<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, 1997
 
                                      OR
 
  [_]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED]
                     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)
 
   20664 BAHAMA STREET, CHATSWORTH,                     91311
              CALIFORNIA                             (ZIP CODE)
    (ADDRESS OF PRINCIPAL EXECUTIVE
               OFFICES)
 
      REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (818) 998-3388
 
          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 3, 1998 based on the
closing price of the Class A Common Stock on the NASDAQ National Market System
on such date was $52,879,274.
 
  The number of shares of the Registrant's Class A Common Stock outstanding at
February 3, 1998 was 3,022,886 shares. The number of shares of the
Registrant's Class B Common Stock outstanding at February 3, 1998 was
2,480,572 shares.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Portions of the proxy statement for the Registrant's 1998 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, 1997
 
<TABLE>
<CAPTION>
            CAPTION                                                          PAGE
            -------                                                          ----
<C>         <S>                                                              <C>
PART I
 Item 1.    Business.....................................................      3
 Item 2.    Properties...................................................     10
 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.........................     11
 
PART II
 Item 5.    Market for Registrant's Common Equity and Related Stockholder       
            Matters......................................................     13 
 Item 6.    Selected Financial Data......................................     14
 Item 7.    Management's Discussion and Analysis of Financial Condition
            and Results of Operations....................................     15
 Item 8.    Financial Statements and Supplementary Data..................     19
 Item 9.    Changes in and Disagreements with Accountants on Accounting
            and Financial Disclosure.....................................     38
 
PART III
 Item 10.   Directors and Executive Officers of the Registrant...........     38
 Item 11.   Executive Compensation.......................................     38
            Security Ownership of Certain Beneficial Owners and
 Item 12.   Management...................................................     38
 Item 13.   Certain Relationships and Related Transactions...............     38
 
PART IV
 Item 14.    Exhibits, Financial Statement Schedules, and Reports on Form       
             8-K.........................................................     38 
</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 and Indonesia. 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 20664 Bahama St., Chatsworth, California 91311, and its telephone
number is (818) 998-3388. 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 42% of 1997
revenues) and women's (approximately 36% of 1997 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,
                                       ----------------------------------------
                                           1997          1996          1995
                                       ------------  ------------  ------------
PRODUCT CATEGORY                          $      %      $      %      $      %
----------------                       -------- ---  -------- ---  -------- ---
                                           (DOLLAR AMOUNTS IN THOUSANDS)
<S>                                    <C>      <C>  <C>      <C>  <C>      <C>
Classic............................... $ 67,163  58% $ 50,573  48% $ 65,745  56%
Tennis/Court..........................   20,505  18    25,511  24    21,624  18
Children's............................   21,288  19    18,693  18    18,811  16
Other(2)..............................    6,169   5    10,733  10    12,112  10
                                       -------- ---  -------- ---  -------- ---
Total................................. $115,125 100% $105,510 100% $118,292 100%
                                       ======== ===  ======== ===  ======== ===
Domestic(3)........................... $ 91,040  79% $ 75,945  72% $ 88,929  75%
                                       ======== ===  ======== ===  ======== ===
</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,
    blemished shoes and sales of shoe components.
 
(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.
 
  Since 1988, the Company has developed new product categories whose initial
styles were extensions of the Classic. Each product category has certain
styles designated as core products. The Company's core products 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
Classic was named one of the "1994 Shoes of the Year" by Footwear News, the
industry's leading trade publication. The core program tends to minimize
retailers' markdowns and maximizes the effectiveness of marketing expenditures
because of longer product life cycles. The Company now competes in three
principal product categories: Tennis, Casual (Classic) and Children's.
 
 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
 
                                       4
<PAGE>
 
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 1997, K-Swiss launched its largest ever television campaign marking the
first time since 1992 that the Company's products have been advertised on
television. The campaign was run primarily on 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, 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, and 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.
 
  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, 3,300 and 3,700 separate accounts as of December 31,
1997, 1996 and 1995, respectively. The Company's strategy is to increase its
account base of upscale retail outlets in a controlled manner.
 
                                       5
<PAGE>
 
  During 1997, the Foot Locker group of stores and affiliates accounted for
approximately 17% 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 12 persons
at its Chatsworth, 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 leased computer facilities 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.
 
  In 1991, the Company entered into a joint venture with C & J Clark
International Ltd., to expand the marketing of its products into Europe. The
joint venture formed K-Swiss Europe Ltd. and launched the K-Swiss brand in the
United Kingdom. During 1992, the Company purchased C & J Clark's 50% share of
K-Swiss Europe Ltd. (renamed K-Swiss (UK) Ltd.) and the joint venture was
terminated. In 1992, the Company opened its own office in Amsterdam, the
Netherlands.
 
  By the end of 1997, K-Swiss was working through 4 international subsidiaries
and 28 distributors to market K-Swiss in potentially 56 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. The Company owned a 56,000 square foot
warehouse in Pacoima, California which was leased to a tenant. This warehouse
was sold in January 1998. See "Item 2. Properties".
 
  The Company purchases footwear from independent manufacturers located
predominantly in China and Indonesia. The time required to fill new orders
placed by the Company with its producers 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 distributors is based out of the
Netherlands office public distribution facility. The Company generally
arranges shipment of international orders directly from its independent
manufacturers.
 
  The Company maintains an open-stock inventory 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 leased
computer facilities that provide on-line capability to determine open-
 
                                       6
<PAGE>
 
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 Chatsworth, 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 1997, approximately 87% of the Company's footwear products were
manufactured in China, 10% in Indonesia, and 3% in Taiwan. In excess of 97% of
the Company's production capacity is located in China and Indonesia. This
shift from prior years in the geographic sourcing of production capacity
occurred primarily because of lower prevailing labor wage rates in China and
Indonesia 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.
 
  During 1992, the Company experienced production sourcing problems in certain
countries which caused delays in the shipment of certain footwear. Since then,
the Company has and continues to implement a strategy to better manage its
product sourcing which includes reducing the number of factories manufacturing
its footwear in order to become a more substantial customer of such factories
and employing more experienced personnel to manage and oversee the
manufacturers. The Company has established its own offices in Taiwan, China,
and Indonesia to perform services which include securing manufacturing
capacity, testing raw materials, handling orders, inspecting production and
performing other procurement functions. However, in 1993, the Company
experienced difficulty in securing sufficient vulcanized construction
production capacity. The canvas product is made primarily by vulcanized
construction. This situation led to delivery delays and cancellations of some
future orders and a diminished ability to fill at once orders for vulcanized
product in 1994. Although the Company has taken steps to solve this problem
and currently believes it has sufficient vulcanized construction capacity, no
assurances can be given that the Company will not again experience similar
difficulties.
 
  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 1997, the Company's apparel and accessory products were manufactured
in Taiwan, Hong Kong, China, Macau, Bangladesh, 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
 
                                       7
<PAGE>
 
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 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 81% of the Company's revenues are derived from
sales of leather footwear and approximately 9% of the Company's revenues are
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
most-favored nation ("MFN") basis. Pursuant to MFN, 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 MFN 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 MFN treatment. The President has waived
these restrictions each year since 1979. There can be no assurance that China
will continue to enjoy MFN status in the future. If goods manufactured in
China enter the United States without benefit of MFN 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, 1997 and 1996, domestic footwear futures orders with start
ship dates from January through June 1998 and 1997 were approximately
$56,189,000 and $29,762,000, respectively. At December 31, 1997 and 1996,
international footwear futures orders with start ship dates from January
through June 1998 and 1997 were approximately $8,473,000 and $11,028,000,
respectively.
 
                                       8
<PAGE>
 
"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 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
 
                                       9
<PAGE>
 
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, 1997, the Company employed 144 persons in the United States,
66 persons in Taiwan, Indonesia and China, and 25 persons in England and the
Netherlands.
 
ITEM 2. PROPERTIES
 
  The Company leases a 27,000 square foot facility in Chatsworth, California
which is used as the Company's principal executive offices. This lease expires
in April 1998, subject to two options, each of which would extend the term of
the lease by one month and one option which would extend the term of the lease
by three and one-half months. The Company and the landlord of the Chatsworth
facility have agreed to extend the lease until September 15, 1998 on or before
such time the Company expects to move into its new headquarters facility in
Westlake Village, California. The effective monthly commitment for the
Chatsworth facility, calculated in accordance with generally accepted
accounting principles, is approximately $18,000.
 
  In December 1996, the Company purchased 3.6 acres of land in Westlake
Village, California for a cash purchase price of $691,000. The Company intends
to develop this site for a new headquarters facility of approximately 50,000
square feet. The Company expects to complete construction of this facility
during the third quarter of 1998 with an estimated building cost of
approximately $4,900,000.
 
  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 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. The Company uses
the Mira Loma facility as its main distribution center. The effective monthly
commitment for the Mira Loma facility, calculated in accordance with generally
accepted accounting principles, 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.
 
                                      10
<PAGE>
 
ITEM 4(a). EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The executive officers of the Company are as follows:
 
<TABLE>
<CAPTION>
                     AGE AT
                  DECEMBER 31,
NAME                  1997                         POSITION
----              ------------                     --------
<S>               <C>          <C>
Steven Nichols         55      Chairman of the Board and President
Preston Davis          53      Vice President--Sales
Edward Flora           46      Vice President--Operations
Lee Green              44      Corporate Counsel
Thomas Harrison        55      Senior Vice President
Donna Lucas            35      Vice President--Apparel
Deborah Mitchell       36      Vice President--Marketing
George Powlick         53      Vice President--Finance, Chief Financial Officer,
                                Secretary and Director
Janice Smith           36      Corporate Controller
Brian Sullivan         44      Vice President--National Accounts
Peter Worley           37      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 June
1982 through December 1985, Mr. Davis was Vice President--Sales for Kaepa,
Inc., another athletic shoe manufacturer.
 
  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.
 
                                      11
<PAGE>
 
  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.
 
                                      12
<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 1997
and 1996 as reported by NASDAQ were as follows:
 
<TABLE>
<CAPTION>
                                   MARCH 31, JUNE 30,  SEPTEMBER 30, DECEMBER 31,
                                   --------- --------  ------------- ------------
      <S>                          <C>       <C>       <C>           <C>
      1997
        Low.......................     9 7/8   10 7/8       14 1/2       15 3/4
        High......................    12 3/4   15 3/4       19 7/8       18
      1996
        Low.......................     7 3/4    7 7/8        9 5/8        9 5/8
        High......................    11 3/4   11 3/4       11 1/4       12 7/8
</TABLE>
 
  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, 1997 was 123. However, based on available information, the Company
believes that the total number of Class A Common stockholders, including
beneficial stockholders, is approximately 1,410.
 
  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, 1997 was 12.
 
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
8 cents per common share. The Board declared quarterly dividends of 2 cents
per share, to stockholders of record as of the close of business on the last
day of each quarter in 1997 and 1996. 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 E to the
Company's Consolidated Financial Statements.
 
                                      13
<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, 1997 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,
                               ------------------------------------------------
                                 1997      1996      1995      1994      1993
                               --------  --------  --------  --------  --------
                                  (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                            <C>       <C>       <C>       <C>       <C>
INCOME STATEMENT DATA
Revenues...................... $116,213  $106,833  $120,252  $154,935  $149,562
Cost of goods sold............   70,769    72,320    77,726    91,934    90,836
                               --------  --------  --------  --------  --------
  Gross Profit................   45,444    34,513    42,526    63,001    58,726
Selling, general and
 administrative expenses......   40,074    33,440    36,131    38,458    38,925
                               --------  --------  --------  --------  --------
  Operating profit............    5,370     1,073     6,395    24,543    19,801
Interest (income) expense,
 net..........................   (1,823)   (1,527)     (789)     (254)      376
                               --------  --------  --------  --------  --------
  Earnings before income
   taxes......................    7,193     2,600     7,184    24,797    19,425
Income tax expense............    3,020     1,869     5,331     9,921     6,904
                               --------  --------  --------  --------  --------
  Net earnings................ $  4,173  $    731  $  1,853  $ 14,876  $ 12,521
                               ========  ========  ========  ========  ========
EARNINGS PER SHARE
Basic......................... $    .71  $    .11  $    .28  $   2.27  $   1.92
                               ========  ========  ========  ========  ========
Diluted....................... $    .70  $    .11  $    .28  $   2.21  $   1.87
                               ========  ========  ========  ========  ========
WEIGHTED AVERAGE NUMBER OF
 SHARES OUTSTANDING
Basic.........................    5,844     6,455     6,578     6,563     6,507
Diluted(1)....................    5,964     6,493     6,630     6,737     6,699
BALANCE SHEET DATA (AT PERIOD
 END)
Current assets................ $ 91,544  $ 90,537  $ 92,786  $ 90,132  $ 75,684
Current liabilities...........   15,951    11,240     9,603    12,891    15,098
Total assets..................  101,686   100,275   102,378   100,324    86,925
Total debt(2).................    1,142     1,711       920     3,402     5,426
Stockholders' equity..........   75,865    79,569    84,069    82,817    68,019
</TABLE>
--------
(1) Includes common stock and dilutive potential common stock (options).
(2) Includes all interest-bearing debt and capital lease obligations, but
    excludes outstanding letters of credit ($12,156,000, $8,000,000,
    $7,741,000, $15,632,000 and $20,018,000 as of December 31, 1997, 1996,
    1995, 1994 and 1993).
 
                                      14
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
      RESULTS OF OPERATIONS
 
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,
                                                            -------------------
                                                            1997   1996   1995
                                                            -----  -----  -----
     <S>                                                    <C>    <C>    <C>
     Revenues.............................................. 100.0% 100.0% 100.0%
     Cost of goods sold....................................  60.9   67.7   64.6
     Gross profit..........................................  39.1   32.3   35.4
     Selling, general and administrative expenses..........  34.5   31.3   30.1
     Interest income, net..................................   1.6    1.4    0.6
     Earnings before income taxes..........................   6.2    2.4    5.9
     Income tax expense....................................   2.6    1.7    4.4
     Net Earnings..........................................   3.6    0.7    1.5
</TABLE>
 
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 product 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.
 
  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; consequently, fourth
quarter sales are generally the Company's lowest.
 
  At December 31, 1997 domestic and international footwear futures orders with
start ship dates from January through June 1998 were approximately $56,189,000
and $8,473,000, respectively, 89% higher and 23% lower, respectively, than
such orders were at December 31, 1996 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 39.1% in 1997
from 32.3% in 1996. Gross profit margins increased due to a decrease in close-
out sales which carry lower margins and to changes in the
domestic/international and product mix of sales.
 
                                      15
<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 $.71 per common share (basic
earnings per share) in 1997 from $731,000 or $.11 per common share (basic
earnings per share) in 1996. Included in the international results of
operations presented in Note M to the Company's Consolidated Financial
Statements were net losses of $1,602,000 incurred by the Company's European
operations. 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.
 
1996 COMPARED TO 1995
 
  Total revenues decreased 11.2% to $106,833,000 in 1996 from $120,252,000 in
1995. This decrease was attributable to decreases in the volume of footwear
sold, in addition to a decrease in the average underlying wholesale price per
pair. The volume of footwear sold decreased 12.1% to 4,697,000 pair in 1996
from 5,341,000 pair in 1995. The average wholesale price per pair decreased by
2.5% to $20.95 in 1996 from $21.49 for 1995. This decrease in the average
wholesale price per pair is primarily attributable to an increase in closeout
sales during 1996 which carry a lower average wholesale price per pair
partially offset by an increase in the tennis/court category which carries a
higher average wholesale price per pair. The major changes in volume for
footwear categories are as follows: Classics and children's categories
decreased 18% and 4%, respectively, and the tennis/court category increased
14%. The overall decline in revenues was due to a difficult retail environment
during 1996 and new products that were less successful than the industry
leaders' products. The Company was the official footwear sponsor of the 1996
U.S. Open Tennis Tournament in an effort to increase tennis sales.
 
  Domestic revenues decreased 14.6% to $76,168,000 in 1996 from $89,192,000 in
1995. International product revenues increased 0.7% in 1996 to $29,565,000
from $29,363,000 in 1995. International product revenues, as a percentage of
total revenues, increased to 27.7% in 1996 from 24.4% in 1995. Fees earned by
the Company on sales by foreign licensees and distributors decreased to
$1,100,000 for 1996 from $1,697,000 for 1995.
 
  Gross profit margins decreased as a percentage of revenues to 32.3% in 1996
from 35.4% in 1995. Gross profit margins decreased partially due to an
increase in close-out sales which carry lower margins. In addition, gross
profit margins decreased due to changes in the domestic/international and
product mix of sales.
 
 
                                      16
<PAGE>
 
  Selling, general and administrative expenses decreased 7.4% to $33,440,000
(31.3% of revenues) in 1996 from $36,131,000 (30.1% of revenues) in 1995. This
decrease in the amounts was primarily the result of increased bad debt expense
recorded during 1995 (due to the unexpected bankruptcies of two of the
Company's larger customers) and expenses recorded relating to the dissolution
of the Company's Canadian subsidiary. In addition, reductions were made for
potential contributions to the employee's profit sharing plan in 1996. These
decreases were partially offset by an increase in the bonus accrual due to the
implementation of an incentive program. The increase in selling, general and
administrative expenses, as a percentage of sales, was due to an increase in
direct advertisement, promotion activities and product development and
bonuses, partially offset by a decrease in bad debts.
 
  Net interest income was $1,527,000 (1.4% of revenues) in 1996 compared to
$789,000 (0.6% of revenues) in 1995, an increase of $738,000 or 93.5%. 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 71.9% in 1996 from 74.2% in
1995. 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. In 1995, the Company recorded deferred income taxes for the previously
untaxed portion of unremitted earnings of a foreign subsidiary.
 
  Net earnings decreased 60.6% to $731,000 or $.11 per common share (basic
earnings per share) in 1996 from $1,853,000 or $.28 per common share (basic
earnings per share) in 1995. Included in the international results of
operations presented in Note M to the Company's Consolidated Financial
Statements were net losses of $1,335,000 incurred by the Company's European
operations. The European operations are wholly-owned subsidiaries of the
Company rather than independent unaffiliated distributors as are utilized
throughout the balance of the Company's international operations. As these
operations are in a start-up mode, their revenues 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 $17,871,000,
$9,183,000, and $18,995,000 from its operating activities during 1997, 1996
and 1995, respectively. 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. Cash provided by operations in 1996
decreased from 1995, primarily due to an increase in prepaid expenses and
other assets (principally a prepayment to secure inventory purchases) and a
decrease in net earnings, partially offset by a decrease in inventories.
 
  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. The Company had a net outflow of
cash from its investing activities during 1996 principally for the purchase of
property, plant and equipment and the purchase of certain assets and rights of
a small apparel brand where products are primarily sold in the Netherlands.
 
  In 1997 and 1996, the net cash provided by operating activities was used for
the purchase of treasury stock and to pay cash dividends.
 
  The Company anticipates future cash needs for principal repayments required
pursuant to the Company's lines of credit facilities. In addition, depending
on the Company's future growth rate,
 
                                      17
<PAGE>
 
additional funds may be required by operating activities. Finally, at December
31, 1997, approximately $24,282,000 of foreign subsidiary earnings which are
not considered indefinitely invested will eventually be remitted to the parent
company as circumstances warrant. Upon receipt of these funds, the Company
will use approximately $9,303,000 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. During 1998, the Company will need approximately
$3,740,000 for the construction of its new headquarters facility. See "Item 2.
Properties". No other material capital commitments exist at December 31, 1997.
With continued use of its revolving credit facility (as discussed below), the
Company believes its present and currently anticipated sources of capital are
sufficient to sustain its anticipated capital needs for the remainder of 1998.
 
  The Company is heavily dependent upon complex computer systems for all
phases of its operations, which include production, sales and distribution.
The Company's computer software programs recognize only the last two digits of
the year in any date (e.g., "97" for "1997"), and therefore some software may
inaccurately process data in 1999 or 2000 if the software is not reprogrammed,
upgraded or replaced (the "Year 2000 Issue"). The Company has initiated a
program intended to timely mitigate and/or prevent the adverse effects of the
Year 2000 Issue, and to pursue compliance by suppliers. The Company believes
that many of its suppliers and customers may also have Year 2000 Issues which
could affect the Company. At this time, while the Company cannot state with
certainty the precise amount of expenditures necessary to resolve the Year
2000 Issue, it appears such expenditures could amount to $200,000 to $300,000
for the Company. However, in any event the Company presently believes that the
cost of fixing the Year 2000 Issue will not have a material adverse impact on
the Company's financial position and results of operations.
 
  In January 1998, the Company announced that under its share repurchase
program, the Board of Directors had authorized the Company to purchase up to
$2,832,000 of its Class A Common Stock on the open market through December
1998. The amount of the authorization represents the remaining amount of the
previous $10,000,000 buy back authorization which expired December 31, 1997.
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. Currently, the Company has made purchases
under this program from August 14, 1996 through February 12, 1998 (the date of
filing of this Form 10-K) of 1,097,700 shares at an aggregate cost totaling
approximately $14,064,000.
 
  In August 1997 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 $18,756,000 at December 31,
1997. This facility currently expires in July 1999. 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 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 $5,000,000 in the form of secured revolving credit facilities.
The unused portion of these credit facilities was $3,446,000 at December 31,
1997. These facilities are made available until terminated by either party.
 
  Total debt decreased 33.3% to $1,142,000 at December 31, 1997 from
$1,711,000 at December 31, 1996 (excluding outstanding letters of credit of
$12,156,000 and $8,000,000 at December 31, 1997 and 1996, respectively). The
increase was primarily due to borrowings under bank lines of credit under the
Company's credit facility.
 
                                      18
<PAGE>
 
  The Company's working capital decreased $3,704,000 to $75,593,000 at
December 31, 1997 from $79,297,000 at December 31, 1996.
 
  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.
 
  At the end of 1995, the Company recorded deferred income taxes of $4,433,000
on the previously untaxed portion of unremitted earnings of a foreign
subsidiary. This change in estimate was precipitated by the Company changing
its intention regarding unremitted earnings of the foreign subsidiary. The
Company decided to no longer indefinitely invest unremitted earnings of this
foreign subsidiary and therefore deferred taxes were recorded. The Company
changed its intention because of changes in the tax law and the lack of
foreign opportunities to invest the unremitted earnings of the foreign
subsidiary.
 
  The federal income tax returns of the Company for the years ended December
31, 1990, 1991 and 1992 are under examination by the Internal Revenue Service
("IRS"). See Note H to the Company's Consolidated Financial Statements. In
December 1995, the IRS issued its report proposing additional taxes of
approximately $3,850,000 plus penalties and interest. The Company protested
the IRS proposed assessment. Also, the federal income tax returns of the
Company for the years ended 1993 and 1994 are currently under examination by
the IRS. In addition, the IRS Appeals Division returned the earlier cycle to
the Examination Division to reopen its examination of the 1991 and 1992 fiscal
years. The IRS has issued a preliminary revised examination report covering
the 1991 through 1994 fiscal years proposing additional taxes of approximately
$4,760,000 plus penalties and interest for these years combined. 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.
 
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.
 
                                      19
<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, 1997 and 1996, and the related consolidated statements of
earnings, stockholders' equity, and cash flows for each of the three years in
the period ended December 31, 1997. 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, 1997 and 1996, and the consolidated results of its
operations and its consolidated cash flows for each of the three years in the
period ended December 31, 1997, 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, 1997. In our opinion, this schedule presents
fairly, in all material respects, the information required to be set forth
therein.
 
/s/ GRANT THORNTON LLP
 
Los Angeles, California
January 30, 1998
 
                                      20
<PAGE>
 
                                 K-SWISS INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
                                  DECEMBER 31,
 
                         (DOLLAR AMOUNTS IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                              1997      1996
                                                            --------  --------
                          ASSETS
                          ------
<S>                                                         <C>       <C>
Current Assets
  Cash and cash equivalents (Note A4)...................... $ 36,123  $ 34,314
  Investment securities (Note A5)..........................    5,995       --
  Accounts receivable, less allowance for doubtful accounts
   of $477 and $630 for 1997 and 1996, respectively (Notes
   E and L)................................................   15,657    14,702
  Inventories (Notes A6 and E).............................   27,214    23,789
  Prepaid expenses and other (Note B)......................    4,299    15,674
  Deferred taxes (Notes A9 and H)..........................    2,256     2,058
                                                            --------  --------
    Total current assets...................................   91,544    90,537
Property, Plant and Equipment, net (Notes A7, C and E).....    4,885     3,910
Other Assets
  Intangible assets (Notes A8, D and E)....................    4,712     5,005
  Other....................................................      545       823
                                                            --------  --------
                                                               5,257     5,828
                                                            --------  --------
                                                            $101,686  $100,275
                                                            ========  ========
           LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
  Bank lines of credit (Note E)............................ $    642  $  1,209
  Current maturities of capital lease obligations and
   subordinated debentures (Note G)........................      400       302
  Trade accounts payable...................................    4,379     3,239
  Accrued liabilities (Note F).............................   10,530     6,490
                                                            --------  --------
    Total current liabilities..............................   15,951    11,240
Subordinated Debentures (Note G)...........................      100       200
Deferred Taxes (Notes A9 and H)............................    9,770     9,266
Commitments and Contingencies (Notes H and I)..............      --        --
Stockholders' Equity (Note K)
  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;
   4,110,586 shares issued, 3,107,886 shares outstanding
   and 1,002,700 shares held in treasury at December 31,
   1997 and 4,087,018 shares issued, 3,585,018 shares
   outstanding and 502,000 shares held in treasury at
   December 31, 1996.......................................       41        41
  Class B--authorized 10,000,000 shares of $.01 par value;
   issued and outstanding 2,485,572 shares at December 31,
   1997 and 2,495,572 shares at December 31, 1996..........       25        25
  Additional paid-in capital...............................   25,271    25,100
  Treasury Stock...........................................  (12,389)   (5,221)
  Retained earnings (Note E)...............................   63,387    59,675
  Foreign currency translation (Note A10)..................     (470)      (51)
                                                            --------  --------
                                                              75,865    79,569
                                                            --------  --------
                                                            $101,686  $100,275
                                                            ========  ========
</TABLE>
 
        The accompanying notes are an integral part of these statements.
 
                                       21
<PAGE>
 
                                 K-SWISS INC.
 
                      CONSOLIDATED STATEMENTS OF EARNINGS
 
                            YEAR ENDED DECEMBER 31,
 
            (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                       1997     1996     1995
                                                     -------- -------- --------
<S>                                                  <C>      <C>      <C>
Revenues (Notes A13, L and M)....................... $116,213 $106,833 $120,252
Cost of goods sold..................................   70,769   72,320   77,726
                                                     -------- -------- --------
  Gross profit......................................   45,444   34,513   42,526
Selling, general and administrative expenses (Note
 A14)...............................................   40,074   33,440   36,131
                                                     -------- -------- --------
  Operating profit..................................    5,370    1,073    6,395
Interest income, net................................    1,823    1,527      789
                                                     -------- -------- --------
  Earnings before income taxes......................    7,193    2,600    7,184
Income tax expense (Notes A9 and H).................    3,020    1,869    5,331
                                                     -------- -------- --------
  NET EARNINGS...................................... $  4,173 $    731 $  1,853
                                                     ======== ======== ========
Earnings per common share (Note A15)
  Basic............................................. $    .71 $    .11 $    .28
                                                     ======== ======== ========
  Diluted........................................... $    .70 $    .11 $    .28
                                                     ======== ======== ========
</TABLE>
 
 
        The accompanying notes are an integral part of these statements.
 
                                       22
<PAGE>
 
                                 K-SWISS INC.
 
                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
 
                      THREE YEARS ENDED DECEMBER 31, 1997
 
                         (DOLLAR AMOUNTS IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                    COMMON STOCK                          TREASURY STOCK
                          ----------------------------------            ------------------
                              CLASS A          CLASS B       ADDITIONAL      CLASS A                    FOREIGN
                          ---------------- -----------------  PAID-IN   ------------------  RETAINED   CURRENCY
                           SHARES   AMOUNT  SHARES    AMOUNT  CAPITAL    SHARES    AMOUNT   EARNINGS  TRANSLATION  TOTAL
                          --------- ------ ---------  ------ ---------- --------- --------  --------  ----------- -------
<S>                       <C>       <C>    <C>        <C>    <C>        <C>       <C>       <C>       <C>         <C>
Balance at January 1,
 1995...................  4,057,779  $41   2,515,572   $25    $24,985         --  $    --   $58,133      $(367)   $82,817
Conversion of shares
 (Note K)...............     20,000  --      (20,000)  --         --          --       --       --         --         --
Proceeds from exercise
 of options (Note K)....      8,072  --          --    --          90         --       --       --         --          90
Income tax benefit of
 options exercised (Note
 K).....................        --   --          --    --          13         --       --       --         --          13
Dividends paid ($.08 per
 share) (Note E)........        --   --          --    --         --          --       --      (526)       --        (526)
Net earnings for the
 year...................        --   --          --    --         --          --       --     1,853        --       1,853
Foreign currency
 translation
 (Note A10).............        --   --          --    --         --          --       --       --        (178)      (178)
                          ---------  ---   ---------   ---    -------   --------- --------  -------      -----    -------
Balance at December 31,
 1995...................  4,085,851   41   2,495,572    25     25,088          --       --   59,460       (545)    84,069
Proceeds from exercise
 of options (Note K)....      1,167  --          --    --          12         --       --       --         --          12
Purchase of treasury
 stock..................        --   --          --    --         --      502,000   (5,221)     --         --      (5,221)
Dividends paid ($.08 per
 share) (Note E)........        --   --          --    --         --          --       --      (516)       --        (516)
Net earnings for the
 year...................        --   --          --    --         --          --       --       731        --         731
Foreign currency
 translation
 (Note A10).............        --   --          --    --         --          --       --       --         494        494
                          ---------  ---   ---------   ---    -------   --------- --------  -------      -----    -------
Balance at December 31,
 1996...................  4,087,018   41   2,495,572    25     25,100     502,000   (5,221)  59,675        (51)    79,569
Conversion of shares
 (Note K)...............     10,000  --      (10,000)  --         --          --       --       --         --         --
Proceeds from exercise
 of options (Note K)....     13,568  --          --    --         144         --       --       --         --         144
Income tax benefit of
 options exercised......        --   --          --    --          27         --       --       --         --          27
Purchase of treasury
 stock..................        --   --          --    --         --      500,700   (7,168)     --         --      (7,168)
Dividends paid ($.08 per
 share) (Note E)........        --   --          --    --         --          --       --      (461)       --        (461)
Net earnings for the
 year...................        --   --          --    --         --          --       --     4,173        --       4,173
Foreign currency
 translation
 (Note A10).............        --   --          --    --         --          --       --       --        (419)      (419)
                          ---------  ---   ---------   ---    -------   --------- --------  -------      -----    -------
Balance at December 31,
 1997...................  4,110,586  $41   2,485,572   $25    $25,271   1,002,700 $(12,389) $63,387      $(470)   $75,865
                          =========  ===   =========   ===    =======   ========= ========  =======      =====    =======
</TABLE>
         The accompanying notes are an integral part of this statement.
 
                                       23
<PAGE>
 
                                 K-SWISS INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                            YEAR ENDED DECEMBER 31,
 
                         (DOLLAR AMOUNTS IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                     1997      1996     1995
                                                    -------  --------  -------
<S>                                                 <C>      <C>       <C>
Cash flows from operating activities:
  Net earnings..................................... $ 4,173  $    731  $ 1,853
  Adjustments to reconcile net earnings to net cash
   provided by operating activities:
    Depreciation and amortization..................     918     1,197    1,181
    Loss on disposal of equipment and goodwill.....       2       --       152
    Deferred income taxes..........................     306     3,199      960
    (Increase) decrease in accounts receivable.....    (954)       64    9,628
    (Increase) decrease in inventories.............  (3,428)   17,399    4,823
    Decrease (increase) in prepaid expenses and
     other assets..................................  11,647   (14,373)   1,354
    Increase (decrease) in accounts payable and
     accrued liabilities...........................   5,207       556     (956)
    Foreign currency translation write off for
     K-Swiss Canada................................     --        410      --
                                                    -------  --------  -------
    Net cash provided by operating activities......  17,871     9,183   18,995
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..   3,624       --     5,102
  Purchase of property, plant and equipment........  (1,641)   (1,034)    (397)
  Proceeds from disposal of property, plant and
   equipment.......................................       9        15       18
                                                    -------  --------  -------
    Net cash (used in) provided by investing
     activities....................................  (7,627)   (1,454)   4,723
Cash flows from financing activities:
  Net (repayments) borrowings under bank lines of
   credit and capital leases.......................    (564)      790   (2,479)
  Purchase of treasury stock.......................  (7,168)   (5,221)     --
  Payment of dividends.............................    (461)     (516)    (526)
  Proceeds from stock options exercised............     144        12       90
  Income tax benefit of options exercised..........      27       --        13
                                                    -------  --------  -------
    Net cash used in financing activities..........  (8,022)   (4,935)  (2,902)
Effect of exchange rate changes on cash ...........    (413)       89     (102)
                                                    -------  --------  -------
      Net increase in cash and cash equivalents....   1,809     2,883   20,714
Cash and cash equivalents at beginning of period...  34,314    31,431   10,717
                                                    -------  --------  -------
Cash and cash equivalents at end of period......... $36,123  $ 34,314  $31,431
                                                    =======  ========  =======
Supplemental disclosure of cash flow information:
  Cash paid during the year for:
    Interest....................................... $   156  $    213  $   239
    Income taxes................................... $ 3,280  $  1,171  $ 3,341
</TABLE>
 
        The accompanying notes are an integral part of these statements.
 
                                       24
<PAGE>
 
                                 K-SWISS INC.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
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 its products from a small number of contract
manufacturers in China and Indonesia. 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 affect operating
results adversely.
 
  Recently, 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 1996
presentation to conform with the 1997 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.
 
                                      25
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
 
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 buildings and related
improvements are 25 and 5 years, respectively. Equipment is depreciated from 5
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
 
                                      26
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
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 (principally German marks and pounds
sterling) 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 or outflows resulting from the sale
of products to foreign customers and purchases from foreign suppliers 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 purchases and 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, 1997 and 1996, deferred gains and losses are not
material to the consolidated financial statements.
 
  The forward exchange contracts generally require the Company to exchange
U.S. dollars for foreign currencies (principally German marks and pounds
sterling) 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 these institutions. 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 $3,680,000 and $176,000 at December 31,
1997, respectively and $3,918,000 and $150,000 at December 31, 1996,
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
$6,553,000, $3,073,000, and $1,941,000 for 1997, 1996, and 1995, respectively.
 
                                      27
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
 
NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED)
 
15. Earnings per Share
 
   In 1997, the Company adopted the provisions of Statement of Financial
Accounting Standards No. 128, Earnings Per Share ("SFAS 128"), which
superseded APB Opinion No. 15. Earnings per share for all periods presented
has been restated to reflect the adoption of SFAS 128. SFAS 128 requires
companies to present basic earnings per share, and, if applicable, diluted
earnings per share, instead of primary and fully diluted 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 reflects
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):
 
<TABLE>
<CAPTION>
                                   1997             1996             1995
                             ---------------- ---------------- ----------------
                                    PER SHARE        PER SHARE        PER SHARE
                             SHARES  AMOUNT   SHARES  AMOUNT   SHARES  AMOUNT
                             ------ --------- ------ --------- ------ ---------
<S>                          <C>    <C>       <C>    <C>       <C>    <C>
Basic EPS................... 5,844    $ .71   6,455    $.11    6,578    $.28
Effect of Dilutive Stock
 Options....................   120     (.01)     38     --        52     --
                             -----    -----   -----    ----    -----    ----
Diluted EPS................. 5,964    $ .70   6,493    $.11    6,630    $.28
                             =====    =====   =====    ====    =====    ====
</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>
                                          1997          1996          1995
                                      ------------- ------------- -------------
<S>                                   <C>           <C>           <C>
Options to purchase shares of common
 stock (in thousands)................      358           463           429
Exercise prices...................... $15.25-$23.00 $10.31-$23.00 $13.75-$23.00
Expiration dates..................... January 2000- January 2000- January 2000-
                                       August 2007   August 2006  February 2005
</TABLE>
 
16. New Accounting Pronouncements
 
  In 1997, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 130 ("SFAS 130"), Reporting
Comprehensive Income, which prescribes standards for reporting comprehensive
income and its components. Comprehensive income consists of net income or loss
for the current period and other comprehensive income (income, expenses, gains
and losses that currently bypass the income statement and are reported
directly in a separate component of equity). SFAS 130 requires that components
of comprehensive income be reported in a financial statement that is displayed
with the same prominence as other financial statements. SFAS 130 is effective
for financial statements issued for periods beginning after December 15, 1997.
 
  In 1997, the FASB issued Statement of Financial Accounting Standards No. 131
("SFAS 131"), Disclosures about Segments of an Enterprise and Related
Information, which applies only to publicly held business entities. A
reportable segment, referred to as an operating segment, is a component of an
entity about which separate financial information is produced internally, that
is evaluated by the
 
                                      28
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
 
NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED)
 
chief operating decision-maker to assess performance and allocate resources.
SFAS 131 is effective for financial statements issued for periods beginning
after December 15, 1997.
 
NOTE B--PREPAID EXPENSES AND OTHER
 
  Prepaid expenses and other as of December 31 consist of the following (in
thousands):
 
<TABLE>
<CAPTION>
                                                                  1997   1996
                                                                 ------ -------
     <S>                                                         <C>    <C>
     Prepayment to secure inventory purchases................... $2,153 $11,327
     Income taxes receivable....................................  1,457   3,682
     Other prepaid expenses.....................................    689     665
                                                                 ------ -------
                                                                 $4,299 $15,674
                                                                 ====== =======
</TABLE>
 
NOTE C--PROPERTY, PLANT AND EQUIPMENT
 
  Property, plant and equipment as of December 31 consists of the following
(in thousands):
 
<TABLE>
<CAPTION>
                                                                1997     1996
                                                               -------  -------
     <S>                                                       <C>      <C>
     Building and improvements................................ $ 3,240  $ 2,071
     Furniture, machinery and equipment.......................   4,433    4,085
     Leased property under capital leases.....................     766      766
                                                               -------  -------
                                                                 8,439    6,922
     Less accumulated depreciation and amortization...........  (5,380)  (4,835)
                                                               -------  -------
                                                                 3,059    2,087
     Land.....................................................   1,826    1,823
                                                               -------  -------
                                                               $ 4,885  $ 3,910
                                                               =======  =======
</TABLE>
 
  Accumulated amortization of leased property is approximately $764,000 and
$760,000 at December 31, 1997 and 1996 respectively.
 
NOTE D--INTANGIBLE ASSETS
 
  Intangible assets as of December 31 consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                                1997     1996
                                                               -------  -------
     <S>                                                       <C>      <C>
     Contingent purchase payments............................. $ 4,579  $ 4,579
     Trademarks...............................................   2,269    2,269
     Other....................................................     198      387
     Less accumulated amortization............................  (2,334)  (2,230)
                                                               -------  -------
                                                               $ 4,712  $ 5,005
                                                               =======  =======
</TABLE>
 
                                      29
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
 
NOTE E--BANK LINES OF CREDIT
 
  The Company maintains revolving credit facilities whereby it may borrow up
to an aggregate of $35,000,000 including outstanding letters of credit and
bankers' acceptances. The weighted average interest rate provided under these
credit facilities was 8.25% and 4.53% at December 31, 1997 and 1996,
respectively. Until August of 1996, a fee of up to 1/4% of the average unused
line was paid for availability of the primary credit facility. Currently, a
fee of up to 1/8% of the average unused line is paid for availability of the
primary credit facility.
 
  The credit agreement contains certain covenants and financial ratio
requirements, including restrictions on dividend payments. At December 31,
1997, $5,628,000 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 $65,912,000 at December 31, 1997.
 
NOTE F--ACCRUED LIABILITIES
 
  Accrued liabilities as of December 31 consist of the following (in
thousands):
 
<TABLE>
<CAPTION>
                                                                   1997    1996
                                                                  ------- ------
     <S>                                                          <C>     <C>
     Income taxes................................................ $ 1,362 $1,315
     Bonuses.....................................................   2,790    680
     Advertising.................................................     866     42
     Other.......................................................   5,512  4,453
                                                                  ------- ------
                                                                  $10,530 $6,490
                                                                  ======= ======
</TABLE>
 
NOTE G--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 require the Company to redeem a
portion of principal semi-annually.
 
NOTE H--INCOME TAXES
 
  The provision for income taxes includes the following for the years ended
December 31 (in thousands):
 
<TABLE>
<CAPTION>
                                                           1997   1996     1995
                                                          ------ -------  ------
     <S>                                                  <C>    <C>      <C>
     Current
      United States
       Federal........................................... $2,366 $(1,961) $3,570
       State.............................................    243     514     677
      Foreign............................................    105     117     124
     Deferred
      United States
       Federal...........................................    273   2,864     859
       State.............................................     33     335     101
                                                          ------ -------  ------
                                                          $3,020 $ 1,869  $5,331
                                                          ====== =======  ======
</TABLE>
 
                                      30
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                        DECEMBER 31, 1997, 1996 AND 1995
 
 
NOTE H--INCOME TAXES--(CONTINUED)
 
  A reconciliation from the U.S. federal statutory income tax rate to the
effective tax rate follows for the years ended December 31:
 
<TABLE>
<CAPTION>
                               1997  1996  1995
                               ----  ----  -----
     <S>                       <C>   <C>   <C>
     U.S. Federal statutory
      rate...................  34.0% 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    --
     Subsidiary liquidation..   --    --   (36.0)
     Unremitted prior years
      earnings of foreign
      subsidiary.............   --    --    61.7
     Net results of other
      foreign subsidiaries...   1.8   7.4    7.0
     Amortization of
      intangibles............   0.9   2.5    0.9
     Other...................   1.2   1.2    2.5
                               ----  ----  -----
                               42.0% 71.9%  74.2%
                               ====  ====  =====
</TABLE>
 
  Deferred 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>
                                                                   1997   1996
                                                                  ------ ------
     <S>                                                          <C>    <C>
     Net current assets.......................................... $2,256 $2,058
     Net non-current liabilities.................................  9,770  9,266
                                                                  ------ ------
      Net liability.............................................. $7,514 $7,208
                                                                  ====== ======
</TABLE>
 
  Significant components of the Company's deferred tax assets and liabilities
are as follows as of December 31 (in thousands):
 
<TABLE>
<CAPTION>
                                                                   1997   1996
                                                                  ------ ------
     <S>                                                          <C>    <C>
     Assets
       State taxes............................................... $  322 $  261
       State tax net operating loss carry forwards...............      5    137
       Bad debts.................................................    130    121
       Inventory reserve and capitalized costs...................  1,251  1,487
       Bonuses...................................................    491    --
       Other.....................................................     96     88
                                                                  ------ ------
         Gross deferred tax assets...............................  2,295  2,094
     Liabilities
       Unremitted earnings of a foreign subsidiary...............  9,303  9,061
       Contingent purchase payments..............................    183    196
       Other.....................................................    323     45
                                                                  ------ ------
         Gross deferred tax liabilities..........................  9,809  9,302
                                                                  ------ ------
       Net deferred tax liability................................ $7,514 $7,208
                                                                  ====== ======
</TABLE>
 
                                       31
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
 
NOTE H--INCOME TAXES--(CONTINUED)
 
  The Company did not record any valuation allowances against deferred tax
assets at December 31, 1997. 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.
 
  At the end of 1995, the Company recorded deferred income taxes of $4,433,000
($.67 per share) on the previously untaxed portion of unremitted earnings of a
foreign subsidiary. This change in estimate was precipitated by the Company
changing its intention regarding unremitted earnings of the foreign
subsidiary. The Company decided to no longer indefinitely invest unremitted
earnings of this foreign subsidiary and therefore deferred taxes were
recorded. The Company changed its intention because of changes in the tax law
and the lack of foreign opportunities to invest the unremitted earnings of the
foreign subsidiary.
 
  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
December 1995, the IRS issued its report proposing additional taxes of
approximately $3,850,000 plus penalties and interest. The Company protested
the IRS proposed assessment. Also, the federal income tax returns of the
Company for the years ended 1993 and 1994 are currently under examination by
the IRS. In addition, the IRS Appeals Division returned the earlier cycle to
the Examination Division to reopen its examination of the 1991 and 1992 fiscal
years. The IRS has issued a preliminary revised examination report covering
the 1991 through 1994 fiscal years proposing additional taxes of approximately
$4,760,000 plus penalties and interest for these years combined. 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. The Company also leases its principal executive
offices under an agreement expiring in April 1998. This lease provides for two
options, each of which would extend the lease for one month and one option
which would extend the lease for three and one-half months. 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, 1997 are
as follows (in thousands):
 
<TABLE>
<CAPTION>
     YEAR ENDING
     DECEMBER 31,
     ------------
     <S>                                                                  <C>
      1998............................................................... $1,362
      1999...............................................................  1,060
      2000...............................................................  1,026
      2001...............................................................    986
      2002...............................................................    955
      Thereafter.........................................................     78
                                                                          ------
                                                                          $5,467
                                                                          ======
</TABLE>
 
                                      32
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
 
NOTE H--INCOME TAXES--(CONTINUED)
 
  Rent expense for operating leases was approximately $1,451,000, $1,615,000,
and $1,676,000 for the years ended December 31, 1997, 1996, and 1995,
respectively.
 
  The Company has outstanding letters of credit totaling approximately
$12,156,000 and $8,000,000 at December 31, 1997 and 1996 respectively. These
letters of credit, which have original terms from one to four months,
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, 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.
 
  During 1998, the Company will need approximately $3,740,000 for the
construction of its new headquarters facility.
 
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 $472,000, $17,000, and $218,000 for 1997, 1996 and 1995,
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.
 
  During 1988, the Company adopted the 1988 Stock Option Plan under which it
was authorized to issue non-qualified stock options, incentive stock options,
and warrants to key employees to purchase up to an aggregate of 157,500 shares
of Class A Common Stock.
 
  In 1990, the unused portion of the 1988 Plan was terminated and the Company
adopted the 1990 Stock Option Plan. As amended, the number of options
available for issuance under the 1990 Stock Option Plan is 825,000 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.
 
                                      33
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                        DECEMBER 31, 1997, 1996 AND 1995
 
 
NOTE K--STOCKHOLDERS' EQUITY--(CONTINUED)
 
  Combined plan transactions for 1997, 1996 and 1995 are as follows:
 
<TABLE>
<CAPTION>
                                1997              1996              1995
                          ----------------- ----------------- -----------------
                                   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,.............. 685,262   $13.51  587,662   $15.47  628,326   $15.53
Granted..................  96,150    10.56  178,800     8.80    8,700     8.50
Exercised................ (13,568)   10.65   (1,167)   10.00   (8,072)   11.24
Canceled................. (63,950)   13.50  (80,033)   17.39  (41,292)   15.79
                          -------           -------           -------
Options outstanding
 December 31,............ 703,894    13.16  685,262    13.51  587,662    15.47
                          =======           =======           =======
Options available for
 grant at December 31,...  88,955           121,155           219,922
</TABLE>
 
  Weighted average fair value of options granted during the year are as
follows:
 
<TABLE>
<CAPTION>
                                                            1997  1996   1995
                                                           ------ ----- ------
     <S>                                                   <C>    <C>   <C>
     Exercise price is below market price at date of
      grant............................................... $12.44 $8.75 $12.29
     Exercise price equals market price at date of grant..   4.86  3.14   4.96
</TABLE>
 
  The following information applies to options outstanding at December 31,
1997:
 
<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>
     $ 1.00--$ 2.51..........      44,157         7       $ 1.30      9,740    $ 2.34
     $ 8.75--$13.00..........     292,702         7         9.96    157,535      9.90
     $13.75--$19.25..........     306,735         5        16.31    257,335     16.24
     $21.25--$23.00..........      60,300         7        21.41     43,031     21.33
                                  -------                           -------
                                  703,894         6        13.16    467,641     14.29
                                  =======                           =======
</TABLE>
 
  The fair value of options at date of grant was estimated using the Black-
Scholes model with the following weighted average assumptions:
 
<TABLE>
<CAPTION>
                                                               1997  1996  1995
                                                               ----  ----  ----
     <S>                                                       <C>   <C>   <C>
     Expected life (years)....................................    7     7     7
     Risk-free interest rate.................................. 6.25% 5.50% 5.50%
     Volatility...............................................   22%   20%   20%
     Dividend yield...........................................   .7%   .7%   .7%
</TABLE>
 
                                       34
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
 
NOTE K--STOCKHOLDERS' EQUITY--(CONTINUED)
 
  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 1997, 1996 and 1995, 21,000, 14,000,and 4,000 options, respectively,
were granted at exercise prices below fair market value. This resulted in net
compensation expense of $32,000, $28,000, and $55,000 for 1997, 1996 and 1995,
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 1997, 1996 and 1995 which have been credited to additional paid-in
capital.
 
  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>
                                                              1997  1996  1995
                                                             ------ ---- ------
     <S>                                                     <C>    <C>  <C>
     Net earnings (in thousands)
      As reported........................................... $4,173 $731 $1,853
      Pro forma.............................................  4,163  742  1,906
     Basic earnings per share
      As reported........................................... $  .71 $.11 $  .28
      Pro forma.............................................    .71  .11    .29
     Diluted earnings per share
      As reported........................................... $  .70 $.11 $  .28
      Pro forma.............................................    .70  .11    .29
</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.
 
                                      35
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
NOTE L--CONCENTRATIONS OF CREDIT RISK--(CONTINUED)
 
  During the years ended December 31, 1997, 1996 and 1995, approximately 17%,
11%, and 12%, respectively, of revenues were made to one domestic customer. At
December 31, 1997 and 1996 approximately 18% and 14%, 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.
 
NOTE M--OPERATIONS BY GEOGRAPHIC AREA
 
  The Company's predominant business is the design, development and
distribution of athletic footwear. Information about the Company's domestic
and international revenues, operating income and other financial information
is presented below (in thousands):
 
<TABLE>
<CAPTION>
                                                    YEAR ENDED DECEMBER 31,
                                                   ----------------------------
                                                     1997      1996      1995
                                                   --------  --------  --------
     <S>                                           <C>       <C>       <C>
     Revenues from unrelated entities:
       United States.............................. $ 91,568  $ 76,170  $ 89,220
       International..............................   24,645    30,663    31,032
                                                   --------  --------  --------
                                                   $116,213  $106,833  $120,252
                                                   ========  ========  ========
     Inter-geographic revenues:
       United States.............................. $  2,721  $  2,102  $  4,337
       International..............................    2,937     4,573     6,240
                                                   --------  --------  --------
                                                   $  5,658  $  6,675  $ 10,577
                                                   ========  ========  ========
     Total Revenues:
       United States.............................. $ 94,289  $ 78,272  $ 93,557
       International..............................   27,582    35,236    37,272
       Less Inter-geographic revenues.............   (5,658)   (6,675)  (10,577)
                                                   --------  --------  --------
                                                   $116,213  $106,833  $120,252
                                                   ========  ========  ========
     Operating profit:
       United States.............................. $ 10,669  $  3,720  $  9,116
       International..............................    1,493     2,271     2,608
       Less corporate expenses and eliminations...   (6,792)   (4,918)   (5,329)
                                                   --------  --------  --------
                                                   $  5,370  $  1,073  $  6,395
                                                   ========  ========  ========
     Identifiable assets:
       United States.............................. $ 47,070  $ 42,068  $ 56,896
       International..............................   19,620    30,531    17,664
       Corporate assets and eliminations .........   34,996    27,676    27,818
                                                   --------  --------  --------
                                                   $101,686  $100,275  $102,378
                                                   ========  ========  ========
</TABLE>
 
                                      36
<PAGE>
 
                                 K-SWISS INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                       DECEMBER 31, 1997, 1996 AND 1995
 
 
NOTE N--QUARTERLY FINANCIAL DATA (UNAUDITED)
 
  Summarized quarterly financial data for 1997 and 1996 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>
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
  Basic earnings (loss) per share... $   .25 $  (.06) $   .30 $   .23  $    .71
  Diluted earnings (loss) per share. $   .25 $  (.06) $   .29 $   .22  $    .70
1996
  Revenues.......................... $34,365 $26,019  $28,781 $17,668  $106,833
  Gross profit......................  12,445   7,740    9,063   5,265    34,513
  Net earnings (loss)...............   2,127    (731)     281    (946)      731
  Basic earnings (loss) per share... $   .32 $  (.11) $   .04 $  (.16) $    .11
  Diluted earnings (loss) per share. $   .32 $  (.11) $   .04 $  (.16) $    .11
</TABLE>
 
 
                                      37
<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, 1998 to be filed with the Securities and Exchange Commission within 120
days after December 31, 1997 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, 1998 to
be filed with the Securities and Exchange Commission within 120 days after
December 31, 1997 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, 1998 to
be filed with the Securities and Exchange Commission within 120 days after
December 31, 1997 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, 1998 to
be filed with the Securities and Exchange Commission within 120 days after
December 31, 1997 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..............         20
Consolidated Balance Sheets as of December 31, 1997 and 1996....         21
Consolidated Statements of Earnings for the three years ended
 December 31, 1997..............................................         22
Consolidated Statement of Stockholders' Equity for the three
 years ended December 31, 1997..................................         23
Consolidated Statements of Cash Flows for the three years ended
 December 31, 1997..............................................         24
Notes to Consolidated Financial Statements......................     25--37
</TABLE>
 
  (B) REPORTS ON FORM 8-K
 
  A Form 8-K, dated October 15, 1997, was filed with the Securities and
Exchange Commission during the fourth quarter of 1997. The Form 8-K reported
the issuance of a press release on October 15, 1997, regarding the filing by
the Company of a Form S-3 Registration Statement covering shares of the
Company's Class A Common Stock held by one of its principal stockholders.
 
                                      38
<PAGE>
 
    In addition, another Form 8-K was filed on January 15, 1998. The Company
  issued a press release relating to the purchase of up to $2,832,000 of its
  Class A Common Stock on the open market through December 1998.
 
(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).
</TABLE>
 
                                       39
<PAGE>
 
<TABLE>
     <C>   <S>
     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).

     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  324 Corp. 1988 Stock Option Plan (incorporated by reference to
           exhibit 10.2 to the Registrant's Form S-1 Registration Statement No.
           33-34369).

     10.5  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).

     10.6  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).

     10.7  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).

     10.8  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).

     10.9  Distributor agreement dated June 10, 1991 by and between K-Swiss
           International Ltd. and Five Lines Corporation (incorporated by
           reference to exhibit 10.5 to the Registrant's Form 10-K Annual
           Report for the fiscal year ended December 31, 1991).

     10.10 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).

     10.11 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).

     10.12 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).

     10.13 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).

     10.14 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).

     10.15 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).
</TABLE>
 
                                       40
<PAGE>
 
<TABLE>
     <C>   <S>
     10.16 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).

     10.17 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).

     10.18 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).

     10.19 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).

     10.20 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).

     10.21 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).

     10.22 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).

     10.23 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).

     10.24 Amendment to Purchase Agreement dated December 29, 1986 by and
           between 324 Corp. (the Registrant's predecessor in interest) and The
           Biltrite Corporation (incorporated by reference to exhibit 10.33 to
           the Registrant's Form S-1 Registration Statement No. 33-62254).

     10.25 Registration Rights Agreement between the Registrant and Steven B.
           Nichols dated as of April 30, 1993 (incorporated by reference to
           exhibit 10.31 to the Registrant's Form S-1 Registration Statement
           No. 33-62254).

     10.26 Amended and Restated Registration Rights Agreement between the
           Registrant and Steven B. Nichols dated as of April 30, 1993
           (incorporated by reference to exhibit 10.32 to the Registrant's Form
           S-1 Registration Statement No. 33-62254).

     10.27 Lease dated April 25, 1990 by and between the Registrant and Premier
           Business Properties, Ltd. No. 1 (incorporated by reference to
           exhibit 10.35 to the Registrant's Form S-1 Registration Statement
           No. 33-34369).

     10.28 Amendment to Lease Agreement dated April 25, 1990 by and between the
           Registrant and Premier Business Properties, Ltd. No. 1 (incorporated
           by reference to exhibit 10 to the Registrant's Form 10-Q for the
           quarter ended September 30, 1994).
</TABLE>
 
                                       41
<PAGE>
 
<TABLE>
     <C>   <S>
     10.29 Lease Agreement dated November 30, 1992 by and between K-Swiss Inc.
           and S. Daryl Parker, d.b.a. Parker Industrial Properties
           (incorporated by reference to exhibit 10.28 to the Registrant's Form
           10-K for the fiscal year ended December 31, 1992).

     10.30 Lease Agreement dated March 25, 1993 between the Registrant and
           Woodpecker Manufacturing Company, Inc. (incorporated by reference to
           exhibit 10.34 to the Registrant's Form S-1 Registration Statement
           No. 33-62254).

     10.31 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).

     10.32 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).

     10.33 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).

     10.34 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).

     10.35 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).

     10.36 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).

     10.37 Standard Offer, Agreement and Escrow Instructions for Purchase of
           Real Estate dated September 29, 1997 by and between K-Swiss Inc.
           (the seller) and Hager Investments, Inc., or Nominee (the buyer).

     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......................  44
     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>
 
                                       42
<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 11, 1998
 
  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                   Chairman of the Board,            February 11, 1998
---------------------------           President and Chief   
Steven Nichols                        Executive Officer      
                                                             
                                                             
  
/s/ George Powlick                   Vice President Finance,           February 11, 1998
----------------------------          Chief Financial Officer, 
George Powlick                        Principal Accounting      
                                      Officer, Secretary and    
                                      Director                  
                                                                
                                                                
  
/s/ Stanley Bernstein                Director                          February 11, 1998
----------------------------
Stanley Bernstein                             
  
/s/ Lawrence Feldman                 Director                          February 11, 1998
----------------------------
Lawrence Feldman                     
  
/s/ Stephen Fine                     Director                          February 11, 1998
----------------------------
Stephen Fine                         
  
/s/ Jonathan Layne                   Director                          February 11, 1998
----------------------------
Jonathan Layne                       
  
/s/ Martyn Wilford                   Director                          February 11, 1998
----------------------------
Martyn Wilford                       
</TABLE>

                                       43
<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.  (1995) $  712   $1,504     $ --        $(1,343)      $  873
                          (1996)    873      247       --           (490)         630
                          (1997)    630      420       --           (573)         477
Allowance for
 inventories............  (1995) $  145   $3,389     $ --        $(1,735)      $1,799
                          (1996)  1,799    2,977       --         (1,896)       2,880
                          (1997)  2,880    1,769       --         (2,022)       2,627
</TABLE>
 
                                       44
<PAGE>
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
 NUMBER
 ------
 <C>    <S>                                                                 <C>
 10.37  Standard Offer, Agreement and Escrow Instructions for Purchase of
         Real Estate......................................................
 21     Subsidiaries of K-Swiss Inc.......................................
 23     Consent of Grant Thornton LLP.....................................
 27     Financial Data Schedule...........................................
</TABLE>