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

                                   FORM 10-K
(Mark One)
[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934

     For the fiscal year ended December 31, 1996
                               -----------------
                                       or

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

    For the transition period from____________________ to ______________________

Commission file Number   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,  California                    91311
-------------------------------------------------------------------------------
(Address of principal executive offices)                       (Zip Code)
 
 
Registrant's telephone number, including area code       (818) 998-3388
                                                         ---------------
 
 
Securities registered pursuant to Section 12(b) of the Act:

                                                        Name of each exchange on
      Title of each Class                                    which registered
             None                                                 None
------------------------------------                    -----------------------

          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.   [X] Yes  [ ] 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 4, 1997 based on the
closing price of the Class A Common Stock on the NASDAQ National Market System
on such date was $35,709,316.

     The number of shares of the Registrant's Class A Common Stock outstanding
at February 4, 1997 was 3,585,018 shares. The number of shares of the
Registrant's Class B Common Stock outstanding at February 4, 1997 was 2,495,572
shares.

                      DOCUMENTS INCORPORATED BY REFERENCE
     Portions of the proxy statement for the Registrant's 1997 Annual
Stockholders Meeting are incorporated by reference into Part III.
<PAGE>
 
                                  K.SWISS INC.

                      INDEX TO ANNUAL REPORT ON FORM 1O-K

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
                             _____________________
<TABLE> 
<CAPTION> 
                 Caption                                                  Page
                 -------                                                  ----
PART I
<S>                                                                     <C>
  Item  1.    Business..............................................       3
  Item  2.    Properties................................................  14
  Item  3.    Legal Proceedings.........................................  15
  Item  4.    Submission of Matters to a Vote of Security Holders.......  15
  Item  4(a). Executive Officers of the Registrant......................  16
 
PART II
 
  Item  5.    Market for Registrant's Common Equity and Related
               Stockholder Matters......................................  19
  Item  6.    Selected Financial Data...................................  20
  Item  7.    Management's Discussion and Analysis of Financial
               Condition and Results of Operations......................  21
  Item  8.    Financial Statements and Supplementary Data...............  27
  Item  9.    Changes in and Disagreements with Accountants on
               Accounting and Financial Disclosure......................  49

PART III

  Item 10.    Directors and Executive Officers of the Registrant........  49
  Item 11.    Executive Compensation....................................  49
  Item 12.    Security Ownership of Certain Beneficial Owners and
               Management...............................................  49
  Item 13.    Certain Relationships and Related Transactions............  49

PART IV

  Item 14.    Exhibits, Financial Statement Schedules, and Reports on
               Form 8-K.................................................  50

</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 and fitness activities. 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.
In January 1996, the Company acquired the rights to the Robey brand. Robey's
products are predominantly tennis related apparel distributed primarily in
Holland.

     The Company's product strategy 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 

                                       3
<PAGE>
 
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.

     Consistent with this strategy, since 1988, management has expanded the
Company's product line in a controlled manner while retaining the Company's
original commitment to quality products with classic styling. Many of these new
products incorporate technical advances to optimize the performance aspects of
the shoes.

     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, with the largest export volume
being sold to a distributor in Japan. The Company now has sales offices or
distributorships 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
distributorships 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.


                                       4
<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 1996 revenues) and
women's (approximately 34% of 1996 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,
                                     ----------------------------------------------------

                                           1996              1995               1994
                                     -------------    ---------------    ---------------
 Product Category                       $       %         $        %         $        %
                                     --------  ---    --------    ---    --------    ---
                                                 (Dollar amounts in thousands)
<S>                                  <C>       <C>    <C>         <C>    <C>         <C> 
Classic...........................   $ 50,573   48%   $ 65,745     56%   $ 77,442     51%
Tennis/Court......................     25,511   24      21,624     18      32,515     21
Children's........................     18,693   18      18,811     16      21,849     14
Other (2).........................     10,733   10      12,112     10      21,009     14
                                      -------  ---     -------    ---     -------    ---
Total.............................   $105,510  100%   $118,292    100%   $152,815    100%
                                      =======  ===     =======    ===     =======    ===
 
Domestic (3)......................   $ 75,945   72%   $ 88,929     75%   $121,501     80%
                                      =======  ===     =======    ===     =======    ===
</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.

                                       5
<PAGE>
 
     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 also markets a line of K.Swiss apparel and accessories
manufactured by third parties.  This line consists of tennis warm-ups, skirts,
shorts, and shirts; fleece tops and pants; t-shirts; caps; bags and socks.  Many
of these apparel items are designed to coordinate with the footwear line.  The
Company believes that the line's classic styling requires few seasonal changes
which reduces the risk of inventory obsolescence.  The apparel and accessories
also serve to provide additional exposure for the K.Swiss brand in the
marketplace.  The products are also used extensively in the Company's
promotional programs.

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.

                                       6
<PAGE>
 
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 1996, the Company advertised primarily in selected tennis magazines and
general interest magazines. Historically, a majority of the Company's
advertising has been directed toward the tennis market. The Company enjoys a
high brand awareness within this category.

  In 1996, the Company continued to employ promotions for tennis. As a sponsor
of several junior tennis tournaments, individual junior players, college teams
and club teaching professionals, the Company believes it has created additional
awareness among targeted consumers at a relatively low cost. During 1996, the
Company conducted, through teaching pros, 200 "Improve Your Standing" clinics in
which tennis enthusiasts participated. In addition, the Company was the Official
Footwear Company of the 1996 U.S. Open and enjoyed increased visibility in this
key event.

  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 41
independent regional sales representatives and four 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
3,300, 3,700 and 4,200 separate accounts at December 31, 1996, 1995 and 1994,
respectively. The Company's strategy is to increase its account base of upscale
retail outlets in a controlled manner.

                                       7
<PAGE>
 
  During 1996, the Foot Locker group of stores and affiliates accounted for
approximately 11% 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 9 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 computer resources 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 and Central American
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.

                                       8
<PAGE>
 
  By the end of 1996, K.Swiss was working through four international
subsidiaries and 22 distributors to market K.Swiss in potentially 60 countries.

DISTRIBUTION

  The Company maintains 250,000 square feet of warehouse space at a leased
facility in Fontana, California.  The Company owns a 56,000 square foot
warehouse in Pacoima, California which is leased to a tenant.  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-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.

DESIGN AND PRODUCT DEVELOPMENT

  The Company maintains offices in Chatsworth, California and Taiwan that
include a design staff of individuals responsible for developing new styles and
performance features. This design staff receives guidance from the Company's
management in California, who meet regularly to discuss trends in sales and
review information gathered from sales representatives, retailers and consumers.
Because the Company is strategically focused on the limited introduction of new
products with long life cycles, the Company believes that its design staff need
not be as extensive as those of its competitors.

                                       9
<PAGE>
 
MANUFACTURING

  In 1996, approximately 75% of the Company's footwear products were
manufactured in China, 23% in Indonesia, and 2% in Taiwan. In excess of 98% 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.

                                       10
<PAGE>
 
  During 1996, the Company's apparel and accessory products were manufactured in
Taiwan, Hong Kong, China, Macau, Malaysia and the United States by certain
manufacturers selected by the Company.

  The Company's operations are subject to compliance with relevant laws and
regulations enforced by the United States Customs Service and to the customary
risks of doing business abroad, including fluctuations in the value of
currencies, increases in customs duties and related fees resulting from position
changes by the United States Customs Service, import controls and trade barriers
(including the unilateral imposition of import quotas), restrictions on the
transfer of funds, work stoppages and, in certain parts of the world, political
instability causing disruption of trade. These factors have not had a material
adverse impact upon the Company's operations to date. Imports into the United
States are also affected by the cost of transportation, the imposition of import
duties, and increased competition from greater production demands abroad. The
United States or the countries in which the Company's products are manufactured
may, from time to time, impose new quotas, duties, tariffs or other
restrictions, or adjust presently prevailing quotas, duty or tariff levels,
which could affect the Company's operations and its ability to import products
at current or increased levels. The Company cannot predict 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 79% of the Company's revenues are derived from sales of
leather footwear and approximately 12% 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.

                                       11
<PAGE>
 
  In 1995, following negotiations with the United States Trade Representative
("USTR"), the Chinese government agreed to take specific enforcement measures
against the piracy of computer software and compact discs and to make other
long-standing changes to ensure the effective protection of intellectual
property rights pursuant to a previous memorandum of understanding executed with
the U.S. government.  Subsequently, in early 1996, USTR threatened trade
sanctions against China for its alleged failure to live up to its enforcement
commitments.  This trade dispute was resolved in June of 1996 when USTR
announced that, based on the enforcement measures the Chinese government had
taken and would take in the future, it was satisfied that China was complying
with its obligations and the threat of trade sanctions was withdrawn.  USTR
continues to monitor the Chinese government's implementation of its intellectual
property enforcement obligations, however, and the failure to meet those
obligations in the future could result in trade sanctions, including 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 quotes, 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, 1996 and 1995, domestic footwear futures orders with start
ship dates from January through June 1997 and 1996 were approximately
$29,762,000 and $27,651,000, respectively.  At 

                                       12
<PAGE>
 
December 31, 1996 and 1995, international footwear futures orders with start
ship dates from January through June 1997 and 1996 were approximately
$11,028,000 and $13,905,000, respectively. "Backlog", as of any date, represents
orders scheduled to be shipped within the next six months. Backlog does not
include orders scheduled to be shipped on or prior to the date of determination
of backlog.

  The mix of "futures" and "at once" orders can vary significantly from quarter
to quarter and year to year and therefore "futures" are not necessarily
indicative of revenues for subsequent periods. Orders generally may be canceled
by customers without financial penalty. The Company believes its rate of net
customer cancellations of domestic orders approximates industry averages for
similar companies. Customers may also reject nonconforming goods. To date, the
Company believes it has 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.

                                       13
<PAGE>
 
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 geographic names.
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, Sock-Lasted(TM)
construction and Silicone Formula 18(R). The Company has obtained patents in the
United States regarding the D.R. Cinch System(R), the stability design
incorporated into the Si-18(R) tennis shoe, and other features. The Company
vigorously defends its trademarks and patent rights against infringement
worldwide and employs independent security consultants to assist in such
protection. To date, the Company is not aware of any significant counterfeiting
problems regarding its products.

EMPLOYEES

  At December 31, 1996, the Company employed 132 persons in the United States,
67 persons in Taiwan, Indonesia and China, and 33 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. The effective monthly commitment for the Chatsworth
facility, calculated in accordance with generally accepted accounting
principles, is approximately $18,000.

                                       14
<PAGE>
 
  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 second
quarter of 1998 with an estimated building cost of approximately $4,900,000.

  The Company owns a 56,000 square foot facility in Pacoima, California, which
was used as the Company's principal executive offices through December 1992.
The Company is a party to an 11 year lease/option arrangement expiring in 2004
for this facility with an unrelated party.

  The Company leases a 250,000 square foot distribution facility in Fontana,
California. This lease expires in January 1998, subject to one option to extend
the lease for three years. The Company uses the Fontana facility as its main
distribution center. The effective monthly commitment for the Fontana facility,
calculated in accordance with generally accepted accounting principles, is
approximately $70,000.

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.

                                       15
<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                                 1996                  Position
   ----                                 ----                  --------
<S>                                     <C>       <C>                                      
Steven Nichols                            54        Chairman of the Board and President      
Preston Davis                             52        Vice President-Sales                     
Edward Flora                              45        Vice President-Operations                
Lewis Goldberg                            54        Senior Vice President                    
Lee Green                                 43        Corporate Counsel                        
Thomas Harrison                           54        Senior Vice President                    
Deborah Mitchell                          35        Vice President-Marketing                 
George Powlick                            52        Vice President-Finance, Chief Financial  
                                                      Officer, Secretary and Director    
Janice Smith                              35        Corporate Controller                     
Brian Sullivan                            43        Vice President-National Accounts         
Peter Worley                              36        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.

                                       16
<PAGE>
 
  Lewis Goldberg, Senior Vice President, has been with the Company since January
1987. From 1985 through 1986, Mr. Goldberg was President of Quoddy Moccasins,
then a division of Wolverine Worldwide, which manufactures and wholesales
moccasins and other leisure footwear. From 1982 through 1985, Mr. Goldberg was
Executive Vice President of Keds Corp., an importer and wholesaler of sneakers
and a division of Stride Rite Corp. From 1981 through 1982, Mr. Goldberg was
Executive Vice President of Sperry Topsider, a manufacturer and wholesaler of
boating and casual shoes and also a division of Stride Rite Corp. From 1971
through 1981, Mr. Goldberg served as President of Quoddy Moccasins, a division
of R.G. Barry Corp.

  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.

  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.

                                       17
<PAGE>
 
  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.

                                       18
<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 1996 and 1995 as
reported by NASDAQ were as follows:

<TABLE>
<CAPTION>
 
                  March 31,    June 30,   September 30,   December 31,
                  ----------   --------   -------------   ------------
  <S>               <C>          <C>        <C>             <C>     
      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
 
      1995
        Low          14 1/4     12 1/4        11 1/2           9 3/4
        High         21         15 1/4        14              13
</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, 1996 was 129. However, based on available information, the Company
believes that the total number of Class A Common stockholders, including
beneficial stockholders, is approximately 1,980.

     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, 1996 was 10.

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 1996 and 1995. 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.

                                       19
<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, 1996 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,
                             -------------------------------------------------------
 
                               1996        1995        1994        1993       1992
                             ---------   ---------   ---------   --------   --------
                                      (In thousands, except per share data)
 
<S>                          <C>         <C>         <C>         <C>        <C>
INCOME STATEMENT DATA
Revenues..................   $106,833    $120,252    $154,935    $149,562   $127,807
Cost of goods sold........     72,320      77,726      91,934      90,836     80,623
                             --------    --------    --------    --------   --------
 Gross Profit.............     34,513      42,526      63,001      58,726     47,184
Selling, general and
 administrative
 expenses.................     33,440      36,131      38,458      38,925     30,372
                             --------    --------    --------    --------   --------
 Operating profit.........      1,073       6,395      24,543      19,801     16,812
Interest (income)
 expense, net.............     (1,527)       (789)       (254)        376      2,011
                             --------    --------    --------    --------   --------
  Earnings before
   income taxes and
   extraordinary charge...      2,600       7,184      24,797      19,425     14,801
Income tax expense........      1,869       5,331       9,921       6,904      5,003
                             --------    --------    --------    --------   --------
  Earnings before
   extraordinary charge...        731       1,853      14,876      12,521      9,798
Extraordinary charge(1)...         -           -           -           -         896
                             --------    --------    --------    --------   --------
  Net earnings............   $    731    $  1,853    $ 14,876    $ 12,521   $  8,902
                             ========    ========    ========    ========   ========
EARNINGS PER SHARE
 Earnings before extra-
  ordinary charge.........   $    .11    $    .28    $   2.20    $   1.87   $   1.49
Extraordinary charge(1)            -           -           -           -         .14
                             --------    --------    --------    --------   --------
 Earnings per share.......   $    .11    $    .28    $   2.20    $   1.87   $   1.35
                             ========    ========    ========    ========   ========
Weighted average number
 of shares
 outstanding(2)...........      6,473       6,645       6,754       6,702      6,585
 
 
BALANCE SHEET DATA
(at period end)
Current assets............   $ 90,537    $ 92,786    $ 90,132    $ 75,684   $ 68,337
Current liabilities.......     11,240       9,603      12,891      15,098     23,200
Total assets..............    100,275     102,378     100,324      86,925     80,194
Total debt(3).............      1,711         920       3,402       5,426     16,893
Stockholders' equity......     79,569      84,069      82,817      68,019     53,717
--------
</TABLE>

 (1) The extraordinary charge primarily results from a prepayment penalty from
     early repayment of senior subordinated debt.
 (2) Includes common stock and common stock equivalents (options and warrants).
 (3) Includes all interest-bearing debt and capital lease obligations, but
     excludes outstanding letters of credit ($8,000,000, $7,741,000,
     $15,632,000, $20,018,000 and $14,710,000 as of December 31, 1996, 1995,
     1994, 1993 and 1992).

                                       20
<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,
                                                       --------------------------
                                                        1996      1995      1994
                                                       -------   -------   ------
<S>                                                    <C>       <C>       <C>
     Revenues.......................................    100.0%    100.0%   100.0%
     Cost of goods sold.............................     67.7      64.6     59.3
     Gross profit...................................     32.3      35.4     40.7
     Selling, general and administrative expenses        31.3      30.1     24.8
     Interest income, net...........................      1.4       0.6      0.1
     Earnings before income taxes...................      2.4       5.9     16.0
     Income tax expense.............................      1.7       4.4      6.4
     Net Earnings...................................      0.7       1.5      9.6
</TABLE>

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.

     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

                                       21
<PAGE>
 
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, 1996 domestic and international footwear futures orders
with start ship dates from January through June 1997 were approximately
$29,762,000 and $11,028,000, respectively, 7.6% higher and 20.7% lower,
respectively, than such orders were at December 31, 1995 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 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.

     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 in 1996
from $1,853,000 or $.28 per common share in 1995. Included in the international
results of operations presented in Note M to the

                                       22
<PAGE>
 
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 A11 to the Company's Consolidated Financial Statements
for the Company's policies relating to risk management of foreign currency.

1995 COMPARED TO 1994

     Revenues decreased 22.4% to $120,252,000 in 1995 from $154,935,000 in 1994.
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 21.2% to 5,341,000 pair in 1995 from 6,778,000
pair in 1994. The average wholesale price per pair decreased by 2.8% to $21.49
in 1995 from $22.12 for 1994. This decrease in the average wholesale price per
pair is primarily attributable to increases, as a percentage of revenues, in
canvas product and the children's category which carry relatively lower
wholesale prices per pair, as well as a decrease in the tennis/court category,
as a percentage of revenues which carry relatively higher wholesale prices per
pair. All major footwear categories decreased in volume as follows: Classics,
tennis/court and children's categories decreased 13%, 36%, and 13%,
respectively.

     Domestic revenues decreased 26.7% to $89,192,000 in 1995 from $121,729,000
in 1994. International product revenues decreased 6.2% in 1995 to $29,363,000
from $31,314,000 in 1994. International product revenues, as a percentage of
total revenues, increased to 24.4% in 1995 from 20.2% in 1994. Fees earned by
the Company on sales by foreign licensees and distributors decreased to
$1,697,000 for 1995 from $1,892,000 for 1994.

     Gross profit margins decreased as a percentage of revenues to 35.4% in 1995
from 40.7% in 1994. Gross profit margins decreased primarily due to recording an
estimated inventory reserve to reduce the carrying value to net realizable value
on certain styles of shoes in the Classic, outdoor and blemished categories. The
outdoor category was dropped from the Company's line in 1995. In addition, gross
profit margins decreased due to changes in the domestic/international and
product mix of sales.

                                       23
<PAGE>
 
     Selling, general and administrative expenses decreased 6.1% to $36,131,000
(30.1% of revenues) in 1995 from $38,458,000 (24.8% of revenues) in 1994. This
decrease was primarily the result of decreases in direct advertising and
promotion activities done to achieve a lower, more appropriate level of
expenditures for selling, general and administrative expenses in relation to
revenues. The Company believes the somewhat reduced level of direct advertising
and promotion will not have a material impact on future sales levels. In
addition, sample and development costs, payroll and payroll costs and bonuses
decreased. These decreases were partially offset by expenses recorded which
relate to the dissolution of the Company's Canadian subsidiary, additional bad
debt expense recorded due to the unexpected bankruptcies of two of the Company's
larger customers and an increase in warehouse storage costs due to higher
inventory levels during 1995.

     Net interest income was $789,000 (0.6% of revenues) in 1995 compared to
$254,000 (0.1% of revenues) in 1994, an increase of $535,000 or 210.6%. This
increase in net interest income was the result of higher average balances and
rates earned on commercial paper investments and lower outstanding balances owed
under the Company's revolving credit facilities.

     The Company's effective tax rate increased to 74.2% in 1995 from 40.0% in
1994. 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 laws and the lack of foreign
opportunities to invest the unremitted earnings of the foreign subsidiary.

     Net earnings decreased 87.5% to $1,853,000 or $.28 per common share in 1995
from $14,876,000 or $2.20 per common share in 1994. Included in the
international results of operations presented in Note M to the Company's
Consolidated Financial Statements were net losses of $1,885,000 and $479,000
incurred by the Company's Canadian and European operations, respectively.

LIQUIDITY AND CAPITAL RESOURCES

     The Company experienced a net cash inflow of approximately $9,183,000,
$18,995,000, and $3,696,000 from its operating activities during 1996, 1995 and
1994, respectively. 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. Cash provided by operations in
1995 increased from 1994, due to a decrease in inventories, accounts receivable
and prepaid expenses and other assets, partially offset by a decrease in net
earnings.

                                       24
<PAGE>
 
     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. The Company had a net inflow of cash from
its investing activities during 1995 principally from the maturity of investment
securities partially offset by capital expenditures.

     In 1996, the net cash provided by operating activities was used for the
purchase of treasury stock and to pay cash dividends. In 1995, the net cash
provided by operating activities was used to repay outstanding borrowings under
the Company's lines of credit facilities 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, additional funds may be required by operating
activities. Finally, at December 31, 1996, approximately $23,046,000 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 $9,061,000 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 1997 and 1998, the Company will
need approximately $4,900,000 for the construction of its new headquarters
facility. See "Item 2. Properties". No other material capital commitments exist
at December 31, 1996. 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 1997.

     In November 1996, the Company extended its share repurchase program from
December 1996 to December 1997. Under this program the Company may purchase,
from time to time as market conditions warrant, up to $10,000,000 of its Class A
Common Stock on the open market. At that time, the authorization was increased
by approximately $5,200,000 from $4,800,000 (the remaining amount of the
previous $10,000,000 authorization) to $10,000,000. 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 of 502,000 shares at an aggregate cost
totaling approximately $5,221,000.

     In August 1996, the Company amended an agreement with a bank whereby the
Company may borrow, in the form of a secured revolving credit facility, up to
$30,000,000. The unused portion of this credit facility, which includes letters
of credit and bankers acceptances, was $23,387,000 at December 31, 1996. This
facility currently expires in July 1998. Substantially all of the Company's
assets (other than real estate) are pledged as security for this facility.

                                       25
<PAGE>
 
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 $2,405,000 at December 31, 1996.
These facilities are made available until terminated by either party.

     Total debt increased 86.0% to $1,711,000 at December 31, 1996 from $920,000
at December 31, 1995 (excluding outstanding letters of credit of $8,000,000 and
$7,741,000 at December 31, 1996 and 1995, respectively). The increase was
primarily due to borrowings under bank lines of credit under the Company's
credit facility.

     The Company's working capital decreased $3,886,000 to $79,297,000 at
December 31, 1996 from $83,183,000 at December 31, 1995.

     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 Fontana, California distribution center to meet at-
once orders. Notwithstanding the above, inventory levels at December 31, 1996
were higher than the Company desires because the Company purchased product to
keep outside factories at level production loads and because the Company
purchased significant amounts of nautical products in response to the nautical
production sourcing difficulties experienced earlier in 1994. The Company is
continuing to explore various ways in which it can reduce its inventory levels
relative to sales.

     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

                                       26
<PAGE>
 
Financial Statements. In December 1995, the IRS issued its report proposing
additional taxes of approximately $3,850,000 plus penalties and interest. The
Company is appealing the IRS assessment. Also, the federal income tax returns of
the Company for the years ended 1993 and 1994 are currently in preliminary
stages of examination by the IRS. 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 the proposed assessments for tax years 1990,
1991 and 1992 as well as any reasonably foreseeable assessments for tax years
1993 and 1994 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.

                                       27
<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, 1996 and 1995, and the related consolidated statements of earnings,
stockholders' equity, and cash flows for each of the three years in the period
ended December 31, 1996. 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, 1996 and 1995, and the consolidated results of its operations
and its consolidated cash flows for each of the three years in the period ended
December 31, 1996, 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, 1996. 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, 1997

                                       28
<PAGE>
 
                                  K.SWISS INC.
                          CONSOLIDATED BALANCE SHEETS
                                  December 31,
                         (Dollar amounts in thousands)

                                     ASSETS
<TABLE>
<CAPTION>
                                                                1996        1995
                                                              --------    --------
CURRENT ASSETS
<S>                                                          <C>         <C>
   Cash and cash equivalents (Note A4)....................   $ 34,314    $ 31,431
   Accounts receivable, less allowance for doubtful
    accounts of $630 and $873 for 1996 and 1995,
    respectively (Notes E and L)..........................      14,702     14,764
   Inventories (Notes A5 and E)...........................      23,789     41,203
   Prepaid expenses and other (Note B)....................      15,674      1,197
   Deferred taxes (Notes A8 and H)........................       2,058      4,191
                                                              --------   --------
         Total current assets.............................      90,537     92,786
PROPERTY, PLANT AND EQUIPMENT, net (Notes A6, C and E)....       3,910      3,570
OTHER ASSETS
   Intangible assets (Notes A7, D and E)..................       5,005      5,096
   Other..................................................         823        926
                                                              --------   --------
                                                                 5,828      6,022
                                                              --------   --------
                                                              $100,275   $102,378
                                                              ========   ========
</TABLE>
                      LIABILITIES AND STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
 
CURRENT LIABILITIES
<S>                                                          <C>         <C>
   Bank lines of credit (Note E)..........................   $  1,209    $    371
   Current maturities of capital lease obligations
    and subordinated debentures (Note G)..................        302          43
   Trade accounts payable.................................      3,239       4,529
   Accrued liabilities (Note F)...........................      6,490       4,660
                                                             --------    --------
         Total current liabilities........................     11,240       9,603
CAPITAL LEASE OBLIGATIONS.................................          -           6
SUBORDINATED DEBENTURES (Note G)..........................        200         500
DEFERRED TAXES (Notes A8 and H)...........................      9,266       8,200
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; 4,087,018 shares issued, 3,585,018 shares
     outstanding and 502,000 shares held in treasury at
     December 31, 1996 and 4,085,851 shares issued and
     outstanding at December 31, 1995.....................         41          41
    Class B-authorized 10,000,000 shares of $.01 par
     value; issued and outstanding 2,495,572 shares at
     December 31, 1996 and 1995, respectively.............         25          25
   Additional paid-in capital.............................     25,100      25,088
   Treasury Stock.........................................     (5,221)          -
   Retained earnings (Note E).............................     59,675      59,460
   Foreign currency translation (Note A9).................        (51)       (545)
                                                             --------    --------
                                                               79,569      84,069
                                                             --------    --------
                                                             $100,275    $102,378
                                                             ========    ========
</TABLE>

        The accompanying notes are an integral part of these statements.

                                       29
<PAGE>
 
                                  K.SWISS INC.
                      CONSOLIDATED STATEMENTS OF EARNINGS
                            Year Ended December 31,
            (Dollar amounts in thousands, except per share amounts)
<TABLE>
<CAPTION>
                                           1996       1995       1994
                                         --------   --------   --------
<S>                                      <C>        <C>        <C>
Revenues (Notes A12, L and M).........   $106,833   $120,252   $154,935
Cost of goods sold....................     72,320     77,726     91,934
                                         --------   --------   --------
   Gross profit.......................     34,513     42,526     63,001
Selling, general and administrative
 expenses (Note A13)..................     33,440     36,131     38,458
                                         --------   --------   --------
   Operating profit...................      1,073      6,395     24,543
Interest income, net..................      1,527        789        254
                                         --------   --------   --------
   Earnings before income taxes.......      2,600      7,184     24,797
Income tax expense (Notes A8 and H)...      1,869      5,331      9,921
                                         --------   --------   --------
   NET EARNINGS.......................   $    731   $  1,853   $ 14,876
                                         ========   ========   ========
 
 
Earnings per share (Note A14).........       $.11       $.28      $2.20
                                         ========   ========   ========
</TABLE>

        The accompanying notes are an integral part of these statements.

                                       30
<PAGE>
 
                                  K.SWISS INC.
                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                        Three years ended December 31, 1996
                         (Dollar amounts in thousands)
<TABLE>
<CAPTION>
 
                                              Common Stock                                                  Treasury Stock         
                               ---------------------------------------------------                     ------------------------
                                       Class A                     Class B              Additional              Class A             
                               -----------------------     -----------------------        paid-in      ------------------------
                                Shares         Amount       Shares         Amount         capital       Shares          Amount   
                               --------       --------     --------       --------      ----------     --------        --------   
<S>                             <C>          <C>          <C>            <C>            <C>          <C>             <C> 
Balance at January 1,
 1994........................    3,987,295       $40       2,568,773          $26         $24,732            -          $     - 
                                                                                                                   
Conversion of shares                                                                                               
 (Note K)....................       53,201         1         (53,201)          (1)              -            -                -
                                                                                                                   
Proceeds from exercise                                                                                             
 of options (Note K).........       17,283         -               -            -             160            -                - 
                                                                                                                                
Income tax benefit of                                                                                                           
 options exercised                                                                                                               
 (Note K)....................            -         -               -            -              93            -                -
                                                                                                             
Dividends paid ($.08                                                                                         
 per share) (Note E).........            -         -               -            -               -            -                -
                                                                                                               
Net earnings for the                                                                                           
 year........................            -         -               -            -               -            -                - 
                                                                                                                               
Foreign currency                                                                                                               
 translation (Note A9).......            -         -               -            -               -            -                - 
                                  ---------      ---       ---------          ---         -------      -------          -------    
                                                                                                                         
Balance at December 31,                                                                                                  
 1994.......................      4,057,779       41       2,515,572           25          24,985            -                -
                                                                                                                              
Conversion of shares                                                                                                          
 (Note K)....................        20,000        -         (20,000)           -               -            -                -
                                                                                                                              
Proceeds from exercise                                                                                                        
 of options (Note K).........         8,072        -               -            -              90            -                -
                                                                                                             
Income tax benefit of                                                                                        
 options exercised                                                                                            
 (Note K)....................             -        -               -            -              13            -                -
                                                                                                             
Dividends paid ($.08                                                                                         
 per share) (Note E).........             -        -               -            -               -            -                -
                                                                                                             
Net earnings for the                                                                                         
 year........................             -        -               -            -               -            -                -
                                                                                                             
Foreign currency                                                                                             
 translation (Note A9).......             -        -               -            -               -            -                -
                                  ---------      ---       ---------          ---         -------      -------          -------    
Balance at December 31,                                                                                      
 1995........................     4,085,851       41       2,495,572           25          25,088            -                -
Proceeds from exercise                                                                                       
 of options (Note K).........         1,167        -               -            -              12            -                -
Purchase of treasury                                                                                         
 stock.......................             -        -               -            -               -      502,000           (5,221)   
                                                                                                             
Dividends paid ($.08                                                                                         
 per share) (Note E).........             -        -               -            -               -            -                -
                                                                                                             
Net earnings for the                                                                                         
 year........................             -        -               -            -               -            -                -
                                                                                                             
Foreign currency                                                                                             
 translation (Note A9).......             -        -               -            -               -            -                -
                                  ---------      ---       ---------          ---         -------      -------          -------    
Balance at December 31,                                                                                            
 1996.........................    4,087,018      $41       2,495,572          $25         $25,100      502,000          $(5,221)
                                  =========      ===       =========          ===         =======      =======          ======= 
</TABLE>  
<TABLE> 
<CAPTION> 
                                                  Foreign 
                                  Retained        currency 
                                  Earnings       translation        Total
                                  --------       -----------        -----
<S>                              <C>            <C>               <C> 
Balance at January 1, 
 1994........................      $43,781          $(560)          $68,019
                                 
Conversion of shares             
(Note K).....................            -              -                 -
                                 
Proceeds from exercise           
of options (Note K)..........            -              -               160
                                 
Income tax benefit of            
options exercised                
(Note K).....................            -              -                93
                                 
Dividends paid ($.08             
per share) (Note E)..........         (524)             -              (524) 
                                 
Net earnings for the             
year.........................       14,876              -            14,876
                                 
Foreign currency                 
translation (Note A9)........            -             193              193  
                                   -------           -----          -------                       
Balance at December 31,          
1994.........................       58,133            (367)          82,817
                                 
Conversion of shares             
  (Note K)...................            -               -                -
                                 
Proceeds from exercise           
of options (Note K)..........            -               -               90
                                 
Income tax benefit of            
options exercised                
(Note K).....................            -               -               13
                                 
Dividends paid ($.08             
per share) (Note E)..........         (526)              -             (526)
                                 
Net earnings for the             
year.........................        1,853               -            1,853 
                                 
Foreign currency                 
 translation (Note A9).......            -            (178)            (178)                 
                                   -------           -----          -------                       
                                 
Balance at December 31,          
 1995........................       59,460            (545)          84,069
   
Proceeds from exercise           
 of options (Note K).........            -               -               12
                                 
Purchase of treasury             
 stock.......................            -               -           (5,221)
                                 
Dividends paid ($.08             
 per share) (Note E).........         (516)              -             (516)   
                                                                           
Net earnings for the                                                       
 year........................          731               -              731      
                                                                           
Foreign currency                                                           
 translation (Note A9).......            -             494              494     
                                   -------           -----          -------                        
                                                                           
Balance at December 31,                                                    
  1996.......................      $59,675           $ (51)         $79,569    
                                   =======           =====          =======  
</TABLE>

The accompanying notes are an integral part of this statement.

                                       31
<PAGE>
 
                                 K.SWISS INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                            Year ended December 31,
                         (Dollar amounts in thousands)
<TABLE>
<CAPTION>
 
                                                            1996        1995       1994
                                                          ---------   --------   --------
<S>                                                       <C>         <C>       <C>
Cash flows from operating activities:
      Net earnings.....................................   $    731    $ 1,853   $ 14,876
      Adjustments to reconcile net earnings to
      net cash provided by operating activities:
             Depreciation and amortization.............      1,197      1,181      1,226
             Loss (gain) on disposal of equipment
             and goodwill..............................          -        152       (114)
             Deferred income taxes.....................      3,199        960      1,062
             Decrease in accounts receivable...........         64      9,628        769
             Decrease (increase)in inventories.........     17,399      4,823    (12,194)
             (Increase) decrease in prepaid expenses
             and other assets..........................    (14,373)     1,354     (1,702)
             Increase (decrease) in accounts payable
             and accrued liabilities...................        556       (956)      (227)
             Foreign currency translation write off
                for K-Swiss Canada.....................        410          -          -
                                                          --------    -------   --------
       Net cash provided by operating activities             9,183     18,995      3,696
 
Cash flows from investing activities:
      Cash paid for acquisition of certain assets
      and rights of Robey Sportswear...................       (435)         -          -
      Purchase of investment securities................                     -     (5,102)
      Proceeds from maturity of investment
      securities.......................................          -      5,102          -
      Purchase of property, plant and equipment........     (1,034)      (397)      (668)
      Proceeds from disposal of property, plant
      and equipment....................................         15         18        619
                                                          --------    -------   --------
       Net cash (used in) provided by investing
             activities................................     (1,454)     4,723     (5,151)
 
Cash flows from financing activities:
      Net borrowings (repayments) under bank lines
      of credit and capital leases.....................        790     (2,479)    (2,064)
      Purchase of treasury stock.......................     (5,221)         -          -
      Payment of dividends.............................       (516)      (526)      (524)
      Proceeds from stock options exercised............         12         90        160
      Income tax benefit of options exercised..........          -         13         93
                                                          --------    -------   --------
       Net cash used in financing activities...........     (4,935)    (2,902)    (2,335)
 
Effect of exchange rate changes on cash................         89       (102)        73
                                                          --------    -------   --------
 
             Net increase (decrease)in cash
             and cash equivalents......................      2,883     20,714     (3,717)
 
Cash and cash equivalents at beginning of period            31,431     10,717     14,434
                                                          --------    -------   --------
 
Cash and cash equivalents at end of period.............   $ 34,314    $31,431   $ 10,717
                                                          ========    =======   ========
 
Supplemental disclosure of cash flow information:
      Cash paid during the year for:
             Interest..................................   $    213    $   239   $    279
             Income taxes..............................   $  1,171    $ 3,341   $ 10,010
 
</TABLE>

       The accompanying notes are an integral part of these statements.

                                       32
<PAGE>
 
                                   K.SWISS INC.
                    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                         December 31, 1996, 1995 and 1994



  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

                                       33
<PAGE>
 
                                   K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994



NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Continued)

transactions and balances have been eliminated. Certain reclassifications have
been made in the 1995 presentation to conform with the 1996 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.   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.

6.   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.

7.   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.

                                       34
<PAGE>
 
                                  K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994



NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Continued)

8.   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.

9.   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.

10.  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 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.

                                       35
<PAGE>
 
                                   K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994



NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Continued)

11.  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 Dutch
guilders) and not to engage in currency speculation. The use of derivatitive
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, 1996
and 1995, 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 Dutch
guilders) at maturity, at rates agreed to at the inception of the contracts. The
counterparty 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 counterparty fail to perform as
contracted.

     The aggregate notional principal amounts and fair values of the Company's
derivative financial instruments were $3,918,000 and $150,000 at December 31,
1996, respectively and $2,439,000 and $90,000 at December 31, 1995,
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.

                                       36
<PAGE>
 
                                   K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994



NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Continued)

12.  Recognition of Revenues
     -----------------------

     Revenues include sales and fees earned on sales by licensees and are
recognized upon shipment of goods.

13.  Advertising Costs
     -----------------

     Advertising costs are expensed as incurred and are included in selling,
general and administrative expenses. Advertising expenses amounted to
$3,073,000, $1,941,000, and $3,482,000 for 1996, 1995, and 1994, respectively.

14.  Earnings per Share
     ------------------

     Earnings per common share is computed based on the weighted average number
of common and common equivalent (stock options and warrants) shares outstanding
for the year. The weighted average number of shares outstanding for the years
ended December 31, 1996, 1995 and 1994 was approximately 6,473,000, 6,645,000,
and 6,754,000, respectively.

                                       37
<PAGE>
 
                                   K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994


NOTE B - PREPAID EXPENSES AND OTHER

     Prepaid expenses and other as of December 31 consist of the following

(in thousands):
<TABLE>
<CAPTION>
                                                                                 1996       1995
                                                                               --------   --------
<S>                                                                            <C>        <C>
      Prepayment to secure inventory purchases..............................   $11,327     $    -
      Income taxes receivable...............................................     3,682        412
      Other prepaid expenses................................................       665        785
                                                                               -------    -------
                                                                               $15,674    $ 1,197
                                                                               =======    =======
 
NOTE C - PROPERTY, PLANT AND EQUIPMENT
 
     Property, plant and equipment as of December 31 consists of the following
(in thousands):
                                                                                 1996       1995
                                                                               -------    -------
 
      Building and improvements.............................................   $ 2,071    $ 2,067
      Furniture, machinery and equipment....................................     4,085      3,910
      Leased property under capital leases..................................       766        786
                                                                               -------    -------
                                                                                 6,922      6,763
      Less accumulated depreciation and
            amortization....................................................    (4,835)    (4,325)
                                                                               -------    -------
                                                                                 2,087      2,438
      Land..................................................................     1,823      1,132
                                                                               -------    -------
                                                                               $ 3,910    $ 3,570
                                                                               =======    =======
</TABLE>
     Accumulated amortization of leased property is approximately $760,000 and
$736,000 at December 31, 1996 and 1995, respectively.


NOTE D - INTANGIBLE ASSETS

     Intangible assets as of December 31 consist of the following (in
thousands):

<TABLE>
<CAPTION>
 
                                           1996       1995
                                         --------   --------
<S>                                      <C>        <C>
 
      Contingent purchase payments....   $ 4,579    $ 4,579
      Trademarks......................     2,269      2,082
      Other...........................       387        198
      Less accumulated amortization...    (2,230)    (1,763)
                                         -------    -------
                                         $ 5,005    $ 5,096
                                         =======    =======
</TABLE> 

                                       38
<PAGE>
 
                                   K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994



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 4.53% and 7.75% at December 31, 1996 and 1995. 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, 1996,
$5,884,000 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 $69,040,000 at December 31, 1996.


NOTE F - ACCRUED LIABILITIES
 
     Accrued liabilities as of December 31 consist of the following (in
thousands):

<TABLE>
<CAPTION>
 
                         1996     1995
                        ------   ------
     <S>               <C>      <C>
 
      Income taxes...   $1,315   $  524
      Bonuses........      680      267
      Other..........    4,495    3,869
                        ------   ------
                        $6,490   $4,660
                        ======   ======
</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.

                                       39
<PAGE>
 
                                   K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994


NOTE H - INCOME TAXES

     The provision for income taxes includes the following for the years ended
December 31 (in thousands):

<TABLE>
<CAPTION>
                                            1996         1995     1994
                                            ----         ----     ----  
       <S>                               <C>           <C>      <C>
        Current
          United States
            Federal......................     $(1,961)  $3,570   $7,351
            State........................         514      677    1,438
          Foreign........................         117      124       70
        Deferred
          United States
            Federal......................       2,864      859      958
            State........................         335      101      104
                                               ------   ------   ------
                                               $1,869   $5,331   $9,921
                                               ======   ======   ======
</TABLE>

     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>
 
                                               1996     1995    1994
                                               -----   ------   -----
         <S>                                   <C>     <C>      <C>
 
          U.S. Federal statutory rate.......   34.0%    34.0%   35.0%
          State income taxes................    4.1      4.1     3.8
          State income tax audit............   18.3        -       -
          California net operating loss
           carryforward limitation..........    4.4        -       -
          Subsidiary liquidation............      -    (36.0)      -
          Unremitted prior years earnings
           of foreign subsidiary............      -     61.7       -
          Net results of other foreign
           subsidiaries.....................    7.4      7.0     0.4
          Amortization of intangibles.......    2.5      0.9     0.3
          Other.............................    1.2      2.5     0.5
                                               ----    -----    ----
                                               71.9%    74.2%   40.0%
                                               ====    =====    ====
</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>
                                              1996     1995
                                             ------   ------
           <S>                              <C>      <C>
 
            Net current assets............   $2,058   $4,191
            Net non-current liabilities...    9,266    8,200
                                             ------   ------
            Net liability.................   $7,208   $4,009
                                             ======   ======
</TABLE>

                                       40
<PAGE>
 
                                   K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994



NOTE H - INCOME TAXES - (Continued)

     Significant components of the Company's deferred tax assets and liabilities
are as follows as of December 31 (in thousands):

<TABLE>
<CAPTION>
 
                                                      1996     1995
                                                      ----     ---- 
               <S>                                    <C>     <C>
                 Assets
                  State taxes.......................  $ 261   $  231
                  State tax net operating
                   loss carryforwards...............    137        -
                  Bad debts.........................    121      175
                  Inventory reserve and
                   capitalized costs................  1,487    1,224
                  Subsidiary stock deduction........      -    2,585
                  Other.............................     88        -
                                                      -----    -----
                   Gross deferred tax assets........  2,094    4,215
 
                 Liabilities
                  Unremitted earnings of a
                   foreign subsidiary...............  9,061    8,035
                  Contingent purchase payments......    196      176
                  Accelerated depreciation..........      -        -
                  Other.............................     45       13
                                                      -----    -----
                   Gross deferred tax
                    liabilities.....................  9,302    8,224
                                                      -----    -----
 
                  Net deferred tax liability........ $7,208   $4,009
                                                      =====    =====
</TABLE>

     At December 31, 1996, the Company had approximately $1,874,000 of
California net operating loss carryforwards available to offset future taxable
income. Such carryforwards reflect state income tax losses incurred which will
expire in 2001.

     The Company did not record any valuation allowances against deferred tax
assets at December 31, 1996. 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.

                                       41
<PAGE>
 
                                   K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994



NOTE H - INCOME TAXES - (Continued)

     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 is appealing
the IRS assessment. Also, the federal income tax returns of the Company for the
years ended 1993 and 1994 are currently in preliminary stages of examination by
the IRS. 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 the proposed assessments for tax years 1990, 1991 and 1992 as well
as any reasonably foreseeable assessments for tax years 1993 and 1994 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 1998,
under an agreement which provides for an option to 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 by one month. 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, 1996 are as follows (in
thousands):

<TABLE> 
<CAPTION> 

       Year ending
       December 31,
       ------------
         <S>                                        <C> 
          1997...................................... $1,483
          1998......................................    302
          1999......................................     89
          2000......................................     54
          2001......................................      2
                                                      -----
                                                     $1,930
                                                      =====
</TABLE> 

     Rent expense for operating leases was approximately $1,615,000, $1,676,000,
and $1,281,000 for the years ended December 31, 1996, 1995, and 1994,
respectively.

                                       42
<PAGE>
 
                                   K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994


NOTE I - COMMITMENTS AND CONTINGENCIES - (Continued)

     The Company has outstanding letters of credit totaling approximately
$8,000,000 and $7,741,000 at December 31, 1996 and 1995 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, 1996 and
1995.

     The Company is, from time to time, a party to litigation which arises in
the normal course of its business operations. The Company does not believe it is
presently a party to litigation which will have a material adverse effect on its
business or operations.

NOTE J - EMPLOYEE BENEFIT PLANS

     In 1988, the Company adopted a discretionary contribution profit sharing
plan covering all employees meeting certain eligibility requirements. In 1993,
the plan was amended to include a 401(k) plan. The expense for this plan was
approximately $17,000, $218,000 and $411,000 for 1996, 1995 and 1994,
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.

                                       43
<PAGE>
 
                                   K.SWISS INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                         December 31, 1996, 1995 and 1994


NOTE K - STOCKHOLDERS' EQUITY - (Continued)

     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.

Combined plan transactions for 1996, 1995 and 1994 are as follows:

<TABLE>
<CAPTION>
 
                           1996                        1995                        1994         
                  ----------------------       ---------------------       ---------------------       
                                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,... 587,662         $15.47      628,326         $15.53      565,545         $14.61       
   Granted....... 178,800           8.80        8,700           8.50      125,750          18.17       
   Exercised.....  (1,167)         10.00       (8,072)         11.24      (17,283)          9.29       
   Canceled...... (80,033)         17.39      (41,292)         15.79      (45,686)         13.77       
                  -------                     -------                     -------                      
   Options                                                                                             
    outstanding                                                                                        
    December 31,. 685,262          13.51      587,662          15.47      628,326          15.53        
                  =======                     =======                     =======                   
                                                                                                    
   Options                                                                                          
    available for                                                                                   
    grant at                                                                                        
    December 31,. 121,155                     219,922                      37,470                    
</TABLE>

 Weighted average fair value of options granted during the year are as follows:
<TABLE> 
<CAPTION> 
                                     1996            1995      
                                    ------          ------      
<S>                               <C>             <C>       
  Exercise price                                            
   is below market                                          
   price at date                                            
   of grant.......                  $ 8.75          $12.29  
                                                            
  Exercise price                                            
   equals market                                            
   price at date                                            
   of grant.......                    3.14            4.96   

</TABLE> 
                                       44

<PAGE>
 
                                  K.SWISS INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                        December 31, 1996, 1995 and 1994


NOTE K - STOCKHOLDERS' EQUITY - (Continued)

The following information applies to options outstanding at December 31, 1996:

<TABLE>
<CAPTION>
 
                                Options Outstanding             Options Exercisable
                        ------------------------------------   ----------------------
                                      Weighted
                                       average      Weighted                 Weighted
                                      remaining     average                  average
                         Number      contractual    exercise     Number      exercise
                        outstanding  life (years)    price     exercisable    price
                        -------------------------   --------   -----------   --------
<S>                     <C>           <C>             <C>        <C>           <C>
 
  Range of
   exercise prices
 
  $ 1.00 - $ 2.51          35,391           7       $ 1.38         9,266     $ 2.45
  $ 8.75 - $12.50         282,536           8         9.88       117,278      10.49
  $13.50 - $19.25         287,835           5        16.33       245,670      16.18
  $21.25 - $23.00          79,500           8        21.63        41,000      21.25 
                          -------                                -------
 
                          685,262                    13.51       413,214      14.76
                          =======                                =======
</TABLE>

     The fair value of options at date of grant was estimated using the Black-
Scholes model with the following weighted average assumptions for 1996 and 1995:

<TABLE> 
  <S>                               <C> 
   Expected life (years).........     7
   Risk-free interest rate.......   5.5%
   Volatility....................    20%
   Dividend yield................    .7%
</TABLE> 

     Statement of Financial Accounting Standards No. 123, "Accounting for Stock-
Based Compensation", encourages, but does not require companies to record
compensation cost for stock-based employee compensation plans at fair value. The
Company has chosen to continue to account for stock-based compensation using the
intrinsic value method prescribed in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees", and related interpretations.
Accordingly, compensation cost for stock options is measured as the excess, if
any, of the quoted market price of the Company's stock at the date of grant over
the amount an employee must pay to acquire the stock.

     During 1996, 1995 and 1994, 14,000, 4,000, and 21,300 options,
respectively, were granted at exercise prices below fair market value. This
resulted in net compensation expense of $28,000, $55,000, and $37,000 for 1996,
1995 and 1994, 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.

                                       45
<PAGE>
 
                                  K.SWISS INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                        December 31, 1996, 1995 and 1994



NOTE K - STOCKHOLDERS' EQUITY - (Continued)

     In connection with the exercise of options, the Company realized income tax
benefits in 1996, 1995 and 1994 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>
 
                                     1996     1995
                                     -----   -------
<S>                                  <C>     <C>
    Net earnings (in thousands)
      As reported.................   $ 731    $1,853
      Pro forma...................     742     1,906
 
    Primary earnings per share
      As reported.................   $ .11    $  .28
      Pro forma...................     .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.

     During the years ended December 31, 1996, 1995 and 1994, approximately 11%,
12%, and 16%, respectively, of revenues were made to one domestic customer. At
December 31, 1996 and 1995 approximately 14% and 8%, 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.

                                       46
<PAGE>
 
                                  K.SWISS INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                        December 31, 1996, 1995 and 1994


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,
                                               --------------------------------
                                                 1996        1995        1994
                                               --------    --------    --------
<S>                                            <C>         <C>         <C>
       Revenues from unrelated entities:
        United States.......................   $ 76,170    $ 89,220    $122,027
        International.......................     30,663      31,032      32,908
                                                -------     -------     -------
                                               $106,833    $120,252    $154,935
                                                =======     =======     =======
       Inter-geographic revenues:
        United States.......................   $  2,102    $  4,337    $  3,995
        International.......................      4,573       6,240       4,975
                                                -------     -------     -------
                                               $  6,675    $ 10,577    $  8,970
                                                =======     =======     =======
       Total Revenues:
        United States.......................   $ 78,272    $ 93,557    $126,022
        International.......................     35,236      37,272      37,883
        Less Inter-geographic revenues......     (6,675)    (10,577)     (8,970)
                                                -------     -------     -------
                                               $106,833    $120,252    $154,935
                                                =======     =======     =======
       Operating profit:
        United States.......................   $  3,720    $  9,116    $ 25,297
        International.......................      2,271       2,608       5,213
        Less corporate expenses and
         eliminations.......................     (4,918)     (5,329)     (5,967)
                                                -------     -------     -------
                                               $  1,073    $  6,395    $ 24,543
                                                =======     =======     =======
       Identifiable assets:
        United States.......................   $ 42,068    $ 56,896    $ 64,422
        International.......................     30,531      17,664      25,868
        Corporate assets and eliminations        27,676      27,818      10,034
                                                -------     -------     -------
                                               $100,275    $102,378    $100,324
                                                =======     =======     =======
</TABLE>


NOTE N - QUARTERLY FINANCIAL DATA (Unaudited)

     Summarized quarterly financial data for 1996 and 1995 follows (in thousands
except for per share amounts):

<TABLE>
<CAPTION>
 
                                    First         Second         Third        Fourth              
                                   Quarter        Quarter       Quarter       Quarter        Year                                 
----------------------------------------------------------------------------------------------------
1996
<S>                                <C>           <C>           <C>           <C>          <C>         
 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   
 Earnings (loss) per share......   $   .32        $  (.11)      $   .04       $  (.16)     $    .11    
 
1995
 Revenues.......................   $42,761        $29,731       $29,361       $18,399      $120,252
 Gross profit...................    17,024         11,517         9,834         4,151        42,526
 Net earnings (loss)............     4,031          1,503         1,016        (4,697)        1,853
 Earnings (loss) per share......   $   .60        $   .23       $   .15       $  (.71)     $    .28
</TABLE>

                                       47
<PAGE>
 
                                  K.SWISS INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
                        December 31, 1996, 1995 and 1994


NOTE N - QUARTERLY FINANCIAL DATA (Unaudited) - (Continued)

     In the fourth quarter of 1995, the Company recorded $4,433,000 of income
taxes on previously unremitted earnings of a foreign subsidiary (see Note H). In
addition, to reduce the carrying value to net realizable value on certain styles
of shoes, the Company recorded in the fourth quarter an estimated inventory
reserve of $1,096,000, net of income taxes. Finally, the Company provided for
estimated costs relating to the liquidation of its Canadian subsidiary of
$824,000, net of income taxes. These charges were partially offset by the tax
benefit of $2,585,000 from the liquidation of the Canadian subsidiary.

                                       48
<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 22,
1997 to be filed with the Securities and Exchange Commission within 120 days
after December 31, 1996 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 22, 1997 to
be filed with the Securities and Exchange Commission within 120 days after
December 31, 1996 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 22, 1997 to
be filed with the Securities and Exchange Commission within 120 days after
December 31, 1996 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 22, 1997 to
be filed with the Securities and Exchange Commission within 120 days after
December 31, 1996 and is incorporated herein by reference.

                                       49
<PAGE>
 
                                    PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

<TABLE> 
<CAPTION> 
                                                             Page Reference
                                                               Form 10-K   
                                                             -------------- 
<S>                                                                 <C> 
(a)       FINANCIAL STATEMENTS:
          Report of Independent Certified Public Accountants....     28
          Consolidated Balance Sheets as of December 31, 1996
            and 1995............................................     29
          Consolidated Statements of Earnings for the three
            years ended December 31, 1996.......................     30
          Consolidated Statement of Stockholders' Equity for
            the three years ended December 31, 1996.............     31
          Consolidated Statements of Cash Flows for the three
            years ended December 31, 1996.......................     32
          Notes to Consolidated Financial Statements............   33 - 48
</TABLE> 

(b)      REPORTS ON FORM 8-K

         A Form 8-K, dated November 8, 1996, was filed with the Securities and
         Exchange Commission during the fourth quarter of 1996. The Form 8-K
         reported the issuance of a press release on November 8, 1996, relating
         to the announcement of the extension by the Company of its share
         repurchase program whereby the Company may purchase up to $10,000,000
         of its Class A Common Stock on the open market through December 1997.
         The program was extended from December 1996 to December 1997 and was
         increased by approximately $5,200,000 from $4,800,000 (the remaining
         amount of the previous $10,000,000 authorization) to $10,000,000. A
         copy of the November 8, 1996 press release was attached as exhibit 99
         to the report.

(c)      EXHIBITS

         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).

                                       50
<PAGE>
 
         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).

                                       51
<PAGE>
 
         10.1  K.Swiss Inc. 1990 Stock Incentive Plan (incorporated by reference
               to exhibit 10.1 to the Registrant's Form S-1 Registration
               Statement No. 33-34369).

         10.2  Amendment to K.Swiss Inc. 1990 Stock Incentive Plan (incorporated
               by reference to exhibit 10.36 to the Registrant's Form 10-K for
               the fiscal year ended December 31, 1993).

         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).

                                       52
<PAGE>
 
         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).

         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).

                                       53
<PAGE>
 
         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).

                                       54
<PAGE>
 
         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).

         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 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).

         10.32 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).

         10.33 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).

         10.34 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).

                                       55
<PAGE>
 
         11    Statement re: Computation of Earnings Per Share.

         21    Subsidiaries of K.Swiss Inc.
 
         23    Consent of Grant Thornton LLP.

         27    Financial Data Schedule
 


   (d)   SCHEDULES
                                                                      Page
                                                                      ----


        Financial Statement Schedules:
          Schedule II - Valuation and Qualifying Accounts.............  58


         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.

                                       56
<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.


                              By /s/ George Powlick
                                -------------------------------------
                                  George Powlick, Vice-President and
                                  Chief Financial Officer

                              February 12, 1997

     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>                         
                                                                                                 
                                     Chairman of the Board,                                      
   /s/ Steven Nichols                President and Chief             February 12, 1997           
---------------------------          Executive Officer                                           
       Steven Nichols                                                                            
                                                                                                 
                                                                                                 
                                     Vice President Finance,                                     
                                     Chief Financial Officer,                                    
   /s/ George Powlick                Principal Accounting                                        
---------------------------          Officer, Secretary and          February 12, 1997           
       George Powlick                Director                                                    
                                                                                                 
                                                                                                 
   /s/ Stanley Bernstein             Director                        February 12, 1997            
---------------------------                                                                      
      Stanley Bernstein                                                                          
                                                                                                 
                                                                                                 
                                                                                                 
   /s/ Lawrence Feldman              Director                        February 12, 1997            
---------------------------                                                                    
      Lawrence Feldman                                                                           
                                                                                                 
                                                                                                 
                                                                                                 
   /s/ Stephen Fine                  Director                        February 12, 1997   
---------------------------
      Stephen Fine                                                                               
                                                                                                 
                                                                                                 
                                                                                                 
   /s/ Jonathan Layne                Director                        February 12, 1997   
---------------------------
      Jonathan Layne                                                                             
                                                                                                 
                                                                                                 
                                                                                                 
   /s/ Martyn Wilford                Director                        February 12, 1997    
----------------------------
      Martyn Wilford


</TABLE> 
                                       57
<PAGE>
 
                                  SCHEDULE II
                       VALUATION AND QUALIFYING ACCOUNTS
                             (Amounts in thousands)
<TABLE>
<CAPTION>
 
          Column A                     Column B                     Column C                  Column D                Column E
   ----------------------       --------------------      --------------------------    --------------------     ------------------
                                                                  Additions
                                                          --------------------------
                                                          Charged to      Charged to                                 Balance at
                                Balance at Beginning       Costs and        Other          Write-offs and                End
         Description                 of Period              Expenses       Accounts        Deductions, Net            of Period
   ----------------------       --------------------      --------------------------    --------------------     ------------------
<S>                               <C>      <C>             <C>             <C>            <C>                      <C> 
  Allowance for bad debts....      (1994)    $1,153         $  632         $ -                $(1,073)                  $  712
                                   (1995)       712          1,504           -                 (1,343)                     873
                                   (1996)       873            247           -                   (490)                     630

  Allowance for inventories..      (1994)       241              -           -                    (96)                     145
                                   (1995)       145          3,389           -                 (1,735)                   1,799
                                   (1996)     1,799          2,977           -                 (1,896)                   2,880
</TABLE> 

                                       58
<PAGE>
 
                                 EXHIBIT INDEX
<TABLE>
<CAPTION>

   Number                                                  Page
   ------                                                  ----
<S>         <C>                                          <C>
 11         Statement re: Computation of Earnings Per       60
            Share.
 
 21         Subsidiaries of K.Swiss Inc.                    61
 
 23         Consent of Grant Thornton LLP.                  62
 
 27         Financial Data Schedule                         63
</TABLE>