sales,
consumer and market trends.
 
Manufacturing
 
   In 1998, approximately 93% of the Company's footwear products were
manufactured in China, 3% in Indonesia, 3% in Thailand, and 1% in Taiwan. This
shift from prior years in the geographic sourcing of production capacity
occurred primarily because of lower prevailing labor wage rates in China and
certain other factors. Although the Company has no long-term manufacturing
agreements and competes with other athletic shoe companies for production
facilities (including companies that are much larger than the Company),
management believes that the Company's relationships with its footwear
producers are satisfactory and that it has the ability to develop, over time,
alternative sources for its footwear. The Company's operations, however, could
be materially and adversely affected if a substantial delay occurred in
locating and obtaining alternative producers.
 
  All manufacturing of footwear is performed in accordance with detailed
specifications furnished by the Company and is subject to quality control
standards, with the Company retaining the right to reject products that do not
meet specifications. The bulk of all raw materials used in such production is
purchased by manufacturers at the Company's direction. The Company's
inspectors at the manufacturing facilities conduct testing and inspection of
footwear products prior to shipment from those facilities.
 
  During 1998, the Company's apparel and accessory products were manufactured
in Taiwan, Hong Kong, China, Macau, Thailand and the United States by certain
manufacturers selected by the Company.
 
  The Company's operations are subject to compliance with relevant laws and
regulations enforced by the United States Customs Service and to the customary
risks of doing business abroad, including fluctuations in the value of
currencies, increases in customs duties and related fees resulting from
position changes by the United States Customs Service, import controls and
trade barriers (including the unilateral imposition of import quotas),
restrictions on the transfer of funds, work stoppages and, in certain parts of
the world, political instability causing disruption of trade. These factors
have not had a material adverse impact upon the Company's operations to date.
Imports into the United States are also affected by the cost of
transportation, the imposition of import duties, and increased competition
from greater production demands abroad. The United States or the countries in
which the Company's products are manufactured may, from time to time, impose
new quotas, duties, tariffs or other restrictions, or adjust presently
prevailing quotas, duty or tariff levels, which could affect the Company's
operations and its ability to import products at current or increased levels.
The Company cannot predict
 
                                       7
<PAGE>
 
the likelihood or frequency of any such events occurring. A change in any such
duties, quotas or restrictions could result in increases in the costs of such
products generally and might adversely affect the sales or profitability of
the Company and the athletic footwear industry as a whole.
 
  The Company's use of common elements in raw materials, lasts and dies gives
the Company flexibility to duplicate sourcing in various countries in order to
reduce the risk that the Company may not be able to obtain products from a
particular country.
 
  The Company's footwear products are subject to the United States customs
duties which range from 8.5% to 10.5% on footwear made principally of leather
to duties on moderately priced canvas shoes of 15.6% to 37.5% plus $.90 per
pair. Currently, approximately 94% of the Company's footwear volume is derived
from sales of leather footwear and approximately 6% of the Company's footwear
volume is derived from sales of canvas footwear.
 
  A large portion of the Company's imported products are manufactured in the
People's Republic of China ("China"). As discussed below, the continued
importation of these products could be affected by any one of several
significant trade issues that presently impact U.S.-China relations.
 
  After a serious dispute with the United States Trade Representative ("USTR")
over the protection of intellectual property rights in China, including the
threat by USTR to impose trade sanctions, the Chinese government agreed to
meet its enforcement obligations. That agreement is now being monitored by
USTR, and the failure of China to comply with its obligations could result in
trade sanctions in the future, including the imposition of retaliatory tariffs
that might affect the Company's imports of footwear from China. From time to
time there have been other trade disputes with China, involving such things as
market access, textile quotas, automotive industry policies, and agricultural
products. These and other such matters could also present problems in the
future that might lead to trade sanctions affecting the Company's imports of
footwear.
 
  Imports from China continue to enter the United States on a conditional
normal-trade-relations ("NTR") basis. Pursuant to NTR, products imported by
the Company from China currently receive the lower tariff rates made available
to most of the United States' major trading partners. In the case of China,
however, this NTR treatment is made possible under the Trade Act of 1974 by
virtue of certain Presidential findings that waive restrictions that would
otherwise render China ineligible for NTR treatment. The President has waived
these restrictions each year since 1979. There can be no assurance that China
will continue to enjoy NTR status in the future. If goods manufactured in
China enter the United States without benefit of NTR treatment, such goods
will be subject to significantly higher duty rates, ranging between 20% and
66% of customs value. Any such increased duties or tariffs could significantly
increase the cost or reduce supply of goods from China.
 
Backlog
 
  At December 31, 1998 and 1997, domestic futures orders with start ship dates
from January through June 1999 and 1998 were approximately $131,452,000 and
$56,189,000, respectively. At December 31, 1998 and 1997, international
futures orders with start ship dates from January through June 1999 and 1998
were approximately $9,011,000 and $8,473,000, respectively. "Backlog", as of
any date, represents orders scheduled to be shipped within the next six
months. Backlog does not include orders scheduled to be shipped on or prior to
the date of determination of backlog.
 
  The mix of "futures" and "at once" orders can vary significantly from
quarter to quarter and year to year and therefore "futures" are not
necessarily indicative of revenues for subsequent periods. Orders generally
may be canceled by customers without financial penalty. The Company believes
its rate of net customer cancellations of domestic orders approximates
industry averages for similar companies. Customers may also reject
nonconforming goods. To date, the Company believes it has
 
                                       8
<PAGE>
 
not experienced returns of its products or bad debts of customers materially
in excess of industry averages for similar companies.
 
Competition
 
  The athletic footwear industry is highly competitive, and recent sales
growth of athletic and athletic-style leisure footwear has spurred the entry
of many new competitors and an increase in competition from established
companies. The largest domestic marketers of such footwear are Nike and
Reebok, while the international market is dominated by Adidas, Nike and
Reebok. Each of these companies has substantially greater financial,
distribution and marketing resources as well as greater brand awareness than
the Company.
 
  The Company has recently increased its emphasis on product lines beyond the
Company's Classic tennis model. In the past, the Company has introduced
products in such highly competitive categories such as court, boating, outdoor
and children's shoes. See "Products". There can be no assurance that the
Company will penetrate these or other new markets or increase the market share
it has established to date.
 
  The principal elements of competition in the athletic footwear market
include brand awareness, product quality, design, pricing, fashion appeal,
marketing, distribution, performance and brand positioning. The Company's
products compete primarily on the basis of technological innovations, quality,
style, and brand awareness among consumers. While the Company believes that
its competitive strategy has resulted in increased brand awareness and market
share, there can be no assurance that the Company will be able to retain or
increase its market share or respond to changing consumer preferences.
 
Trademarks and Patents
 
  The Company utilizes trademarks on all of its products and believes that its
products are more marketable on a long-term basis when identified with
distinctive markings. K-Swiss(R) is a registered trademark in the United
States and certain other countries. The Company's name is not registered as a
trademark in certain countries because of restrictions on registering names
having geographic connotations. However, since K-Swiss is not a geographic
name, the Company has often secured registrations despite such objections. The
Company's shield emblem and the five-stripe design are also registered in the
United States and certain foreign countries. The five-stripe design is not
presently registered in some countries because it has been deemed ornamental
by regulatory authorities. The five-stripe design has not been registered in
Germany because of a possible conflict with Adidas' three stripe design mark.
The Company selectively seeks to register the names of its shoes, its logos
and the names given to certain of its technical and performance innovations,
including Aosta(R) rubber and Silicone Formula 18(R). The Company has obtained
patents in the United States regarding the D.R. Cinch System(R), the stability
design incorporated into the Si-18(R) tennis shoe, and other features. The
Company vigorously defends its trademarks and patent rights against
infringement worldwide and employs independent security consultants to assist
in such protection. To date, the Company is not aware of any significant
counterfeiting problems regarding its products.
 
Employees
 
  At December 31, 1998, the Company employed 160 persons in the United States,
65 persons in Taiwan and China, and 28 persons in England and the Netherlands.
 
Item 2. Properties
 
  In August 1998, the Company moved into its new headquarters facility in
Westlake Village, California. This facility, which is owned by the Company, is
approximately 50,000 square feet. The Company occupies one-half of this
facility and is in the process of leasing the remaining portion.
 
                                       9
<PAGE>
 
  The Company owned a 56,000 square foot facility in Pacoima, California,
which was used as the Company's principal executive offices through December
1992. This facility was sold and escrow closed in January 1998.
 
  The Company leases a 309,000 square foot distribution facility in Mira Loma,
California. This lease expires in January 2003, subject to two options, each
of which would extend the term of the lease for three years. Approximately
90,000 square feet of this facility is subleased to a tenant through January
2003. The Company uses the Mira Loma facility as its main distribution center.
The effective monthly commitment for the Mira Loma facility is approximately
$79,000.
 
Item 3. Legal Proceedings
 
  The Company is, from time to time, a party to litigation which arises in the
normal course of its business operations. The Company does not believe it is
presently a party to litigation which will have a material adverse effect on
its business or operations.
 
Item 4. Submission of Matters to a Vote of Security Holders
 
  None.
 
Item 4(a). Executive Officers of the Registrant
 
  The executive officers of the Company are as follows:
 
<TABLE>
<CAPTION>
                     Age at
                  December 31,
      Name            1998                      Position
      ----        ------------                  --------
<S>               <C>          <C>
Steven Nichols         56      Chairman of the Board and President
Preston Davis          54      Vice President--Sales
Edward Flora           47      Vice President--Operations
Lee Green              45      Corporate Counsel
Thomas Harrison        56      Senior Vice President
Donna Lucas            36      Vice President--Apparel
Deborah Mitchell       37      Vice President--Marketing
George Powlick         54      Vice President--Finance, Chief Financial
                                Officer, Secretary and Director
Janice Smith           37      Corporate Controller
Brian Sullivan         45      Vice President--National Accounts
Peter Worley           38      Vice President--Product Development
</TABLE>
 
  Officers are appointed by and serve at the discretion of the Board of
Directors.
 
  Steven Nichols has been President and Chairman of the Board of the Company
since 1987. From 1980 to 1986, Mr. Nichols was a director and Vice President--
Merchandise of Stride Rite Corp., a footwear manufacturer and holding company.
In addition, Mr. Nichols was President of Stride Rite Footwear from 1982 to
1986. From 1979 to 1982, Mr. Nichols served as an officer and President of
Stride Rite Retail Corp., the largest retailer of branded children's shoes in
the United States. From 1962 through 1979, he was an officer of Nichols Foot
Form Corp., which operated a chain of New York retail footwear stores.
 
  Preston Davis, Vice President--Sales, joined the Company in March 1987 as a
consultant and served as Vice President--Sales from June 1987 to January 1989
and Vice President--Marketing from February 1989 to February 1991. Prior to
joining the Company, Mr. Davis owned and managed Preston Davis Associates, a
marketing and sales consulting firm, specializing in sporting goods. From
 
                                      10
<PAGE>
 
June 1982 through December 1985, Mr. Davis was Vice President--Sales for
Kaepa, Inc., another athletic shoe company.
 
  Edward Flora, Vice President--Operations, joined the Company as a consultant
in June 1990 and served as Director--Administration from October 1990 to
February 1994. Prior to joining the Company, Mr. Flora was Vice President--
Distribution for Bugle Boy Industries, a manufacturer and distributor of
Men's, Women's, and Children's apparel, from 1987 through May 1990.
 
  Lee Green, Corporate Counsel, joined the Company in December 1992. Mr. Green
was formerly a partner in the international law firm of Baker & McKenzie. He
worked in the firm's Taipei office from 1985 to 1988 and its Palo Alto office
from 1988 to 1992.
 
  Thomas Harrison, Senior Vice President, joined the Company in January 1989.
From 1987 through 1988, Mr. Harrison was President of Osh Kosh Footwear, a
manufacturer and wholesaler of casual footwear. From 1985 to 1987, Mr.
Harrison was President of Keds Corp., a division of Stride Rite Corp. From
1984 to 1985, Mr. Harrison was national account representative for Osh Kosh
Footwear. From 1977 through 1984, Mr. Harrison was manager of the consumer
products division of Uniroyal, Inc., which included the footwear lines of
Keds, Pro-Keds and Sperry Topsider. Mr. Harrison joined Uniroyal in 1967 as a
sales representative for its Keds Division.
 
  Donna Lucas, Vice President--Apparel, joined the Company in December 1996.
Ms. Lucas was the Director of Design and Merchandising for Benetton
Sportsystem USA from 1990 to 1996. Previous to that she was with Adidas USA in
several different capacities from 1986 to 1990. Her responsibilities ranged
from design to merchandising of all the product categories from tennis to
special markets ending in Senior Merchandising for the entire product range.
 
  Deborah Mitchell, Vice President--Marketing, joined the Company in October
1994. Ms. Mitchell served as Director of Marketing for Fruit of the Loom, the
largest manufacturer of men's underwear, from December 1993 through October
1994. Ms. Mitchell worked at Procter and Gamble in various positions ending in
brand management from 1984 through 1993 except while she was earning her
degree from Harvard Business School.
 
  George Powlick, Director, Vice President--Finance, Chief Financial Officer
and Secretary, joined the Company in January 1988. Mr. Powlick is a certified
public accountant and was an audit partner in the independent public
accounting firm of Grant Thornton from 1975 to 1987.
 
  Janice Smith, Corporate Controller, joined the Company in August 1987. Ms.
Smith is a certified public accountant. From 1984 to July 1987, Ms. Smith was
an auditor with the independent public accounting firm of Grant Thornton.
 
  Brian Sullivan, Vice President--National Accounts, joined the Company in
December 1989. From 1986 to 1989, he was Vice-President and General Manager of
Tretorn, Inc., a manufacturer and distributor of tennis shoes. From 1984
through 1985, Mr. Sullivan was Vice-President of Sales of Bancroft/Tretorn, a
tennis shoe manufacturer and distributor and predecessor to Tretorn. From 1978
to 1984, Mr. Sullivan held various positions at Bancroft/Tretorn, including
Field Salesperson, Marketing and Sales Planning Manager and National Sales
Manager.
 
  Peter Worley, Vice President--Product Development, joined the Company in May
1996. Mr. Worley worked for Reebok International, Ltd. from May 1986 through
October 1989, and again from July 1991 through April 1996 in various
merchandising and product line management positions, including Director of
Classic, Director of Cross Training and Director of Tennis. From October 1989
through July 1991, Mr. Worley was Sport Product Manager of Bausch & Lomb's
Ray-ban Sunglass Division.
 
 
                                      11
<PAGE>
 
                                    PART II
 
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
 
  The Company's Class A Common Stock began trading June 4, 1990 on the
National Market System maintained by the National Association of Securities
Dealers upon completion of the Company's initial public offering. Per share
high and low sales prices (in dollars) for the quarterly periods during 1998
and 1997 as reported by NASDAQ were as follows:
 
<TABLE>
<CAPTION>
                                   March 31, June 30, September 30, December 31,
                                   --------- -------- ------------- ------------
      <S>                          <C>       <C>      <C>           <C>
      1998
        Low.......................   8.00      9.50       10.00        10.00
        High......................   9.75     11.50       14.50        15.63
      1997
        Low.......................   4.94      5.44        7.25         7.88
        High......................   6.38      7.88        9.94         9.00
</TABLE>
 
  The Company announced on February 8, 1999 that the Company's Board of
Directors approved a two-for-one stock split for both Class A and Class B
common stock. This stock split will be in the form of a 100 percent stock
dividend to be distributed on March 26, 1999 to stockholders of record at the
close of business on March 15, 1999. See Note O to the Company's Consolidated
Financial Statements. The high and low sales prices above have been restated
to reflect the effect of the two-for-one stock split.
 
  The Class A Common Stock is listed on the automatic quotation system of the
National Association of Securities Dealers under the symbol KSWS.
 
  The number of stockholders of record of the Class A Common Stock on December
31, 1998 was 105. However, based on available information, the Company
believes that the total number of Class A Common stockholders, including
beneficial stockholders, is approximately 1,350.
 
  There is currently no established public trading market for the Company's
Class B Common Stock. The number of stockholders of record of the Class B
Common Stock on December 31, 1998 was 11.
 
 
Dividend Policy
 
  The Company announced on February 16, 1994 that the Company's Board of
Directors was initiating a cash dividend program payable at an annual rate of
4 cents per common share. The Board declared quarterly dividends of 1 cents
per share, to stockholders of record as of the close of business on the last
day of each quarter in 1998 and 1997. The payment of any future dividends will
be at the discretion of the Company's Board of Directors and will depend upon,
among other things, future earnings, operations, capital requirements, the
general financial condition of the Company and general business conditions.
The Company is currently limited in the extent to which it is able to pay
dividends under the Company's revolving credit agreement. See Note D to the
Company's Consolidated Financial Statements.
 
  The Company announced on February 8, 1999 that the Company's Board of
Directors increased the cash dividend per share to an annual rate, on a post-
split basis, of 6 cents per common share from an annual rate of 4 cents per
common share. See Note O to the Company's Consolidated Financial Statements.
 
                                      12
<PAGE>
 
Item 6. Selected Financial Data
 
  The selected consolidated financial data presented below for each of the
five years in the period ended December 31, 1998 have been derived from
audited financial statements which for the most recent three years appear
elsewhere herein. The data presented below should be read in conjunction with
such financial statements, including the related notes thereto and the other
information included herein.
 
<TABLE>
<CAPTION>
                                              Year ended December 31,
                                    --------------------------------------------
                                      1998     1997     1996     1995     1994
                                    -------- -------- -------- -------- --------
                                       (In thousands, except per share data)
<S>                                 <C>      <C>      <C>      <C>      <C>
Income Statement Data
Revenues..........................  $161,540 $116,213 $106,833 $120,252 $154,935
Cost of goods sold................    90,925   70,769   72,320   77,726   91,934
                                    -------- -------- -------- -------- --------
  Gross Profit....................    70,615   45,444   34,513   42,526   63,001
Selling, general and
 administrative expenses..........    51,220   40,074   33,440   36,131   38,458
                                    -------- -------- -------- -------- --------
  Operating profit................    19,395    5,370    1,073    6,395   24,543
Interest income, net..............     1,853    1,823    1,527      789      254
                                    -------- -------- -------- -------- --------
  Earnings before income taxes....    21,248    7,193    2,600    7,184   24,797
Income tax expense................     8,702    3,020    1,869    5,331    9,921
                                    -------- -------- -------- -------- --------
  Net earnings....................  $ 12,546 $  4,173 $    731 $  1,853 $ 14,876
                                    ======== ======== ======== ======== ========
Earnings per share (1)
Basic.............................  $   1.15 $    .36 $    .06 $    .14 $   1.13
                                    ======== ======== ======== ======== ========
Diluted...........................  $   1.10 $    .35 $    .06 $    .14 $   1.10
                                    ======== ======== ======== ======== ========
Weighted average number of shares
 outstanding
Basic.............................    10,914   11,688   12,911   13,155   13,125
Diluted (2).......................    11,432   11,927   12,985   13,259   13,473
Balance Sheet Data (at period end)
Current assets....................  $102,002 $ 91,053 $ 90,537 $ 92,786 $ 90,132
Current liabilities...............    18,703   14,662   11,240    9,603   12,891
Total assets......................   115,465  101,195  100,275  102,378  100,324
Total debt (3)....................       655    1,142    1,711      920    3,402
Stockholders' equity..............    83,268   75,865   79,569   84,069   82,817
</TABLE>
--------
(1) The amounts reflect the effect of the two-for-one stock split announced by
    the Company on February 8, 1999. See Note O to the Company's Consolidated
    Financial Statements.
(2) Includes common stock and dilutive potential common stock (options).
(3) Includes all interest-bearing debt and capital lease obligations, but
    excludes outstanding letters of credit ($7,703,000, $12,156,000,
    $8,000,000, $7,741,000 and $15,632,000 as of December 31, 1998, 1997,
    1996, 1995 and 1994).
 
                                      13
<PAGE>
 
Item 7. Management's Discussion and Analysis of Financial Condition and
      Results of Operations
 
Note Regarding Forward-Looking Statements and Analyst Reports
 
  "Forward-looking statements", within the meaning of the Private Securities
Litigation Reform Act of 1995 (the "Act"), include certain written and oral
statements made, or incorporated by reference, by the Company or its
representatives in this report, other reports, filings with the Securities and
Exchange Commission ("the S.E.C."), press releases, conferences, or otherwise.
Such forward-looking statements include, without limitation, any statement
that may predict, forecast, indicate, or imply future results, performance, or
achievements, and may contain the words "believe", "anticipate", "expect",
"estimate", "intend", "plan", "project", "will be", "will continue", "will
likely result", or any variations of such words with similar meaning. These
statements are not guarantees of future performance and are subject to certain
risks, uncertainties and assumptions that are difficult to predict; therefore,
actual results may differ materially from those expressed or forecasted in any
such forward-looking statements. Investors should carefully review the risk
factors set forth in other reports or documents the Company files with the
S.E.C., including Forms 10-Q, 10-K and 8-K. Some of the other risks and
uncertainties that should be considered include, but are not limited to, the
following: international, national and local general economic and market
conditions (including the current Asian economic crisis); the size and growth
of the overall athletic footwear and apparel markets; the size of the
Company's competitors; intense competition among designers, marketers,
distributors and sellers of athletic footwear and apparel for consumers and
endorsers; demographic changes; changes in consumer preferences; popularity of
particular designs, categories of products, and sports; seasonal and
geographic demand for the Company's products; the size, timing and mix of
purchases of the Company's products; fluctuations and difficulty in
forecasting operating results, including, without limitation, the fact that
advance "futures" orders may not be indicative of future revenues due to the
changing mix of futures and at-once orders; the ability of the Company to
continue, manage or forecast its growth and inventories; new product
development and commercialization; the ability to secure and protect
trademarks, patents, and other intellectual property; performance and
reliability of products; customer service; adverse publicity; the loss of
significant customers or suppliers; dependence on distributors; business
disruptions; increased costs of freight and transportation to meet delivery
deadlines; changes in business strategy or development plans; general risks
associated with doing business outside the United States, including, without
limitation, import duties, tariffs, quotas and political and economic
instability; changes in government regulations; liability and other claims
asserted against the Company; the ability to attract and retain qualified
personnel; and other factors referenced or incorporated by reference in this
report and other reports.
 
  The Company operates in a very competitive and rapidly changing environment.
New risk factors can arise and it is not possible for management to predict
all such risk factors, nor can it assess the impact of all such risk factors
on the Company's business or the extent to which any factor, or combination of
factors, may cause actual results to differ materially from those contained in
any forward-looking statements. Given these risks and uncertainties, investors
should not place undue reliance on forward-looking statements as a prediction
of actual results.
 
  Investors should also be aware that while the Company does, from time to
time, communicate with securities analysts, it is against the Company's policy
to disclose to them any material non-public information or other confidential
commercial information. Accordingly, investors should not assume that the
Company agrees with any statement or report issued by any analyst irrespective
of the content of the statement or report. Furthermore, the Company has a
policy against issuing or confirming financial forecasts or projections issued
by others. Thus, to the extent that reports issued by securities analysts
contain any projections, forecasts or opinions, such reports are not the
responsibility of the Company.
 
 
                                      14
<PAGE>
 
Results of Operations
 
  The following table sets forth, for the periods indicated, the percentage of
certain items in the consolidated statements of earnings relative to revenues.
 
<TABLE>
<CAPTION>
                                                      Year ended December 31,
                                                      -------------------------
                                                       1998     1997     1996
                                                      -------  -------  -------
      <S>                                             <C>      <C>      <C>
      Revenues.......................................   100.0%   100.0%   100.0%
      Cost of goods sold.............................    56.3     60.9     67.7
      Gross profit...................................    43.7     39.1     32.3
      Selling, general and administrative expenses...    31.7     34.5     31.3
      Interest income, net...........................     1.2      1.6      1.4
      Earnings before income taxes...................    13.2      6.2      2.4
      Income tax expense.............................     5.4      2.6      1.7
      Net Earnings...................................     7.8      3.6      0.7
</TABLE>
 
1998 Compared to 1997
 
  Total revenues increased 39.0% to $161,540,000 in 1998 from $116,213,000 in
1997. This increase was attributable to increases in the average underlying
wholesale price per pair, in addition to an increase in the volume of footwear
sold. The volume of footwear sold increased 30.1% to 6,334,000 pair in 1998
from 4,870,000 pair in 1997. The average wholesale price per pair increased by
7.9% to $24.54 in 1998 from $22.74 in 1997. This increase in the average
wholesale price per pair is primarily attributable to an increase in the
Classic category, in both units and average price per pair. The major changes
in volume for footwear categories are as follows: Classics and children's
categories increased 31% and 60%, respectively, and the tennis/court category
decreased 2%. Revenues increased despite a poor retail environment due
principally to the popularity of several new Classic products and the
cumulative results of additional spending on marketing and advertising.
 
  Domestic revenues increased 58.7% to $145,293,000 in 1998 from $91,568,000
in 1997. International product revenues decreased 33.4% in 1998 to $16,030,000
from $24,085,000 in 1997. International revenues, as a percentage of total
revenues, decreased to 10.1% in 1998 from 20.7% in 1997. Fees earned by the
Company on sales by foreign licensees and distributors decreased to $217,000
for 1998 from $560,000 for 1997.
 
  The Company believes that the athletic and casual footwear industry
experiences seasonal fluctuations, due to increased domestic sales during
certain selling seasons, including Easter, back-to-school and the year-end
holiday seasons. The Company presents full-line offerings for the Easter and
back-to-school seasons, for delivery during the first and third quarters,
respectively, but not for the year-end holiday season. However, one particular
shoe out of the holiday line became very popular, accounting for the large
increase in sales during the fourth quarter of 1998.
 
  At December 31, 1998 domestic and international futures orders with start
ship dates from January through June 1999 were approximately $131,452,000 and
$9,011,000, respectively, 134% and 6% higher, respectively, than such orders
were at December 31, 1997 for start ship dates of the comparable period of the
prior year. These orders are not necessarily indicative of revenues for
subsequent periods because: (1) the mix of "future" and "at-once" orders can
vary significantly from quarter to quarter and year to year and (2) the rate
of customer order cancellations can also vary from quarter to quarter and year
to year.
 
  Gross profit margins increased as a percentage of revenues to 43.7% in 1998
from 39.1% in 1997. Gross profit margins increased primarily due to the
Company introducing new styles at relatively higher margins. In addition,
gross profit margins increased due to changes in the domestic/international
and product mix of sales.
 
                                      15
<PAGE>
 
  Selling, general and administrative expenses increased 27.8% to $51,220,000
(31.7% of revenues) in 1998 from $40,074,000 (34.5% of revenues) in 1997. The
increase in the amounts for the year ended December 31, 1998 compared to the
year ended December 31, 1997 was primarily the result of an increase in direct
advertising costs and commissions, as well as an increase in the bonus accrual
for an employee incentive program. These increases were partially offset by a
bad debt recovery of a 1995 write-off. The decrease in selling, general and
administrative expenses, as a percentage of sales, was due primarily to these
expenses not increasing as greatly as sales during 1998.
 
  Net interest income was $1,853,000 (1.2% of revenues) in 1998 compared to
$1,823,000 (1.6% of revenues) in 1997, an increase of $30,000 or 1.6%. This
increase in net interest income was the result of higher average balances on
commercial paper investments and reduced average outstanding balances owed
under the Company's revolving credit facilities partially offset by lower
rates earned on commercial paper investments and additional interest expense
recognized in relation to a state tax audit.
 
  The Company's effective tax rate decreased to 41.0% in 1998 from 42.0% in
1997.
 
  Net earnings increased 200.6% to $12,546,000 or $1.15 per common share
(basic earnings per share) in 1998 from $4,173,000 or $.36 per common share
(basic earnings per share) in 1997. Net earnings for 1998 included net losses
of the Company's European operations of $806,000. The European operations are
wholly-owned subsidiaries of the Company rather than independent unaffiliated
distributors as are utilized throughout most of the balance of the Company's
international operations. The Company's European operations do not generate
sufficient margins to exceed the necessary fixed costs involved in creating a
presence in this foreign market. The Company is attempting to increase
revenues in this market as well as exploring ways to reduce costs. See
Note A12 to the Company's Consolidated Financial Statements for the Company's
policies relating to risk management of foreign currency.
 
1997 Compared to 1996
 
  Total revenues increased 8.8% to $116,213,000 in 1997 from $106,833,000 in
1996. This increase was attributable to increases in the average underlying
wholesale price per pair, in addition to an increase in the volume of footwear
sold. The volume of footwear sold increased 3.7% to 4,870,000 pair in 1997
from 4,697,000 pair in 1996. The average wholesale price per pair increased by
8.5% to $22.74 in 1997 from $20.95 for 1996. This increase in the average
wholesale price per pair is primarily attributable to an increase in the
Classic category, in both units and average price per pair. Also, there was a
decrease in close-out sales during 1997 which carry a lower average wholesale
price per pair. The major changes in volume for footwear categories are as
follows: Classics and children's categories increased 12% and 11%,
respectively, and the tennis/court category decreased 20%. Revenue increased
despite a poor retail environment due principally to the popularity of several
new Classic products and the cumulative results of additional spending on
marketing and advertising.
 
  Domestic revenues increased 20.2% to $91,568,000 in 1997 from $76,168,000 in
1996. International product revenues decreased 18.5% in 1997 to $24,085,000
from $29,565,000 in 1996. International revenues, as a percentage of total
revenues, decreased to 20.7% in 1997 from 27.7% in 1996. Fees earned by the
Company on sales by foreign licensees and distributors decreased to $560,000
for 1997 from $1,100,000 for 1996.
 
  Gross profit margins increased as a percentage of revenues to 39.1% in 1997
from 32.3% in 1996. Gross profit margins increased partially due to a decrease
in close-out sales which carry lower margins. In addition, gross profit
margins increased due to changes in the domestic/international and product mix
of sales.
 
                                      16
<PAGE>
 
  Selling, general and administrative expenses increased 19.8% to $40,074,000
(34.5% of revenues) in 1997 from $33,440,000 (31.3% of revenues) in 1996. The
increase in the amounts, as well as the percentage of sales for the year ended
December 31, 1997 compared to the year ended December 31, 1996 was primarily
the result of an increase in direct advertisement and promotion activities, as
well as an increase in the bonus accrual for an employee incentive program.
 
  Net interest income was $1,823,000 (1.6% of revenues) in 1997 compared to
$1,527,000 (1.4% of revenues) in 1996, an increase of $296,000 or 19.4%. This
increase in net interest income was the result of higher average balances and
rates earned on commercial paper investments partially offset by higher
outstanding balances owed under the Company's revolving credit facilities.
 
  The Company's effective tax rate decreased to 42.0% in 1997 from 71.9% in
1996. In 1996, the rate was higher than the federal and state statutory rates
due primarily to recording of income taxes relating to a state income tax
audit.
 
  Net earnings increased 470.9% to $4,173,000 or $.36 per common share (basic
earnings per share) in 1997 from $731,000 or $.06 per common share (basic
earnings per share) in 1996. Net earnings for 1997 included net losses of the
Company's European operations of $1,602,000. The European operations are
wholly-owned subsidiaries of the Company rather than independent unaffiliated
distributors as are utilized throughout most of the balance of the Company's
international operations. The Company's European operations do not generate
sufficient margins to exceed the necessary fixed costs involved in creating a
presence in this foreign market. The Company is attempting to increase
revenues in this market as well as exploring ways to reduce costs. See Note
A12 to the Company's Consolidated Financial Statements for the Company's
policies relating to risk management of foreign currency.
 
Liquidity and Capital Resources
 
  The Company experienced a net cash inflow of approximately $4,271,000,
$17,871,000 and $9,183,000 from its operating activities during 1998, 1997 and
1996, respectively. Cash provided by operating activities for the year ended
1998 as compared to 1997 varied primarily due to differences in the amounts of
changes in prepaid expenses and other assets, inventories, and accounts
receivable, as well as an increase in net earnings. Cash provided by
operations in 1997 increased from 1996, due to an increase in net earnings,
and accounts payable and accrued liabilities and a decrease in prepaid
expenses and other assets, partially offset by an increase in inventories.
 
  The Company had a net inflow of cash from its investing activities during
1998 principally from the maturity of investment securities partially offset
by net purchases of property, plant and equipment. The Company had a net
outflow of cash from its investing activities during 1997 principally from the
purchase of investment securities partially offset by the maturity of
investment securities.
 
  In 1998 and 1997, the net cash provided by operating activities was used for
the purchase of treasury stock, the repayment of borrowings under bank lines
of credit and to pay cash dividends.
 
  The Company anticipates future cash needs for principal repayments required
pursuant to its lines of credit facilities. In addition, depending on the
Company's future growth rate, additional funds may be required by operating
activities. Finally, at December 31, 1998, approximately $24,590,000 of
foreign subsidiary earnings which are not considered indefinitely invested may
eventually be remitted to the parent company as circumstances warrant. Upon
receipt of these funds, the Company will use approximately $9,626,000 in cash
to pay income taxes previously accrued on these foreign subsidiary earnings.
The Company's intention is to repatriate earnings of foreign operations as
cash needs and other circumstances require. No other material capital
commitments exist at December 31, 1998. With continued use of its revolving
credit facility (as discussed below), the Company believes its present and
 
                                      17
<PAGE>
 
currently anticipated sources of capital are sufficient to sustain its
anticipated capital needs for the remainder of 1999.
 
  In April 1998, the Company announced a new share repurchase program. The
Board of Directors has authorized the Company to purchase up to $20 million of
its Class A Common Stock on the open market through April 2002. Such open
market purchases, if any, will occur from time to time as market conditions
warrant. The Company adopted this program because it believes repurchasing its
shares can be a good use of excess cash depending on the Company's array of
alternatives. From inception under its new share repurchase program, the
Company purchased 203,532 shares of Class A Common Stock at a cost totaling
approximately $2,539,000. Currently, the Company has made purchases under all
programs from August 14, 1996 through February 8, 1999 (the date of filing of
this Form 10-K) of 2,518,932 shares at an aggregate cost totaling
approximately $17,760,000.
 
  In September 1998, the Company amended an agreement with a bank whereby the
Company may borrow, in the form of a secured revolving credit facility, up to
$30,000,000. The unused portion of this credit facility, which includes
letters of credit and bankers acceptances, was $23,245,000 at December 31,
1998. This facility currently expires in July 2001. Substantially all of the
Company's assets (other than real estate) are pledged as security for this
facility. The credit facility provides for interest to be paid at the prime
rate less 3/4% or, at the Company's discretion and with certain restrictions,
other market based rates. The Company pays a commitment fee of 1/8% of the
unused line for availability of the credit facility.
 
  The Company's European offices have agreements with a bank whereby they can
borrow up to $4,500,000 in the form of secured revolving credit facilities.
The unused portion of these credit facilities was $3,397,000 at December 31,
1998. These facilities are made available until terminated by either party.
 
  Total debt decreased 42.6% to $655,000 at December 31, 1998 from $1,142,000
at December 31, 1997 (excluding outstanding letters of credit of $7,703,000
and $12,156,000 at December 31, 1998 and 1997, respectively). The decrease was
due to borrowings under bank lines of credit under the Company's credit
facility.
 
  The Company's working capital increased $6,908,000 to $83,299,000 at
December 31, 1998 from $76,391,000 at December 31, 1997.
 
  The Company has historically maintained higher levels of inventory relative
to sales compared to its competitors because (1) it does not ship directly to
its major domestic customers from its foreign contract manufacturers, to the
same extent as its larger competitors, which would reduce inventory levels and
increase inventory turns, and (2) unlike many of its competitors, the Company
designates certain shoes as core products whereby the Company commits to its
retail customers that it will carry core products from season to season and,
therefore, the Company attempts to maintain open stock positions on its core
products in the Company's Mira Loma, California distribution center to meet
at-once orders.
 
  The federal income tax returns of the Company for the years ended 1990, 1991
and 1992 are under examination by the Internal Revenue Service ("IRS"). See
Note H to the Company's Consolidated Financial Statements. In May 1998, the
IRS issued its final report proposing additional taxes of an aggregate of
approximately $1,561,000 plus penalties and interest for these years. The
Company is protesting the IRS assessment. Also, the federal income tax returns
of the Company for the years ended 1993, 1995 and 1996 are currently under
examination by the IRS. The IRS has issued a preliminary examination report
covering the 1993 fiscal year proposing adjustments to income of approximately
$3,426,000 for this year. Although no assurance can be given regarding the
outcome of such examinations, the Company believes that any taxes which might
become payable as a result of
 
                                      18
<PAGE>
 
these examinations would not result in additional expense recognized in the
financial statements other than interest and penalties, if any, as the Company
has recorded deferred income taxes on the untaxed portion of unremitted
earnings of a foreign subsidiary. Therefore, management believes that
resolution of the IRS examinations should not have a material adverse impact
on the Company's financial position and results of operations.
 
Impact of Year 2000
 
  The Year 2000 Issue is the result of computer-controlled systems using two
digits rather than four to define the applicable year. For example, computer
programs that have time-sensitive software may recognize a date ending in "00"
as the year 1900 rather than the year 2000. This could result in system
failure or miscalculations causing disruptions of operations including, among
other things, an inability to process transactions, send invoices, or engage
in similar normal business activities. If the Company, its significant
customers, or suppliers fail to make necessary modifications and conversions
on a timely basis, the Year 2000 Issue could have a material adverse effect on
Company operations. However, the impact cannot be quantified at this time.
 
  To address these Year 2000 Issues with its internal systems, the Company has
initiated a comprehensive program which is designed to deal with the most
critical systems first. Assessment and remediation are proceeding in tandem,
and the Company currently plans to have changes to critical systems completed
and tested in the first quarter of 1999. These activities are intended to
encompass all major categories of systems in use by the Company, including
manufacturing, sales and finance. Beginning the first quarter of 1999, the
Company will work with critical suppliers of products and services, and
customers to determine that they are year 2000 capable or to monitor their
progress toward year 2000 capability. Once supplier and customer capability is
determined, the Company will commence work on various types of contingency
planning to address potential problem areas with internal systems and with
suppliers, customers, and other third parties. Nevertheless, there can be no
assurance that there will not be a material adverse effect on the Company if
third party governmental or business entities do not convert or replace their
systems in a timely manner and in a way that is compatible with the Company's
systems.
 
  Costs related to the Year 2000 Issues are funded through operating cash
flows. Currently, the Company has expended approximately $350,000 in
remediation efforts, principally the cost of modifying the applicable code of
existing software. The Company estimates remaining costs to be approximately
$150,000. The Company presently believes that the total cost of achieving Year
2000 compliant systems is not expected to be material to financial condition,
liquidity, or results of operations.
 
  Time and cost estimates are based on currently available information.
Developments that could affect estimates include, but are not limited to, the
availability and cost of trained personnel; the ability to locate and correct
all relevant computer code and systems; and remediation success of the
Company's suppliers and customers.
 
Quantitative and Qualitative Disclosures About Market Risk
 
 Market Risk
 
  Market risk is the potential change in an instrument's value caused by, for
example, fluctuations in interest and currency exchange rates. The Company's
primary market risk exposure is the risk of unfavorable movements in exchange
rates between the U.S. dollar and the UK pound and between the U.S. dollar and
the German mark. Monitoring and managing these risks is a continual process
carried out by senior management, which reviews and approves the Company's
risk management policies. Market risk is managed based on an ongoing
assessment of trends in foreign exchange rates
 
                                      19
<PAGE>
 
and economic developments, giving consideration to possible effects on both
total return and reported earnings.
 
 Foreign Exchange Rate Risk
 
  Sales denominated in currencies other than the U.S. dollar, which are
primarily sales to customers in Europe, expose the Company to market risk from
unfavorable movements in foreign exchange rates between the U.S. dollar and
the foreign currency. The Company's historical primary risk exposures have
been from changes in the rates between the U.S. dollar and the UK pound and
between the U.S. dollar and the German mark, and this trend is expected to
continue. To fix the U.S. dollar amount it will receive on sales denominated
in UK pounds and German marks, the Company enters into forward exchange
contracts to sell the foreign currency denominated in those currencies. The
extent to which forward exchange contracts are used is modified periodically
in response to management's estimate of market conditions and the terms and
length of specific sales contracts.
 
  The Company enters into foreign exchange contracts in order to reduce the
impact of foreign currency fluctuations and not to engage in currency
speculation. The use of derivative financial instruments allows the Company to
reduce its exposure to the risk that the eventual dollar net cash inflow
resulting from the sale of products to foreign customers will be adversely
affected by changes in exchange rates. Fluctuations in the value of hedging
instruments are offset by fluctuations in the value of the underlying
exposures being hedged. The Company does not hold or issue financial
instruments for trading purposes. The foreign exchange contracts are
designated for firmly committed or forecasted sales. These contracts are
generally for terms of less than one year. Gains and losses related to hedges
of firmly committed transactions are deferred and are recognized in income or
as adjustments of carrying amounts when the hedged transaction occurs. Gains
and losses of foreign exchange contracts that are designated for forecasted
transactions are recognized as the exchange rates change.
 
  The forward exchange contracts generally require the Company to exchange
foreign currencies for U.S. dollars at maturity, at rates agreed at the
inception of the contracts. The counter party to derivative transactions is a
major financial institution with investment grade or better credit rating;
however, the Company is exposed to credit risk with this institution. The
credit risk is limited to the unrealized gains in such contracts should this
counter party fail to perform as contracted.
 
  The table below provides information as of December 31, 1998 and 1997 about
the Company's foreign currency forward exchange contracts by currency. The
information is presented in U.S. dollars:
 
<TABLE>
<CAPTION>
                                                          December 31,
                                                          ------------
                                                       1998           1997
                                                       ----           ----
<S>                                               <C>            <C>
United Kingdom (Pound Sterling)
  Notional amount................................ $    1,200,000 $      900,000
  Fair value.....................................            --           2,000
  Average contractual exchange rate.............. $1.63/UK pound $1.64/UK pound
Germany (Deutsche Mark)
  Notional amount................................ $    3,839,000 $    2,780,000
  Fair value.....................................          9,000        174,000
  Average contractual exchange rate.............. $       .58/DM $       .60/DM
</TABLE>
 
  The Company does not anticipate any material adverse effect on its results
of operations or financial position relating to these foreign currency forward
exchange contracts. Based on the Company's overall currency rate exposure at
December 31, 1998, a 10% change in currency rates would not have had a
material effect on the financial position, results of operations and cash
flows of the Company.
 
                                      20
<PAGE>
 
Inflation
 
  The Company believes that distributors of footwear in the higher priced end
of the footwear market, including the Company, are able to adjust their prices
in response to an increase in direct and general and administrative expenses,
without a significant loss in sales. Accordingly, to date, inflation and
changing prices have not had a material adverse effect on the Company's
revenues or earnings.
 
Item 8. Financial Statements and Supplementary Data
 
  The Consolidated Financial Statements required in response to this section
are submitted as part of Item 14(a) of this Report.
 
                                      21
<PAGE>
 
              REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
 
Board of Directors and Stockholders
K-Swiss Inc.
 
  We have audited the consolidated balance sheets of K-Swiss Inc. as of
December 31, 1998 and 1997, and the related consolidated statements of
earnings and comprehensive earnings, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 1998. These financial
statements are the responsibility of management. Our responsibility is to
express an opinion on these financial statements based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of K-Swiss Inc.
as of December 31, 1998 and 1997, and the consolidated results of its
operations and its consolidated cash flows for each of the three years in the
period ended December 31, 1998, in conformity with generally accepted
accounting principles.
 
  We have also audited Schedule II of K-Swiss Inc. for each of the three years
in the period ended December 31, 1998. In our opinion, this schedule presents
fairly, in all material respects, the information required to be set forth
therein.
 
GRANT THORNTON LLP
 
Los Angeles, California
January 29, 1999, except for Note O
 as to which the date is February 9, 1999
 
                                      22
<PAGE>
 
                                  K-SWISS INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
                                  December 31,
 
                         (Dollar amounts in thousands)
 
<TABLE>
<CAPTION>
                                                                1998      1997
                                                              --------  --------
                           ASSETS
                           ------
<S>                                                           <C>       <C>
Current Assets
  Cash and cash equivalents (Note A4)........................ $ 37,360  $ 36,123
  Investment securities (Note A5)............................      --      5,995
  Accounts receivable, less allowance for doubtful accounts
   of $825 and $477 for 1998 and 1997, respectively (Notes D
   and L)....................................................   26,478    15,657
  Inventories (Notes A6 and D)...............................   33,535    27,214
  Prepaid expenses and other.................................    2,883     4,299
  Deferred taxes (Notes A9 and H)............................    1,746     1,765
                                                              --------  --------
    Total current assets.....................................  102,002    91,053
Property, Plant and Equipment, net (Notes A7, B and D).......    8,009     4,885
Other Assets
  Intangible assets (Notes A8, C and D)......................    4,429     4,712
  Other......................................................    1,025       545
                                                              --------  --------
                                                                 5,454     5,257
                                                              --------  --------
                                                              $115,465  $101,195
                                                              ========  ========
            LIABILITIES AND STOCKHOLDERS' EQUITY
            ------------------------------------
Current Liabilities
  Bank lines of credit (Note D).............................. $    155  $    642
  Current maturities of subordinated debentures (Note E).....      500       400
  Trade accounts payable.....................................    7,783     4,379
  Accrued liabilities (Note F)...............................   10,265     9,241
                                                              --------  --------
    Total current liabilities................................   18,703    14,662
Subordinated Debentures (Note E).............................      --        100
Other Liabilities (Note G)...................................    5,267     1,289
Deferred Taxes (Notes A9 and H)..............................    8,227     9,279
Commitments and Contingencies (Notes H and I)................      --        --
Stockholders' Equity (Notes K and O)
  Preferred Stock--authorized 2,000,000 shares of $.01 par
   value; none issued and outstanding........................      --        --
  Common Stock:
  Class A--authorized 18,000,000 shares of $.01 par value;
   9,832,728 shares issued, 7,313,796 shares outstanding, and
   2,518,932 shares held in treasury at December 31, 1998 and
   8,221,172 shares issued, 6,215,772 shares outstanding and
   2,005,400 shares held in treasury at December 31, 1997....       98        82
  Class B--authorized 10,000,000 shares of $.01 par value;
   issued and outstanding 3,426,556 shares at December 31,
   1998 and 4,971,144 shares at December 31, 1997............       34        50
  Additional paid-in capital.................................   25,830    25,205
  Treasury Stock.............................................  (17,760)  (12,389)
  Retained earnings (Note D).................................   75,500    63,387
  Accumulated other comprehensive earnings--
   Foreign currency translation (Note A10)...................     (434)     (470)
                                                              --------  --------
                                                                83,268    75,865
                                                              --------  --------
                                                              $115,465  $101,195
                                                              ========  ========
</TABLE>
 
        The accompanying notes are an integral part of these statements.
 
                                       23
<PAGE>
 
                                  K-SWISS INC.
 
                      CONSOLIDATED STATEMENTS OF EARNINGS
                           AND COMPREHENSIVE EARNINGS
 
                            Year Ended December 31,
 
            (Dollar amounts in thousands, except per share amounts)
 
<TABLE>
<CAPTION>
                                                      1998     1997      1996
                                                    -------- --------  --------
<S>                                                 <C>      <C>       <C>
Revenues (Notes A13, L and M)...................... $161,540 $116,213  $106,833
Cost of goods sold.................................   90,925   70,769    72,320
                                                    -------- --------  --------
  Gross profit.....................................   70,615   45,444    34,513
Selling, general and administrative expenses (Note
 A14)..............................................   51,220   40,074    33,440
                                                    -------- --------  --------
  Operating profit.................................   19,395    5,370     1,073
Interest income, net...............................    1,853    1,823     1,527
                                                    -------- --------  --------
  Earnings before income taxes.....................   21,248    7,193     2,600
Income tax expense (Notes A9 and H)................    8,702    3,020     1,869
                                                    -------- --------  --------
  NET EARNINGS..................................... $ 12,546 $  4,173  $    731
                                                    ======== ========  ========
Earnings per common share (Note A15)
  Basic............................................ $   1.15 $    .36  $    .06
                                                    ======== ========  ========
  Diluted.......................................... $   1.10 $    .35  $    .06
                                                    ======== ========  ========
 
Net Earnings....................................... $ 12,546 $  4,173  $    731
Other comprehensive earnings (loss), net of tax--
 Foreign currency translation adjustments..........       36     (419)      494
                                                    -------- --------  --------
Comprehensive net earnings......................... $ 12,582 $  3,754  $  1,225
                                                    ======== ========  ========
</TABLE>
 
 
        The accompanying notes are an integral part of these statements.
 
                                       24
<PAGE>
 
                                  K-SWISS INC.
 
                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
 
                      Three years ended December 31, 1998
 
                         (Dollar amounts in thousands)
 
<TABLE>
<CAPTION>
                                 Common Stock                          Treasury Stock
                      -----------------------------------            ------------------             Accumulated
                          Class A           Class B       Additional      Class A                      other
                      ---------------- ------------------  paid-in   ------------------  Retained  comprehensive
                       Shares   Amount   Shares    Amount  capital    Shares    Amount   earnings    earnings     Total
                      --------- ------ ----------  ------ ---------- --------- --------  --------  ------------- -------
<S>                   <C>       <C>    <C>         <C>    <C>        <C>       <C>       <C>       <C>           <C>
Balance at January
 1, 1996............  8,171,702  $82    4,991,144   $50    $25,022         --  $    --   $59,460       $(545)    $84,069
Proceeds from
 exercise of options
 (Note K)...........      2,334  --           --    --          12         --       --       --          --           12
Purchase of treasury
 stock..............        --   --           --    --         --    1,004,000   (5,221)     --          --       (5,221)
Dividends paid ($.04
 per share) (Note
 D).................        --   --           --    --         --          --       --      (516)        --         (516)
Net earnings for the
 year...............        --   --           --    --         --          --       --       731         --          731
Foreign currency
 translation (Note
 A10)...............        --   --           --    --         --          --       --       --          494         494
                      ---------  ---   ----------   ---    -------   --------- --------  -------       -----     -------
Balance at December
 31, 1996...........  8,174,036   82    4,991,144    50     25,034   1,004,000   (5,221)  59,675         (51)     79,569
Conversion of shares
 (Note K)...........     20,000  --       (20,000)  --         --          --       --       --          --          --
Proceeds from
 exercise of options
 (Note K)...........     27,136  --           --    --         144         --       --       --          --          144
Income tax benefit
 of options
 exercised..........        --   --           --    --          27         --       --       --          --           27
Purchase of treasury
 stock..............        --   --           --    --         --    1,001,400   (7,168)     --          --       (7,168)
Dividends paid ($.04
 per share) (Note
 D).................        --   --           --    --         --          --       --      (461)        --         (461)
Net earnings for the
 year...............        --   --           --    --         --          --       --     4,173         --        4,173
Foreign currency
 translation (Note
 A10)...............        --   --           --    --         --          --       --       --         (419)       (419)
                      ---------  ---   ----------   ---    -------   --------- --------  -------       -----     -------
Balance at December
 31, 1997...........  8,221,172   82    4,971,144    50     25,205   2,005,400  (12,389)  63,387        (470)     75,865
Conversion of shares
 (Note K)...........  1,544,588   16   (1,544,588)  (16)       --          --       --       --          --          --
Proceeds from
 exercise of options
 (Note K)...........     66,968  --           --    --         423         --       --       --          --          423
Income tax benefit
 of options
 exercised..........        --   --           --    --         202         --       --       --          --          202
Purchase of treasury
 stock..............        --   --           --    --         --      513,532   (5,371)     --          --       (5,371)
Dividends paid ($.04
 per share) (Note
 D).................        --   --           --    --         --          --       --      (433)        --         (433)
Net earnings for the
 year...............        --   --           --    --         --          --       --    12,546         --       12,546
Foreign currency
 translation (Note
 A10)...............        --   --           --    --         --          --       --       --           36          36
                      ---------  ---   ----------   ---    -------   --------- --------  -------       -----     -------
Balance at December
 31, 1998...........  9,832,728  $98    3,426,556   $34    $25,830   2,518,932 $(17,760) $75,500       $(434)    $83,268
                      =========  ===   ==========   ===    =======   ========= ========  =======       =====     =======
</TABLE>
 
 
         The accompanying notes are an integral part of this statement.
 
                                       25
<PAGE>
 
                                  K-SWISS INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                            Year ended December 31,
 
                         (Dollar amounts in thousands)
 
<TABLE>
<CAPTION>
                                                      1998     1997     1996
                                                     -------  -------  -------
<S>                                                  <C>      <C>      <C>
Cash flows from operating activities:
  Net earnings...................................... $12,546  $ 4,173  $   731
  Adjustments to reconcile net earnings to net cash
   provided by operating activities:
    Depreciation and amortization...................     940      918    1,197
    Net (gain) loss on disposal of property, plant
     and equipment..................................    (384)       2      --
    Deferred income taxes...........................  (1,033)     306    3,199
    (Increase) decrease in accounts receivable...... (10,811)    (954)      64
    (Increase) decrease in inventories..............  (6,321)  (3,428)  17,399
    Decrease (increase) in prepaid expenses and
     other assets...................................     937   11,647  (14,373)
    Increase (decrease) in accounts payable and
     accrued liabilities............................   8,397    5,207      556
    Foreign currency translation write off for
     K-Swiss Canada.................................     --       --       410
                                                     -------  -------  -------
    Net cash provided by operating activities.......   4,271   17,871    9,183
Cash flows from investing activities:
  Cash paid for acquisition of certain assets and
   rights of Robey Sportswear.......................     --       --      (435)
  Purchase of investment securities.................     --    (9,619)     --
  Proceeds from maturity of investment securities...   5,995    3,624      --
  Purchase of property, plant and equipment.........  (5,654)  (1,641)  (1,034)
  Proceeds from disposal of property, plant and
   equipment........................................   2,268        9       15
                                                     -------  -------  -------
    Net cash provided by (used in) investing
     activities.....................................   2,609   (7,627)  (1,454)
Cash flows from financing activities:
  Net (repayments) borrowings under bank lines of
   credit and capital leases........................    (487)    (564)     790
  Purchase of treasury stock........................  (5,371)  (7,168)  (5,221)
  Payment of dividends..............................    (433)    (461)    (516)
  Proceeds from stock options exercised.............     423      144       12
  Income tax benefit of options exercised...........     202       27      --
                                                     -------  -------  -------
    Net cash used in financing activities...........  (5,666)  (8,022)  (4,935)
Effect of exchange rate changes on cash.............      23     (413)      89
                                                     -------  -------  -------
      Net increase in cash and cash equivalents.....   1,237    1,809    2,883
Cash and cash equivalents at beginning of year......  36,123   34,314   31,431
                                                     -------  -------  -------
Cash and cash equivalents at end of year............ $37,360  $36,123  $34,314
                                                     =======  =======  =======
Supplemental disclosure of cash flow information:
  Cash paid during the year for:
    Interest........................................ $   334  $   156  $   213
    Income taxes.................................... $10,133  $ 3,280  $ 1,171
</TABLE>
 
        The accompanying notes are an integral part of these statements.
 
                                       26
<PAGE>
 
                                 K-SWISS INC.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
                       December 31, 1998, 1997 and 1996
 
NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
1. Nature of Operations
 
  The Company designs, develops and markets footwear for high performance use,
fitness and casual activities. The Company operates in an industry dominated
by a small number of very large competitors. The size of these competitors
enables them to lead the product direction of the industry, and therefore,
potentially diminish the value of the Company's products. In addition to
generally greater resources, these competitors spend substantially more money
on advertising and promotion than the Company and therefore dominate market
share. The Company's market share is estimated at approximately one percent.
Lastly, the retail environment forecasted for the near term is difficult,
which could put additional pressure on the Company's ability to maintain
margins.
 
  The Company purchases a significant portion of its products from a small
number of contract manufacturers in China and Thailand. This concentration of
suppliers in these locations subjects the Company to the risk of interruptions
of product flow for various reasons and possible loss of sales, which would
adversely affect operating results.
 
  The United States Trade Representative ("USTR") has expressed concern about
the protection of intellectual property rights within China. The failure of
the Chinese government to make substantial progress with respect to these
concerns could result in the imposition of retaliatory duties on imports from
China, including footwear, which could affect the cost of products purchased
and sold by the Company.
 
2. Estimates in Financial Statements
 
  In preparing financial statements in conformity with generally accepted
accounting principles, management is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities; the
disclosure of contingent assets and liabilities at the date of the financial
statements; and revenues and expenses during the reporting period. Actual
results could differ from those estimates.
 
3. Basis of Consolidation
 
  The consolidated financial statements include the accounts of the Company
and its subsidiaries. All significant intercompany transactions and balances
have been eliminated. Certain reclassifications have been made in the 1997
presentation to conform with the 1998 presentation.
 
4. Cash Equivalents
 
  For purposes of the statements of cash flows, the Company considers all
highly liquid debt instruments purchased with an original maturity of three
months or less to be cash equivalents.
 
5. Investment Securities
 
  The Company's investment securities, which consist of U.S. Government
obligations, are classified as held-to-maturity, carried at amortized cost and
mature within one year. Fair market value of these investments approximates
cost at December 31, 1997.
 
                                      27
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
 
6. Inventories
 
  Inventories, consisting of merchandise held for resale, are stated at the
lower of cost (first-in, first-out method) or market. Management continually
evaluates its inventory position and implements promotional or other plans to
reduce inventories to appropriate levels relative to its sales estimates for
particular product styles or lines. Estimated losses are recorded when such
plans are implemented. It is at least reasonably possible that management's
plans to reduce inventory levels will be less than fully successful, and that
such an outcome would result in a change in the inventory reserve in the near-
term.
 
7. Property, Plant and Equipment
 
  Property, plant and equipment are carried at cost. For financial reporting
and tax purposes, depreciation and amortization are calculated using straight-
line and accelerated methods over the estimated service lives of the
depreciable assets. The service lives of the Company's building and related
improvements are 30 and 5 years, respectively. Equipment is depreciated from 3
to 10 years and leasehold improvements are amortized over the lives of the
respective leases.
 
8. Intangible Assets
 
  Intangible assets are being amortized using the straight-line method over
their estimated economic useful lives at the time of acquisition. The
intangible assets principally include trademarks and contingent purchase
payments and are amortized over 30 to 35 years. Other intangible assets
consist of organization costs and trademark defense costs and are amortized
over 5 to 7 years.
 
9. Income Taxes
 
  The Company accounts for income taxes under Statement of Financial
Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109). SFAS 109
is an asset and liability approach that requires the recognition of deferred
tax assets and liabilities for the expected future tax consequences of events
that have been recognized in the Company's financial statements or tax
returns. Provision is made for appropriate United States income taxes on
earnings of subsidiary companies which are intended to be remitted to the
parent company.
 
10. Foreign Currency Translation
 
  Assets and liabilities of certain foreign operations are translated into
U.S. dollars at current exchange rates. Income and expenses are translated
into U.S. dollars at average rates of exchange prevailing during the period.
Adjustments resulting from translating foreign functional currency financial
statements into U.S. dollars are taken directly to a separate component of
stockholders' equity. Foreign currency transaction gains and losses are
included in income.
 
11. Fair Value of Financial Instruments
 
  For certain of the Company's financial instruments, including cash and cash
equivalents, accounts receivable, outstanding borrowings under the line of
credit, accounts payable and other accrued liabilities, the carrying amounts
approximate fair value due to their short maturities. Long-term
 
                                      28
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
 
subordinated debentures are carried at amounts that approximate fair value.
The estimated fair value of the subordinated debentures is based on borrowing
rates currently available to the Company for bank loans with similar terms and
maturities.
 
12. Financial Risk Management and Derivatives
 
  The Company enters into foreign exchange contracts in order to reduce the
impact of foreign currency fluctuations (British pounds and German marks) and
not to engage in currency speculation. The use of derivative financial
instruments allows the Company to reduce its exposure to the risk that the
eventual dollar net cash inflow resulting from the sale of products to foreign
will be adversely affected by changes in exchange rates. Fluctuations in the
value of hedging instruments are offset by fluctuations in the value of the
underlying exposures being hedged. The Company does not hold or issue
financial instruments for trading purposes. The foreign exchange contracts are
designated for firmly committed or forecasted sales. These transactions are
generally expected to occur in less than one year. Gains and losses related to
hedges of firmly committed transactions are deferred and are recognized in
income or as adjustments of carrying amounts when the hedged transaction
occurs. Gains and losses of foreign exchange contracts that are designated for
forecasted transactions are recognized as the exchange rates change. At
December 31, 1998 and 1997, deferred gains and losses are not material to the
consolidated financial statements.
 
  The forward exchange contracts generally require the Company to exchange
foreign currencies (British pounds and German marks) for U.S. dollars at
maturity, at rates agreed to at the inception of the contracts. The counter
party to derivative transactions is a major financial institution with
investment grade or better credit rating; however, the Company is exposed to
credit risk with this institution. The credit risk is limited to the
unrealized gains in such contracts should this counter party fail to perform
as contracted.
 
  The aggregate notional principal amounts and fair values of the Company's
derivative financial instruments were $5,040,000 and $9,000 at December 31,
1998, respectively and $3,680,000 and $176,000 at December 31, 1997,
respectively. The estimated fair value of derivatives used to hedge the
Company's risks will fluctuate over time. The fair value of the forward
exchange contracts is estimated by obtaining quoted market prices.
 
13. Recognition of Revenues
 
  Revenues include sales and fees earned on sales by licensees and are
recognized upon shipment of goods.
 
14. Advertising Costs
 
  Advertising costs are expensed as incurred and are included in selling,
general and administrative expenses. Advertising expenses amounted to
$13,323,000, $6,553,000 and $3,073,000 for 1998, 1997, and 1996, respectively.
 
                                      29
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(Continued)
 
15. Earnings per Share
 
   Basic earnings per share excludes dilution and is computed by dividing net
earnings available to common stockholders by the weighted average number of
common shares outstanding for the period. Diluted earnings per share reflect
the potential dilution that could occur if options to issue common stock were
exercised into common stock.
 
  The following is a reconciliation of the number of shares (denominator) used
in the basic and diluted earnings per share computations (shares in thousands)
(after giving effect to the two-for-one stock split described in Note O):
 
<TABLE>
<CAPTION>
                                   1998             1997             1996
                             ---------------- ---------------- ----------------
                                    Per Share        Per Share        Per Share
                             Shares  Amount   Shares  Amount   Shares  Amount
                             ------ --------- ------ --------- ------ ---------
<S>                          <C>    <C>       <C>    <C>       <C>    <C>
Basic EPS................... 10,914   $1.15   11,688   $ .36   12,911   $.06
Effect of Dilutive Stock
 Options....................    518    (.05)     239    (.01)      74    --
                             ------   -----   ------   -----   ------   ----
Diluted EPS................. 11,432   $1.10   11,927   $ .35   12,985   $.06
                             ======   =====   ======   =====   ======   ====
</TABLE>
 
  The following options were not included in the computation of diluted EPS
because the options' exercise price was greater than the average market price
of the common shares:
 
<TABLE>
<CAPTION>
                                          1998          1997          1996
                                      ------------- ------------- -------------
<S>                                   <C>           <C>           <C>
Options to purchase shares of common
 stock (in thousands)................      16            716           926
Exercise prices...................... $11.50-$12.81  $7.63-$11.50  $5.16-$11.50
Expiration dates..................... January 2003- January 2000- January 2000-
                                       August 2008   August 2007   August 2006
</TABLE>
 
16. New Accounting Pronouncement
 
  In 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 ("SFAS 133"), Accounting for Derivative
Instruments and Hedging Activities, which is effective for 2000. SFAS 133 will
require the Company to record all derivatives on the balance sheet at fair
value. For derivatives that are hedges, changes in the fair value of
derivatives will be offset by the changes in the fair value of the hedged
assets, liabilities or firm commitments. The Company believes the impact of
adopting this standard will not be material to results of operations or
equity.
 
                                      30
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE B--PROPERTY, PLANT AND EQUIPMENT
 
  Property, plant and equipment as of December 31 consists of the following
(in thousands):
 
<TABLE>
<CAPTION>
                                                                1998     1997
                                                               -------  -------
     <S>                                                       <C>      <C>
     Building and improvements................................ $ 5,443  $ 3,240
     Furniture, machinery and equipment.......................   6,186    5,199
                                                               -------  -------
                                                                11,629    8,439
     Less accumulated depreciation and amortization...........  (4,315)  (5,380)
                                                               -------  -------
                                                                 7,314    3,059
     Land.....................................................     695    1,826
                                                               -------  -------
                                                               $ 8,009  $ 4,885
                                                               =======  =======
</TABLE>
 
NOTE C--INTANGIBLE ASSETS
 
  Intangible assets as of December 31 consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                                1998     1997
                                                               -------  -------
     <S>                                                       <C>      <C>
     Contingent purchase payments............................. $ 4,579  $ 4,579
     Trademarks...............................................   2,269    2,269
     Other....................................................     198      198
     Less accumulated amortization............................  (2,617)  (2,334)
                                                               -------  -------
                                                               $ 4,429  $ 4,712
                                                               =======  =======
</TABLE>
 
NOTE D--BANK LINES OF CREDIT
 
  The Company maintains revolving credit facilities whereby it may borrow up
to an aggregate of $34,500,000 including outstanding letters of credit and
bankers' acceptances. The weighted average interest rate provided under these
credit facilities was 8.50% and 8.25% at December 31, 1998 and 1997,
respectively. A fee of up to 1/8% of the average unused line is paid for
availability of the primary credit facility.
 
  One of the credit agreements contains certain covenants and financial ratio
requirements, including restrictions on dividend payments. At December 31,
1998, $9,277,000 was unrestricted as to the payment of dividends. The amounts
borrowed under the facilities are collateralized by substantially all of the
assets of the Company.
 
  Under the most restrictive covenant, the Company must maintain stockholders'
equity, including subordinated debt, less intangible assets and exclusive of
treasury stock of at least $70,039,000 at December 31, 1998.
 
NOTE E--SUBORDINATED DEBENTURES
 
  The subordinated debentures are payable to an officer and a director of the
Company. The debentures bear interest at 10%. Interest is due on the unpaid
balance quarterly. The debentures are due in full in 2001, however, beginning
June 30, 1996 the debenture holders could have required the Company to redeem
a portion of principal semi-annually.
 
                                      31
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE F--ACCRUED LIABILITIES
 
  Accrued liabilities as of December 31 consist of the following (in
thousands):
 
<TABLE>
<CAPTION>
                                                                  1998    1997
                                                                 ------- -------
      <S>                                                        <C>     <C>
      Income taxes.............................................. $   741 $ 1,362
      Bonuses...................................................   1,960   1,501
      Advertising...............................................   2,280     866
      Other.....................................................   5,284   5,512
                                                                 ------- -------
                                                                 $10,265 $ 9,241
                                                                 ======= =======
</TABLE>
 
NOTE G--OTHER LIABILITIES
 
  Included in other liabilities is $4,441,000 and $1,289,000 as of December
31, 1998 and 1997, respectively, representing accrued bonuses under the
Company's Economic Value Added ("EVA") incentive program not payable within
one year. These amounts are at risk of forfeiture to the plan participants
depending on the Company maintaining presently achieved levels of EVA.
 
NOTE H--INCOME TAXES
 
  The provision for income taxes includes the following for the years ended
December 31 (in thousands):
 
<TABLE>
<CAPTION>
                                                          1998    1997   1996
                                                         ------  ------ -------
      <S>                                                <C>     <C>    <C>
      Current
       United States
        Federal......................................... $8,258  $2,366 $(1,961)
        State...........................................  1,406     243     514
       Foreign..........................................     71     105     117
      Deferred
       United States
        Federal.........................................   (925)    273   2,864
        State...........................................   (108)     33     335
                                                         ------  ------ -------
                                                         $8,702  $3,020 $ 1,869
                                                         ======  ====== =======
</TABLE>
 
 
                                      32
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE H--INCOME TAXES--(Continued)
 
  A reconciliation from the U.S. federal statutory income tax rate to the
effective tax rate for the years ended December 31 is as follows:
 
<TABLE>
<CAPTION>
                                1998  1997  1996
                                ----  ----  ----
      <S>                       <C>   <C>   <C>
      U.S. Federal statutory
       rate...................  35.0% 34.0% 34.0%
      State income taxes......   4.1   4.1   4.1
      State income tax audit..   --    --   18.3
      California net operating
       loss carry forward
       limitation.............   --    --    4.4
      Net results of foreign
       subsidiaries...........   1.3   1.8   7.4
      Amortization of
       intangibles............   0.3   0.9   2.5
      Other...................   0.3   1.2   1.2
                                ----  ----  ----
                                41.0% 42.0% 71.9%
                                ====  ====  ====
</TABLE>
 
  Deferred income taxes are determined based on the estimated future tax
effects of differences between the financial statement and the tax basis of
assets and liabilities given the provisions of the enacted tax laws. The net
current and non-current components of deferred income taxes recognized in the
balance sheets are as follows as of December 31 (in thousands):
 
<TABLE>
<CAPTION>
                                                                  1998    1997
                                                                 ------- ------
      <S>                                                        <C>     <C>
      Net current assets........................................ $ 1,746 $1,765
      Net non-current liabilities...............................   8,227  9,279
                                                                 ------- ------
        Net liability........................................... $ 6,481 $7,514
                                                                 ======= ======
</TABLE>
 
  Significant components of the Company's deferred tax assets and liabilities
are as follows as of December 31 (in thousands):
 
<TABLE>
<CAPTION>
                                                                  1998    1997
                                                                 ------- ------
      <S>                                                        <C>     <C>
      Assets
        State taxes.............................................   $ 527 $  322
        Bad debt reserve........................................     299    130
        Inventory reserve and capitalized costs.................     812  1,251
        Bonuses.................................................   1,737    491
        Other...................................................     431    101
                                                                 ------- ------
          Gross deferred tax assets.............................   3,806  2,295
      Liabilities
        Unremitted earnings of a foreign subsidiary.............   9,626  9,303
        Contingent purchase payments............................     180    183
        Other...................................................     481    323
                                                                 ------- ------
          Gross deferred tax liabilities........................  10,287  9,809
                                                                 ------- ------
        Net deferred tax liability.............................. $ 6,481 $7,514
                                                                 ======= ======
</TABLE>
 
 
                                      33
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE H--INCOME TAXES--(Continued)
 
  The Company did not record any valuation allowances against deferred tax
assets at December 31, 1998. Management has determined, based on the Company's
history of prior operating earnings and its expectations for the future, that
operating income of the Company will more likely than not be sufficient to
recognize fully these deferred tax assets.
 
  The federal income tax returns of the Company for the years ended 1990, 1991
and 1992 are under examination by the Internal Revenue Service ("IRS"). In May
1998, the IRS issued its final report proposing additional taxes of an
aggregate of approximately $1,561,000 plus penalties and interest for these
years. The Company is protesting the IRS assessment. Also, the federal income
tax returns of the Company for the years ended 1993, 1995 and 1996 are
currently under examination by the IRS. The IRS has issued a preliminary
examination report covering the 1993 fiscal year proposing adjustments to
income of approximately $3,426,000 for this year. Although no assurance can be
given regarding the outcome of such examinations, the Company believes that
any taxes which might become payable as a result of these examinations would
not result in additional expense recognized in the financial statements other
than interest and penalties, if any, as the Company has recorded deferred
income taxes on the untaxed portion of unremitted earnings of a foreign
subsidiary. Therefore, management believes that resolution of the IRS
examinations should not have a material adverse impact on the Company's
financial position and results of operations.
 
NOTE I--COMMITMENTS AND CONTINGENCIES
 
  The Company leases its principal warehouse facility through January 2003,
under an agreement which provides for two options, each of which would extend
the lease for three years. In addition, certain property and equipment is
leased primarily on a month to month basis. Future minimum rental payments
under these leases as of December 31, 1998 are as follows (in thousands):
 
<TABLE>
<CAPTION>
      Year ending
      December 31,
      ------------
      <S>                                                                 <C>
       1999.............................................................. $1,247
       2000..............................................................  1,146
       2001..............................................................  1,040
       2002..............................................................    968
       2003..............................................................     86
       Thereafter........................................................      6
                                                                          ------
                                                                          $4,493
                                                                          ======
</TABLE>
 
  Rent expense for operating leases was approximately $1,502,000, $1,451,000
and $1,615,000 for the years ended December 31, 1998, 1997, and 1996,
respectively. Sublease rental income was approximately $54,000 for the year
ended December 31, 1998.
 
  The Company has subleased approximately 90,000 square feet of its principal
warehouse facility to another company for the remainder of its initial lease
term. The total of the future minimum rentals to be received as of December
31, 1998 is $1,322,000.
 
  The Company has outstanding letters of credit totaling approximately
$7,703,000 and $12,156,000 at December 31, 1998 and 1997 respectively. These
letters of credit, which have original terms from one month to one year,
collateralize the Company's obligation to third parties for the purchase of
inventory. The fair value of these letters of credit is based on fees
currently charged for similar agreements and is not significant at December
31, 1998 and 1997.
 
                                      34
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE I--COMMITMENTS AND CONTINGENCIES--(Continued)
 
 
  The Company is, from time to time, a party to litigation which arises in the
normal course of its business operations. The Company does not believe it is
presently a party to litigation which will have a material adverse effect on
its business or operations.
 
NOTE J--EMPLOYEE BENEFIT PLANS
 
  In 1988, the Company adopted a discretionary contribution profit sharing
plan covering all employees meeting certain eligibility requirements. In 1993,
the plan was amended to include a 401(k) plan. The expense for this plan was
approximately $343,000, $472,000 and $17,000 for 1998, 1997 and 1996,
respectively.
 
NOTE K--STOCKHOLDERS' EQUITY
 
  Each share of Class B Common Stock is freely convertible into one share of
Class A Common Stock at the option of the Class B stockholder. Holders of
Class A Common Stock are entitled to one vote per share and holders of Class B
Common Stock are entitled to ten votes per share for all matters submitted to
a vote of the stockholders of the Company, other than the election of
directors. Holders of Class A Common Stock are initially entitled to elect two
directors and holders of Class B Common Stock are entitled to elect all
directors other than directors that the holders of Class A Common Stock are
entitled to elect. If the number of members of the Company's Board of
Directors is increased to not less than eleven and not greater than fifteen
(excluding directors representing holders of Preferred Stock, if any), holders
of Class A Common Stock will be entitled to elect three directors. If the
number of members of the Company's Board of Directors is increased to a number
greater than fifteen (excluding directors representing holders of Preferred
Stock, if any), holders of Class A Common Stock will be entitled to elect four
directors.
 
  In 1990, the Company adopted the 1990 Stock Option Plan under which it was
authorized to issue non-qualified stock options, incentive stock options, and
warrants to key employees. As amended, the number of options available for
issuance under the 1990 Stock Option Plan is 1,650,000 shares of Class A
Common Stock. The options have a term of ten years and generally become fully
vested by the end of the fifth year.
 
  Plan transactions for 1998, 1997 and 1996 are as follows (after giving
effect to the two-for-one stock split described in Note O):
 
<TABLE>
<CAPTION>
                                 1998                1997                1996
                          ------------------- ------------------- -------------------
                                     Weighted            Weighted            Weighted
                                     average             average             average
                                     exercise            exercise            exercise
                           Shares     price    Shares     price    Shares     price
                          ---------  -------- ---------  -------- ---------  --------
<S>                       <C>        <C>      <C>        <C>      <C>        <C>
Options outstanding
 January 1,.............  1,407,788   $6.58   1,370,524   $6.76   1,175,324   $7.73
Granted.................     46,450    3.38     192,300    5.28     357,600    4.40
Exercised...............    (66,968)   5.93     (27,136)   5.32      (2,334)   5.00
Canceled................    (52,250)   7.11    (127,900)   6.75    (160,066)   8.70
                          ---------           ---------           ---------
Options outstanding
 December 31,...........  1,335,020    6.48   1,407,788    6.58   1,370,524    6.76
                          =========           =========           =========
Options available for
 grant at December 31,..    183,710             177,910             242,310
</TABLE>
 
                                      35
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE K--STOCKHOLDERS' EQUITY--(Continued)
 
  Weighted average fair value of options granted during the year are as
follows:
 
<TABLE>
<CAPTION>
                                                             1998  1997  1996
                                                            ------ ----- -----
      <S>                                                   <C>    <C>   <C>
      Exercise price is below market price at date of
       grant............................................... $11.90 $6.22 $4.37
      Exercise price equals market price at date of grant..   4.60  2.43  1.57
</TABLE>
 
  The following information applies to options outstanding at December 31,
1998:
 
<TABLE>
<CAPTION>
                                      Options Outstanding         Options Exercisable
                                --------------------------------- --------------------
                                             Weighted
                                              average    Weighted             Weighted
                                             remaining   average              average
                                  Number    contractual  exercise   Number    exercise
     Range of exercise prices   outstanding life (years)  price   exercisable  price
     ------------------------   ----------- -----------  -------- ----------- --------
     <S>                        <C>         <C>          <C>      <C>         <C>
     $  .50..................      93,782         9       $  .50      5,998    $  .50
     $ 4.38--$6.50...........     566,536         6         4.98    304,870      4.94
     $ 6.88--$9.63...........     544,102         4         8.04    471,388      8.00
     $10.13--$12.82..........     130,600         7        10.75     98,768     10.69
</TABLE>
 
  The fair value of options at date of grant was estimated using the Black-
Scholes model with the following assumptions:
 
<TABLE>
<CAPTION>
                                                               1998  1997  1996
                                                               ----  ----  ----
      <S>                                                      <C>   <C>   <C>
      Expected life (years)...................................    7     7     7
      Risk-free interest rate................................. 5.50% 6.25% 5.50%
      Expected volatility.....................................   30%   22%   20%
      Expected dividend yield.................................   .4%   .7%   .7%
</TABLE>
 
  Statement of Financial Accounting Standards No. 123, Accounting for Stock-
Based Compensation, encourages, but does not require companies to record
compensation cost for stock-based employee compensation plans at fair value.
The Company has chosen to continue to account for stock-based compensation
using the intrinsic value method prescribed in Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations. Accordingly, compensation cost for stock options is measured
as the excess, if any, of the quoted market price of the Company's stock at
the date of grant over the amount an employee must pay to acquire the stock.
 
  During 1998, 1997 and 1996, 34,450, 42,000 and 28,000 options, respectively,
were granted at exercise prices below fair market value. This resulted in net
compensation expense of $74,000, $32,000 and $28,000 for 1998, 1997 and 1996,
respectively. All other options were granted at an exercise price equal to the
fair market value of the Company's common stock at the date of grant.
Accordingly, no compensation cost has been recognized for such options
granted.
 
  In connection with the exercise of options, the Company realized income tax
benefits in 1998, 1997 and 1996 which have been credited to additional paid-in
capital.
 
                                      36
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE K--STOCKHOLDERS' EQUITY--(Continued)
 
  Had compensation cost for the plan been determined based on the fair value
of the options at the grant dates consistent with the method of SFAS No. 123,
the Company's net earnings and earnings per share would have been:
 
<TABLE>
<CAPTION>
                                                             1998    1997  1996
                                                            ------- ------ ----
      <S>                                                   <C>     <C>    <C>
      Net earnings (in thousands)
       As reported......................................... $12,546 $4,173 $731
       Pro forma...........................................  12,428  4,163  742
      Basic earnings per share
       As reported......................................... $  1.15 $  .36 $.06
       Pro forma...........................................    1.14    .36  .06
      Diluted earnings per share
       As reported......................................... $  1.10 $  .35 $.06
       Pro forma...........................................    1.09    .35  .06
</TABLE>
 
  The effects of applying SFAS 123 in this proforma disclosure are not
indicative of future amounts. SFAS 123 does not apply to awards prior to 1995,
and additional awards in future years are anticipated.
 
NOTE L--CONCENTRATIONS OF CREDIT RISK
 
  Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of cash and cash
equivalents, trade accounts receivable and financial instruments used in
hedging activities. The Company maintains cash and cash equivalents with high
quality institutions and limits the amount of credit exposure to any one
institution. As part of its cash and risk management processes, the Company
performs periodic evaluations of the relative credit standing of the financial
institutions.
 
  During the years ended December 31, 1998, 1997 and 1996, approximately 26%,
17% and 11%, respectively, of revenues were made to one domestic customer. At
December 31, 1998 and 1997 approximately 16% and 18%, respectively, of
accounts receivable were from this major customer. Credit risk with respect to
other trade accounts receivable is generally diversified due to the large
number of entities comprising the Company's customer base and their dispersion
across many geographies. The Company controls credit risk through credit
approvals, credit limits and monitoring procedures and for international
receivables, the use of letters of credit and letters of guarantee.
 
                                      37
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE M--SEGMENT INFORMATION
 
  The Company's predominant business is the design, development and
distribution of athletic footwear. The Company is organized into three
geographic regions: the United States, Europe and other international
operations. The following tables summarize segment information (in thousands):
 
<TABLE>
<CAPTION>
                                    Year ended December 31,
                                   ----------------------------
                                     1998      1997      1996
                                   --------  --------  --------
      <S>                          <C>       <C>       <C>
      Revenues from unrelated
       entities:
        United States............. $145,293  $ 91,568  $ 76,170
        Europe....................    9,324     8,818    11,552
        Other International.......    6,923    15,827    19,111
                                   --------  --------  --------
                                   $161,540  $116,213  $106,833
                                   ========  ========  ========
      Inter-geographic revenues:
        United States............. $  2,718  $  2,721  $  2,102
        Europe....................    2,420     2,937     4,573
        Other International.......    4,926     2,744     3,893
                                   --------  --------  --------
                                   $ 10,064  $  8,402  $ 10,568
                                   ========  ========  ========
      Total revenues:
        United States............. $148,011  $ 94,289  $ 78,272
        Europe....................   11,744    11,755    16,125
        Other International.......   11,849    18,571    23,004
        Less inter-geographic
         revenues.................  (10,064)   (8,402)  (10,568)
                                   --------  --------  --------
                                   $161,540  $116,213  $106,833
                                   ========  ========  ========
      Operating profit (loss):
        United States............. $ 28,148  $ 10,669  $  3,720
        Europe....................   (1,122)   (1,751)   (1,450)
        Other International.......    1,067     3,244     3,721
        Less corporate expenses
         and eliminations.........   (8,698)   (6,792)   (4,918)
                                   --------  --------  --------
                                   $ 19,395  $  5,370  $  1,073
                                   ========  ========  ========
      Interest income:
        United States............. $  1,079  $  1,395  $  1,152
        Europe....................       44        35        29
        Other International.......      966       596       857
                                   --------  --------  --------
          Total interest income...    2,089     2,026     2,038
      Interest expense:
        United States.............      200       126       408
        Europe....................       36        76        82
        Other International.......      --          1        21
                                   --------  --------  --------
          Total interest expense..      236       203       511
                                   --------  --------  --------
      Interest income, net........ $  1,853  $  1,823  $  1,527
                                   ========  ========  ========
</TABLE>
 
 
                                      38
<PAGE>
 
                                  K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                        December 31, 1998, 1997 and 1996
 
 
NOTE M--SEGMENT INFORMATION--(Continued)
 
<TABLE>
<CAPTION>
                                                      Year ended December 31,
                                                     --------------------------
                                                       1998     1997     1996
                                                     -------- -------- --------
      <S>                                            <C>      <C>      <C>
      Income tax expense:
        United States............................... $  8,631 $  2,915 $  1,752
        Europe......................................       47       61       84
        Other International.........................       24       44       33
                                                     -------- -------- --------
                                                     $  8,702 $  3,020 $  1,869
                                                     ======== ======== ========
      Identifiable assets:
        United States............................... $ 67,487 $ 46,579 $ 42,068
        Europe......................................    6,299    4,312    6,305
        Other International.........................   15,720   15,308   24,226
        Corporate assets and eliminations (1).......   25,959   34,996   27,676
                                                     -------- -------- --------
                                                     $115,465 $101,195 $100,275
                                                     ======== ======== ========
      Provision for depreciation and amortization:
        United States............................... $    713 $    671 $    791
        Europe......................................      167      198      330
        Other International.........................       60       49       76
                                                     -------- -------- --------
                                                     $    940 $    918 $  1,197
                                                     ======== ======== ========
      Capital expenditures:
        United States............................... $  5,370 $  1,532 $    861
        Europe......................................      207       57      171
        Other International.........................       77       52        2
                                                     -------- -------- --------
                                                     $  5,654 $  1,641 $  1,034
                                                     ======== ======== ========
</TABLE>
--------
(1)Corporate assets include cash and cash equivalents, investments and
intangible assets.
 
                                       39
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
                       December 31, 1998, 1997 and 1996
 
 
NOTE N--QUARTERLY FINANCIAL DATA (Unaudited)
 
  Summarized quarterly financial data for 1998 and 1997 follows (in thousands
except for per share amounts):
 
<TABLE>
<CAPTION>
                                       First  Second    Third  Fourth
                                      Quarter Quarter  Quarter Quarter   Year
                                      ------- -------  ------- ------- --------
<S>                                   <C>     <C>      <C>     <C>     <C>
1998
  Revenues........................... $42,274 $41,015  $38,212 $40,039 $161,540
  Gross profit.......................  17,146  17,600   17,606  18,263   70,615
  Net earnings.......................   3,545   2,255    3,031   3,715   12,546
Earnings per share (1)
  Basic.............................. $   .32 $   .21  $   .28 $   .34 $   1.15
  Diluted............................ $   .31 $   .20  $   .26 $   .32 $   1.10
1997
  Revenues........................... $31,199 $28,415  $32,835 $23,764 $116,213
  Gross profit.......................  11,722   9,610   13,418  10,694   45,444
  Net earnings (loss)................   1,539    (379)   1,714   1,299    4,173
Earnings (loss) per share (1)
  Basic.............................. $   .13 $  (.03) $   .15 $   .12 $    .36
  Diluted............................ $   .13 $  (.03) $   .15 $   .11 $    .35
</TABLE>
--------
(1) Earnings (loss) per share reflect the effect of the two-for-one stock
    split as described in Note O.
 
NOTE O--SUBSEQUENT EVENTS
 
  On February 8, 1999, the Company's Board of Directors approved a two-for-one
stock split for both Class A and Class B common stock. This stock split will
be in the form of a 100 percent stock dividend to be distributed on March 26,
1999 to stockholders of record at the close of business on March 15, 1999. The
Board of Directors also approved an increase in the cash dividend per share to
an annual rate, on a post-split basis, of 6 cents per common share from an
annual rate of 4 cents per common share.
 
                                      40
<PAGE>
 
Item 9. Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure
 
  None.
 
                                   PART III
 
Item 10. Directors and Executive Officers of the Registrant
 
  Except for the information disclosed in Item 4(a) of this Annual Report on
Form 10-K, the information required by this item will be contained in the
Company's Proxy Statement for its Annual Stockholders Meeting to be held May
20, 1999 to be filed with the Securities and Exchange Commission within 120
days after December 31, 1998 and is incorporated herein by reference.
 
Item 11. Executive Compensation
 
  The information required by this item will be contained in the Company's
Proxy Statement for its Annual Stockholders Meeting to be held May 20, 1999 to
be filed with the Securities and Exchange Commission within 120 days after
December 31, 1998 and is incorporated herein by reference.
 
Item 12. Security Ownership of Certain Beneficial Owners and Management
 
  The information required by this item will be contained in the Company's
Proxy Statement for its Annual Stockholders Meeting to be held May 20, 1999 to
be filed with the Securities and Exchange Commission within 120 days after
December 31, 1998 and is incorporated herein by reference.
 
Item 13. Certain Relationships and Related Transactions
 
 The information required by this item will be contained in the Company's
Proxy Statement for its Annual Stockholders Meeting to be held May 20, 1999 to
be filed with the Securities and Exchange Commission within 120 days after
December 31, 1998 and is incorporated herein by reference.
 
                                    PART IV
 
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
 
  (a) Financial Statements:
 
<TABLE>
<CAPTION>
                                                                 Page Reference
                                                                   Form 10-K
                                                                 --------------
<S>                                                              <C>
Report of Independent Certified Public Accountants..............       22
Consolidated Balance Sheets as of December 31, 1998 and 1997....       23
Consolidated Statements of Earnings and Comprehensive Earnings
 for the three years ended December 31, 1998....................       24
Consolidated Statement of Stockholders' Equity for the three
 years ended December 31, 1998..................................       25
Consolidated Statements of Cash Flows for the three years ended
 December 31, 1998..............................................       26
Notes to Consolidated Financial Statements......................     27-40
</TABLE>
 
  (b) Reports on Form 8-K
 
  There were no reports on Form 8-K filed during the fourth quarter of 1998.
 
                                      41
<PAGE>
 
(c) Exhibits
 
<TABLE>
     <C>  <S>
      3.1 Amended and Restated Certificate of Incorporation of K-Swiss Inc.
          (incorporated by reference to exhibit 3.4 to the Registrant's 
          Form S-1 Registration Statement No. 33-34369).
      3.2 Certificate of Designations of Class A Common Stock of K-Swiss Inc.
          (incorporated by reference to exhibit 3.2 to the Registrant's 
          Form S-1 Registration Statement No. 33-34369).
      3.3 Certificate of Designations of Class B Common Stock of K-Swiss Inc.
          (incorporated by reference to exhibit 3.3 to the Registrant's 
          Form S-1 Registration Statement No. 33-34369).
      3.4 Amended and Restated Bylaws of K-Swiss Inc. (incorporated by
          reference to exhibit 3.4 to the Registrant's Form 10-K for the fiscal
          year ended December 31, 1991).
      4.1 Specimen K-Swiss Inc. Class A Common Stock Certificate (incorporated
          by reference to exhibit 4.1 to the Registrant's Form S-1 Registration
          Statement No. 33-34369).
      4.2 Specimen K-Swiss Inc. Class B Common Stock Certificate (incorporated
          by reference to exhibit 4.2 to the Registrant's Form S-1 Registration
          Statement No. 33-34369).
      4.3 $400,000 324 Corp. 10% Junior Subordinated Debenture due December 31,
          2001 originally issued to The Rug Warehouse, Inc. Pension Plan and
          Trust (incorporated by reference to exhibit 4.7 to the Registrant's
          Form S-1 Registration Statement No. 33-34369).
      4.4 $100,000 324 Corp. 10% Junior Subordinated Debenture due December 31,
          2001 issued to George E. Powlick (incorporated by reference to
          exhibit 4.8 to the Registrant's Form S-1 Registration Statement No.
          33-34369).
      9.1 Voting Agreement by and between Steven B. Nichols and each of
          Lawrence Feldman and George Powlick dated as of June 11, 1990, as
          amended (incorporated by reference to exhibit 9.1 to the Registrant's
          Form 10-K for the year ended December 31, 1990).
      9.2 Stockholders Agreement dated as of December 30, 1986 by and among 324
          Corp., Steven B. Nichols, Kenneth J. Zises and The Biltrite
          Corporation (incorporated by reference to exhibit 9.2 to the
          Registrant's Form S-1 Registration Statement No. 33-34369).
      9.3 Letter Agreement dated May 3, 1990 by and among the Company, Steven
          B. Nichols, Kenneth J. Zises, The Biltrite Corporation and certain
          affiliates (incorporated by reference to exhibit 9.3 to the
          Registrant's Form S-1 Registration Statement No. 33-34369).
      9.4 Voting Agreement dated May 3, 1990 by and between The Biltrite
          Corporation and the Nichols Family Trust (incorporated by reference
          to exhibit 9.4 to the Registrant's Form S-1 Registration Statement
          No. 33-34369).
     10.1 K-Swiss Inc. 1990 Stock Incentive Plan (incorporated by reference to
          exhibit 10.1 to the Registrant's Form S-1 Registration Statement No.
          33-34369).
     10.2 Amendment to K-Swiss Inc. 1990 Stock Incentive Plan (incorporated by
          reference to exhibit 10.36 to the Registrant's Form 10-K for the
          fiscal year ended December 31, 1993).
</TABLE>
 
                                       42
<PAGE>
 
<TABLE>
     <C>   <S>
     10.3  Amendment to K-Swiss Inc. 1990 Stock Incentive Plan (incorporated by
           reference to exhibit 10.32 to the Registrant's Form 10-K for the
           fiscal year ended December 31, 1995).
     10.4  K-Swiss Inc. Profit Sharing Plan, as amended (incorporated by
           reference to exhibit 10.3 to the Registrant's Form S-1 Registration
           Statement No. 33-34369).
     10.5  Amendment to K-Swiss Inc. 401(k) and Profit Sharing Plan
           (incorporated by reference to exhibit 10.35 to the Registrant's Form
           10-K for the fiscal year ended December 31, 1993).
     10.6  Amendment to K-Swiss Inc. 401(k) and Profit Sharing Plan dated May
           26, 1994 (incorporated by reference to exhibit 10.32 to the
           Registrant's Form 10-K for the fiscal year ended December 31, 1994).
     10.7  Form of Indemnity Agreement entered into by and between K-Swiss Inc.
           and directors (incorporated by reference to exhibit 10.4 to the
           Registrant's Form S-1 Registration Statement No. 33-34369).
     10.8  Employment Agreement dated as of June 11, 1990 with Steven B.
           Nichols (incorporated by reference to exhibit 10.11 to the
           Registrant's Form S-1 Registration Statement No. 33-34369).
     10.9  First Amendment to Employment Agreement with Steven B. Nichols dated
           November 13, 1991 (incorporated by reference to exhibit 10.32 to the
           Registrant's Form 10-K for the fiscal year ended December 31, 1991).
     10.10 Employment Agreement between the Registrant and Steven B. Nichols
           dated as of April 30, 1993 (incorporated by reference to exhibit
           10.30 to the Registrant's Form S-1 Registration Statement No. 33-
           62254).
     10.11 Employment Agreement between the Registrant and Steven B. Nichols
           dated as of March 1, 1995 (incorporated by reference to exhibit 10.2
           to the Registrant's Form 10-Q for the quarter ended June 30, 1995).
     10.12 Note and Warrant Agreement dated as of December 29, 1986 by and
           among K-Swiss, 324 Corp. and John Hancock Mutual Life Insurance
           Company (incorporated by reference to exhibit 10.18 to the
           Registrant's Form S-1 Registration Statement No. 33-34369).
     10.13 Amendment to Note and Warrant Agreement dated as of August 1, 1988
           by and among K-Swiss, 324 Corp. and John Hancock Mutual Life
           Insurance Company (incorporated by reference to exhibit 10.19 to the
           Registrant's Form S-1 Registration Statement No. 33-34369).
     10.14 Note Agreement dated August 25, 1989 and Amendment to Note and
           Warrant Agreement dated as of December 29, 1986, as amended, by and
           between K-Swiss Inc. and John Hancock Mutual Life Insurance Company
           (incorporated by reference to exhibit 10.20 to the Registrant's Form
           S-1 Registration Statement No. 33-34369).
     10.15 Amendment to Note and Warrant Agreement, as amended, dated as of
           April 26, 1990 by and among K-Swiss Inc., the Registrant and John
           Hancock Mutual Life Insurance Company (incorporated by reference to
           exhibit 10.21 to the Registrant's Form S-1 Registration Statement
           No. 33-34369).
     10.16 Amendment to Note and Warrant Agreement as amended, and Note
           Agreement, dated as of January 15, 1991, between the Registrant and
           John Hancock Mutual Life Insurance Company (incorporated by
           reference to exhibit 10.17 to the Registrant's Form 10-K for the
           year ended December 31, 1990).
</TABLE>
 
                                       43
<PAGE>
 
<TABLE>
     <C>   <S>
     10.17 Stock Pledge Agreement, Secured Promissory Note and Letter Agreement
           dated as of December 26, 1990 by and between the Registrant and
           George Powlick (incorporated by reference to exhibit 10.18 to the
           Registrant's Form 10-K for the year ended December 31, 1990).
     10.18 Stock Pledge Agreement, Secured Promissory Note and Letter Agreement
           dated as of April 10, 1991 by and between Registrant and George
           Powlick (incorporated by reference to exhibit 10.33 to the
           Registrant's Form 10-K for the fiscal year ended December 31, 1991).
     10.19 Stock Pledge Agreement and Secured Promissory Note dated as of April
           10, 1991 by and between the Registrant and Lawrence D. Feldman
           (incorporated by reference to exhibit 10.34 to the Registrant's Form
           10-K for the fiscal year ended December 31, 1991).
     10.20 Purchase Agreement dated as of December 29, 1986 by and between 324
           Corp. and The Biltrite Corporation (incorporated by reference to
           exhibit 10.37 to the Registrant's Form S-1 Registration Statement
           No. 33-34369).
     10.21 Amendment to Purchase Agreement dated December 29, 1986 by and
           between 324 Corp. and The Biltrite Corporation (incorporated by
           reference to exhibit 10.34 to the Registrant's Form S-1 Registration
           Statement No. 33-34369).
     10.22 Lease Agreement dated March 11, 1997 by and between K-Swiss Inc. and
           Space Center Mira Loma, Inc. (incorporated by reference to exhibit
           10 to the Registrant's Form 10-Q for the quarter ended March 31,
           1997).
     10.23 Credit Agreement dated March 25, 1994 by and among the Registrant
           and Bank of America National Trust and Savings Association, with
           schedules (incorporated by reference to exhibit 10.33 to the
           Registrant's Form 10-K for the fiscal year ended December 31, 1994).
     10.24 Amendment to Credit Agreement dated March 25, 1994 by and among the
           Registrant and Bank of America National Trust and Savings
           Association (incorporated by reference to exhibit 10.1 to the
           Registrant's Form 10-Q for the quarter ended June 30, 1995).
     10.25 Second Amendment to Credit Agreement (incorporated by reference to
           exhibit 10 to the Registrant's Form 10-Q for the quarter ended
           September 30, 1996).
     10.26 Third Amendment to Credit Agreement (incorporated by reference to
           exhibit 10 to the Registrant's Form 10-Q for the quarter ended
           September 30, 1997).
     10.27 Fourth Amendment to Credit Agreement (incorporated by reference to
           exhibit 10 to the Registrant's Form 10-Q for the quarter ended
           September 30, 1998).
     10.28 Agreement for the Purchase of Assets and Rights of Robey between N.
           Chr. M. Wilke and NMB-Heller N.V. and K-Swiss International Ltd.,
           dated January 4, 1996 (incorporated by reference to exhibit 10 to
           the Registrant's Form 10-Q for the quarter ended March 31, 1996).
     10.29 K-Swiss Inc. Deferred Compensation Plan, Master Plan Document
           (incorporated by reference to exhibit 10.1 to the Registrant's Form
           10-Q for the quarter ended March 31, 1998).
     10.30 K-Swiss Inc. Deferred Compensation Plan, Master Trust Agreement
           (incorporated by reference to exhibit 10.2 to the Registrant's Form
           10-Q for the quarter ended March 31, 1998).
</TABLE>
 
                                       44
<PAGE>
 
<TABLE>
     <C>   <S>
     10.31 Fifth Amendment to Credit Agreement.
     21    Subsidiaries of K-Swiss Inc.
     23    Consent of Grant Thornton LLP.
     27    Financial Data Schedule
</TABLE>
 
  (d) Schedules
 
<TABLE>
<CAPTION>
                                                                            Page
                                                                            ----
<S>                                                                         <C>
    Financial Statement Schedules:
     Schedule II--Valuation and Qualifying Accounts........................  47
    All supplemental schedules other than as set forth above are omitted as
     inapplicable or because the required information is included in the
     Consolidated Financial Statements or the Notes to Consolidated
     Financial Statements.
</TABLE>
 
                                       45
<PAGE>
 
                                  SIGNATURES
 
  Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Form 10-K to be
signed on its behalf by the undersigned, thereunto duly authorized.
 
                                          K-Swiss Inc.
 
                                               /s/ George Powlick
                                          By __________________________________
                                               George Powlick, Vice-President
                                               and Chief Financial Officer
 
                                          February 8, 1999
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
             Signature                      Title                             Date
             ---------                      -----                             ----
<S>                                  <C>                              <C>
  /s/ Steven Nichols                                                      February 8, 1999
------------------------------------
Steven Nichols                       Chairman of the Board,
                                      President and Chief
                                      Executive Officer
  /s/ George Powlick                                                      February 8, 1999
------------------------------------
George Powlick                       Vice President Finance,
                                      Chief Financial Officer,
                                      Principal Accounting
                                      Officer, Secretary and
                                      Director
  /s/ Lawrence Feldman                                                    February 8, 1999
------------------------------------
Lawrence Feldman                     Director


  /s/ Jonathan Layne                                                      February 8, 1999
------------------------------------
Jonathan Layne                       Director


  /s/ Martyn Wilford                                                      February 8, 1999
------------------------------------
Martyn Wilford                       Director
</TABLE>
 
                                      46
<PAGE>
 
                                  SCHEDULE II
 
                       VALUATION AND QUALIFYING ACCOUNTS
 
                             (Amounts in thousands)
 
<TABLE>
<CAPTION>
        Column A            Column B          Column C           Column D     Column E
        --------          ------------- --------------------- -------------- ----------
                                              Additions
                                        ---------------------
                           Balance at   Charged to Charged to Write-offs and Balance at
                          Beginning of  Costs and    Other     Deductions,      End
      Description            Period      Expenses   Accounts       Net       of Period
      -----------         ------------- ---------- ---------- -------------- ----------
<S>                       <C>    <C>    <C>        <C>        <C>            <C>
Allowance for bad debts.  (1998) $  477   $   63     $ --        $   285       $  825
                          (1997)    630      420       --           (573)         477
                          (1996)    873      247       --           (490)         630
Allowance for
 inventories............  (1998) $2,627   $  537     $ --        $(1,643)      $1,521
                          (1997)  2,880    1,769       --         (2,022)       2,627
                          (1996)  1,799    2,977       --         (1,896)       2,880
</TABLE>
 
                                       47
<PAGE>
 
                                 EXHIBIT INDEX

Number                                                     Page
------                                                     ----
10.31  Fifth Amendment to Credit Agreement                  49

21     Subsidiaries of K-Swiss Inc.                         50

23     Consent of Grant Thornton LLP.                       51

27     Financial Data Schedule                              52