<PAGE>   1
                       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, 1997

                                       OR

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

             FOR THE TRANSITION PERIOD FROM                 TO

                         COMMISSION FILE NUMBER 0-18813

                                    THQ INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
                              --------------------

             DELAWARE                                          13-3541686
  (STATE OR OTHER JURISDICTION OF                           (I.R.S. EMPLOYER
   INCORPORATION OR ORGANIZATION)                          IDENTIFICATION NO.)

    5016 NORTH PARKWAY CALABASAS
            CALABASAS, CA                                        91302
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                       (ZIP CODE)

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (818) 591-1310
                              --------------------

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

                                      None

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

                          Common Stock, $.01 par value

      Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes X  No___

      Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (Section 229.405 of this chapter) 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.  Yes X

      As of March 20, 1998, approximately 6,888,560 shares of Common Stock of
the Registrant were outstanding and the aggregate market value of voting Common
Stock held by non-affiliates was approximately $144,187,000.

                       DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the THQ Inc. 1998 Notice of Annual Meeting of Stockholders and
Proxy Statement, to be filed with the Securities and Exchange Commission within
120 days after the close of the Registrant's fiscal year (incorporated into Part
III).
<PAGE>   2
                                    THQ INC.
                       INDEX TO ANNUAL REPORT ON FORM 10-K
                FILED WITH THE SECURITIES AND EXCHANGE COMMISSION
                          YEAR ENDED DECEMBER 31, 1997

                               ITEMS IN FORM 10-K

                                                                            Page
                                                                            ----
Facing page

Part I

      Item 1.     Business.                                                    1
      Item 2.     Properties.                                                 13
      Item 3.     Legal Proceedings.                                          13
      Item 4.     Submission of Matters to a Vote of Security Holders.        13

Part II

      Item 5.     Market for the Registrant's Common Equity and Related
                  Stockholder Matters.                                        14
      Item 6.     Selected Financial Data.                                    15
      Item 7.     Management's Discussion and Analysis of Financial
                  Condition and Results of Operations.                        17
      Item 8.     Financial Statements and Supplementary Data.                25
      Item 9.     Changes in and Disagreements with Accountants on
                  Accounting and Financial Disclosure.                        26

Part III

      Item 10.    Directors and Executive Officers of the Registrant.         26
      Item 11.    Executive Compensation.                                     26
      Item 12.    Security Ownership of Certain Beneficial Owners and
                  Management.                                                 26
      Item 13.    Certain Relationships and Related Transactions.             26


Part IV

      Item 14.    Exhibits, Financial Statement Schedule and Reports on
                  Form 8-K.                                                   27

Signatures                                                                    31
<PAGE>   3
      The Annual Report of THQ Inc. (the "Company") on Form 10-K contains
statements which constitute forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. Such statements appear in a
number of places in this Report, including, without limitation "Business" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations". Such forward-looking statements include statements regarding the
intent, belief or current expectations of the Company and its management with
respect to the matters discussed in this Report. Prospective investors are
cautioned that any such forward-looking statements involve risks and
uncertainties, and that the actual results may differ materially from those in
the forward-looking statements as a result of various uncertainties, including,
without limitation, uncertainties relating to the interactive entertainment
software industry and other factors, as more specifically set forth in the
Company's report on Form 8-K, filed on March 30, 1998 with the Securities and
Exchange Commission.

                                     PART I

ITEM 1.  BUSINESS

         INTRODUCTION

         THQ Inc. (the "Company") develops, publishes and distributes
interactive entertainment software ("Software") for the various hardware
platforms ("Platform") that collectively dominate the home video game market.
The Company historically has published titles for all major dedicated Platforms
manufactured by Sony, Sega and Nintendo (the "Manufacturers"), and multimedia
personal computers. The Company currently publishes titles for Platforms
manufactured by Sony, Nintendo and multimedia personal computers. Current
products published by the Company are in most interactive Software genres,
including action, adventure, arcade, fighting, driving, strategy, simulation
and sports. The Company's principal customers include Toys "R" Us, Wal-Mart,
Kay Bee Toys and Target, other national and regional retailers, discount store
chains and specialty retailers.

         The Company's titles are developed both internally and under contract
with independent developers, and are typically based on properties licensed from
third parties. The Company continually seeks to identify and exploit for
development, titles based upon entertainment projects (such as movies,
television programs and arcade games), sports and entertainment personalities,
or popular sports, trends or concepts ("Properties") that have high public
visibility or recognition or that reflect the trends of popular culture. Other
than titles that the Company may release on CD-ROM for use on multimedia
personal computers ("PCs"), all of the Company's products consist of cartridges
and CD-ROMs manufactured for the Company by the Manufacturers.

         The Company achieved a turnaround in 1995, reversing two years of
significant losses. Under new leadership, the Company focused its product
strategy, improved inventory management and reduced fixed costs. As a result,
the Company's revenues increased from $13.3 million in 1994 to $33.3 million,
$50.3 million and $89.4 million in 1995, 1996 and 1997, respectively.


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<PAGE>   4
THE INTERACTIVE ENTERTAINMENT INDUSTRY AND TECHNOLOGY

         The home video game Software market consists both of (i)
cartridge-based and CD-ROM-based Software for use solely on dedicated hardware
systems manufactured by the Manufacturers, and to a significantly lesser extent,
other vendors, and (ii) Software distributed on CD-ROMs for use on PCs. Until
1996, most Software for dedicated Platforms was sold in cartridge form. However,
CD-ROMs have become increasingly popular because they have substantially greater
data storage capacity and lower manufacturing costs than cartridges.

         The first modern Platform was introduced by Nintendo in 1985 using
"8-bit" technology. "8-bit" means that the central processing unit, or "chip,"
on which the Software operates is capable of processing data in 8-bit units.
Subsequent advances in technology have resulted in continuous increases in the
processing power of the chips that power both the Platforms and PCs. As the
technology of the hardware has advanced, the Software designed for the Platforms
has similarly advanced, with faster and more complex images, more lifelike
animation and sound effects and more intricate scenarios. The larger data
storage capacity of CD-ROMs enables them to provide richer content and longer
play. Currently, the non-portable Platforms being marketed are based primarily
on 32-bit and 64-bit technology. Portable Platforms manufactured by the
Manufacturers are less sophisticated technologically and do not require
television monitors.

         The following table sets forth the year of release in the United States
of each of the Manufacturers' Platforms for which the Company has published
titles and the technology on which such Platforms are based:

<TABLE>
<CAPTION>
                                 DATE OF U.S.
MANUFACTURER     PRODUCT NAME    INTRODUCTION     TECHNOLOGY
------------     ------------    ------------    ------------
<S>              <C>             <C>            <C>
Nintendo         Game Boy            1989       8-bit (portable)
Sega             Game Gear           1991       8-bit (portable)
Sega             Genesis             1989                16-bit
Nintendo         SNES                1991                16-bit
Sega             Saturn              1995                32-bit
Sony             PlayStation         1995                32-bit
Nintendo         Nintendo 64         1996                64-bit
</TABLE>

         The Company believes that the success of Software is dependent on the
graphic look and feel of the Software, the depth and variation of game play and
the popularity of the Property on which the Software is based. As new Platforms
are introduced, Software for such Platforms requires new standards of design and
technology to fully exploit such Platforms' capabilities and requires that
Software developers devote substantial resources to product design and
development.


                                       2
<PAGE>   5
BUSINESS STRATEGY

         The Company's objective is to become a leading provider of exciting,
high-quality Software that appeals to a broad range of consumers for use on a
variety of Platforms. The Company's business strategy is based on the following:

         - Developing a portfolio of games, primarily for use on advanced
         Platforms, based on Properties that are proprietary or are exclusively
         licensed to the Company ("Franchise" Properties). Franchise Properties
         allow the Company to release titles based on such Properties on a
         variety of hardware Platforms, to create sequels to such titles and to
         re-release such titles at secondary and tertiary price points in the
         future. The Company's exclusively licensed Properties currently consist
         of Viacom / Nickelodeon's Rugrats (exclusive console rights), BASS,
         Masters Classic, Turner's World Championship Wrestling (contract
         expires December 29, 1998, and allows the Company to continue to sell
         products on hand and in process at that date through June 29, 1999) and
         Brunswick World Tournament of Champions. Currently, the Company's
         proprietary products are Pax Imperia, Dead Unity, SpeedTribes and Vs.

         - Identifying and licensing titles originally developed by others
         primarily in foreign territories with proven or anticipated consumer
         acceptance and publishing localized versions for advanced Platforms for
         distribution in the United States and other countries. This strategy
         enables the Company to more fully participate in the market for
         advanced Platform games while limiting risk. In 1996, the Company
         commenced publishing and distributing for the next generation
         Platforms, Sony PlayStation, and Sega Saturn titles under license from
         foreign independent Software developers, primarily from Japan. In 1998,
         the Company expects to publish approximately 11 additional titles
         acquired in such manner, including The Granstream Saga, Quest 64,
         RedJack: Revenge of the Bretheren and Shao Lin.

         - Publishing high quality Software for the large installed base of the
         Game Boy Platform for so long as the Company believes there is a
         significant market for such titles. The Company believes that the
         relatively low cost of development of titles for this Platform and
         reduced competition in this market creates an opportunity to generate
         continuing sales and profits from this segment of the video game
         market. Examples of such titles published by the Company include
         Disney's Jungle Book and Disney's Lion King and Universal Studio's
         Jurassic Park Lost World. Licenses acquired for titles currently under
         development include Disney's Mulan and Disney's A Bug's Life. While the
         Company historically has published titles for the 16-bit Platforms, it
         does not intend to publish any new titles after the release of its last
         Super Nintendo title in March 1998.

         - Expanding its presence in foreign markets that demonstrate (through
         an increasing installed base of Platforms) the potential for commercial
         success of the Company's titles. To accomplish this strategy in 1997,
         the Company hired a new Vice President of International Sales to lead
         this initiative.


                                       3
<PAGE>   6
         - Managing the development and marketing of its titles in a manner that
         minimizes financial risk. The Company has experienced and expects to
         continue to experience fluctuations in its revenues, both on a
         quarterly basis and otherwise, as a result of numerous factors. The
         Company attempts to minimize its fixed expenses by such means as
         adjusting the relative use of employees and independent contractors who
         perform Software development, adopting warehouse and shipping systems
         that closely link product fulfillment costs to sales volume, and
         compensating sales representatives based on sales volume. In addition,
         by implementing strict product ordering and inventory controls, the
         Company attempts to reduce the risks associated with excessive or
         obsolete inventory.

         To further its strategy of obtaining or creating Franchise Properties,
the Company has enhanced its development abilities by making certain strategic
acquisitions. In 1993, the Company acquired Black Pearl Software, Inc. ("Black
Pearl"), an independent Software developer. In August 1996, the Company
consummated the acquisition of Heliotrope Studios, Inc. and retained the
services of that company's principals (the "Heliotrope Acquisition") in order to
develop and publish Pax Imperia: Eminent Domain which was released in 1997 and
to develop other strategy games for the PC market. (See " -- Software Design and
Development.")

         The Company may also rely upon strategic investments to facilitate
access to proprietary Software and skilled developers outside the Company. In
July 1996, the Company acquired a 25% interest in Inland Productions, Inc.
("Inland"), a recently formed Software developer. Inland is currently developing
the Company's PlayStation and Nintendo 64 versions of Turner's World
Championship Wrestling and PC and PlayStation versions of BASS Masters Classic.
The Company seeks to acquire or invest in other Software development companies
to further its development of Proprietary titles.

TITLES

         The Company has released an aggregate of 134 titles as of December 31,
1997, consisting of 42 SNES titles, 44 Game Boy titles, 13 Nintendo
Entertainment System titles, 12 Genesis titles, 6 Game Gear titles, 3 Saturn
titles, 11 PlayStation titles, 2 PC CD-ROM titles and 1 Nintendo 64 title. The
Company continually seeks to acquire licenses to publish and distribute
additional titles.

         The following tables set forth, for each Platform, the titles (i)
released by the Company in 1997 and anticipated to be released in 1998, and (ii)
the date of release (or anticipated release) of each title. There can be no
assurance that each of the titles anticipated for release in 1998 will be
released when scheduled, or at all.


                                       4
<PAGE>   7
<TABLE>
<CAPTION>
                                                                      RELEASE
  TITLES RELEASED IN 1997          CATEGORY        PLATFORM            DATE
---------------------------        --------      ------------        ----------
<S>                                <C>           <C>                 <C>
Williams Arcade Greatest Hits       Arcade       Super Nintendo         1/97
                                                 Mega Drive             1/97
Williams Ms. Pacman                 Arcade       Super Nintendo         2/97
Williams NBA Hangtime               Arcade       Super Nintendo         2/97
                                                 Mega Drive             2/97
Super Return of the Jedi            Adventure    Super Nintendo         2/97
Super Empire Strikes Back           Adventure    Super Nintendo         2/97
WCW vs. the World                   Fighting     PlayStation            3/97
Disney's The Hunchback of Notre     Arcade       Game Boy               3/97
   Dame - Topsy Turvy Games
Strikepoint "Hex Mission"           Action       PC                     4/97
                                                 PlayStation            4/97
Tokyo Highway Battle                Racing       PlayStation            4/97
K-1 The Arena Fighters              Fighting     PlayStation            4/97
Disney's The Jungle Book            Adventure    Game Boy               6/97
Disney's Aladdin                    Adventure    Game Boy               6/97
Disney's The Lion King              Adventure    Game Boy               6/97
Disney's Ducktales                  Adventure    Game Boy               6/97
Disney's Hercules                   Adventure    Game Boy               7/97
Brunswick World Tournament of       Sports       Super Nintendo         8/97
   Champions
Bravo Air Race                      Racing       PlayStation            9/97
Madden NFL 98                       Sports       Sega Genesis           9/97
Timon & Pumbaa                      Arcade       Super Nintendo        10/97
Pax Imperia: Eminent Domain         Strategy     PC                    10/97
NHL 98                              Sports       Sega Genesis          10/97
Disney's The Lion King              Adventure    Super Nintendo        10/97
Disney's The Jungle Book            Adventure    Super Nintendo        10/97
WCW vs NWO: World Tour              Fighting     Nintendo 64           11/97
Ghost in the Shell                  Shooter      PlayStation           11/97
NBA Live 98                         Sports       Sega Genesis          11/97
Vs.                                 Fighting     PlayStation           12/97
Madden NFL 98                       Sports       Super Nintendo        12/97
Jurassic Park Lost World            Adventure    Game Boy              12/97
FIFA Road to World Cup 98           Sports       Game Boy              12/97
</TABLE>


                                       5
<PAGE>   8
<TABLE>
<CAPTION>
                                                                         ANTICIPATED
TITLES ANTICIPATED TO BE RELEASED                                          RELEASE
            IN 1998*                  CATEGORY          PLATFORM            DATE
---------------------------------    -----------       ----------         ---------
<S>                                  <C>               <C>                <C>
WCW Nitro**                           Fighting         PlayStation          1/98
Pax Imperia: Eminent Domain**         Strategy         Macintosh            1/98
Ray Tracers**                         Driving          PlayStation          2/98
NBA Live 98**                         Sports           Super Nintendo       3/98
Broken Sword Shadow of the            Adventure        PlayStation          3/98
   Templars**
World Cup 98                          Sports           Game Boy             Spring '98
Quest 64                              Adventure/       Nintendo 64          Spring '98
                                      Role Playing
The Granstream Saga                   Role Playing     PlayStation          Summer '98
BASS Masters Classic: Tournament      Simulation       PlayStation          Summer '98
   Edition                                             PC                   Summer '98
RedJack: Revenge of the Bretheren     Adventure        PC                   Summer '98
                                                       Macintosh
Disney's Mulan                        Adventure        Game Boy             Summer '98
Small Soldiers                        Adventure        Game Boy             Summer '98
Dead Unity                            Action           PlayStation          Summer '98
                                      Adventure        PC
Brunswick Circuit Pro Bowling         Sports           PlayStation          Summer '98
                                                       PC                   Summer '98
Shao Lin                              Fighting         PlayStation          Fall '98
SpeedTribes                           Action           PlayStation          Fall '98
                                                       PC                   Fall '98
WCW/NWO Live                          Fighting         Nintendo 64          Fall '98
WCW/ NWO Nitro                        Fighting         PC                   Fall '98
Disney's A Bug's Life                 Adventure        Game Boy             Fall '98
Yoda Stories                          Adventure        Game Boy             Fall '98
Rugrats                               Adventure        PlayStation          Fall '98
                                                       Game Boy             Fall '98
</TABLE>

* Excludes titles the Company expects to release in 1998 but which have not yet
been publicly announced.

** Title released as of March 29, 1998.


                                       6
<PAGE>   9
INTELLECTUAL PROPERTY LICENSES

         The Company's strategy includes the creation of exciting games based on
licensed Properties that have attained a high level of consumer recognition or
acceptance. The Company believes it enjoys excellent relationships with a number
of licensors, including Disney, Viacom / Nickelodeon and Lucas Arts.

         The Company pays royalties to its Property licensors that generally
range from 5% to 12% of the Company's net sales of the title. The Company must
typically pay minimum guaranteed royalties over the license term and advance
payments against such guarantees. License fees tend to be higher for Properties
with proven popularity and less perceived risk of commercial failure. To the
extent competition intensifies for licenses of highly desirable Properties, the
Company may encounter difficulty in obtaining these licenses. (See " --
Competition.") Licenses typically extend for two to three years, may be
exclusive for a specific title or line of titles, and may in some instances be
renewable upon payment of certain minimum royalties or the attainment of
specified sales levels. Other licenses are not renewable upon expiration, and
there can be no assurance that the Company and the licensor will reach agreement
to extend the term. (See " --Management Discussion and Analysis-Overview --
Revenue Fluctuations and Seasonality.")

         The Company's Property licenses generally grant to the Company
exclusive use of the Property for the specified titles, on specified Platforms,
within a defined territory and during the license term. However, licensors
typically retain the right to exploit the Property for all other purposes,
including the right to license the Property for use with other Platforms.
Software published by third parties for use with other Platforms based on such
Property may compete with titles offered by the Company.

PLATFORM LICENSES

         The Company's business is dependent on its license agreements with the
Manufacturers. All of such licenses are for fixed terms and are not exclusive.
Each license grants to the Company the right to develop, publish and distribute
titles for use on such Manufacturers' Platforms, and requires that such titles
be embodied in products that are manufactured solely by such Manufacturer.


                                       7
<PAGE>   10
         The following table sets forth information with respect to the
Company's Platform Licenses. In some instances, the Company has more than one
Platform License for a particular Platform.

<TABLE>
<CAPTION>
                                  NUMBER OF
MANUFACTURER    PLATFORM           TITLES             TERRITORY         EXPIRATION DATE(S)
------------    ------------   -----------------   -----------------    ------------------
<S>             <C>            <C>                 <C>                  <C>
Nintendo        N64            title-by-title(1)   North America and      November 1999
                                                   Latin America
Nintendo        Game Boy       15/contract yr.     North America and      April 1999
                                                   Latin America
Nintendo        Game Boy       10/contract yr.     Europe and certain     June 2000
                                                   Asian countries
Sony            PlayStation    title-by-title(1)   U.S. and Canada        June 1998
Sony            PlayStation    title-by-title(1)   Europe                 December 2005(2)
</TABLE>

----------
(1) This Platform License does not set a maximum number of titles that the
    Company may publish in the designated territory; however, each title must be
    approved by the Manufacturer prior to development of the Software.

(2) Agreement continues year-to-year after such date unless terminated by either
    party.

         Nintendo charges the Company a fixed amount for each cartridge, which
amount varies based, in part, on memory capacity and processor power. Sony
similarly charges a per unit amount for each CD-ROM. These charges include a
manufacturing, printing and packaging fee as well as a royalty for the use of
the Manufacturer's name, proprietary information and technology, and are subject
to adjustment by the Manufacturers at their discretion. The Manufacturers have
the right to review, evaluate and approve a prototype of each title and all
packaging used by the Company in connection with the products.

         In addition, the Company must indemnify the Manufacturers with respect
to all loss, liability and expense resulting from any claim against the
Manufacturer involving the development, marketing, sale or use of the Company's
titles, including any claims for copyright or trademark infringement brought
against the Manufacturer. As a result, the Company bears a risk not only that
the Properties upon which the titles are based, but also the information and
technology licensed from the Manufacturer and incorporated in the products, may
infringe the rights of third parties. While the Company's agreements with its
independent Software developers and Property licensors typically provide for
indemnification of the Company with respect to certain matters, there can be no
assurance that, if any claim is brought by a Manufacturer against the Company
for indemnification, such developers or licensors would have sufficient
resources to in turn indemnify the Company, or that such indemnification would
cover the matter that gave rise to the Manufacturer's claim against the Company.

         Each Platform License may be terminated by the Manufacturer if a breach
or default by the Company is not cured by the Company after receipt of written
notice thereof from the Manufacturer, or if the Company becomes insolvent. Upon
termination of a Platform License for any reason other than a breach or default
by the Company, the Manufacturer has the right to


                                       8
<PAGE>   11
purchase from the Company, at the price paid by the Company, any product
inventory manufactured by such Manufacturer for the Company that remains unsold
for a specified period after such termination. Any such inventory not purchased
by the Manufacturer must be destroyed. Upon termination as a result of a breach
or default by the Company, any remaining inventory at such time must be
destroyed, subject to the right of any institutional lender to the Company to
sell such inventory for a specified period.

SOFTWARE DESIGN AND DEVELOPMENT

         Once the Company identifies and acquires a Property from a licensor,
the Company designs and develops a game with features intended to exploit the
characteristics of the Property and to appeal to the target consumers for such
game. The Company's Software development process generally takes one of two
forms.

         Internal Software Development. The Company's in-house development is
supervised by the Company's Vice President -- Software Development and is
staffed by producers, programmers, Software engineers, artists, animators and
game testers. The Heliotrope Acquisition enhanced the Company's internal
development capabilities by adding a Software development team and related
facilities in Connecticut. The Heliotrope team worked with the Company's other
development staff to produce Pax Imperia: Eminent Domain for publication on
CD-ROM for PCs. The Company uses a variety of advanced hardware and Software
development tools, proprietary hardware emulator systems, and various graphics,
animation, sound and compression applications. As of December 31, 1997, the
Company had 38 development employees.

         External Software Development. The Company also contracts with
independent Software developers to conceptualize and develop titles under the
Company's supervision. As of December 31, 1997, the Company had contracted
development efforts to 17 such developers. The Company generally pays
independent developers certain advances against royalties based on specified
development completion milestones. Royalties in excess of the advances are based
on a fixed amount per unit sold and range from $.25 to $6.00 per unit. The
Company generally obtains ownership of the Software code and related
documentation. The Company's agreements with its independent Software developers
are usually entered into on a title-by-title basis. The Company may make
strategic investments in independent developers for the purpose of securing
access to proprietary Software and talented developers. In June 1996, the
Company acquired a 25% interest in Inland, the developer currently working on
versions of Turner's World Championship Wrestling and BASS Masters Classics.

         Upon completion of development, each title is extensively "play-tested"
by the Company and sent to the Manufacturer for its review and approval. Related
artwork, user instructions, warranty information, brochures and packaging
designs are also developed under the Company's supervision. The development
cycle for new titles, including the development of the necessary Software,
approval by the Manufacturer and production of the initial products, typically
has ranged from nine to 18 months. This relatively long development cycle
requires the Company to


                                       9
<PAGE>   12
determine whether there will be adequate retailer and consumer demand for a
title well in advance of its release.

MANUFACTURING

         Except for certain Genesis and SNES cartridges, the Manufacturers are
the sole manufacturers of the products sold for use on their respective
Platforms.

         After placing a purchase order with a Manufacturer and opening either a
letter of credit in favor of the Manufacturer or line of credit with the
Manufacturer, the Company sends to the Manufacturer the title's Software code
and a prototype, together with related artwork, user instructions, warranty
information, brochures and packaging designs, for approval, defect testing and
manufacture. The Manufacturers currently deliver cartridges to the Company
within 30 to 60 days, and CD-ROMs within 10 to 14 days, after their receipt of
an order and a corresponding letter of credit, if required.

MARKETING, SALES AND DISTRIBUTION

         The Company depends in large part on the high name recognition of the
Properties on which its titles are based to attract customers and to obtain
shelf space in stores. The Company's sales activities are directed by the
Company's Senior Vice President -- Sales, which maintains contact with major
retail accounts and manages the activities of the Company's independent regional
sales representatives.

         The Company is required by the Platform Licenses to provide a standard
defective product warranty on all of the products sold. Generally, the Company
is responsible for resolving, at its own expense, any warranty or repair claims.
The Company has not experienced any material warranty claims.

         United States and Canadian Sales. The Company's titles are promoted to
retailers by display at trade shows, such as the annual Electronic Entertainment
Expo (E3). The Company also conducts print and cooperative retail advertising
campaigns for most titles and prepares promotional materials, including product
videos, to increase awareness among retailers and consumers.

         Product marketing highlights for the Company's 1997 titles included
national television, radio, and print advertising campaigns in console and PC
gaming publications, worldwide. Bravo Air Race, Pax Imperia, Brunswick World
Tournament of Champions, and the World Championship Wrestling titles for the
PlayStation and Nintendo 64 were several titles featured at various live events
and in nationwide Sony and Nintendo van tours. Prima Publishing further
supported Pax Imperia, Vs., Ghost in the Shell, and the WCW titles at launch
with strategy guides at retail. The Company's 1997 product line was launched
with major in-store retail promotions such as demos, discs, posters, and
pre-sell giveaways. International publicity campaigns in console and PC gaming
publications, consumer and business magazines and newspapers delivered covers,
contests, product preview, reviews and features. Additionally, the Company


                                       10
<PAGE>   13
developed product-specific web sites and expanded their online publicity and
advertising efforts. The Company is considering supporting several new title
launches with television advertising in 1998.

         Most of the Company's sales consist of direct sales to retailers. The
Company distributes its titles primarily to mass merchandisers and national
retail chain stores, including Toys "R" Us (representing 19% of net sales),
Wal-Mart (representing 10% of net sales), Best Buy, Blockbuster Video, Kay Bee
Toys, Electronics Boutique and Target. Sales to the Company's ten largest
customers collectively accounted for approximately 54% of the Company's gross
sales in 1996 and 67% of the Company's gross sales in 1997. The Company has no
written agreement or other understanding with any of its customers that relate
to future purchases by such customers, and thus, purchases by such customers may
terminate at any time.

         The Company utilizes electronic data interchange with most of its major
domestic customers in order to (i) efficiently receive, process and ship
customer product orders, and (ii) accurately track and forecast sell-through of
products to consumers in order to determine whether to order additional products
from the Manufacturers. The Company ships its products to its domestic customers
from a public bonded warehouse in Southern California.

         The Company's agreements with its independent regional sales
representatives set forth the representatives' exclusive territory, types of
customers to be solicited, commission rate and payment terms. Such
representatives do not have contractual authority to obligate the Company.

         The domestic retail price for the Company's Software generally ranges
between $19 and $35 for Game Boy, between $19 and $49 for PlayStation, between
$50 and $70 for Nintendo 64, and between $30 and $50 for PCs.

         Foreign Sales. Historically, the Company distributed its titles in the
United Kingdom, Europe and Australia. In 1997, the Company expanded its sales to
Brazil, Singapore and other countries. The Company sells its titles directly to
retailers in the United Kingdom and to distributors for distribution in other
countries. Products are shipped at the Company's expense to a public warehouse
in the United Kingdom for foreign distribution. Foreign sales to distributors in
countries other than the United Kingdom are shipped at the customer's expense
directly to the customer's location.

INTELLECTUAL PROPERTY RIGHTS

         Each product and title typically embody a number of separately
protected intellectual Property rights of the Manufacturer, the Property
licensors and, to a lesser extent, the Company. The licensors of the Properties
own the trademarks, trade names, copyrights and other intellectual Property
rights relating to the Property on which the titles are based. The Manufacturer
owns the patents and substantially all of the other intellectual Property
embodied in the products. While the Company owns the game Software embodied in
the products, the Company believes that such Software has little independent
economic value. Accordingly, the Company must rely on the


                                       11
<PAGE>   14
Manufacturers and the Property licensors with respect to protection from
infringement of these Property rights by third parties.

         Each of the Manufacturers incorporates security devices in their
respective Platforms and products to prevent unlicensed use of its Platforms. In
addition, Nintendo requires its licensees to display the "Nintendo Seal of
Approval" to notify the public that the title has been approved by Nintendo for
use with a Nintendo Platform.

COMPETITION

         The interactive entertainment industry is intensely competitive. The
ability of the Company to compete successfully is based on its ability to
identify and obtain licenses to commercially marketable Properties, to develop
appealing titles, to adapt its development capabilities with new technologies
and to secure retail distribution. The Company competes, for both licenses to
Properties and the sale of its titles, with the Manufacturers, each of which is
the largest developer and marketer of Software for its Platforms. There can be
no assurance that these companies will not increase their own development
efforts. As a result of their commanding positions in the industry as primary
manufacturers of dedicated interactive entertainment hardware and publishers of
Software, the Manufacturers generally have better bargaining positions with
respect to retail pricing, shelf space and purchases than do any of their
licensees, including the Company. The Manufacturers often have lower suggested
retail prices for their Software than do their licensees.

         Each of the Manufacturers has dozens of active licensees, each of which
is also a competitor of the Company. Each of the Manufacturers and many of these
other competitors (such as Acclaim Entertainment, Inc., Disney Interactive,
Inc., Electronic Arts Inc., GT Interactive Software Corp., Microsoft Corporation
and Midway Games Inc.) have broader Software lines and greater financial,
marketing and other resources than the Company; these competitive advantages
enable such competitors to market their Software more aggressively and make
higher offers or guarantees in connection with the acquisition of licensed
Properties. In addition, as competition for retail shelf space becomes more
intense, the Company may need to increase marketing expenditures to maintain
sales of its titles; and as competition for popular Properties increases, the
cost of acquiring licenses for such Properties is likely to increase, resulting
in reduced margins.

         In addition, the market for the Company's products is characterized by
significant price competition, and the Company expects that it will face
increasing pricing pressures from its current competitors. Accordingly, there
can be no assurance that the Company will be able to provide products that
compare favorably with the products of the Company's competitors or that
competitive pressures will not require the Company to reduce its prices. Any
material reduction in the price of the Company's products would negatively
affect operating income as a percentage of net revenue and would require the
Company to increase unit sales in order to maintain net revenue.


                                       12
<PAGE>   15
         The Company believes that some large diversified entertainment
companies, in addition to large Software companies, are increasing their focus
on the interactive entertainment market, which will result in greater
competition for the Company. In particular, many of the Company's competitors
are developing on-line interactive games and interactive networks that will be
competitive with the Company's interactive products. There can be no assurance
that the Company will be able to compete successfully against current or future
competitors or that competitive pressures faced by the Company will not
materially and adversely affect its business, operating results and financial
condition.

EMPLOYEES

         As of December 31, 1997, the Company had 81 full-time employees. All
but ten of such persons are located in the United States. None of the Company's
employees is represented by a labor union or covered by a collective bargaining
agreement. The Company believes that its relations with its employees are good.

ITEM 2.  PROPERTIES

         The Company's executive offices occupy approximately 13,400 square feet
of office space at 5016 North Parkway Calabasas, Calabasas, California, pursuant
to a lease expiring in July 2000. The Company also leases office space for sales
and marketing personnel in Cupertino, California and Woking, England, and for
development personnel in East Haven, Connecticut. The Company believes that its
office facilities are adequate.

ITEM 3.  LEGAL PROCEEDINGS

         While the Company has been a party to legal proceedings from time to
time, such legal proceedings have been ordinary and incidental to the Company's
business and have not had a material adverse affect on the Company.

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

         There were no matters submitted to a vote of security holders during
the fourth quarter of 1997.


                                       13
<PAGE>   16
                                     PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
        MATTERS

         From February 20, 1995 until February 13, 1997, the Company's common
stock ("Common Stock") was quoted on the Nasdaq SmallCap Market under the symbol
"TOYH". On February 14, 1997, the Company's Common Stock began trading on the
Nasdaq National Market under the symbol "THQI". The following table sets forth
for the periods indicated the high and low closing sales prices of the Common
Stock as reported on the Nasdaq National Market or the Nasdaq SmallCap Market.

<TABLE>
<CAPTION>
                                              CLOSING SALES
                                                 PRICES
                                       ----------------------------
                                           HIGH            LOW
                                       -------------   ------------
<S>                                    <C>             <C>
1997
  First Quarter                            9 1/4           5 7/8
  Second Quarter                          11 1/8           6 3/8
  Third Quarter                           13               9 1/2
  Fourth Quarter                          23              12 1/8

1996
  First Quarter                            5 3/16          3 1/2
  Second Quarter                           6 1/4           3 3/16
  Third Quarter                            7 9/16          4 1/8
  Fourth Quarter                          10 3/8           7 1/16
</TABLE>

         As of March 20, 1998, there were approximately 6,888,560 shares
outstanding, 368 holders of record and 5,850 beneficial owners of the Common
Stock.

DIVIDEND POLICY

         The Company has never declared or paid any dividends on the Common
Stock and does not intend to pay any cash dividends on the Common Stock in the
foreseeable future. The Company intends to retain its earnings, if any, for the
future operation and expansion of its business. The Company's agreement with its
domestic bank prohibits the Company from declaring or paying any dividend on, or
making any distribution in respect of, the Company's capital stock. (See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations --Liquidity and Capital Resources.")

SECURITIES ISSUED IN PRIVATE TRANSACTIONS

         There were no securities issued in private transactions in 1997.


                                       14
<PAGE>   17
ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE
         DATA)

         The following selected consolidated financial data of the Company for
each of the years ended December 31, 1995, 1996 and 1997 have been derived from
and are qualified by reference to the audited consolidated financial statements
of the Company included elsewhere herein which have been audited by Deloitte &
Touche LLP, independent auditors. The following selected consolidated financial
data as of and for the periods ended December 31, 1993 and 1994 were derived
from audited financial statements not included elsewhere herein. This selected
consolidated financial data should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Consolidated Financial Statements and Notes thereto included elsewhere
herein.


                                       15
<PAGE>   18
                          STATEMENT OF OPERATIONS DATA

<TABLE>
<CAPTION>
                                                          YEARS ENDED DECEMBER 31,
                                          ------------------------------------------------------------
                                            1993         1994         1995         1996         1997
                                          --------     --------     --------     --------     --------
                                                     (In thousands, except per share data)
<S>                                       <C>          <C>          <C>          <C>          <C>
Net sales                                 $ 37,478     $ 13,289     $ 33,250     $ 50,255     $ 89,362
Costs and expenses:
  Cost of sales                             31,415       12,651       19,501       29,301       48,110
  Royalties                                  6,028        2,327        3,641        7,977       14,158
  Product development                        1,392          888          889        1,324        1,610
  Project abandonment                        5,489        3,754        1,025          610          600
  Selling                                    6,163        6,864        3,114        4,444        8,670
  General and administrative                 5,695        3,676        3,139        3,496        5,064
  Operating interest                           529          496        1,184          878          315
                                          --------     --------     --------     --------     --------
         Total costs and expenses           56,711       30,656       32,493       48,030       78,527
                                          --------     --------     --------     --------     --------
Income (loss) from operations              (19,233)     (17,367)         757        2,225       10,835
Interest income (expense) - net               (420)        (112)        (134)        (316)         464
                                          --------     --------     --------     --------     --------
Income (loss) before income taxes          (19,653)     (17,479)         623        1,909       11,299
Provision (benefit) for income taxes        (3,413)          11           22            8        1,954
                                          --------     --------     --------     --------     --------
Net income (loss)                         $(16,240)    $(17,490)    $    601     $  1,901        9,345
                                          ========     ========     ========     ========     ========
Net income (loss) per share -- basic      $ (10.80)    $  (8.75)    $    .21     $    .42     $   1.48
                                          ========     ========     ========     ========     ========
Net income (loss) per share -- diluted    $ (10.80)    $  (8.75)    $    .17     $    .39     $   1.35
                                          ========     ========     ========     ========     ========
Weighted-average number of
     Common shares -- basic                  1,504        1,998        2,858        4,525        6,320
                                          ========     ========     ========     ========     ========
Weighted-average number of
     common shares, stock options
     and warrants -- diluted                 1,504        1,998        3,556        4,836        6,901
                                          ========     ========     ========     ========     ========

<CAPTION>
                               BALANCE SHEET DATA

                                                            YEARS ENDED DECEMBER 31,
                                          ------------------------------------------------------------
                                            1993         1994         1995         1996         1997
                                          --------     --------     --------     --------     --------
<S>                                       <C>          <C>          <C>          <C>          <C>
Working capital                           $ 11,046     $  3,736     $  7,082     $  9,672     $ 31,462
Total assets                              $ 22,305     $ 15,531     $ 16,916     $ 22,840     $ 59,453
Advance from bank                               --           --           --     $  5,355           --
Stockholders' equity                      $ 11,627     $  4,254     $  7,598     $ 11,048     $ 33,527
</TABLE>


                                       16
<PAGE>   19
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS

OVERVIEW

         In 1997, the Company developed, published and distributed Software for
the major Platforms sold by the Manufacturers. Sales of Nintendo Software
constituted 65% of the Company's sales, Sony PlayStation sales were 22%, Sega
Software sales were 10%, and the remaining 3% were derived from PC titles.

         The Company achieved a turnaround in 1995, reversing two years of
significant losses. Under new leadership, the Company focused its product
strategy, improved inventory management and reduced fixed costs. As a result,
the Company's revenues increased from $13.3 million in 1994 to $33.3 million,
$50.3 million and $89.4 million in 1995, 1996 and 1997, respectively.

         While the Company historically has published titles for the 16-bit
Platforms, it does not intend to publish any new titles after the release of its
last Super Nintendo title in March 1998. The Company does not intend to publish
any new titles for the Sega Platforms during 1998.

         The Company's business cycle generally commences with the securing of a
license to publish one or more titles based on a Property. Such licenses
typically require an advance payment to the licensor and a guarantee of minimum
future royalties. (See " -- Recovery of Prepaid Royalties, Guarantees and
Capitalized Development Costs.") After securing the Property, the Company
commences Software development for the title. Upon completion of development and
approval of the title by the Manufacturer, the Company orders products and
generally causes a letter of credit to be opened in favor of the Manufacturer or
obtains a line of credit from the Manufacturer. Products are shipped at the
Company's expense to a public warehouse in California for domestic distribution
or in the United Kingdom for foreign distribution. Foreign sales to distributors
in countries other than the United Kingdom are shipped at the customer's expense
directly to the customer's location.

         The Company has unfilled sales orders the amount of which fluctuates
from time to time, commonly referred to as "backlog." However, substantially all
of the Company's product orders are fulfilled shortly after they are received.
Accordingly, the Company does not believe that the amount of its unfilled sales
orders as of the end of a period is a meaningful indicator of sales in future
periods.

         Revenue Fluctuations and Seasonality. The Company has experienced and
may continue to experience significant quarterly fluctuations in net sales and
operating results due to a variety of factors, including the timing of releases
of new titles by the Company, the popularity of both new titles and titles
released in prior periods, fluctuations in the mix of titles with varying profit
margins, the timing of customer orders, the timing of shipments by the
Manufacturers, fluctuations in the size and rate of growth of consumer demand
for Software for various Platforms, the timing of the introduction of new
Platforms and the accuracy of retailer's forecasts of consumer demand. The
Company's expenses are based, in part, on its expectations of future


                                       17
<PAGE>   20
revenues and, as a result, operating results would be disproportionately and
adversely affected by a decrease in sales or a failure by the Company to meet
its sales expectations. In addition, the Software market is highly seasonal,
with sales typically significantly higher during the fourth quarter (due
primarily to the increased demand for interactive games during the year-end
holiday buying season). There can be no assurance that the Company can maintain
consistent profitability on a quarterly or annual basis.

         On March 10, 1998, the Company announced that its current license
agreement with World Championship Wrestling will not be be renewed. The current
license agreement expires on December 29, 1998, and permits the Company to
continue to sell products on hand and in process at that date through June 29,
1999. Products released by the Company under this license accounted for 39% of
the Company's revenues in 1997 and are expected to account for a substantial
portion of the Company's revenues in 1998. There can be no assurance that this
development will not have a material adverse affect on the Company.

         Profit margins may vary over time as a result of a variety of other
factors. Profit margins for cartridge products can vary based on the cost of the
memory chip used for a particular title. As Software has grown more complex, the
trend in the Software industry has been to utilize chips with greater capacity
and thus greater cost. CD-ROMs have significantly lower per unit manufacturing
costs than cartridge-based products. However, such savings may be offset by
typically higher development costs for titles published on CD-ROMs; such higher
costs result from the creation of increased and enhanced content to take
advantage of the greater storage capacity available on CD-ROMs.

         Recovery of Prepaid Royalties, Guarantees and Capitalized Development
Costs. The Company typically enters into agreements with licensors of Properties
and developers of titles that require advance payments of royalties and/or
guaranteed minimum royalty payments. There can be no assurance that the sales of
products for which such royalties are paid will be sufficient to cover the
amount of these required royalty payments. The Company capitalizes its prepaid
royalties, and capitalizes Software development costs upon the establishment of
technological feasibility of the title under development. Amortization of these
payments and costs is determined on a title-by-title basis based on the greater
of (i) the ratio of current gross revenues for a title to the sum of its current
and anticipated gross revenues, or (ii) the straight-line method over the
estimated remaining economic life of the title. The Company analyzes such
capitalized costs quarterly and writes off as project abandonment losses those
capitalized payments and costs (and expenses any unpaid guaranteed minimum
royalties) when, based on the Company's estimate, future revenues will not be
sufficient to recover such costs. As of December 31, 1997, the Company had
prepaid royalties and capitalized development costs of $11.4 million. If the
Company were required to write off a material portion of its prepaid royalties
or capitalized development costs, the Company's results of operations could be
adversely affected.

         Discounts, Allowances and Returns; Inventory Management. Although the
Company's arrangements with its customers generally do not give such customers
the right to return products to the Company (other than defective products) or
to cancel firm orders, the Company often negotiates accommodations to retailers
(and, less often, to distributors) when demand for specific


                                       18
<PAGE>   21
items falls below expectations for the purpose of maintaining its relationships
with its customers. Such accommodations consist of acquiescing to the customer's
request that not all booked orders be filled or that not all shipped orders be
accepted, negotiated price discounts, credits against future orders and, less
often, the return of products to the Company. It is the Company's practice to
accept all returns of defective or damaged products.

         At the time of product shipment, the Company establishes provisions
against the gross revenues generated by such shipment based on estimates of
future returns of, other customer accommodations and doubtful accounts that may
be granted with respect to, such products, based on the Company's historical
experience, retailer inventories of the titles and other factors. For the year
ended December 31, 1996 and 1997, provisions of $5.2 million and $10.5 million,
respectively, were taken against gross sales made during such periods, and as of
December 31, 1997, the Company's aggregate reserve against accounts receivable
for returns, customer accommodations and doubtful accounts was $9.3 million.

         The identification by the Company of slow-moving or obsolete inventory,
whether as a result of requests from customers for accommodations or otherwise,
would require the Company to establish reserves against such inventory or to
write-down the value of such inventory to its estimated net realizable value.

         XBAND Modem. Pursuant to an agreement between the Company and Catapult
Entertainment, Inc. ("Catapult") entered into in April 1994, the Company was
granted exclusive distribution rights for Catapult's modems (the "XBAND Modem")
for use in connection with the Genesis and SNES systems in North America. The
XBAND Modem enables video game players to compete against each other in real
time from different locations through a communications network created and
maintained by Catapult.

         The Company spent approximately $5.8 million through December 31, 1994,
in connection with inventory purchases and the marketing and promotion of the
XBAND Modem. In May 1995, the Company sold to Catapult the Company's XBAND Modem
inventory and related accounts receivable for $3.2 million, of which $1.3
million was paid at such time and the balance was payable over a specified
period (less the amount collected by the Company with respect to such
receivables). Subsequently, Catapult filed for bankruptcy under Chapter 11 of
the U.S. Bankruptcy Code. Under Catapult's plan of reorganization, the Company
received approximately 15% of its remaining claim against Catapult, or
approximately $200,000, in December 1996. Because the Company determined in May
1995 that receipt of any additional payment by Catapult was highly uncertain, at
such time the Company established a reserve in the amount of such remaining
payments. As a result, substantially all of the amount received pursuant to the
plan of reorganization is reflected in the Company's statement of operations for
the year ended December 31, 1996.

         Net Operating Loss Carryforwards. At December 31, 1997, for federal
income tax purposes the Company had $15.4 million of NOL carryforwards incurred
since 1993. The Company's public offering of common stock in February 1997
resulted in an "ownership change" of the Company for purposes of Sections 382
and 383 of the Internal Revenue Code of 1986, as


                                       19
<PAGE>   22
amended. As a result, the amount of the NOL carryforwards available to reduce
the Company's federal income tax liability in future years in which the Company
has taxable income is limited to an annual amount equal to (i) the fair market
value of the Company's capital stock immediately prior to the consummation of
the offering on February 11, 1997, multiplied by (ii) the "long-term tax exempt
rate" published by the Internal Revenue Service for the month in which the
offering was consummated. Based upon a long-term tax exempt rate for February
1997 of 5.48% and an assumed market price of the Common Stock immediately prior
to consummation of this offering of $8.56 per share (the last reported sale
price of the Common Stock on February 10, 1997), such amount is approximately
$2,225,000 per year.

YEAR 2000 DISCLOSURE

  The inability of computers, software and other equipment utilizing
microprocessors to recognize and properly process data fields containing a 2-
digit year is commonly referred to as the "Year 2000 Compliance" issue. As the
year 2000 approaches, such systems may be unable to accurately process certain
date-based information.

         The Company has identified all significant applications that will
require modification to ensure Year 2000 Compliance. Internal and external
resources are being used to make the required modifications and test Year 2000
Compliance. The modification process of all significant applications is
substantially complete. The Company plans on completing the testing process of
all significant applications by December 31, 1998.

         In addition, the Company is in the process of communicating with others
with whom it does significant business to determine their Year 2000 Compliance
readiness and the extent to which the Company is vulnerable to any third party
Year 2000 issues. However, there can be no guarantee that the systems of other
companies on which the Company's systems rely will be timely converted, or that
a failure to convert by another company, or a conversion that is incompatible
with the Company's systems, would not have a material adverse effect on the
Company.

         The total cost to the Company of these Year 2000 Compliance activities
has not been and is not anticipated to be material to its financial position or
to its results of operations for any given year. These costs and the date on
which the Company plans to complete the Year 2000 modification and testing
processes are based on management's best estimates, which were derived utilizing
numerous assumptions of future events including the continued availability of
certain resources, third party modification plans and other factors. However,
there can be no guarantee that these estimates will be achieved and actual
results could differ from those plans.


                                       20
<PAGE>   23
RESULTS OF OPERATIONS

         The following table sets forth, for the periods indicated, the
components of the Company's net sales and its consolidated operating data as a
percentage of net sales:


<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                              ---------------------------------
                                               1995          1996          1997
                                              -----         -----         -----
<S>                                           <C>           <C>           <C>
Domestic sales                                 74.9%         70.4%         84.3%
Foreign sales                                  25.1          29.6          15.7
                                              -----         -----         -----
Net sales                                     100.0%        100.0%        100.0%
Costs and expenses:
  Cost of sales                                58.6%         58.3%         53.8%
  Royalties                                    10.9          15.9          15.8
  Product development                           2.7           2.6           1.8
  Project abandonment                           3.1           1.2           0.7
  Selling                                       9.4           8.9           9.7
  General and administrative                    9.3           7.0           5.7
  Operating interest                            3.6           1.7           0.4
                                              -----         -----         -----
Total costs and expenses                       97.6%         95.6%         87.9%
                                              -----         -----         -----
Income from operations                          2.4%          4.4%         12.1%
Interest income (expense) -- net               (0.5)         (0.6)          0.5
                                              -----         -----         -----
Income before income taxes                      1.9%          3.8%         12.6%
                                              -----         -----         -----
Net income                                      1.8%          3.8%         10.5%
                                              =====         =====         =====
</TABLE>

COMPARISON OF THE YEAR ENDED DECEMBER 31, 1997 TO THE YEAR ENDED DECEMBER 31,
1996

         The following table sets forth, for the years ended December 31, 1996
and 1997, the titles released during such periods for the Platforms indicated:

<TABLE>
<CAPTION>
                          YEARS ENDED DECEMBER 31,
                        ----------------------------
                            1996            1997
                        ------------    ------------
<S>                     <C>             <C>
Nintendo 64                  --               1
PC CD-ROM                    --               2
PlayStation                   4               7
Saturn                        3              --
SNES                         11              10
Genesis                       4               5
Game Boy                     10               8
Game Gear                     1              --
                        ------------    ------------
          Total              33              33
                        ============    ============
</TABLE>


                                       21
<PAGE>   24
         The Company's net sales increased to $89,362,000 in the year ended
December 31, 1997, from $50,255,000 in the same period of 1996, primarily as a
result of higher unit sales per title shipped. For the year ended December 31,
1997, net sales of the Company's WCW titles, Madden 98 titles and Disney
re-releases (Lion King, Jungle Book, Aladdin, and Duck Tales), were $36,181,000
(39% of net sales), $6,032,000 (6.8% of net sales), and $5,214,000 (5.8% of net
sales), respectively

         Cost of sales for the year ended December 31, 1997 decreased
significantly as a percentage of net sales to 53.8% from 58.3% in the same
period of 1996, primarily as a result of the increase in CD-ROM product sales,
which generally have more favorable gross margins.

         Foreign net sales were $13,998,000, (15.7% of net sales) for the year
ended December 31, 1997, down slightly from $14,856,000, (29.6% of net sales) in
the same period of 1996 because the Company's WCW vs. NWONWO: World Tour, K-1
The Arena Fighters, and Vs. titles were shipped only in the United States. WCW
vs. NWONWO: World Tour and K-1 The Arena Fighters are scheduled to ship in
foreign markets in the first quarter of 1998. Vs. will be shipped later in the
year.

         Royalty expense for the year ended December 31, 1997 increased
$6,181,000 over the same period in 1996 but remained relatively constant as a
percentage of net sales.

         For the year ended December 31, 1997, product development expenses
increased by $286,000 compared to the year ended December 31, 1996, as a result
of increased investment in internal product development during the period as
well as increased product packaging costs relating to titles released in 1997 as
compared to 1996.

         For the year ended December 31, 1997, selling expenses increased by
$4,226,000 compared to the year ended December 31, 1996, as a result of
increased marketing efforts for new titles consisting primarily of print and
retail cooperative advertising and increased warehouse expenses which are the
result of increased sales volumes. Selling expenses as a percentage of net sales
were 9.7% in 1997 as compared to 8.8% in 1996.

         General and administrative expenses for the year ended December 31,
1997, decreased as a percentage of net sales to 5.7% from 7.0% for the same
period of 1996, but increased in dollar terms by $1,568,000 over 1996. The
increased expenses were due in part to increased infrastructure and personnel
costs in 1997 (as a result of the increased sales volume over 1996) and an
increase in shareholder relations costs.

         Operating interest, which consists of interest and fees paid to the
Company's bank and fees paid to other issuers of letters of credit, decreased to
$315,000 for the year ended December 31, 1997, from $878,000 for 1996. The
decline is the result of a more advantageous banking arrangement (See " --
Credit Facilities") and the use of funds generated by the Company's common stock
offering which was completed on February 14, 1997. (See " -- Liquidity and
Capital Resources.")


                                       22
<PAGE>   25
COMPARISON OF THE YEAR ENDED DECEMBER 31, 1996 TO THE YEAR ENDED DECEMBER 31,
1995

         The following table sets forth, for the years ended December 31, 1995
and 1996, the titles released during such periods for the Platforms indicated:

<TABLE>
<CAPTION>
                           YEARS ENDED DECEMBER 31,
                        ----------------------------
                            1995           1996
                        ------------    ------------
<S>                     <C>             <C>
PlayStation                  --              4
Saturn                       --              3
SNES                          6             11
Genesis                       2              4
Game Boy                     10             10
Game Gear                     6              1
                        ------------    ------------
          Total              24             33
                        ============    ============
</TABLE>

         The Company's net sales increased to $50,255,000 in the year ended
December 31, 1996, from $33,250,000 in the same period of 1995, primarily as a
result of the increase in the number of new titles released in 1996. For the
year ended December 31, 1996, net sales of the Company's Olympic Summer Games,
Disney's Toy Story and NHL Hockey 97 titles were $6,631,000 (13.2% of net
sales), $5,981,000 (11.9% of net sales) and $4,953,000 (9.9% of net sales),
respectively. Foreign net sales grew to $14,856,000, (29.6% of net sales) for
the year ended December 31, 1996, from $8,356,000, (26.2% of net sales) in the
same period of 1995, as a result of an increase in the number of titles shipped
and an increase in unit sales per title. The results for fiscal 1995 included
sales of $1,200,000 and cost of sales of $600,000 resulting from the sale of the
XBAND Modem inventory to Catapult. (See " -- Overview -- XBAND Modem.")

         Cost of sales decreased slightly as a percentage of net sales to 58.3%
for the year ended December 31, 1996 as compared to 58.6% of net sales for 1995.
The commencement in 1996 of the sale of higher-margin CD-ROM titles was
mitigated by increased foreign sales, for which margins are generally lower, and
a greater percentage of sales of SNES titles, for which margins are slightly
lower.

         Royalty expense as a percentage of net sales increased to 15.9% for the
year ended December 31, 1996 from 10.9% for 1995. License agreements for titles
released in 1996 provided for royalties at higher rates, particularly the
Company's licenses for Disney's Pocahontas and Disney's Toy Story and its titles
for advanced Platforms.

         For the year ended December 31, 1996, product development expenses
increased by $435,000 compared to the year ended December 31, 1995, as a result
of increased investment in internal product development during the period as
well as increased product packaging costs relating to the increase in titles
released in 1996 as compared to 1995.

         Project abandonment expenses decreased by $415,000 in the year ended
December 31, 1996, as compared to the same period of 1995 as a result of the
Company bringing more of its


                                       23
<PAGE>   26
scheduled products to market and achieving a greater proportion of its minimum
royalty guarantees.

         For the year ended December 31, 1996, selling expenses increased by
$1,330,000 compared to the year ended December 31, 1995, as a result of
increased marketing efforts for new titles consisting primarily of print and
retail cooperative advertising, but remained relatively constant as a percentage
of sales at 6.9% of net sales in 1996 as compared to 7.2% in 1995.

         General and administrative expenses for the year ended December 31,
1996, decreased as a percentage of net sales to 9.2% from 11.9% for the same
period of 1995, but increased in dollar terms by $357,000 over 1995. The
increased expenses were due in part to a charge of $375,000 in 1996 resulting
from the bankruptcy of one of the Company's customers.

         Operating interest, which consists of interest and fees paid to the
Company's bank and fees paid to other issuers of letters of credit, decreased to
$878,000 for the year ended December 31, 1996, from $1,184,000 for the same
period of 1995. The decline is the result of the Company's entering into more
favorable agreements with the Company's domestic and European letter of credit
providers.

LIQUIDITY AND CAPITAL RESOURCES

         The Company's principal uses of cash are product purchases, guaranteed
payments to licensors, advance payments to developers and the costs of internal
Software development. In order to purchase products from the Manufacturers, the
Company typically opens letters of credit in their favor or obtains a line of
credit from the Manufacturer. As of December 31, 1997, the Company had
obligations with respect to future guaranteed minimum royalties of $11,499,000,
substantially all of which are payable within the subsequent twelve months. As
of December 31, 1997, the Company had obligations with respect to open letters
of credit of $10,080,000.

         Due to increased sales volume , accounts receivable increased
significantly from December 31, 1996 to December 31, 1997. Prepaid and deferred
royalties and Software development costs increased from December 31, 1996 as a
result of the Company entering into several new contracts for both Properties
and new product development. (See " -- Recovery of Prepaid Royalties, Guarantees
and Capitalized Development Costs.") Since the Company records as a liability
the entire guarantee of a contract at its inception, accrued royalties also
increased significantly from December 31, 1996. Accounts payable and accrued
expenses increased significantly from December 31, 1996 as a result of the
timing of large product receipts in the last part of 1997.

         The amount of the Company's accounts receivable is subject to
significant seasonal variations due to the seasonality of sales, and is
typically highest at the end of the year. As a result, the Company's working
capital requirements are greatest during its third and fourth quarters. The
Company believes that the funds provided by operations and funds available under
the Company's revolving credit facility with its bank, will be adequate to meet
the Company's anticipated requirements for operating expenses, product
purchases, guaranteed payments to


                                       24
<PAGE>   27
licensors and Software development through 1998. However, to the extent accounts
receivable, inventories and guaranteed and advance payments increase as a result
of growth of the Company's business, the Company could require additional
working capital to fund its operations. The Company does not anticipate making
material additional capital expenditures in 1998.

         For the year ended December 31, 1997, the Company spent $923,000
(primarily as a result of the installation of an upgraded computer network and
accounting software package).

         The net proceeds of $11.7 million from the Company's public offering of
Common Stock in February 1997 were used in part for general corporate purposes
including obtaining new licenses for, and development expenses related to, new
titles and the repayment of amounts outstanding under the Company's revolving
credit facility.

         Credit Facilities. In July 1996, the Company terminated its factoring
and credit agreement and entered into the Revolving Credit Facility with
Imperial Bank. On September 22, 1997, the Company entered into a new agreement
for a larger and lower cost banking facility with Imperial Bank. The new bank
credit agreement is designed to mirror the seasonal trends of the Company's
business, providing advances under the credit line of up to $23 million during
the Company's peak selling season (October 1 to January 31), and up to $12
million outside of the peak season. Although the agreement contains certain
covenants regarding financial and other matters, the Company's borrowings are no
longer restricted to a formula based on receivables and inventory. Interest on
the outstanding balance is payable at Imperial Bank's prime rate. The Line of
Credit Facility matures on June 30, 1998 subject to earlier termination. As of
December 31, 1997, the Company had no advances under the Line of Credit;
however, open letters of credit at year end were $10,080,000.



ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         Reference is made to the Financial Statements referred to in the
accompanying Index, setting forth the consolidated financial statements of THQ
Inc. and subsidiaries, together with the report of Deloitte & Touche LLP dated
February 20, 1998.

Independent Auditors' Consent

         We consent to the incorporation by reference in Registration Statement
No. 333-30655 of THQ Inc. on Form S-8 of our report dated February 20, 1998,
appearing in this Annual Report on Form 10-K of THQ Inc. for the year ended
December 31, 1997.


DELOITTE & TOUCHE LLP

Los Angeles, California
March 27, 1998


                                       25
<PAGE>   28
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

         The information required under this Item relating to members of the
Board of Directors and Executive Officers of the Company will be included in the
Company's 1998 Notice of Annual Meeting of Shareholders and Proxy Statement
under the headings "Election of Directors," "Executive Officers," "Key
Employees," "Late Filings" and "Director and Officer Holdings," which will be
filed within 120 days after the close of the Company's fiscal year, and is
incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

         The information required under this Item relating to executive
compensation will be included in the Company's 1998 Notice of Annual Meeting of
Shareholders and Proxy Statement under the heading "Executive Compensation,"
which will be filed within 120 days after the close of the Company's fiscal
year, and is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The information required under this Item relating to security ownership
of certain beneficial owners and management will be included in the Company's
1998 Notice of Annual Meeting of Shareholders and Proxy Statement under the
heading "Principal Shareholders," which will be filed within 120 days after the
close of the Company's fiscal year, and is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The information required under this Item relating to certain
relationships and related transactions will be included in the Company's 1998
Notice of Annual Meeting of Shareholders and Proxy Statement under the headings
"Employment Agreements" and "Director and Officer Transactions," which will be
filed within 120 days after the close of the Company's fiscal year, and is
incorporated herein by reference.


                                       26
<PAGE>   29
                                     PART IV

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

         (a) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES.

                  See Index to Financial Statements.

         (b) REPORTS ON FORM 8-K.

                  Filed on March 30, 1998.

         (c) EXHIBITS.

Exhibit
Number   Title
------   -----

3.1      Certificate of Incorporation (Filed as Exhibit 3.1 to the Company's
         Registration Statement on Form S- 3 (File No. 333-32221), Amendment
         No.1, and incorporated herein by reference)

3.2      Amendment to Certificate of Incorporation (Filed as Exhibit 3.2 to the
         Company's Registration Statement on Form S-3 (File No. 333-32221),
         Amendment No.1, and d incorporated herein by reference)


3.3      Bylaws (Filed as Exhibit 3.3 to the Company's Registration Statement on
         Form S-3 (File No. 333- 32221), Amendment No.1, and incorporated herein
         by reference)

10.1     Amended and Restated 1990 Stock Option Plan, as amended (Filed as
         Exhibit 10.1 to the Company's Registration Statement on form S-2 (File
         No. 333-18641) and incorporated herein by reference)

10.2     Confidential Second Renewal License Agreement for Super Nintendo
         Entertainment System effective October 16, 1995, between Nintendo of
         America Inc. and the Company (Filed as Exhibit 10.2(a) to the Company's
         Annual Report on Form 10-K for the year ended December 31, 1995, and
         incorporated herein by reference)

10.3     Confidential First Renewal License Agreement for Gameboy effective
         January 1, 1995, between Nintendo of America Inc. and the Company
         (Filed as Exhibit 10.3(a) to the Company's Annual Report on Form 10-K
         for the year ended December 31, 1995, and incorporated herein by
         reference)

10.4     Confidential First Renewal International License Agreement for Super
         Nintendo Entertainment System effective February 6, 1995, between
         Nintendo Co., Ltd., and the Company (Filed as Exhibit 10.4(a) to the
         Company's Annual Report on Form 10-K for the year ended December 31,
         1995, and incorporated herein by reference)

10.5     First Extension Letter dated June 5, 1996, and Second Extension Letter
         dated September 13, 1996 to Confidential First Renewal International
         License Agreement for Super Nintendo Entertainment System effective
         February 6, 1995, between Nintendo Co., Ltd., and the Company (Filed as
         Exhibit 10.5 to the Company's Registration Statement on Form S-2 (File
         No. 333-18641) and incorporated herein by reference)


                                       27
<PAGE>   30
10.6     Confidential First Renewal International License Agreement for Gameboy
         dated November 6, 1995, between Nintendo Co., Ltd., and the Company
         (Filed as Exhibit 10.5(a) to the Company's Annual Report on Form 10-K
         for the year ended December 31, 1995, and incorporated herein by
         reference)

10.7     Confidential License Agreement for Super Nintendo Entertainment System
         dated September 28, 1995, between Nintendo of America, Inc. and Black
         Pearl Software, Inc. (Filed as Exhibit 10.6(a) to the Company's Annual
         Report on Form 10-K for the year ended December 31, 1995, and
         incorporated herein by reference)

10.8     Confidential License Agreement for Gameboy dated April 4, 1994, between
         Nintendo of America, Inc. and Malibu Games, Inc. (Filed as an exhibit
         to the Company's Registration Statement on Form S- 2 (File No.
         33-81632) which became effective December 7, 1995, and incorporated
         herein by reference)

10.9     Confidential First Renewal International License Agreement for Super
         Nintendo Entertainment System dated as of July 19, 1995, between
         Nintendo Co., Ltd., and Black Pearl Software, Inc. (Filed as Exhibit
         10.8(a) to the Company's Annual Report on Form 10-K for the year ended
         December 31, 1995, and incorporated herein by reference)

10.10    Addendum dated September 28, 1995, together with Extension Letter dated
         July 9, 1996, and Second Extension Letter dated November 21, 1996, to
         Confidential International License Agreement for Game Boy dated July
         19, 1993, between Nintendo Co., Ltd., and Black Pearl Software, Inc.
         (Filed as Exhibit 10.11 to the Company's Registration Statement on form
         S-2 (File No. 333-18641) and incorporated herein by reference)

10.11    License Agreement for Sega Genesis System dated as of October 20, 1994,
         between Sega Enterprises, Ltd., and the Company (Filed as Exhibit
         10.10(a) to the Company's Annual Report on Form 10-K for the year ended
         December 31, 1995, and incorporated herein by reference)

10.12    Employment Agreement of Brian J. Farrell dated as of December 31, 1996,
         between the Company and Brian J. Farrell (Filed as Exhibit 10.14 to the
         Company's Annual Report on Form 10-K for the year ended December 31,
         1996, and incorporated herein by reference)

10.13    Stock Option Agreement dated as of February 15, 1995, between the
         Company and Brian J. Farrell (Filed as an exhibit to the Registration
         Statement on Form S-8 (Registration No. 333-00136) filed on January 11,
         1996, and incorporated herein by reference)

10.14    401(k) Plan of the Company (Filed as an exhibit to Registration
         Statement on Form S-18 (File No. 33-35582-NY) of Trinity, and
         incorporated herein by reference. Amendments made since original filing
         were filed as exhibits to the Company's Proxy Statements dated April
         24, 1992, April 30, 1993 and April 28, 1994, respectively, as are
         incorporated herein by reference and modification made to this document
         was filed as an exhibit to the Company's Annual Report on Form 10-K for
         the year ended December 31, 1991, and incorporated herein by reference)

10.15    Form of Indemnification Agreement (Filed as an exhibit to the Company's
         Registration Statement on Form S-1 (File No. 33-47767) or Amendment No.
         1, Amendment No. 2, Amendment No. 3 or Amendment No. 4 thereto and
         incorporated herein by reference)

10.16    Security and Loan Agreement dated June 7, 1996, by and between the
         Company and Imperial Bank (Filed as an exhibit to the Company's
         Quarterly Report on Form 10-Q


                                       28
<PAGE>   31
         for the quarter ended June 30, 1996, and incorporated herein by
         reference)

10.17    First Amendment to Security and Loan Agreement dated June 7, 1996, by
         and between the Company and Imperial Bank (Filed as Exhibit 10.20 to
         the Company's Registration Statement on Form S-2 (File No. 333-18641)
         and incorporated herein by reference)

10.18+   Conversion, Manufacturing and Distribution Agreement dated as of March
         8, 1995, by and between Electronic Arts Inc. and the Company (Filed as
         Exhibit 10.35 to the Company's Annual Report on Form 10-K for the year
         ended December 31, 1995, and incorporated herein by reference)

10.19+   Licensed Publisher Agreement dated November 10, 1995, by and between
         the Company and Sony Computer Entertainment Europe, a division of Sony
         Electronic Publishing Limited (Filed as Exhibit 10.42 to the Company's
         Annual Report on Form 10-K for the year ended December 31, 1995, and
         incorporated herein by reference)

10.20    Licensed Publisher-Supplemental Agreement dated April 11, 1996, by and
         between the Company and Sony Computer Entertainment Europe, a division
         of Sony Electronic Publishing Limited (Filed as Exhibit 10.23 to the
         Company's Registration Statement on form S-2 (File No. 333-18641) and
         incorporated herein by reference)

10.21    Sony PSX License Agreement dated June 29, 1994, by and between the
         Company and Sony Computer Entertainment of America, a division of Sony
         Electronic Publishing Company (Filed as Exhibit 10.24 to the Company's
         Registration Statement on Form S-2 (File No. 333-18641) and
         incorporated herein by reference)

10.22    Stock Purchase Agreement dated as of June 28, 1996, by and between the
         Company and Inland Productions, Inc. (Filed as an exhibit to the
         Company's Quarterly Report on Form 10-Q for the quarter ended September
         30, 1996, and incorporated herein by reference)

10.23    Stock Purchase Agreement dated as of August 2, 1996, by and between the
         Company and Heliotrope Studios, Inc. (Filed as an exhibit to the
         Company's Quarterly Report on Form 10-Q for the quarter ended September
         30, 1996, and incorporated herein by reference)

10.24    License Agreement dated December 29, 1995, between the Company and
         Turner New Media, Inc. (Filed as Exhibit 10.41 to the Company's Annual
         Report on Form 10-K for the year ended December 31, 1995, and
         incorporated herein by reference)

10.25    Stock Option Agreement dated as of August 28, 1996, between the Company
         and Brian J. Farrell (Filed as Exhibit 10.31 to the Company's Annual
         Report on Form 10-K for the year ended December 31, 1996, and
         incorporated herein by reference)

10.26*+  Confidential License Agreement for Nintendo 64 dated November 4, 1996,
         between Nintendo of America, Inc. and THQ Inc.

10.27    Imperial Bank Line of Credit Agreement dated September 22, 1997. (Filed
         as exhibit 10 on the company's form 10Q for the nine months ended
         September 30, 1997, and incorporated herein by reference)

10.28    1997 Stock Option Plan, (Filed as Exhibit 10.1 to the Company's
         Registration Statement on form S-8 (File No. 333-30655) and
         incorporated herein by reference)

10.29*+  Employment Agreement of Fred A Gysi dated as of October 01, 1997,
         between the Company and Fred A. Gysi.

21*      Subsidiaries of the Registrant

27*      Financial Data Schedule

----------


                                       29
<PAGE>   32
    *Filed herewith.

    + Confidential treatment requested as to portions of this exhibit.


                                       30
<PAGE>   33
                                   SIGNATURES

         Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.

Dated: March 27, 1998               THQ INC.

                                    By: /s/ Brian J. Farrell
                                        -----------------------------
                                        Brian J. Farrell
                                        President

         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.

Signature                 Title                                  Date
---------                 -----                                  ----

/s/ Brian J. Farrell                                             March 27, 1998
-----------------------
Brian J. Farrell          President, Chief Executive Officer,
                          and Director

/s/ Lawrence Burstein                                            March 27, 1998
-----------------------
Lawrence Burstein         Director

/s/ Bruce Jagid                                                  March 27, 1998
-----------------------
Bruce Jagid               Director

/s/ Jeffrey C. Lapin                                             March 27, 1998
-----------------------
Jeffrey C. Lapin          Director

/s/ L. Michael Haller                                            March 27, 1998
-----------------------
L. Michael Haller         Senior Vice President
                          and Director
/s/ Fred A. Gysi                                                 March 27, 1998
-----------------------
Fred A. Gysi              Vice President Finance
                          (Chief Financial Officer)


                                       31
<PAGE>   34
                                    THQ INC.
                          INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                   PAGE
                                                                                   ----
<S>                                                                                <C>
INDEPENDENT AUDITORS' REPORT                                                       F-2

CONSOLIDATED FINANCIAL STATEMENTS
  Consolidated Balance Sheets -- December 31, 1996 and December 31, 1997           F-3                       .
  Consolidated Statements of Operations for Each of the Three Years in the
     Period Ended December 31, 1997                                                F-4
  Consolidated Statements of Shareholders' Equity for Each of the Three Years
     in the Period Ended December 31, 1997                                         F-5
  Consolidated Statements of Cash Flows for Each of the Three Years in the
     Period Ended December 31, 1997                                                F-6

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                         F-8
</TABLE>

         All financial statement schedules have been omitted since either
(i) the schedule or condition requiring a schedule is not applicable or (ii) the
information required by such schedule is contained in the Consolidated Financial
Statements and Notes thereto.


                                       F-1
<PAGE>   35
                          INDEPENDENT AUDITORS' REPORT


To the Shareholders of THQ Inc.,
Calabasas, California

We have audited the accompanying consolidated balance sheets of THQ Inc. And
subsidiaries (the "Company") as of December 31, 1996 and 1997, and the related
consolidated statements of operations, shareholders' equity, and cash flows for
each of the three years in the period ended December 31, 1997. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our 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, such consolidated financial statements present fairly, in all
material respects, the financial position of the Company as of December 31, 1996
and 1997 and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 1997 in conformity with generally
accepted accounting principles.


DELOITTE & TOUCHE LLP

Los Angeles, California
February 20, 1998


                                       F-2
<PAGE>   36
                            THQ INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS

                                     ASSETS

<TABLE>
<CAPTION>
                                                                    DECEMBER 31,
                                                           -----------------------------
                                                               1996             1997
                                                           ------------     ------------
<S>                                                        <C>              <C>
Current assets:
  Cash and cash equivalents                                $  2,734,000     $ 11,724,000
  Accounts receivable -- net                                 14,186,000       30,856,000
  Inventory                                                   1,013,000        1,425,000
  Prepaid and deferred royalties                                717,000        3,645,000
  Software development costs                                  2,329,000        6,044,000
  Deferred income taxes                                              --        1,666,000
  Prepaid expenses and other current assets                     485,000          478,000
                                                           ------------     ------------
          Total current assets                               21,464,000       55,838,000
Property and equipment -- net                                   581,000        1,163,000
Deferred royalties -- net of current portion                         --          500,000
Software development costs -- net of current portion                 --        1,300,000
Other long-term assets                                          795,000          652,000
                                                           ------------     ------------
        TOTAL ASSETS                                       $ 22,840,000     $ 59,453,000
                                                           ============     ============

<CAPTION>
                      LIABILITIES AND SHAREHOLDERS' EQUITY

<S>                                                        <C>              <C>
Current liabilities:
  Accounts payable and accrued expenses                    $  3,304,000     $ 10,952,000
  Accrued royalties                                           3,133,000        9,949,000
  Income taxes payable                                               --        3,475,000
  Advance from bank                                           5,355,000               --
                                                           ------------     ------------
          Total current liabilities                          11,792,000       24,376,000
Accrued royalties -- net of current portion                          --        1,550,000
Commitments and contingencies                                        --               --
Shareholders' equity:
  Common Stock, par value $.01, 35,000,000
     shares authorized; 4,739,883 shares, and 6,775,899
     shares issued and outstanding as of December 31,
     1996 and 1997, respectively                                  4,000            4,000
Additional paid-in capital                                   34,558,000       47,559,000
Cumulative foreign currency translation adjustment              (52,000)          81,000
Accumulated deficit                                         (23,462,000)     (14,117,000)
                                                           ------------     ------------
          Total shareholders' equity                         11,048,000       33,527,000
                                                           ------------     ------------
          TOTAL LIABILITIES AND
                 SHAREHOLDERS' EQUITY                      $ 22,840,000     $ 59,453,000
                                                           ============     ============
</TABLE>

                 See notes to consolidated financial statements.


                                       F-3
<PAGE>   37
                            THQ INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                               YEARS ENDED DECEMBER 31,
                                   ----------------------------------------------
                                       1995             1996             1997
                                   ------------     ------------     ------------
<S>                                <C>              <C>              <C>
Net sales                          $ 33,250,000     $ 50,255,000     $ 89,362,000
Costs and expenses:
  Cost of sales                      19,501,000       29,301,000       48,110,000
  Royalties                           3,641,000        7,977,000       14,158,000
  Product development                   889,000        1,324,000        1,610,000
  Project abandonment                 1,025,000          610,000          600,000
  Selling                             3,114,000        4,444,000        8,670,000
  General and administrative          3,139,000        3,496,000        5,064,000
  Operating interest                  1,184,000          878,000          315,000
                                   ------------     ------------     ------------
Total costs and expenses             32,493,000       48,030,000       78,527,000
                                   ------------     ------------     ------------
Income from operations                  757,000        2,225,000       10,835,000
Interest income (expense), net         (134,000)        (316,000)         464,000
                                   ------------     ------------     ------------
Income before income taxes              623,000        1,909,000       11,299,000
Provision for income taxes               22,000            8,000        1,954,000
                                   ------------     ------------     ------------
Net income                         $    601,000     $  1,901,000     $  9,345,000
                                   ============     ============     ============
Net income per share -- basic      $        .21     $        .42     $       1.48
                                   ============     ============     ============
Net income per share -- diluted    $        .17     $        .39     $       1.35
                                   ============     ============     ============
</TABLE>

                 See notes to consolidated financial statements.


                                       F-4
<PAGE>   38
                            THQ INC. AND SUBSIDIARIES

                 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

                  YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

<TABLE>
<CAPTION>
                                                                                          CUMULATIVE
                                                                                           FOREIGN
                                                                             ADDITIONAL    CURRENCY
                                           PREFERRED    COMMON     COMMON     PAID-IN     TRANSLATION  ACCUMULATED
                                             STOCK      SHARES     AMOUNT     CAPITAL     ADJUSTMENT     DEFICIT          TOTAL
                                             ------    ---------   ------   -----------   ---------    ------------    -----------
<S>                                        <C>         <C>         <C>      <C>           <C>          <C>             <C>
Balance at January 1, 1995                       --    2,790,650   $4,000   $30,656,000   $(442,000)   $(25,964,000)   $ 4,254,000
Exercise of warrants and options                 --       91,530       --        48,000          --              --         48,000
Issuance of preferred stock for cash          3,190           --       --     2,613,000          --              --      2,613,000
Conversion of preferred stock to
  Common Stock                               (2,865)   1,335,211       --            --          --              --             --
Net income                                       --           --       --            --          --         601,000        601,000
Foreign currency translation adjustment          --           --       --            --      82,000              --         82,000
                                             ------    ---------   ------   -----------   ---------    ------------    -----------
Balance at December 31, 1995                    325    4,217,391    4,000    33,317,000    (360,000)    (25,363,000)     7,598,000
Exercise of warrants and options                 --      272,115       --       712,000          --              --        712,000
Conversion of preferred stock to
  Common Stock                                 (325)     127,717       --            --          --              --             --
Issuance of Common Stock                         --      122,660       --       529,000          --              --        529,000
Net income                                       --           --       --            --          --       1,901,000      1,901,000
Foreign currency translation adjustment          --           --       --            --     308,000              --        308,000
                                             ------    ---------   ------   -----------   ---------    ------------    -----------
Balance at December 31, 1996                     --    4,739,883    4,000    34,558,000     (52,000)    (23,462,000)    11,048,000
Exercise of warrants and options                 --      311,016       --     1,293,000          --              --      1,293,000
Issuance of Common Stock                         --    1,725,000       --    11,708,000          --              --     11,708,000
Net income                                       --           --       --            --          --       9,345,000      9,345,000
Foreign currency translation adjustment          --           --       --            --     133,000              --        133,000
                                             ------    ---------   ------   -----------   ---------    ------------    -----------
Balance at December 31, 1997                     --    6,775,899   $4,000   $47,559,000   $  81,000    $(14,117,000)   $33,527,000
                                             ======    =========   ======   ===========   =========    ============    ===========
</TABLE>

                 See notes to consolidated financial statements.


                                      F-5
<PAGE>   39
                            THQ INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                             YEARS ENDED DECEMBER 31,
                                                    ------------------------------------------
                                                       1995            1996           1997
                                                    -----------    -----------    ------------
<S>                                                 <C>            <C>            <C>
Cash flows from operating activities:
Net income                                          $   601,000    $ 1,901,000    $  9,345,000
Adjustments to reconcile net income
    to net cash used in operating activities:
    Depreciation and amortization                       240,000        337,000         483,000
    Provision for doubtful accounts,
    discounts and returns                             4,145,000      5,203,000      10,509,000
    Deferred income taxes                                    --             --      (1,666,000)
  Changes in operating assets and liabilities:
    Accounts receivable                              (5,875,000)    (7,270,000)    (20,726,000)
    Inventory and inventory deposits                    779,000        202,000        (441,000)
    Prepaid and deferred royalties and
      Software development costs                      2,592,000      2,799,000       1,548,000
    Prepaid expenses and other current assets            99,000       (322,000)         (4,000)
    Income tax refund receivable                        201,000             --              --
    Accounts payable and accrued expenses             1,040,000     (1,233,000)      7,707,000
    Accrued royalties                                (3,628,000)      (649,000)     (1,627,000)
    Income taxes payable                                     --             --       3,451,000
    Accrued returns and allowances                   (3,589,000)    (5,316,000)     (6,573,000)
    Income taxes payable                                     --             --              --
                                                    -----------    -----------    ------------
Net cash provided by (used in) operating
    activities                                       (3,395,000)    (4,348,000)      2,006,000
                                                    -----------    -----------    ------------
Cash flows used in investing activities:
    Other long-term assets                                   --       (578,000)             --
    Acquisition of equipment                           (239,000)      (314,000)       (923,000)
                                                    -----------    -----------    ------------
Net cash used in investing activities                  (239,000)      (892,000)       (923,000)
                                                    -----------    -----------    ------------
Cash flows from financing activities:
    Advances from bank                                       --      5,355,000      (5,355,000)
    Proceeds from exercise of warrants and
      options                                            48,000        712,000       1,293,000
    Net proceeds from issuance of convertible
      preferred stock                                 2,613,000             --              --
    Net proceeds from issuance of common
      stock                                                  --             --      11,708,000
                                                    -----------    -----------    ------------
Net cash provided by financing activities             2,661,000      6,067,000       7,646,000
                                                    -----------    -----------    ------------
Effect of exchange rate changes on cash and
   cash equivalents                                      61,000         12,000         261,000
                                                    -----------    -----------    ------------
Net increase (decrease) in cash and cash
   equivalents                                         (912,000)       839,000       8,990,000
                                                    -----------    -----------    ------------
Cash and cash equivalents -- beginning of             2,807,000      1,895,000       2,734,000
  period
                                                    -----------    -----------    ------------
Cash and cash equivalents -- end of period          $ 1,895,000    $ 2,734,000    $ 11,724,000
                                                    ===========    ===========    ============
Supplemental disclosure of cash flow information:
  Cash paid during the period for income taxes      $    22,000    $    14,000    $    127,000
                                                    ===========    ===========    ============
  Cash paid during the period for interest          $   230,000    $   375,000    $     51,000
                                                    ===========    ===========    ============
</TABLE>

                 See notes to consolidated financial statements.


                                       F-6
<PAGE>   40
NON-CASH TRANSACTIONS:

   As of July 1, 1996 the Company issued 70,000 shares of Common Stock in lieu
of cash to a former employee of the Company. This transaction resulted in a
reduction in accounts payable and accrued expenses and a like increase in
additional paid-in capital in the amount of $229,000, the fair value of the
stock issued on the date of issuance. Also on July 1, 1996, the Company issued
52,660 shares of Common Stock as part of the purchase price for a 25% interest
in Inland Productions, Inc. ("Inland") increasing other long-term investments
and additional paid-in capital by $300,000.

                 See notes to consolidated financial statements.


                                       F-7
<PAGE>   41
                            THQ INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  ORGANIZATION

         Business. THQ Inc., a Delaware corporation, develops and publishes
interactive entertainment software ("Software") for the hardware platforms that
collectively dominate the market ("Platforms"). Substantially all of the
Company's products are based on licenses for popular cultural trends and
high-recognition names ("Properties").

         Unless the context otherwise requires, references in this document to
"THQ" or the "Company" include THQ Inc. and all of its wholly owned
subsidiaries.

         License Agreements. The Company has two license agreements with Sony
pursuant to which it has the non-exclusive right to utilize the Sony name and
its proprietary information and technology in order to develop and market
Software for use with the 32-bit Sony PlayStation in the United States and
Canada, and Europe, respectively, which expire in June 1998 and December of
2005, respectively.

         The Company has various license agreements with Nintendo pursuant to
which it has the non-exclusive right to utilize the Nintendo name and its
proprietary information and technology in order to develop and market Software
for use with the 64-bit Nintendo 64, 16-bit Super Nintendo Entertainment System
("SNES"), and with the Nintendo Game Boy portable game console. The license
agreements with Nintendo for such hardware Platforms expire at various times
through 1999 and 2000.

         On March 10, 1998, the Company announced that its current license
agreement with World Championship Wrestling will not be renewed. The current
license agreement expires on December 29, 1998, and permits the Company to
continue to sell products on hand and in process at that date through June 29,
1999. Products released by the Company under this license accounted for 39% of
the Company's revenues in 1997 and are expected to account for a substantial
portion of the Company's revenues in 1998. There can be no assurance that this
development will not have a material adverse affect on the Company.

         The Company's Software business is dependent on its license agreements
with Sony and Nintendo. Substantially all of the Company's Software products are
manufactured by Sony and Nintendo, who charge the Company a fixed amount for
each Software CD-ROM or cartridge manufactured, which charge includes a
manufacturing, printing and packaging fee as well as a royalty for the use of
their respective names, proprietary information and technology.

         In addition, the Company must indemnify Sony or Nintendo as
appropriate, with respect to all loss, liability and expense resulting from any
claim against Sony or Nintendo involving the development, marketing, sale or use
of the Company's Titles, including any claims for copyright or trademark
infringement brought against Sony or Nintendo. As such, the Company bears the
risk that the Properties and information and technology licensed from Sony or
Nintendo and incorporated in the Software may infringe the rights of third
parties. Generally, the Company is


                                       F-8
<PAGE>   42
entitled to indemnification from its Software developers and Property licensors
to cover its indemnification obligations to Sony or Nintendo but no assurance
can be given that, if any claim is brought against the Company, said developers
and/or licensors will have sufficient resources to indemnify the Company.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

         Principles of Consolidation. The consolidated financial statements
include the accounts of THQ Inc. and its wholly owned subsidiaries. All material
intercompany balances and transaction have been eliminated.

         Foreign Currency Translation. Assets and liabilities of foreign
operations are translated at current rates of exchange while results of
operations are translated at average rates in effect for the period. Translation
gains or losses are shown as a separate component of shareholders' equity.
Foreign currency translation gains and losses result from exchange rate changes
denominated in currencies other than the U.S. dollar. The Company has not
experienced significant foreign currency transaction gains or losses.

         Cash Equivalents. The Company considers all highly liquid investments
purchased with maturities less than three months to be cash equivalents.

         Fair Values of Financial Instruments. The carrying value of accounts
receivable and payables approximate the fair value due to their short-term
maturities. The carrying value of the Company's advances from its bank is
considered to approximate its fair value because the interest rate of this
instrument is based on a variable reference rate.

         Inventory. Inventories, which consist principally of finished products,
are stated at the lower of cost (first-in, first-out basis) or market. The
Company estimates the net realizable value of slow-moving inventory on a title
by title basis, and charges the excess of cost over net realizable value to cost
of sales. Inventory deposits are prepayments to Software Manufacturers or
deposits to lenders opening letters of credit on behalf of the Company for the
manufacture of specific products.

         Property and Equipment. Property and equipment are stated at cost.
Depreciation is computed using the straight-line method over the estimated
useful lives of the assets which range from three to five years. Leasehold
improvements are amortized over the shorter of their useful lives or the
remaining lease term. Equipment consists of the following at:

<TABLE>
<CAPTION>
                                                          DECEMBER 31,
                                                 ------------------------------
                                                    1996               1997
                                                 -----------        -----------
<S>                                              <C>                <C>
Furniture, fixtures and equipment                $ 1,164,000        $ 1,634,000
Leasehold improvements                                20,000             49,000
Less accumulated depreciation and
  amortization                                      (603,000)          (520,000)
                                                 -----------        -----------
                                                 $   581,000        $ 1,163,000
                                                 ===========        ===========
</TABLE>


                                       F-9
<PAGE>   43
         Depreciation and amortization expense for the years ended December 31,
1995, 1996 and 1997 was $199,000, $238,000 and $483,000, respectively.

         Royalties and Software Development Costs. Advance royalty payments for
intellectual Property licenses are recorded as prepaid royalties. All minimum
guaranteed royalty payments are initially recorded as an asset (prepaid and
deferred royalties) and as a liability (accrued royalties) at the contractual
amount upon execution of the contract. Royalty payments for intellectual
Property licenses are classified as current assets and current liabilities to
the extent they relate to anticipated sales during the subsequent year and
long-term assets and long-term liabilities if the sales are anticipated after
one years time. The Company utilizes both independent Software developers (who
are paid advances against future royalties) and internal development teams to
develop its Software. Under generally accepted accounting principles, such
Software development costs are capitalizable when technological feasibility has
been established. Technological feasibility for entertainment Software such as
the Company's has been established by Sony, Nintendo, and Sega for use with
their respective hardware Platforms. Amortization of prepaid royalty and
Software development costs, as a part of royalties expense, is provided on a
product-by-product basis commencing with the general release of each product,
based on the greater of the ratio of current gross revenues for the product to
the sum of its current and anticipated gross revenues, or the straight line
method over the remaining estimated economic life of the product. The Company
also expenses as project abandonment losses advances or capitalized Software
development costs when, in management's estimate, future revenues will not be
sufficient to recover previously capitalized costs. Such abandonment losses are
solely attributable to changes in market conditions or product quality
considerations. Software development costs of $1,768,000, $2,390,000, and
$7,955,000 were amortized in 1995, 1996, and 1997, respectively. Project
abandonment losses related to Software development costs of $1,025,000, $509,000
and $35,000 were charged to expense in 1995, 1996, and 1997, respectively.
Research and development costs are expensed as incurred.

         Revenue Recognition. Revenue is recognized when the product is shipped,
provided that no significant vendor support obligations remain outstanding, and
provided that the collection of the resulting receivable is deemed probable by
management. Although the Company sells its products on a no-return basis, in
certain circumstances the Company may allow returns, price concessions, or
allowances on a negotiated basis. The Company estimates such returns and
allowances based upon management's evaluation of the Company's historical
experience and current industry trends. Such estimates are deducted from gross
revenue. Software is sold under a limited 90-day warranty against defects in
material and workmanship. To date, the Company has not experienced material
warranty claims. (See Note 3).

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

         Basic and Diluted Earnings Per Share. At December 31, 1997, the Company
adopted Statement of Financial Accounting Standard No. 128 ("SFAS"), "Earnings
per Share". SFAS 128 replaces the presentation of earnings per share ("EPS")
with a presentation of basic EPS


                                      F-10
<PAGE>   44
based upon the weighted-average number of common shares for the period. It also
requires dual presentation of basic and diluted EPS for companies with "complex
capital structures". EPS for the current and prior periods has been presented in
conformity with the provisions of SFAS 128. The following table is a
reconciliation of the weighted-average shares used in the computation of basic
and diluted EPS for the years presented herein:

<TABLE>
<CAPTION>
                                                              YEARS ENDED
                                                              DECEMBER 31,
                                                 --------------------------------------
                                                    1995          1996          1997
                                                 ----------    ----------    ----------
<S>                                              <C>           <C>           <C>
Net income used to compute basic and
  diluted earnings per share                     $  601,000    $1,901,000    $9,345,000
                                                 ----------    ----------    ----------
Weighted average number of shares
  Outstanding -- basic                            2,858,000     4,525,000     6,320,000
Dilutive effect of stock options and warrants       222,000       311,000       581,000
Dilutive effect assuming conversion of
  Preferred stock                                   476,000            --            --
                                                 ----------    ----------    ----------
Number of shares used to compute
  earnings per share -- diluted                   3,556,000     4,836,000     6,901,000
                                                 ==========    ==========    ==========
</TABLE>

         Reclassifications. Certain items in the 1995 and 1996 financial
statements have been reclassified to conform to the 1997 presentation.

         Recently Issued Accounting Pronouncements. In June 1997, the FASB
issued SFAS No. 130, "Reporting Comprehensive Income". SFAS No. 130 establishes
standards for the reporting and display of comprehensive income and its
components (revenues, expenses, gains and losses) in a full set of general
purpose financial statements. SFAS No. 130 requires that an enterprise (a)
classify items of other comprehensive income by their nature in a financial
statement and (b) display the accumulated balance of other comprehensive income
separately from retained earnings and additional paid-in capital in the equity
section of a statement of financial position. SFAS No. 130 is effective for
fiscal years beginning after December 15, 1997. The Company does not expect the
impact of SFAS No. 130 to be material in relation to its financial statements.

         In June 1997, the FASB issued SFAS No. 131, "Disclosure About Segments
of an Enterprise and Related Information." SFAS No. 131 established standards
for the way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to stockholders. It also establishes standards for related
disclosure about products and services, geographic areas and major customers.
SFAS No. 131 is effective for financial statements for periods beginning after
December 15, 1997. The Company does not expect the impact of SFAS No. 131 to be
material in relation to its financial statements.

         In October of 1997, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants issued Statement of Position
97-2 "Software Revenue Recognition" ("SOP 97-2"). This statement provides
guidance on applying generally accepted


                                      F-11
<PAGE>   45
accounting principles in recognizing revenues on software transactions. This
Statement supersedes Statement of Position 91-1 "Software Revenue Recognition".
This Statement is effective for transactions entered into in fiscal years
beginning after December 15, 1997. Earlier application is encouraged as of the
beginning of the fiscal year or interim period for which financial statements or
information have not been issued. Retroactive application of the provisions of
this statement is prohibited. The Company has evaluated its revenue recognition
policies of the adaptation of SOP 97-2; and believes that such adoption will not
have any impact.

         Pervasiveness of Estimates. The preparation of financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
The most significant estimates relate to prepaid and deferred royalties,
Software development costs, accrued returns and allowances and the allowance for
doubtful accounts.

3. ACCOUNTS RECEIVABLE, FACTORING AGREEMENT, DUE FROM FACTOR AND ACCRUED RETURNS
   AND ALLOWANCES

         Until July 18, 1996, the Company had a factoring and credit agreement
(the "BNY Agreement") with BNY Financial Corporation ("BNY"), a wholly owned
subsidiary of The Bank of New York. On July 18, 1996, the Company terminated its
factoring and credit agreement with BNY and entered into a new financing and
banking arrangement with Imperial Bank (the "Imperial Agreement"). On September
22, 1997, the Company entered into a new agreement for a larger and lower cost
banking facility with Imperial Bank. The new bank credit agreement is designed
to mirror the seasonal trends of the Company's business, providing advances
under the credit line of up to $23 million during the Company's peak selling
season, and up to $12 million outside of the peak season. The former agreement
provided for advances of up to $9 million based on a formula of accounts
receivable and inventory. Although the agreement contains certain covenants
regarding financial and other matters, the Company's borrowings are no longer
restricted to a formula based on receivables and inventory. Interest on the
outstanding balance is payable at Imperial Bank's prime rate. The line of credit
is collateralized by all tangible personal property including inventory and
equipment.

         Accounts receivable are due primarily from domestic and foreign
retailers and distributors, including mass merchants and specialty stores.
Accounts receivable at December 31, 1996 and 1997 are composed of the following:


                                      F-12
<PAGE>   46
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                  -----------------------------
                                                      1996             1997
                                                  ------------     ------------
<S>                                               <C>              <C>
Accounts receivable -- domestic                   $ 13,428,000     $ 33,787,000
Other accounts receivable -- primarily foreign       5,004,000        5,075,000
Other receivables                                      112,000          133,000
Allowance for foreign doubtful accounts             (1,294,000)         (10,000)
Allowance for foreign discounts and returns           (292,000)        (362,000)
Allowance for domestic accrued returns and
  allowances                                        (2,772,000)      (7,767,000)
                                                  ------------     ------------
          Accounts receivable -- net              $ 14,186,000     $ 30,856,000
                                                  ============     ============
</TABLE>

         The allowance for foreign doubtful accounts consists of the following:

<TABLE>
<CAPTION>
                                                    DECEMBER 31,
                                    -------------------------------------------
                                       1995             1996           1997
                                    -----------     -----------     -----------
<S>                                 <C>             <C>             <C>
Balance at January 1                $  (827,000)    $(1,380,000)    $(1,294,000)
Provision for doubtful accounts        (505,000)        (10,000)         (4,000)
Actual doubtful accounts
(recoveries)                            (48,000)         96,000       1,288,000
                                    -----------     -----------     -----------
Ending balance                      $(1,380,000)    $(1,294,000)    $   (10,000)
                                    ===========     ===========     ===========
</TABLE>

         The allowance for foreign discounts and returns consists of the
following:

<TABLE>
<CAPTION>
                                                    DECEMBER 31,
                                    -------------------------------------------
                                       1995             1996           1997
                                    -----------     -----------     -----------
<S>                                 <C>             <C>             <C>
Balance at January 1                $  (190,000)    $  (311,000)    $  (292,000)
Provision for discounts and
   returns                             (766,000)       (422,000)       (333,000)
Actual discounts and returns            645,000         441,000         263,000
                                    -----------     -----------     -----------
Ending balance                      $  (311,000)    $  (292,000)    $  (362,000)
                                    ===========     ===========     ===========
</TABLE>


         The allowance for domestic accrued returns and allowances consists of
the following:


<TABLE>
<CAPTION>
                                                    DECEMBER 31,
                                    -------------------------------------------
                                       1995             1996           1997
                                    -----------     -----------     -----------
<S>                                 <C>             <C>             <C>
Balance at January 1                $(3,574,000)    $(2,859,000)    $(2,772,000)
Provision for discounts and
   returns                           (2,874,000)     (4,771,000)    (10,172,000)
Actual discounts and returns          3,589,000       4,858,000       5,177,000
                                    -----------     -----------     -----------
Ending balance                      $(2,859,000)    $(2,772,000)    $(7,767,000)
                                    ===========     ===========     ===========
</TABLE>



                                      F-13
<PAGE>   47
4.  EMPLOYEE PENSION PLAN

         The Company sponsors for its employees a defined contribution plan
intended to qualify under Section 401(k) of the Internal Revenue Code (the
"Plan"). The Plan, as amended in 1991, provides that employees may defer up to
12% of annual compensation, and that the Company will make a matching
contribution equal to each employee's deferral, up to 4% of compensation. The
Company may also contribute funds to the Plan in the form of a profit sharing
contribution. Expenses under the Plan were $30,000, $161,000, and $119,000 in
1995, 1996 and 1997, respectively.

5.  INCOME TAXES

         The provision for income taxes consists of the following:

<TABLE>
<CAPTION>
                                       1995            1996            1997
                                    -----------     -----------     -----------
<S>                                 <C>             <C>             <C>
Current
  Federal                           $    22,000     $     2,000     $ 2,760,000
  State                                      --           6,000         821,000
  Foreign                                    --              --          39,000
                                    -----------     -----------     -----------
                                         22,000           8,000       3,620,000
                                    -----------     -----------     -----------
Deferred
  Federal                                    --              --      (1,283,000
  State                                      --              --        (383,000)
                                    -----------     -----------     -----------
Provision for income taxes          $    22,000     $     8,000     $ 1,954,000
                                    ===========     ===========     ===========
</TABLE>

         A reconciliation of the provision for income taxes at the federal
statutory rate to the provision recorded in the accompanying financial
statements is as follows:

<TABLE>
<CAPTION>
                                                    1995      1996       1997
                                                    -----     -----      -----
<S>                                                 <C>       <C>        <C>
Federal provision at statutory rate                  35.0%     35.0%      35.0%
State taxes (net of Federal benefit)                   --        --        4.0%

Effect of net operating loss carryforward           (31.5)    (34.9)     (21.7)
                                                    -----     -----      -----
                                                      3.5%      0.1%      17.3%
                                                    =====     =====      =====
</TABLE>


                                      F-14
<PAGE>   48
         The components of deferred tax assets (liabilities) are as follows:

<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                      -----------------------------------------------------------
                                                 1996                            1997
                                      ---------------------------     ---------------------------
                                        FEDERAL          STATE          FEDERAL          STATE
                                      -----------     -----------     -----------     -----------
<S>                                   <C>             <C>             <C>             <C>
Deferred tax assets:
  Allowance for doubtful accounts,
     Discounts and returns            $   943,000     $   212,000     $ 2,641,000     $   566,000
  Net operating loss                    5,946,000       1,176,000       4,980,000         473,000
  License abandonment                     671,000         151,000         652,000         140,000
  Other -- net                            121,000          28,000         540,000          56,000
                                      -----------     -----------     -----------     -----------
Total deferred tax assets               7,681,000       1,567,000       8,813,000       1,235,000
Deferred tax liabilities:
  Software development costs             (897,000)       (202,000)     (2,260,000)       (379,000)
  State income taxes                     (465,000)             --        (290,000)             --
                                      -----------     -----------     -----------     -----------
Net deferred tax assets                 6,319,000       1,365,000       6,263,000         856,000
Valuation reserve                      (6,319,000)     (1,365,000)     (4,980,000)       (473,000)
                                      -----------     -----------     -----------     -----------
Deferred income taxes                 $        --     $        --     $ 1,283,000     $   383,000
                                      ===========     ===========     ===========     ===========
</TABLE>

         The valuation reserve decreased $291,000, $21,000 and $2,231,000 during
1995, 1996 and 1997, respectively.

         As of December 31, 1997 the Company had federal and state net operating
loss carryforwards of approximately $15,394,000 (expiring from years 2008 to
2009) and approximately $9,284,000 (expiring from years 1998 to 1999),
respectively.

         The sale of 1,500,000 shares of Common Stock offered by the Company on
February 11, 1997 resulted in an "ownership change" of the Company for purposes
of Sections 382 and 383 of the Internal Revenue Code of 1986, as amended (the
"Code"). As a result, the amount of the Company's net operating loss
carryforward available to reduce the Company's federal income tax liability in
future years in which the Company has taxable income will be limited to an
annual amount equal to (i) the fair market value of the Company's capital stock
immediately prior to the consummation of the offering on February 11, 1997,
multiplied by (ii) the "long-term tax exempt rate" published by the Internal
Revenue Service for the month in which the offering was consummated. Based upon
a long-term tax exempt rate for February 1997 of 5.48% and an assumed market
price of the Common Stock immediately prior to consummation of this offering of
$8.56 per share (the last reported sale price of the Common Stock on February
10, 1997) such amount is approximately $2,225,000 per year.

6.  STOCK OPTION PLAN

         The Company has two stock option plans (the "1990 Plan" and "1997
Plan") which provide for the issuance of up to 650,000 and 650,000 shares,
respectively, available for employees, consultants and non-employee directors.
An additional 5,154 options under the 1990 Plan and 250,750 options under the
1997 Plan were available for grant at December 31, 1997.


                                      F-15
<PAGE>   49
Stock options granted under the option plans may be incentive stock options
under the requirements of the Internal Revenue Code, or may be nonstatutory
stock options, which do not meet such requirements. Options may be granted under
the option plans to, in the case of incentive stock options, all employees
(including officers) of the Company; or, in the case of nonstatutory stock
options, all employees (including officers) or non-employee directors of the
Company.

         The exercise price per share of all options granted under the plans in
1995, 1996 and 1997 has been the market price of the stock on the date of the
grant. Generally, options granted become exercisable over three years and must
be exercised within five years of the date of grant.

<TABLE>
<CAPTION>
                                                                       NUMBER OF
                      STOCK OPTIONS                                     SHARES
--------------------------------------------------------------         --------
<S>                                                                    <C>
Balance at January 1, 1995 (weighted average price of $22.51)           104,090
Granted at a weighted average price of $3.02 per share                  609,833
Exercised at a weighted average price of $2.87 per share                (16,666)
Canceled at a weighted average price of $6.02 per share                 (42,666)
                                                                       --------
Balance at December 31, 1995 (weighted average price of $6.04
   per share)                                                           654,591
                                                                       --------
Granted at a weighted average price of $4.23 per share                  141,500
Exercised at a weighted average price of $3.09 per share               (120,274)
Canceled at a weighted average price of $9.72 per share                (185,584)
                                                                       --------
Balance at December 31, 1996 (weighted average price of $3.41
   per share)                                                           490,233
                                                                       --------
Granted at a weighted average price of $11.70 per share                 416,750
Exercised at a weighted average price of $3.66 per share               (119,841)
Canceled at a weighted average price of $ 3.52 per share                (11,998)
                                                                       --------
Balance at December 31, 1997 (weighted average price of $7.79
   per share)                                                           775,144
                                                                       ========
Options exercisable at December 31, 1997                                265,613
                                                                       ========
</TABLE>

         During 1995, the Company granted 240,000 options outside of the option
plans, which consisted of 140,000 options at $3.06 to Brian J. Farrell, the
Company's president; 70,000 options to a former employee as a part of the
employee's severance package (50,000 at $2.81 and 20,000 at $2.25); and 30,000
options at $2.87 to two outside consultants who have subsequently become
employees of the Company. In 1996, the Company issued 200,000 options outside of
the option plans to Mr. Farrell at an exercise price of $5.00 per share. Share
exercise prices for these options equal the market price of the Company's Common
Stock at the date of the grant. In 1996 and 1997 one of the two outside
consultants exercised 3,333 and 1,667 shares, respectively. In 1997 Mr. Farrell
exercised 60,000 shares, as well as the Company's former employee whom exercised
70,000 shares.


                                      F-16
<PAGE>   50
         The following table summarizes information about stock options
outstanding at December 31, 1997:

<TABLE>
<CAPTION>
     NUMBER                WEIGHTED AVERAGE               WEIGHTED
 OUTSTANDING AT                REMAINING                   AVERAGE
DECEMBER 31, 1997          CONTRACTUAL LIFE             EXERCISE PRICE
-----------------         ------------------         --------------------
<S>                       <C>                        <C>
      339,730                     3                        $  2.91
      291,580                     7                        $  4.57
      277,167                     5                        $  9.29
      171,667                     5                        $ 14.33
-----------------         ------------------         --------------------
    1,080,144                     5                        $  6.81
=================         ==================         ====================

<CAPTION>
     SHARES                    WEIGHTED
 EXERCISABLE AT                 AVERAGE
DECEMBER 31, 1997           EXERCISE PRICE
-----------------         ------------------
<S>                       <C>
    210,239                     $  2.89
    187,458                     $  4.63
     47,917                     $  7.51
     11,667                     $ 12.07
-----------------         ------------------
    457,281                     $  4.32
=================         ==================
</TABLE>

         The estimated fair value of the options granted in 1995, 1996 and 1997
was $1,566,000 $1,094,000 and $3,041,000, respectively. The Company applies
Accounting Principles Board Opinion No. 25 and related Interpretations in
accounting for its stock option plan. Accordingly, no compensation cost for the
Company's stock option plan and has been recognized in 1995, 1996 or 1997. Had
compensation cost for the Company's stock option plans been determined based on
the fair value at the grant dates for awards under the plan consistent with FASB
Statement No. 123, Accounting for Stock Based Compensation, the Company's net
income and earnings per share for the years ended December 31, 1995, 1996 and
1997 would have been reduced to the pro forma amounts indicated below:

<TABLE>
<CAPTION>
                                                  YEARS ENDED
                                  ----------------------------------------------
                                  DECEMBER 31,    DECEMBER 31,      DECEMBER 31,
                                     1995            1996               1997
                                  ----------     -------------     -------------
<S>                               <C>            <C>               <C>
Net income:
    As reported                   $  601,000     $   1,901,000     $   9,345,000
    Pro forma                     $    2,000     $   1,123,000     $   8,144,000
Net income per common and
  common equivalent share:
    As reported                   $      .17     $         .39     $        1.35
    Pro forma                     $       --     $         .23     $        1.18
</TABLE>


                                      F-17
<PAGE>   51
         The fair market value of options granted under the stock option plans
during 1995, 1996 and 1997 was determined using the Black-Scholes option pricing
model utilizing the following assumptions:

<TABLE>
<CAPTION>
                                                 YEARS ENDED
                                ------------------------------------------------
                                DECEMBER 31,      DECEMBER 31,      DECEMBER 31,
                                   1995              1996               1997
                                -----------       -----------       -----------
<S>                             <C>               <C>               <C>
Dividend yield                       0%                0%                0%
Anticipated volatility              83%               83%               83%
Risk-free interest rate         5.3% - 7.5%       5.2% - 6.7%       5.9% - 6.1%
Expected lives                    4 years           4 years           4 years
</TABLE>

7.  MAJOR CUSTOMERS AND RELATED PARTY TRANSACTIONS

         Sales (before returns and allowances) to a major customer represented
12%, 12% and 19% of gross sales in the years ended December 31, 1995, 1996 and
1997, respectively. In 1996 one other customer represented 10% of sales (before
returns and allowances). In 1997 another customer represented 10% of sales
(before returns and allowances). The Company performs ongoing credit evaluations
of its customers and maintains an allowance for potential credit losses.

         In 1995, 1996 and 1997, the Company paid the law firm of Feder,
Kaszovitz, Isaacson, Weber, Skala & Bass, of which Mr. Skala, a director of the
Company through January 14, 1997, is a partner, approximately $214,000,
$215,000, and $107,000, respectively. As of December 31, 1996 and 1997, the
Company had owing to Feder, Kaszovitz, Isaacson, Weber, Skala & Bass
approximately $76,000 and $0, respectively.

         In 1996 and 1997, the Company paid Inland Productions, Inc., a Software
developer in which the Company acquired 25% interest in on July 1, 1996 (See
Note 9), $775,000, and $985,000. As of December 31, 1996 and 1997, the Company
had owing to Inland Productions, Inc. $625,000 and $640,000, respectively.

8.  CAPITAL STOCK TRANSACTIONS

         In the months of July, August and September 1995, the Company received
aggregate net proceeds of $2,613,000 from the sales of certain of its
convertible preferred stock pursuant to Regulation S under the Act. The
preferred shares were convertible by the holders thereof into 1,462,928 common
shares of the Company. These shares were redeemable at the Company's option upon
30 days' written notice, and earned dividends at the rate of 9% per annum,
payable at the Company's option in cash or by issuance of common shares equal to
the dividend amount divided by the average market price of the preceding five
days. As of December 31, 1995, a total of 1,335,211 shares of common stock had
been issued upon conversion. During 1996, all shares of preferred stock had been
converted to common stock, a total of 1,462,928 shares of common stock were
issued upon conversion.


                                      F-18
<PAGE>   52
         During 1996, the Company issued 70,000 shares of common stock, at the
fair market value of the stock on such date, in settlement of an accrued
liability of $229,000 due to a former employee.

         During the years ended December 31, 1996 and 1997, the number of
warrants to purchase the Company's Common Stock exercised were 70,000, and
15,164, respectively. The Company received proceeds from the exercise of such
warrants totaling $149,000 and $123,000, in the years ended December 31, 1996
and 1997, respectively. There were 74,864 warrants exercised during the year
ended December 31, 1995. At December 31, 1997 outstanding warrants were 58,497
at an average exercise price of $22.98.

         On February 14, 1997, the Company completed a public offering of
1,500,000 shares of the Company's Common Stock. In conjunction with the
offering, the Company granted to the underwriters an over-allotment option,
exercisable within 30 days of February 11, 1997, to purchase up to 225,000
additional shares of the Common Stock at the public offering price of $7.50 per
share. On March 11, 1997, the underwriters exercised their over-allotment
option. All of these shares were newly issued and sold on behalf of the Company.
The net proceeds of the 1,725,000 shares sold by the Company, were approximately
$11.7 million.


9.  OTHER LONG-TERM ASSETS

         On July 1, 1996, the Company acquired a 25% interest in Inland, a
Software developer for home entertainment game systems. The investment consisted
of $300,000 in cash and 52,660 shares of Common Stock valued at $300,000, and is
included in other long-term assets in the accompanying balance sheet. The
Company has contracted with Inland for the development of 32-bit and 64-bit
versions of Turner's World Championship Wrestling and 32-bit and PC versions of
BASS Masters Classic. The Company's investment exceeded its equity in the
underlying net assets by $613,000, which is being amortized over five years. The
Company's equity in the operating results of Inland is not material to the
results of operations.

         On August 2, 1996, the Company acquired the business of Heliotrope
Studios, Inc. ("Heliotrope"), an interactive Software developer for PC and an
assignment of the distribution license and certain work-in-progress for a PC
title (Pax Imperia: Eminent Domain) from Blizzard Entertainment, a division of
Davidson Associates. In connection with the acquisition, the Company incurred
costs of $115,000 and assumed certain liabilities (approximately $150,000) of
Heliotrope. The excess of the Company's cost of the acquisition over the
estimated fair value of assets acquired (approximately $265,000) has been
included as a long-term investment in the accompanying balance sheet. Such
excess cost is being amortized over five years. Because Heliotrope's assets and
operations prior to the acquisition were insignificant, no pro forma information
is presented.


                                      F-19
<PAGE>   53
10. COMMITMENTS AND CONTINGENCIES

         Royalties. At December 31, 1996 and 1997, future minimum guaranteed
royalties were $3,133,000 and $11,499,000, respectively. Royalties are
classified as current liabilities if initial sales are to commence within one
year.

         Leases. The Company is committed under operating leases with lease
termination dates to 2003. Minimum future rentals pursuant to these leases as of
December 31, 1997 are as follows:

<TABLE>
<S>                                           <C>
               1998                           $   558,000
               1999                               540,000
               2000                               538,000
               2001                               234,000
               2002                               154,000
               2003                               142,000
                                              -----------
                                              $ 2,166,000
                                              ===========
</TABLE>

         Rent expense was $184,000, $183,000, and $258,000 in 1995, 1996 and
1997, respectively.


                                      F-20
<PAGE>   54
11. OPERATIONS IN GEOGRAPHIC AREAS

                  The Company is engaged in the development, marketing and
distribution of Software products. The following information sets forth
geographic information on the Company's sales, earnings (losses) from operations
and identifiable assets for the years ended December 31, 1995, 1996 and 1997:

<TABLE>
<CAPTION>
                                       UNITED
                                       STATES      EUROPE        ASIA     ELIMINATION   CONSOLIDATED
                                      --------    --------     --------     --------      --------
                                                        (in thousands of dollars)
<S>                                   <C>         <C>          <C>        <C>           <C>
Year ended December 31, 1995:
Sales to unaffiliated customers       $ 24,894    $  8,356           --           --      $ 33,250
Transfers between geographic areas          --          --           --           --            --
                                      --------    --------     --------     --------      --------
Total net revenue                     $ 24,894    $  8,356           --           --      $ 33,250
                                      ========    ========     ========     ========      ========
Pretax earnings (loss)                $  1,621    $   (869)    $     (4)    $   (125)     $    623
                                      ========    ========     ========     ========      ========
Identifiable assets at
  December 31, 1995                   $ 13,681    $  3,415     $      2     $   (182)     $ 16,916
                                      ========    ========     ========     ========      ========
Year ended December 31, 1996:
Sales to unaffiliated customers       $ 35,399    $ 14,856           --           --      $ 50,255
Transfers between geographic areas          --          --           --           --            --
                                      --------    --------     --------     --------      --------
Total net revenue                     $ 35,399    $ 14,856           --           --      $ 50,255
                                      ========    ========     ========     ========      ========
Pretax earnings                       $  1,222    $    668     $     19           --      $  1,909
                                      ========    ========     ========     ========      ========
Identifiable assets at
  December 31, 1996                   $ 17,163    $  5,860     $     --     $   (183)     $ 22,840
                                      ========    ========     ========     ========      ========
Year ended December 31, 1997:
Sales to unaffiliated customers       $ 75,365    $ 13,997           --           --      $ 89,362
Transfers between geographic areas          --          --           --           --            --
                                      --------    --------     --------     --------      --------
Total net revenue                     $ 75,365    $ 13,997           --           --      $ 89,362
                                      ========    ========     ========     ========      ========
Pretax earnings                       $  8,538    $  2,761           --           --      $ 11,299
                                      ========    ========     ========     ========      ========
Identifiable assets at
  December 31, 1997                   $ 52,067    $  7,568           --     $   (182)     $ 59,453
                                      ========    ========     ========     ========      ========
</TABLE>


                                      F-21
<PAGE>   55
12. QUARTERLY FINANCIAL DATA (UNAUDITED)

         The Company's summarized quarterly financial data are as follows:

<TABLE>
<CAPTION>
                                                                     QUARTER ENDED
                                                   -------------------------------------------------
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)      MARCH 31     JUNE 30     SEPTEMBER 30  DECEMBER 31
---------------------------------------------      --------     --------      --------      --------
<S>                                                <C>          <C>         <C>           <C>
Year ended December 31, 1996
Revenues                                           $  6,582     $ 12,087      $ 11,102      $ 20,484
Expenses                                              6,839       11,591        10,450        19,466
                                                   --------     --------      --------      --------
Income before income taxes                             (257)         496           652         1,018
Income taxes                                              4           --            --             4
                                                   ========     ========      ========      ========
Net income                                         $   (261)    $    496      $    652      $  1,014
                                                   ========     ========      ========      ========

Net income per share:
       Basic                                       $   (.06)    $    .11      $    .14      $    .21
                                                   ========     ========      ========      ========
       Diluted                                     $   (.06)    $    .11      $    .13      $    .19
                                                   ========     ========      ========      ========

Year ended December 31, 1997
Revenues                                           $ 11,839     $ 12,265      $ 16,355      $ 48,903
Expenses                                             11,115       11,205        14,517        41,226
                                                   --------     --------      --------      --------
Income before income taxes                              724        1,060         1,838         7,677
Income taxes                                              4           66           410         1,474
                                                   ========     ========      ========      ========
Net income                                         $    720     $    994      $  1,428      $  6,203
                                                   ========     ========      ========      ========

Net income per share:
       Basic                                       $    .13     $    .15      $    .22      $    .93
                                                   ========     ========      ========      ========
       Diluted                                     $    .12     $    .14      $    .20      $    .84
                                                   ========     ========      ========      ========
</TABLE>


                                      F-22