<PAGE>
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, DC 20549

                                   FORM 10-K
                     _____________________________________

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

For the fiscal year ended December 31, 1998

                                       OR

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

For the transition period from _________  to ___________

                        Commission File Number: 0-22944

                                 US WATS, INC.
                                 -------------
            (Exact name of Registrant as specified in its charter)

<TABLE>
<CAPTION>
 
<S>                                        <C>
     New York                                           22-3055962
----------------------------------                    --------------
(State or other jurisdiction of            (I.R.S.  Employer Identification No.)
incorporation or organization)
 
2 Greenwood Square, 3331 Street Road
Bensalem, Pennsylvania                                      19020
----------------------------------------               --------------
(Address of principal executive offices)                 (Zip Code)
</TABLE> 
 
(Registrant's telephone number, including area code):  (215) 633-9400
                                                       --------------
Securities registered pursuant to Section 12 (b) of the Act:   None
                                                               ----
Securities registered pursuant to Section 12 (g) of the Act:

                        Common Stock ($0.001 par value)
                        -------------------------------
                               (Title of Class)

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

                         Yes       X              No 
                               ---------               ---------

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form10-K.

                         Yes                      No       X
                               ---------               ---------

As of February 26, 1999 the aggregate market value of the Company's Common Stock
held by non-affiliates of the Registrant, based on the average closing sale
price, was approximately $12,300,000.

As of  February 26, 1999 the Registrant has 18,959,894 shares of Common Stock
outstanding.

                                       1
<PAGE>
 
                               TABLE OF CONTENTS



                                    PART I
                                    ======
<TABLE>
<CAPTION>
 
 
<S>        <C>                                                         <C>
Item 1.    Business...................................................   4
Item 2.    Properties.................................................  10
Item 3.    Legal Proceedings..........................................  10
Item 4.    Submission of Matters to a Vote of Security Holders........  11
 

                                    PART II
                                    =======
 
 
Item 5.   Market for the Registrant's Common Equity and Related
             Stockholder Matters......................................  12
Item 6.   Selected Financial Data.....................................  13
Item 7.   Management's Discussion and Analysis of Financial Condition
             and Results of Operations................................  14
Item 8.   Financial Statements and Supplementary Data.................  20
Item 9.   Changes in and Disagreements with Accountants on Accounting
             and Financial Disclosure.................................  20
 

                                   PART III
                                   ========

 
Item 10.  Directors and Executive Officers of the Registrant..........  21
Item 11.  Executive Compensation and Options Outstanding..............  22
Item 12.  Security Ownership of Certain Beneficial Owners and 
             Management...............................................  25
Item 13.  Certain Relationships and Related Transactions..............  26


                                    PART IV
                                    =======

                                        
Item 14.  Exhibits, Financial Statement Schedules and Reports on 
             Form 8-K.................................................  28
</TABLE> 

                                       2
<PAGE>
 
                                    PART 1
                                    ==== =
                                        
ITEM 1.   BUSINESS
------------------

Description of Business

US WATS, Inc. ("the Company") is a switch-based interexchange carrier providing
long distance telephone communications services primarily to small and medium-
size business customers.  The Company also provides inbound-800 long distance
services, as well as other telecommunications services such as travel cards
(calling cards), cellular, paging, internet service, dedicated access, data
services, pre-paid calling cards (debit cards), International Callback and
carrier termination services.   The Company uses its own switches and facilities
to originate, transport and terminate calls for customers generally located
between Boston, Massachusetts and Norfolk, Virginia and California (on-net
area).   Approximately 85% of the calls billed by the Company each month are
processed through the Company's own switches. For calls originating or
terminating outside the Company's own network (off-net area), the Company
utilizes the services provided by other long distance companies.

The Company's revenues are derived primarily from the transport of outgoing and
incoming calls which are billed by the Company to end-users at specified rates.
Transport costs of these calls are billed to the Company from other carriers at
contractual rates.  These carriers supply the Company with call detail
information which enables the Company to bill its customers depending upon the
Company's individual rates.  The combination of the efficiency of the Company's
network and facilities, and the purchase of long distance services in bulk from
other carriers allow the Company to offer competitive rates to small and medium-
sized businesses.

The Company's principal executive offices are located at 2 Greenwood Square,
3331 Street Road, Suite 275, Bensalem, Pennsylvania 19020.  The Company's
telephone number at that location is (215) 633-9400.

CORPORATE STRATEGY

The Company's objective is to provide its customers with a comprehensive range
of telecommunications services with value-added features at competitive prices.
The Company markets through three channels (direct, agent and reseller) and
offers a diversified mix of products and services.  The Company employs a direct
sales force, and also markets through independent agents. The Company offers
individual value-added services to resellers depending on each reseller's
requirements.  The Company offers competitive wholesale pricing to its agents
which it expects will lead to significant revenue growth. Net sales revenue
attributable to the Company's agents and resellers accounts for approximately
55% of the Company's non-wireless revenue. The Company also utilizes numerous
carriers allowing for network redundancy.  This allows the Company to offer both
carrier specific and private label services.  The Company is focused on
servicing commercial accounts. Revenue from commercial accounts represented
greater than 90% of gross revenue during 1998.

                                       3
<PAGE>
 
SERVICES

The Company provides domestic outbound long distance service to and from
anywhere in the United States, international calling services to 263 countries,
inbound 800 services, cellular local and long distance services, regional and
national paging services, internet service, travel/calling cards, prepaid
calling cards (debit cards), dedicated access services, private line networks,
data services, international callback, and carrier termination services.

The Company charges its customers based upon minutes of usage, at both flat and
banded rates (price is based on termination of call).  In those areas which
provide for equal access customers have the ability to choose their long
distance carrier for all intra-Local Access Transport Area ("LATA") calls.  The
Company is a "RESPORG" (Responsible Organization) for the inbound 800 services
it provides to its customers.  This allows the Company direct access to the 800
number database allowing for faster 800 number service.  This increases the
speed at which the Company can perform such services as blocking and routing
changes for its customers' inbound 800 services.

The Company utilizes Bell Atlantic NYNEX Mobile Systems to carry its cellular,
local calls.  The Company provides its cellular customers with competitive long
distance services provided by its own network. The Company's travel cards
provide its customers with an "easy-to-remember" 800 number access to the
Company's network from all locations in the United States and Canada, and
feature personal identification numbers ("PINs") which are selected by the
individual customer.  The Company's prepaid calling cards (debit cards) are
marketed wholesale primarily to retail distribution and specialty advertising
outlets.

SWITCH AND NETWORK FACILITIES

The Company maintains a digital network on both the East and West coasts of the
United States.  The Company's East Coast network extends from Boston,
Massachusetts south to Norfolk, Virginia and west to Pittsburgh, Pennsylvania.
The Company's switching facilities are located in Philadelphia, Pennsylvania and
Oakland, California.  Calls terminating off-net are transported and terminated
for the Company on circuits operated by other carriers.  The Company's network
utilizes SS7 common channel signaling.  SS7 signaling increases network
efficiency by reducing call set-up time.

The network is supported by a Digital Switch Corporation DEX400 switch in
Philadelphia, which is scheduled to be replaced with a new Digital Switch
Corporation Megahub 600E by June, 1999, and a Digital Switch Corporation DEX600
in Oakland which are used to process customer calls.  Intelligent call
processing required by the Company's enhanced services products (calling card
and international callback) is provided by a NACT SCX switching platform.  This
switching platform provides customized voice prompts and other enhanced services
required by these products.  The ability of the Company to transport calls over
its company owned switches and leased facilities allows the company to maximize
gross margins and control network quality of service.

The Company is continually re-configuring its call processing through the
utilization of least-cost routing software.  The Company has contracted with
numerous domestic and international transport carriers which allow for
international country-specific least-cost routing and the maintenance of diverse
routes.

MARKETING

The Company markets its services utilizing three sales channels focused on
developing a customer base primarily within the New York City to Washington DC
corridor.  The Company employs a direct sales force who are paid a salary plus
commission basis.  The Company also maintains an independent agent network of
more than 200 agents who receive a commission based on monthly  billings.  The
Company's reseller channel is comprised of approximately 12 switchless resellers
which contract for services at a fixed price (buy price).  These resellers are
permitted to establish their own retail billing rates, and do not lease or own
any switching equipment, transmission facilities, or  billing software.  Because
of this, they are dependent on switch-based carriers for products and services.
The Company offers these resellers competitive wholesale rates, a variety of
products, customer support services, billing, credit and 

                                       4
<PAGE>
 
collection services, as well as other value-added features such as on-line
electronic access to customer account information, back office support,
automatic electronic order entry and account profitability reporting. The
Company offers its customers a comprehensive invoice including extensive
management reports to all sales channels. Included in the Company's invoices are
more than 20 management reports covering call distribution studies, time of day
analysis, call duration distribution, as well as individual telephone number
call detail records allowing them to quickly analyze their calling patterns and
costs.

The Company's current average retail customer uses approximately $155 in monthly
long distance revenue, which is similar to the industry average for revenue
generated through an agent sales force.  Typically, agents focus on high margin
small business and residential accounts where the retail rates and margins sold
to a customer support the agents residual commission.

Coincident to entering the Competitive Local Exchange business, initially as a
Bell Atlantic Reseller in the Mid-Atlantic states, the Company plans to develop
a direct sales force to solicit and secure larger middle market accounts, where
the combination of local and long distance revenue justifies dedicated access.
The nature of dedicated access products, requires a more detailed and focused
sales approach by experienced telecommunications sales professionals who are
capable of directing their efforts to specific market segments in clearly
defined geographic territories.  As a result of the Company's initiatives in the
local area, the Company believes that its agents and certain smaller business
accounts will benefit from simple resale of Bell Atlantic local services, in
those instances where the bundling approach does not justify dedicated T1
connectivity.

COMPETITION

The Company views the long distance industry as a three-tiered industry which is
dominated by the nation's three largest long distance providers: AT&T, MCI
WorldCom and Sprint Communications Company, L.P.  ("Sprint").  AT&T, MCI
WorldCom and Sprint, collectively  generate, approximately 80% of the nation's
long distance revenue (approximately $87 billion) and comprise what is known as
"Tier 1" International Long Distance Companies.  The second tier consists of
several other companies with annual revenues of $250 million to $5 billion each.
The third tier, which includes the Company, consists of more than 300 companies
with annual revenues of less than $250 million each, the majority below $50
million each.

The Company targets small and medium-sized commercial customers. The number of
telecommunications services offered by the Company on a consolidated, one-bill
basis serves, to some extent, to distinguish the Company from some of its
competitors.  Competitive distinctions are made based upon the number of
services offered, the pricing plans, the length of contracts, as well as the
billing information provided.  The Company currently owns switch capacity,
develops and implements its own products, monitors and deploys its transmission
facilities and prepares and designs its own billing and reporting systems.

In addition to direct competition from what the Company estimates are several
hundred switchless resellers, the Company competes with the sales organizations
and resellers of large telecommunications companies such as MCI and Sprint,
which at any particular time may offer more desirable services or prices than
those offered by the Company.

On October 29, 1996, the FCC adopted an order in which it eliminated the
requirement that non-dominant interstate carriers such as the Company maintain
tariffs on file with the FCC for domestic interstate interexchange services.
The FCC's order was issued pursuant to authority granted to the FCC in the
Telecommunications Act to "forebear" from regulating any telecommunications
service provider if the FCC determines that the public interest will be served.
Pursuant to the FCC's order, after a transition period, relationships between
carriers and their customers would be set by contract and long distance
companies would no longer be permitted to file with the FCC tariffs for
interstate interexchange services.  However, MCI, Sprint and The American
Carriers Telephone Association have separately appealed the FCC's order to the
United States Court of Appeals for the District of Columbia Circuit ("DC
Circuit").  On February 13, 1997, the DC Circuit ruled that the FCC's order
became effective.  The Company may benefit from the elimination of FCC tariffs
by gaining more flexibility and speed in dealing with 

                                       5
<PAGE>
 
marketplace changes. However, the absence of tariffs will also require that the
Company secure contractual agreements with its customers regarding many of the
terms of its existing tariffs or face possible claims arising because of the
rights of the parties are no longer clearly defined.

In spite of AT&T's additional flexibility and the pending interexchange
competition from the Regional Bell Operating Companies, the Company believes
that it continues to provision and sell telecommunications service to small to
medium sized businesses at competitive rates.  In addition, the Company believes
that the deregulation of the local exchange telecom market represents a
significant opportunity similar to the opportunity provided at the deregulation
of AT&T in 1984.

EMPLOYEES

At the end of 1998, the Company had 70 full-time employees working at three
locations.  The Company is not a party to any organized labor contracts.  The
Company considers its relationship with its employees to be satisfactory.


REGULATORY MATTERS

REGULATORY REQUIREMENTS.  The Company is a regulated entity at the Federal level
-----------------------                                                         
with regard to international traffic and interstate traffic.  The Company has
received Section 214 authorization to resell international switched services and
has filed an FCC tariff for its domestic interstate services.

State regulatory requirements vary from state to state.  The Company has
obtained certification in all states which require certification in order to
provide long distance services, with the exception of two (2) states in which
certifications are pending (Maine and Arizona).  Some states place statutory
restrictions on the operations of "telecommunications service resellers," as
that term is defined in these states.  Some states require telecommunications
service resellers to file and operate in accordance with service and rate
"tariffs." Changes in existing regulations or their interpretation in any state
could classify the Company as a "telecommunications service reseller" and
subject it to regulation.  Such regulation could result in an increase in
customers' usage charges and, in some cases, could limit or eliminate the
Company's ability to service customers in that jurisdiction.  The Company would
incur, among other expenses, certain administrative costs and legal fees in
contesting or complying with such regulatory changes that would increase the
Company's cost of doing business.

The providers of local exchange telecommunications services to the Company are
also heavily regulated at the Federal level and in the states in which they
operate.  Changes in existing regulations or their interpretation affecting
these providers could materially adversely affect their business or even prevent
them from offering telecommunications services to their customers, including the
Company, on favorable terms.

In addition, certain services offered by the Company which are not presently
regulated in all states may become regulated.  Such regulation could delay the
deployment of products and/or services and would increase certain administrative
costs and legal fees in contesting or complying with such regulation.  The FCC
has granted applications by companies seeking to provide international callback
(also known as "call reorigination" services) to those countries where the
practice is legal under local law.  The FCC has taken the view that call
reorigination services created incentive to lower foreign collection rates to
the benefit of U.S. ratepayers and serve the FCC's general policies favoring
resale and increased competition in the international marketplace.  Although the
FCC has consistently expressed its support for call reorigination services
enacted by foreign countries.  In response to the input of certain foreign
countries in rulemaking proceedings, the FCC has acknowledged that foreign
countries face unusual difficulties in implementing prohibitions on call
reorigination but has stated that such countries continue to bear the principal
responsibility for enforcing their domestic laws.  However, the FCC has stated
that, as a matter of international comity the FCC will prohibit U.S.  authorized
carriers from providing call reorigination in countries where it is expressly
prohibited.  The FCC established a variety of requirements that a foreign
country must meet before the FCC will consider assisting a foreign government in
enforcing its 

                                       6
<PAGE>
 
domestic ban. To date, the FCC has taken no action to enforce a foreign
country's ban with respect to a U.S. provider. However, there can be no
assurance that the FCC will not enforce such a ban.


LEGISLATION.   On February 8, 1996, President Clinton signed into law the
-----------                                                              
Telecommunications Act of 1996.  The law capped a multi-year effort to amend the
Communications Act of 1934 to take into account the extraordinary changes in the
telecommunications market which have occurred since passage of the original act.
The bill is intended to spur additional competition in telecommunications
services particularly within the local exchange markets which are now dominated
by incumbent local exchange carriers.

The law codifies a new set of interconnection principles which will apply to
interconnection for both interstate and intrastate services.  State public
utilities commissions are given a significant role in administering the
interconnection provisions of the new act, and deadlines are imposed for
decisions by both the FCC and state commissions.

The new act also eliminates the existing AT&T antitrust consent decree which
barred the provision of long distance services and manufacturing by the Bell
Operating Companies (BOCs).  Under the new act, BOCs may immediately offer long
distance services outside their home regions.  The BOCs may offer service within
their regions as soon as they satisfy the following requirements:

        i)  the BOC has provided interconnection to a competitor under Section
            252 of the Act, or,
       ii)  the BOC has been granted state commission approval of its
            interconnection tariff, the BOC has received no interconnection
            request after 10 months after enactment, and no carrier has
            submitted a request for interconnection within the 3 months prior to
            the BOC's application to provide inter-LATA service.

The BOC must also submit and have granted an application to the FCC to provide
the service.

The law provides for the Commission to establish new universal service
principles and a regulatory mechanism to insure that financial support is
available for universal service.  This program benefits schools, health care
providers, and libraries and was initiated in January, 1998.  The law requires
that all telecommunication service providers contribute financial support for
universal service.  The law allows the Company to pass these universal service
fees to the end users.  The Company, as well as most competitors, began this
process in January, 1998.

The interconnection provisions of the new law are intended to benefit the
Company by making available local exchange connections which are more efficient
and potentially cheaper than those available today.  In August, 1996, the FCC
reached a decision in its proceeding implementing the new Act's interconnection
provisions.  This ruling is intended to reduce interconnection costs for
competing local carriers connecting with incumbent local exchange companies.
Certain provisions of the ruling have been appealed to various U.S. Courts of
Appeals.  These appeals have been consolidated into proceedings currently
pending before the U.S. Court of Appeals for the Eighth Circuit ("Eighth
Circuit").  Applications for a stay of the proposed rules were rejected by the
FCC.  However, the Eighth Circuit has granted a temporary stay of certain
provisions of the Interconnection Decision, including the pricing rules and
rules that would have permitted new entrants to "pick and choose" among various
provisions of existing interconnection agreements, pending a decision on the
merits.  The FCC applied to the U.S.  Supreme Court to vacate the judicial stay,
but the U.S.  Supreme Court, on November 12, 1996, refused to vacate the stay.
All other provisions of the Interconnection Decision remain in effect pending
resolution of the appeal on the merits.

Additional competition with existing local exchange carriers should provide
price discipline in an area which has been monopolized by incumbent local
exchange carriers.  The Company can also expect a substantial increase in the
competition which it faces in interexchange markets as a result of the entry of
the Bell Operating Companies into long distance services.  Not only will there
be additional competition providing services which are similar to those provided
by the Company, but they can be expected to 

                                       7
<PAGE>
 
bundle those services with other offerings such as local service, cellular and
video services. These package offerings may be more attractive to consumers than
offerings of stand-alone services.

EQUAL ACCESS CHARGES.  The FCC has also commenced a proceeding to reform the
--------------------                                                        
rules governing interstate access charges.  Access charges are charges imposed
by LECs on 1ong distance providers for access to the local exchange network, and
are designed to pay LECs for investment in the local network.  Prior to December
1993, pricing of those "access services" was on an equal rate per minute ("equal
per unit") basis for "local transport." On September 17, 1992, the FCC announced
it would: (1) maintain the existing "equal per unit" pricing rules until late
1993; (2) implement an interim rate structure and pricing plan during the
subsequent two years: and (3) implement a further rulemaking for consideration
of a permanent rate structure beginning no earlier than late 1995.  (The local
access restructuring plan went into effect in December 1993.)

In December 1996, the FCC issued an order which, among other things, requested
comment on a number of access charge reform issues designed to foster efficient
pricing of access, competition for access services, and to reflect the
development of local services prompted by the 1996 Telecommunications Act.  The
FCC has also sought comment on whether Internet service providers and other
information service providers should be subject to access charges.  As of
January, 1998, these access charges are being incurred by the Company, and are
being passed on to the end users.

As part of the AT&T Divestiture Decree, the divested regional BOCs were required
to charge AT&T and all other carriers (including US WATS) equal per minute rates
for "local transport" service (the transmission of switched long distance
traffic between the BOCs' central offices and the interexchange carriers' points
of presence).  BOC and other Local Exchange Carrier ("LEC") tariffs for local
transport service have been based upon these "equal per unit" rules since 1984,
pursuant to the AT&T Divestiture Decree and the FCC's waiver of its inconsistent
local transport pricing rules.  Although the portion of the AT&T Divestiture
Decree containing this rule ceased to be effective by its terms on September 1,
1991, the FCC had extended its effect until it concluded the rulemaking
proceeding in which it is considering whether to retain or modify the "equal per
unit" local transport pricing structure.  In its September 1992 "First Transport
Order", the FCC adopted an interim transport rate structure plan that replaced
the FCC's former equal-charge rules.  The interim plan incorporated both flat-
rate and usage-sensitive charges which, together with an interconnection charge,
was designed to enable the LECs to receive approximately the same revenues they
would have received under the former equal-charge plan.  In the "First Transport
Order", the FCC provided that the interim rate structure would remain in effect
through October 31, 1995.  On December 30, 1993, the LECs' interim transport
rate structure tariffs became effective.  In July 1993, January 1994 and
December 1994 the FCC issued orders refining and clarifying its interim rate
structure.  On September 22, 1995 the Commission extended the effectiveness of
the interim transport rate structure pending further Commission action.  Based
upon the analysis set forth in the FCC's December 22nd Order, the Company does
not anticipate that these decisions will have a material impact.

The FCC has required LECs to provide virtual co-location arrangements to LEC
competitors to enable them to provide alternative transport services to
interexchange carriers, although SBC Corporation has challenged this requirement
in the Court of Appeals for the District of Columbia Circuit.  As a result of
these arrangements, the Company may have alternatives to purchasing all of its
local access from LECs.

The Telecommunications Act of 1996 codifies a new set of interconnection
principles which significantly overlap the Commission's expanded interconnection
requirements.  Under the law the Commission is required to conduct a rulemaking,
to be completed within six months after passage of the act, to implement the new
interconnection principles.  This rulemaking could alter the existing rules
regarding expanded interconnection.

As part of the Telecommunications Act of 1996, the Federal Communications
Commission mandated that all telecommunication companies support the Universal
Service Fund.  This fund was established in 1998, to support quality, affordable
telecommunication services for all rural citizens, schools, libraries and
hospitals.  A determined rate for the "specific fee" portion of this surcharge
is applied to all interstate and international calls.  A determined rate for the
"surcharge" portion is applied to all 

                                       8
<PAGE>
 
invoiced charges, excluding taxes.

Also, as part of Access Reform mandated in the Telecommunications Act of 1996,
beginning in 1998 local phone companies are permitted to assess the Pre-
subscribed Interexchange Carrier Charge, also known as "PICC."  The "PICC" is
a monthly per line cost charged by the local telephone company to each long
distance carrier for every customer phone line that is pre-subscribed to that
carrier.  These charges are passed on to the end users.

TELECOMMUNICATION FRAUD

The Company is subject to attempts by outsiders to gain access to the Company's
telecommunications network.  Such attempts can take the form of the theft of
calling cards, and the cloning of cellular phones.  Breaches of security can
also involve improper use of 800 telephone numbers and customer PBX equipment.
The Company monitors the use of its network through certain fraud detection
devices and believes that its procedures are satisfactory.  Due to the highly
technical nature of the business, complete assurance that sufficient controls
are in place to prevent a material loss is not possible, however, the Company
does not believe that it has been subject to material telecommunications fraud.


ITEM 2.  PROPERTIES
-------------------

The Company currently leases approximately 27,000 square feet in four buildings
at a monthly cost of approximately $35,000.  Its executive offices and
headquarters at 2 Greenwood Square, 3331 Street Road, Suite 275 in Bensalem,
Pennsylvania is leased for a term of three years expiring in 2001.  The
Company's leased switch space in Philadelphia, Pennsylvania expires in 2003.
The Company's second leased switch space in Philadelphia, Pennsylvania expires
in 2007.  The Company's leased switch space in Oakland, California expires in
2000.  The Company considers its space to be adequate for its current needs.


ITEM 3.  LEGAL PROCEEDINGS
--------------------------

On June 13, 1997, Mark Scully, a former President and Chief Operating Officer
of the Company, filed a complaint against the Company, and certain former
officers of the Company, in the United States District Court for the Eastern
District of Pennsylvania.  Mr. Scully asserts various claims in connection with
his termination of employment with the Company on December 30, 1996.  In
particular, he alleges, among other things, breach of contract in connection
with the termination of certain stock options, breach of the alleged contract
for employment, breach of an asserted duty of good faith and fair dealing,
fraudulent and negligent misrepresentation, and civil conspiracy.  Mr. Scully
alleges damages of at least $1.6 million, plus attorneys' fees, costs and other
disbursements and the cost of COBRA payments and interest; $1 million of the
alleged damages claimed are punitive.  The Company contests the allegations of
the complaint and intends to vigorously defend against the action.  The case was
tried to the Court sitting without a jury on December 14-16, 1998.  The parties
recently filed post-trial memorandum and are awaiting the decision of the Court.

The Company is party, in the ordinary course of business, to other litigation
involving services rendered, contract claims and other miscellaneous causes of
action arising from its business.  The Company has established reserves relating
to its legal claims and believes that potential liabilities in excess of those
recorded will not have a material adverse effect on the Company's Consolidated
Financial Statements, however, there can be no assurances to this effect.

                                       9
<PAGE>
 
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
------------------------------------------------------------

On November 25, 1998, the Company held its 1998 Annual Meeting of Shareholders.
At that meeting the Company's shareholders voted on the following issues:

        1) The election of (4) four Board of Directors to serve until the next
           annual meeting of shareholders. At the meeting, Aaron R. Brown was
           reelected Chairman, President and Chief Executive Officer. Walt
           Anderson was reelected to the Board of Directors. Artie Regan was
           reelected as Secretary and Director and Murray Goldberg was reelected
           to the Board of Directors.

        2) To transact such other business as may properly come before the
           Annual Meeting or any postponement or adjournment thereof.


Since the date of the Annual Meeting of Shareholders above, Aaron R. Brown has
stepped down from his position of Chairman, President and Chief Executive
Officer and Walt Anderson has been named Chairman of the Board of Directors.
Currently, the Board of Directors includes Mr. Anderson, Mr. Regan and Mr.
Goldberg.  The Company plans to elect additional outside Directors in the
future.

                                       10
<PAGE>
 
                                    PART II
                                    ==== ==
                                        

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

The following figures represent the high and low closing price as reported by
NASDAQ during each successive quarter beginning in 1997.

 

      QUARTER              HIGH         LOW
      -------              ----         ---

4th     Quarter 1998      $ 1.91      $ 1.38
3rd     Quarter 1998      $ 2.19      $ 1.50
2nd     Quarter 1998      $ 2.25      $ 1.91
1st     Quarter 1998      $ 2.38      $ 1.16
4th     Quarter 1997      $ 2.31      $ 1.25
3rd     Quarter 1997      $ 2.00      $ 1.34
2nd     Quarter 1997      $ 1.63      $  .84
1st     Quarter 1997      $ 1.53      $ 1.03


Effective January 21, 1994, the Company's Common Stock was listed on the
National Association of Securities Dealers Automated System (NASDAQ) under the
symbol "USWI".

As of  March 17, 1999 there were approximately 131 holders of record of the
Company's Common Stock.  Most of the shares of the Common Stock are held in
street name for a larger number of beneficial owners.

The Company has not paid any dividends on its Common Stock, however, the Company
is paying quarterly dividends on its Preferred Stock at a rate of 9% or
approximately $6,750 per quarter.  The Company does not currently anticipate the
payment of dividends on its Common Stock.

On March 23, 1999, the Company through a private placement transaction, issued
900,000 shares of common stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, for an aggregate purchase price of $1,530,000 or
$1.70 per share.  The proceeds of the issuance will be used for general working
capital.  The terms of such transaction were negotiated between the Company and
Gold & Appel Transfer, S.A. on an arms length basis, with Mr. Anderson
abstaining from all negotiations and approvals.

                                       11
<PAGE>
 
ITEM 6.  SELECTED FINANCIAL DATA
--------------------------------

The selected financial data presented below is for the years ended December 31,
for each of the periods indicated below.  The following information should be
read in connection with the consolidated financial statements of the Company and
related notes included elsewhere in this report and with Item 7 of this report.

<TABLE>
<CAPTION>
 
                                                Year Ended December 31,
                                                -----------------------
Operating Data               1998           1997           1996          1995          1994
-----------------------  -------------  -------------  ------------  ------------  -------------
<S>                      <C>            <C>            <C>           <C>           <C>
 
Net sales                 $44,679,060    $56,466,698    $40,304,442  $27,755,388    $23,633,312
 
Net Income (loss)(1)      $(1,828,369)   $(3,699,821)   $    88,625  $  (277,723)   $(1,246,076)
 
Net Income (loss)
  per common share(2)     $      (.10)   $      (.23)   $        --  $      (.02)   $      (.09)
 
                                                       December 31,
                                                       -----------
Balance Sheet Data           1998           1997           1996         1995           1994
-----------------------   -----------    -----------    -----------  -----------    -----------
 
Total assets              $11,021,464    $11,813,475    $11,992,359  $ 9,500,361    $ 9,552,833
 
Capital
  lease obligations       $   376,760    $   653,355    $   703,696  $   731,701    $ 1,396,364
 
Redeemable
  preferred stock         $   330,000    $   330,000    $   300,000  $   300,000    $ 1,300,000
 
Cash dividends            $    27,000    $    27,000    $    27,000  $    67,255    $   120,000
  on preferred stock
</TABLE>

(1)  1994 results include a reduction of network costs of $783,000 in connection
     with the reversal of an account payable due to a former vendor.

     1995 results reflect favorable resolution of the Company's dispute with
     Colonial Penn Group, Inc. and Colonial Penn Insurance, resulting in the
     reversal of an account payable in the amount of approximately $2,880,000.
     However, this benefit was substantially offset by the cost of
     unsuccessfully litigating the resultant AT&T case on the basis of anti-
     trust.  The costs of litigation with AT&T incurred during 1995 approximated
     $850,000.  These costs do not include the additional expense of
     approximately $305,000 of related expenses pertaining to the write-down of
     certain AT&T signal conversion equipment and accounts receivable written
     off, which were attributable to AT&T services provided by the Company.  In
     addition, AT&T was awarded a counter claim in the litigation in the amount
     of $669,000 pertaining to services utilized in prior years. As a result of
     settlement of these matters, the Company recognized a net favorable impact
     of approximately $1,056,000 in 1995.

     1997 results include an increase in bad debt expense of approximately
     $986,000 due to higher than anticipated carrier write-offs.  In addition,
     the Company incurred approximately $173,000 of severance expense upon the
     termination of three members of management during 1997.  Finally, costs
     associated with the proposed merger with ACC Corp. (see Note 14 to the
     financial statements, Aborted Merger Costs) amounted to approximately
     $567,000 in 1997.

     1998 results include approximately $393,000 in additional depreciation
     expense due to the acceleration of depreciation of assets associated with
     the Philadelphia Switch, which is to be replaced by the middle of 1999.  In
     addition, the Company incurred approximately $300,000 of 

                                       12
<PAGE>
 
     salary expense for severance paid to a former President. Finally,
     approximately $102,000 in miscellaneous expense was due to moving the
     corporate office in 1998.

(2)  The Company has retroactively adopted Statement of Financial Accounting
     Standards No. 128, Earnings Per Share ("SFAS 128").  In accordance with
     SFAS 128, since the Company has incurred losses from continuing operations
     for the years ended December 31, 1994, 1995, 1997 and 1998 no potential
     Common Shares have been included in the computation of any diluted per
     share amount.  For the year ended December 31, 1996 the difference between
     diluted and basic earnings per share is not significant.  Accordingly, only
     basic earnings per share have been presented.


ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
--------------------------------------------------------------------------------
OF OPERATIONS
-------------


Certain information contained herein may include "forward-looking statements"
within the meaning of Section 21E of the Securities Exchange Act of 1934, as
amended.  All statements, other than statements of historical facts included in
this report are forward-looking statements. Such statements are subject to
certain risks and uncertainties, including but not limited to: changes in
general economic conditions, increasing levels of competition in the
telecommunications industry, changes in telecommunications technologies, changes
in FCC regulations, the Company's reliance on transmission facilities based
carriers, risks involved in conducting international operations, the inability
to generate sufficient revenues to meet debt service obligations and operating
expenses, unanticipated costs associated with the Company's recent and future
acquisitions and the failure of the Company to manage its growth effectively.
Should one or more of these risks or uncertainties materialize, actual results
may vary materially from those estimated, anticipated or projected.  Although
the Company believes that the expectations reflected by such forward-looking
statements are reasonable based on information currently available to the
Company, no assurance can be given that such expectations will prove to have
been correct.  Cautionary statements identifying important facts that could
cause actual results to differ materially from the Company's expectations are
set forth in this report.  All forward-looking statements included herein are
expressly qualified in their entirety by these cautionary statements.


RESULTS OF OPERATIONS
---------------------

                            ~ 1998 Compared to 1997~

Overview

US WATS, Inc. is a switch-based interexchange carrier providing long distance
telephone communications services primarily to small and medium-size business
customers.  The Company also provides inbound-800 long distance services, as
well as other telecommunications services such as travel cards (calling cards),
cellular, paging, internet service, dedicated access, data services, pre-paid
calling cards (debit cards), International Callback and carrier termination
services. The Company uses its own switches and facilities to originate,
transport and terminate calls for customers generally located between Boston,
Massachusetts and Norfolk, Virginia and in California (on-net area).
Approximately 85% of the calls billed by the Company each month are processed
through the Company's own switches.  For calls originating or terminating
outside the Company's own network (off-net area), the Company utilizes the
services provided by other long distance companies.

The Company experienced significant changes in its business that negatively
impacted its results of operations for the year ended December 31, 1998. In the
first quarter of 1998, the Company and ACC Corp. mutually terminated an
Agreement and Plan of Merger between the two Companies. During the first quarter
of 1998, prior to the termination of such agreement, the Company's operating and
sales initiatives

                                       13
<PAGE>
 
were not met due to management's focus on integration plans with ACC Corp. As a
result, the Company's revenues in the first quarter of 1998 were negatively
impacted.

Also, revenues decreased in 1998 by approximately $3,023,000 due to a decline in
the International Callback revenue channel.  This was a result of management's
decision to gradually exit the International Callback business.  This decision
was based primarily on the telecommunications deregulation in European and Asian
countries.  As pricing for long distance services has decreased in these areas,
the International Callback business as a whole has diminished.

In addition, approximately $3,875,000 of the decrease in revenue was due to a
decline in the retail revenue channel, mostly attributed to decreasing selling
rates because of strong competition in the marketplace.  Also, revenue through
the carrier sales channel decreased by approximately $4,200,000 for the year
ended December 31, 1998.  In 1997, revenue through the carrier channel consisted
of a large amount of high credit risk international traffic.  In 1998, the
Company limited the amount of this traffic in order to reduce bad debt exposure.



REVENUE

Total revenues decreased 20.9% or approximately $11,788,000 to approximately
$44,679,000 in 1998,  primarily due to a decrease in carrier revenue of
approximately $4,200,000, a decrease in International Callback revenue of
approximately $3,023,000, and a decrease in retail revenue of approximately
$3,875,000.  As a result of strong competition in the long distance market, the
Company's average retail rate per minute decreased $.018 from January, 1998 to
December, 1998. This accounted for approximately $2,009,000 of the $3,875,000
decrease in retail revenue.


The table below shows the distribution of revenues on a percentage basis by
product line:


                            DISTRIBUTION OF REVENUES

<TABLE>
<CAPTION>
 
<S>                                                  <C>      <C>
          Service                                    % 1998   % 1997
----------------------------------------------------------------------
          Domestic 1+                                   45%      37%
          International                                 23%      31%
          Inbound                                       15%      15%
          Wireless                                       4%       4%
          Domestic Carrier Termination                  13%      13%
 
</TABLE>

GROSS PROFIT

Gross profit margin in 1998 increased 8.7% to 28.8% from 1997.  The increase in
gross profit margin is primarily attributable to the decrease in carrier
revenue, which generates a much lower margin than the Company's retail products,
but are a necessary component of fully utilizing network facilities.  As a
percentage of total revenue, carrier revenue decreased to approximately 26% for
1998 versus 28% in 1997.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSE

Selling, General and Administrative ("SG&A") expenses for 1998 were
approximately $3,088,000 lower than the amount incurred during 1997.  However,
SG&A expenses as a percentage of revenue 

                                       14
<PAGE>
 
increased marginally from 30.0% in 1997 to 31.0% in 1998. Depreciation expense
increased approximately $441,000 in 1998. Of this increase, $393,000 was due to
accelerating the depreciation of assets associated with one of the Company's
switches (See footnote 2 under Property and Equipment). Commission expense
decreased approximately $1,408,000 or 21.0% from 1997 due primarily to a
decrease in revenues on which commissions are paid. Salary compensation expense
decreased approximately $570,000 to approximately $3,045,000 due to less
headcount throughout 1998. Also, other miscellaneous SG&A expenses decreased
approximately $1,537,000 in 1998.

PROVISION FOR BAD DEBT

Bad debt expense decreased approximately $677,000 (from approximately 2.6% of
net sales in 1997 to approximately 1.8% of net sales in 1998).  In 1997, the
Company incurred bad debts related to three large carrier accounts.  The
improvement in 1998 is mainly attributed to the Company's ability to more
effectively monitor and control exposure from revenue derived from the carrier
channel.

NET LOSS FROM OPERATIONS

The Company recorded a net loss before preferred dividends for 1998 of
approximately $1,828,000 versus a net loss before preferred dividends of
approximately $3,700,000 for 1997.  This improvement is mainly due to an
increase in gross profit margins, a decrease in bad debt expense, a decrease in
commission expense, a decrease in legal and accounting fees and a decrease in
salary expense offset by an increase in depreciation expense.  A portion of the
net loss before preferred dividends of approximately $1,828,000 in 1998 was
attributable to the following: a one time salary expense of approximately
$300,000 associated with severance paid to a former President, an increase in
miscellaneous expense of approximately $102,000 associated with moving the
corporate office, an increase in depreciation expense of approximately $393,000
(See footnote 2 under Property and Equipment), consulting expenses of
approximately $100,000 associated with the engagement of Paine Webber to explore
potential strategic alternatives for the Company and approximately $256,000 for
other consulting, legal and accounting fees associated with potential strategic
alternatives for the Company.


                           ~ 1997 Compared to 1996 ~

OVERVIEW

The Company experienced significant changes in its business that negatively
impacted its results of operations for the year ended December 31, 1997.  The
Company hired new management late in 1996 and early in 1997 in order to seek
entry into the local telecommunications provider market.  Late in 1997, however,
the Company's board of directors determined to replace the management team and,
as a result, experienced operational disruptions and incurred severance costs
during 1997 of approximately $173,000.

In addition, margins on the Company's products and services continued to
decrease in 1997, as competitive pressures continued to affect both the
Company's retail and wholesale (or carrier) price points.  The decreased margins
more than offset the gains in the Company's gross revenues in 1997.  In
addition, commission expense increased by more than $2,115,000 over commission
expense in 1996 due primarily to an increase in revenues on which commissions
are paid.  The Company's bad debt expense also increased significantly in 1997
by approximately $986,000.  Of this increase, approximately $780,000 is related
to the provision for bad debts of three specific carrier accounts, $137,000 is
related to uncollectable international toll calls, and $56,000 is the result of
the bankruptcy of one of the Company's rebillers.

                                       15
<PAGE>
 
The Company raised $2,300,000 in a private placement of 1,590,000 shares of its
Common Stock in November 1997.  This enabled the Company to temporarily meet the
capital and surplus requirements for the continued listing of its Common Stock
on The Nasdaq Small Cap Market, and provided the necessary cash to sustain the
Company's operations.

On October 28, 1997, the Company entered into an Agreement and Plan of Merger
with ACC Corp. and a wholly-owned subsidiary of ACC Corp., pursuant to which ACC
Corp. would issue approximately $46 million worth of its Common Stock to holders
of US WATS capital stock, and US WATS would become a wholly-owned subsidiary of
ACC Corp. The merger was subject to the satisfaction of certain conditions,
including that the merger be treated as a pooling of interests.  Costs
associated with the merger of $567,000 incurred by the Company prior to December
31, 1997 are included in selling, general, and administrative expenses in the
Company's Statement of Operations.  Subsequent to 1997, the Company expects to
incur costs of approximately $131,000 associated with the merger. On March 11,
1998, the Company announced an agreement with ACC Corp. for mutual termination
of the Agreement and Plan of Merger, by and among US WATS, ACC Corp. and a
subsidiary of ACC Corp.



REVENUE

Total revenues increased 40.1% or approximately $16,162,000 to approximately
$56,467,000 in 1997,  primarily due to an increase in agent revenue of
approximately $11,350,000, an increase in carrier revenue of approximately
$8,792,000, and an increase in switchless revenue of approximately $2,454,000.
The increase in revenues was partially offset by a decrease in reseller revenue
of approximately $5,012,000.


The table below shows the distribution of revenues on a percentage basis by
product line:


                           DISTRIBUTION OF REVENUES
<TABLE>
<CAPTION>
 
<S>                             <C>      <C>
          Service               % 1997   % 1996
-------------------------------------------------
Domestic 1+                         37%      39%
International                       31%      24%
Inbound                             15%      16%
Wireless                             4%       7%
Domestic Carrier Termination        13%      14%
 
</TABLE>

GROSS PROFIT

Gross profit margin in 1997 decreased 7.0% to 26.5% from 1996.  The decrease in
gross profit margin is primarily attributable to the substantial increase in
carrier revenue, which generates a much lower margin than the Company's retail
products, but are a necessary component of fully utilizing network facilities.
In addition, the rate charged to the Company's retail customers for long
distance service decreased by an average of  $ .021 per minute as a result of
increased competition in the industry, while the Company's costs to deliver such
services has remained relatively constant.  As a percentage of total revenue,
carrier revenue increased to approximately 28% for 1997 versus 17% in 1996.

                                       16
<PAGE>
 
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE

Selling, General and Administrative ("SG&A") expenses for 1997 were
approximately $4,222,000 higher than the amount incurred during 1996.  SG&A
expenses for 1997 were 30.0% of revenue compared with 31.6% in 1996.  Commission
expense increased approximately $2,115,000 or 46% from 1996 due primarily to an
increase in revenues on which commissions are paid. Salary compensation expense
increased approximately $466,000 to approximately $3,615,000 resulting in part
from severance costs in the amount of approximately $173,000 related to the
termination of certain executives.  In addition, in 1997, the Company incurred
consulting, legal and accounting fees related to the proposed merger of the
Company with ACC Corp. of approximately $567,000.

PROVISION FOR BAD DEBT

Bad debt expense increased approximately $986,000 (from approximately 1.2% of
net sales in 1996 to approximately 2.6% of net sales in 1997). Of this increase,
approximately $780,000 is related to the provision for bad debts of three
specific carrier accounts, $137,000 is related to uncollectible international
toll calls, and $56,000 is the result of the bankruptcy of one of the Company's
rebillers.

NET LOSS FROM OPERATIONS

The Company recorded a net loss before preferred dividends for 1997 of
approximately $3,700,000 versus a profit of approximately $89,000 for 1996.  The
net loss reported in 1997 resulted primarily from lower gross margins and higher
SG&A expenses as mentioned above.


LIQUIDITY AND CAPITAL RESOURCES
-------------------------------

At December 31, 1998, cash and cash equivalents were approximately $1,665,000.
Cash flow used in operations in 1998 was approximately $2,866,000.  Net cash
used in investing activities in 1998 was approximately $1,237,000, which
resulted from the purchase of property and equipment.

Working capital at December 31, 1998 was approximately $(369,000) as compared to
approximately $(2,664,000) at December 31, 1997.  The increase in working
capital was primarily due to the decrease in net loss from 1997 to 1998 as
stated above.

The Company has a revolving $2,000,000 credit facility with Century Business
Credit Corporation, which was automatically renewed for two successive one year
periods and expires on May 11, 1999. Interest on the revolving credit facility
is currently calculated at the prime lending rate plus 3 3/4%, with a minimum
loan value of $750,000. The loan is collateralized by accounts receivable and
fixed and intangible assets of the Company. As of December 31, 1998, the
Company's outstanding balance on its credit facility was approximately
$1,121,000, leaving approximately $879,000 available for future borrowing under
the credit facility. The Company was not in compliance with several of its
covenants at December 31, 1998. However, the Company received a waiver through
1999, related to such conditions of non-compliance. The Company is currently
negotiating the terms for the renewal of three successive one year periods with
Century Business Credit Corporation to begin on May 11, 1999. Interest for the
new term is expected to be at a lower rate. The renewal period will also include
a revolving $2,000,000 credit facility with a minimum loan value of $750,000.
The Company anticipates that the new term will not require any limited personal
guarantees.

The Company has capital lease obligations for various equipment pursuant to
leases with terms of three to five years.  These leases expire at various times
through the year 2000.  The leases carry interest 

                                       17
<PAGE>
 
rates ranging from 9.0% to 13.9%, and are collateralized by the equipment
purchased. The aggregate lease balance as of December 31, 1998 was approximately
$427,000. The Company anticipates that its minimum lease payments for 1999 will
be approximately $265,000.

The Company's cash and equity positions were significantly improved during 1998.
The Company's former Chairman and former Chief Executive Officer each exercised
300,000 stock options and 569,000 warrants for a total of approximately
$2,034,000. In addition, short-swing profits of approximately $2,481,000 were
remitted to the Company as a result of a violation of Section 16(b) of the
Securities Exchange Act of 1934 by a beneficial owner.

On March 23, 1999, the Company through a private placement transaction, issued
900,000 shares of common stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, for an aggregate purchase price of $1,530,000 or
$1.70 per share.  The proceeds of the issuance will be used for general working
capital.  The terms of such transaction were negotiated between the Company and
Gold & Appel Transfer, S.A. on an arms length basis, with Mr. Anderson
abstaining from all negotiations and approvals.

Management will focus on obtaining additional financing or possibly raising
additional equity through private placement, in order to ensure adequate funding
is available to support operations, if necessary. The Company's ability to
operate beyond the immediate future is dependent upon its ability to achieve
levels of revenues to support the Company's cost structure, decrease its network
costs, maintain adequate financing, and generate sufficient cash flow from
operations to meet its operating needs. However, no assurance can be given that
the Company will be successful in its efforts to implement its plans and achieve
a level of profitability.


YEAR 2000
---------


Many computers and computer applications define dates by the last two digits of
the year, and as such may not be able to accurately calculate, store, use or
identify a date after December 31, 1999.  This could result in major system
errors that could adversely affect the Company's operation.  This Year 2000
issue might also adversely affect the systems of the Company's customers,
vendors or resellers.

The Company has initiated a project to identify and address the Year 2000 issue
and is addressing the most critical needs first.  The Company has completed an
inventory of its computer systems, network elements, software applications and
other office systems.  The preliminary results indicated that the Company would
be required to replace its long distance switch located in Philadelphia.    The
Company has recently purchased a new DSC DEX600 switch, which is Year 2000
compliant, to replace its existing switch in Philadelphia.  The Company
anticipates that the new switch will be installed by the end of the second
quarter of 1999.  Although the original Philadelphia switch required replacement
as a result of Year 2000 compliance issues, the Company also needed to replace
the switch due to its inability to support any significant growth.  The total
estimated cost of replacing the switch will be approximately $1.9 million.
Approximately $1.1 million was incurred in 1998.

The Company has identified all vendors that the Company interacts with
electronically or otherwise relies on in order to conduct business.  The Company
is contacting those vendors in order to obtain the appropriate assurances that
those third parties are or will be Year 2000 compliant.  As of this writing, the
Company has requested Year 2000 compliance status from 171 vendor/suppliers and
has received 93 responses that have indicated that they are indeed Year 2000
compliant or would be compliant by December 31, 1999.  The Company continues to
monitor these returns and will make assessments as to their relative impact on
the Company's systems.  If compliance is not achieved in a timely manner by the
Company or any significant related third party, the Year 2000 issue could have a
material adverse effect on the Company's operations.

                                       18
<PAGE>
 
The Company plans to develop and, if necessary, implement contingency plans to
minimize the effects of any significant Year 2000 noncompliance.  On the
telecommunications network side, these contingency plans would include, but
would not be limited to, immediately directing terminating traffic away from a
long distance carrier who was not Year 2000 compliant.  Traffic would then be
transferred to different carriers with potentially higher rates to desired
locations for an undetermined period of time.  This could have a material
adverse effect on the Company's results of operations and liquidity.

On the data network side, information would be compiled and transferred manually
to firms that were unable to accept data electronically because of
noncompliance.  The Company currently has these manual alternative procedures in
place. The cost of all such plans cannot be assessed at this time but are not
expected to have a material adverse financial impact on the Company.  However,
these and any other plans may not be adequate and any additional significant
expenditures could have a material adverse affect on the Company's results of
operations and liquidity.


ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
----------------------------------------------------

See "Index To Consolidated Financial Statements and Notes To Consolidated
Financial Statements" on page F-i herein.


ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
------------------------------------------------------------------------
FINANCIAL DISCLOSURE
--------------------

     1) None

                                       19
<PAGE>
 
                                   PART III
                                   ==== ===
                                        
Item 10.  Directors and Executive Officers of the Registrant
------------------------------------------------------------

The following table sets forth information with respect to all of the
incumbent directors of the Company at February 26, 1999.

<TABLE>
<CAPTION>
 
      NAME         AGE            POSITION            DIRECTOR SINCE
-----------------  ----  ---------------------------  --------------
<S>                <C>   <C>                          <C>
 
Walt Anderson      (46)  Chairman (1)                           1998
 
Murray Goldberg    (55)  Director (2)                           1996
 
Arthur Regan       (34)  Director and Secretary (3)             1997
 
</TABLE>

(1)  WALT ANDERSON, owns more than 50% of the Company's shares, was elected to
     Board of Directors in 1998 and was recently named Chairman of the Board of
     Directors in March, 1999. Mr. Anderson is a pioneer in the
     telecommunications industry. He founded Mid Atlantic Telecom, a regional
     long distance carrier, in 1984 to take advantage of the breakup of AT&T. He
     also founded Espirit Telecom in 1991 and was Chairman of that company until
     recently. Mr. Anderson is also on the Board of Directors of several other
     companies including TotalTel USA Communications, Net-tel Corp., Teleport UK
     Ltd., American Technology Labs, Inc., Galactech Corp. and Rotary Rocket Co.

(2)  MURRAY GOLDBERG, a shareholder of the Company since 1989, and an
     independent sales agent of the Company since 1993, is also currently
     employed as a sales agent for Goldberg & Associates, a partnership, Mr.
     Goldberg also is the owner and a Vice-President of Jamco, Inc., a discount
     shoe distributor in Florida and the owner and Director of Doxs, Inc., an
     anaesthesia equipment developer and distributor.  Prior to January 1993,
     Mr. Goldberg worked as an anesthesiologist at Paoli Memorial Hospital.
     From June 1994 until May 1996, he was an owner of Strathmore Bagel
     Franchise Company.  Mr. Goldberg was elected a Director of the Company in
     November, 1996.

(3)  ARTHUR REGAN has been a director of the Company since August 1997.  Mr.
     Regan is currently President of Regan & Associates, Inc., a proxy
     solicitation/shareholder services firm in New York, New York that has been
     a vendor of USW since 1993.  Mr. Regan also is the Chairman, President and
     Chief Executive Officer of RD's Place, Inc., a messenger/courier company
     located in Jersey City, New Jersey.  Mr. Regan was previously a Director
     and President of David Francis & Co., Inc., a proxy
     solicitation/shareholder services firm, from 1988 through 1991.



Executive Officers

The Company's executive officers are appointed by the Board of Directors and,
except as described herein, hold office at the pleasure of the Board until their
successors are appointed and have qualified.  The Company has two executive
officers, David B. Hurwitz and Michael McAnulty.  Mr. Hurwitz, age 36, became
the President and Chief Executive Officer in February, 1999.  He started with
the Company in December, 1996 as the Executive Vice President of Sales and
Marketing of the Company.  From 1995 to 1996 he served as the Vice President of
Sales and Marketing of Commonwealth Long Distance, a C-TEC company. Prior to the
position with Commonwealth, he served as Executive Vice President and Chief
Operating Officer of InterNet Communications Services, Inc. and as General
Manager of FiberNet from 1992 to 1995.  Both InterNet and FiberNet are
affiliated with one another.  From 1985 to 1992 Mr. Hurwitz held 

                                       20
<PAGE>
 
sales and sales management positions with RCI Long Distance, a subsidiary of
Rochester Telephone Corp. (now Frontier Corporation). Michael McAnulty, age 32,
is the Chief Financial Officer. He has been with the Company since August, 1996
when he began as the Controller. He was the Accounting Manager for PageNet Inc.
where he worked from 1992 to 1996. Prior to the position he held at PageNet, he
was employed by Crown, Cork and Seal Co., Inc. as a Plant Controller from 1990
to 1992.


ITEM 11.  EXECUTIVE COMPENSATION AND OPTIONS OUTSTANDING
--------------------------------------------------------

The following table shows for the years ended December 31, 1996, 1997 and 1998,
certain compensation paid or accrued by the Company for services by the named
officers.


                          SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
 
----------------------------------------------------------------------------------------------------------
                                                             Long Term
                                                           Compensation
                                                           ------------ 
                   Annual Compensation                        Awards                   Payouts
----------------------------------------------------------------------------------------------------------
Name                                              Other     Restricted      Common                  All
And                                               Annual      Stock         Stock       LTIP       Other
Principal                      Salary    Bonus    Comp.       Awards      Underlying   Payouts     Comp.
Position                 Year    ($)      ($)     ($)(1)       ($)        Options (#)    ($)        ($)
----------------------------------------------------------------------------------------------------------
<S>                      <C>   <C>       <C>      <C>      <C>            <C>          <C>       <C>
David B. Hurwitz          `98  215,030       --       --             --       50,000        --          --
Interim President and     `97  150,000   69,821       --             --           --        --          --
Chief Executive           `96    6,250       --       --             --      700,000        --          --
Officer (3)
----------------------------------------------------------------------------------------------------------
Stephen J. Parker         `98  118,133       --       --             --           --        --     300,000(5)
Former President and      `97  169,125       --       --             --           --        --          --
Chief Executive           `96  165,000       --       --             --           --        --       2,065(2)
Officer (5)
----------------------------------------------------------------------------------------------------------
Aaron R. Brown            `98   64,171       --       --             --           --        --      82,747
Former President and      `97    6,875       --       --             --           --        --     119,792
Chief Executive           `96  165,000       --       --             --           --        --       1,116(2)
Officer (4)
----------------------------------------------------------------------------------------------------------
</TABLE>
                                        
(1) For 1996, 1997 and 1998 the aggregate amount of such Other Annual
    Compensation for each named officer is not reportable under SEC rules
    because such amount is the lesser of either $50,000 or 10% of the total
    salary for such named officer.

(2) Includes amounts paid for life insurance of the named officer where the
    Company is not the beneficiary of the policy.

(3) Mr. Hurwitz became interim President and Chief Executive Officer on February
    17, 1999.

(4) Effective August 21, 1998, Mr. Brown became the interim President and Chief
    Executive Officer with a salary of $178,125 per annum.  Prior to that he was
    a consultant to the Company since January 14, 1997 

                                       21
<PAGE>
 
    at a fee of $128,125 per annum. Effective February 17, 1999, Mr. Brown
    resigned as interim president and Chief Executive Officer, at which time he
    resumed the terms of his consulting contract.

(5) Effective August 21, 1998, Stephen Parker, President and Chief Executive
    Officer, terminated his employment with the Company.  Mr. Parker was
    immediately replaced by Aaron Brown as interim President and Chief Executive
    Officer.  Upon termination Mr. Parker received severance pay of
    approximately $300,000.  Mr. Parker originally had a seven year employment
    agreement effective December 23, 1993.



OPTION GRANTS IN LAST FISCAL YEAR

The following table summarizes the number of options granted to named officers
during the year ended December 31, 1998.  The Company did not grant any stock
appreciation rights in 1998.

<TABLE>
<CAPTION>
 
-----------------------------------------------------------------------------------------------------------
                                                                                   Potential Realizable
               Number of Shares of     Percent of Total                              Value of Assumed
    Name          Common Stock         Options Granted    Exercise    Expiration   Annual Rates of Stock 
               Underlying Options     in Fiscal Year(1)     Price        Date      Price Appreciation for 
                    Granted                                                            Option Term(2)
-----------------------------------------------------------------------------------------------------------
<S>            <C>                  <C>                  <C>         <C>             <C>        <C>
                                                                                            5%       10%
-----------------------------------------------------------------------------------------------------------
David B.            50,000                 10.6%          $1.1875     03/10/01         $9,359   $19,653
 Hurwitz         
-----------------------------------------------------------------------------------------------------------
Aaron R.                --                   --                --           --             --        --
 Brown           
-----------------------------------------------------------------------------------------------------------
Stephen J.              --                   --                --           --             --        --
 Parker          
-----------------------------------------------------------------------------------------------------------
</TABLE>
                                        

(1) Based upon options to purchase a total of 473,000 shares granted to all
    officers and employees of the Company in 1998 under its Amended and Restated
    Stock Option Plan or its predecessor plans.

(2) These amounts represent hypothetical gains that could be achieved for the
    respective stock options if exercised at the end of the option term.  These
    gains are based on assumed rates of stock appreciation of 5% and 10%
    compounded annually from the date the respective options were granted to
    their expiration date.

                                       22
<PAGE>
 
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION
VALUES

The following table summarizes the number and value of unexercised options held
by the named officers as of December 31, 1998.

<TABLE>
<CAPTION>
 
--------------------------------------------------------------------------------------------------------------------------------
                        Number of        Value           Number of Shares of Common                  Value of Unexercised
                         Shares         Realized                   Stock                             In-The-Money Options
                        Acquired                           Underlying Unexercised                        or Warrants
                       on Exercise                                Options                            at Fiscal Year-End(1)    
                                                       or Warrants at Fiscal Year-End                                 
                                                       =========================================================================
                                                              EXERCISABLE     UNEXERCISABLE     EXERCISABLE      UNEXERCISABLE
NAME                                                               #                #                $                 $
================================================================================================================================
<S>                <C>                <C>                 <C>                <C>            <C>                 <C>
David B. Hurwitz             --               --                475,000        225,000            $221,563        $61,875
--------------------------------------------------------------------------------------------------------------------------------
Aaron R. Brown          869,000(2)            --                     --             --                  --             --
--------------------------------------------------------------------------------------------------------------------------------
Stephen J. Parker       869,000(2)            --                     --             --                  --             --
--------------------------------------------------------------------------------------------------------------------------------
</TABLE>
                                        

(1) Based upon a market price of the Company's common stock on December 31, 1998
    of $1.5625 per share (last trading day in December 1998).

(2) Includes exercise of 300,000 shares of common stock issued on September 1,
    1993 under the Company's 1993 Executive Stock Option Plan (the "Executive
    Plan", now consolidated with the Employee Compensation Stock Option Plan in
    the Amended and Restated Stock Option Plan) at an exercise price of $1.375
    per share and exercise of 569,000 warrants of common stock issued on May 11,
    1995 at $1.0625 per share.


COMPENSATION OF DIRECTORS

Directors who also serve as salaried employees of the Company do not receive any
additional compensation for their services as directors.

In 1998, non-employee directors are entitled to receive $1,000 for each Board
meeting attended in person, and $500 for participation in each Board meeting
conducted by telephone conference call.  In addition, the Company granted to
each non-employee director options to purchase 25,000 shares of the Company
Common Stock for his services as a director during 1998.  These grants consist
of options to purchase 25,000 shares of the Company Common Stock at $1.1875 per
share granted to Mr. Regan and Mr. Goldberg.


EMPLOYMENT AGREEMENTS

Mr. Hurwitz has a three year Employment Agreement terminating January 5, 2000.
The contract provides for an annual base salary of not less than $150,000
subject to annual cost of living increases as measured by the Consumer Price
Index.

                                       23
<PAGE>
 
ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
------------------------------------------------------------------------

The following table sets forth, as of February 26, 1999 information concerning
the shares of the Company's Common Stock beneficially owned by: (i) each person
or group known to the Company to be the beneficial owner of more than 5% of the
outstanding shares of Common Stock; (ii) each director; (iii) each Executive
Officer; and (iv) all directors and executive officers as a group.  Except as
otherwise indicated, each person named or included in a group has sole voting
and investment power with respect to his or its shares of Common Stock.  The
Company also has outstanding 30,000 shares of Preferred Stock.  For purposes of
this table, it has been assumed that the outstanding shares of Preferred Stock
have been converted into 300,000 shares of Common Stock in accordance with its
terms as of February 26, 1999.  No Executive Officer or Director of the Company
owns any shares of the Company's Preferred Stock.

<TABLE>
<CAPTION>
 
Name and Address of Beneficial                        Amount and Nature
Owner or Identity of Group                         of Beneficial Ownership   Percent of Class
-------------------------------------------------  ------------------------  -----------------
<S>                                                <C>                       <C>
Aaron R. Brown                                           869,000(1)               4.5%                        
2 Greenwood Square                                                                                            
3331 Street Road, Suite 275                                                                                   
Bensalem, PA  19020                                                                                           
                                                                                                              
Murray Goldberg                                        2,295,000(2)              11.9%                        
26 Anthony Drive                                                                                              
Malvern, PA 19355                                                                                             
                                                                                                              
Arthur Regan                                              57,000(3)                 *                         
15 Park Row                                                                                                   
New York, NY  10038                                                                                           
                                                                                                              
Gold & Appel Transfer, S.A.                           10,119,934(4)              52.5%                        
Omar Hodge Building                                                                                           
Wickhams Cay                                                                                                  
Road Town                                                                                                     
Tortula, British Virgin Islands                                                                               
                                                                                                              
David B. Hurwitz                                         636,000(5)               3.2%                        
48 Dalton Way                                                                                                 
Holland, PA  18966                                                                                            
                                                                                                              
All Directors and Executive Officers as a group       13,976,934(6)              70.2%                        
(5 persons)                                                                                                    
</TABLE>

*  Less than 1%

                                       24
<PAGE>
 
(1)  Mr. Brown is a former director and officer of the Company.
(2)  Includes 2,270,000 shares of common stock owned by Mr. Goldberg as well as
     options to purchase 25,000 shares of common stock at $1.1875 per share.
(3)  Includes 12,000 shares of common stock owned by Mr. Regan, options to
     purchase 25,000 shares of common stock at $1.1875 per share and options to
     purchase 20,000 shares of common stock at $1.69 per share.
(4)  As reported on Schedule 13D, under the 1934 Act, filed by Gold & Appel
     Transfer, S.A.
(5)  Includes 61,000 shares of common stock owned by Mr. Hurwitz as well as
     options to purchase 350,000 shares of common stock at $1.03125 per share,
     options to purchase 200,000 shares of common stock at $1.30 per share and
     options to purchase 25,000 shares of common stock at $1.1875 per share.
(6)  Includes shares issuable to Messrs. Goldberg, Regan, and Hurwitz
     upon the exercise of options described in notes 2, 3 and 5.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
--------------------------------------------------------

LOAN GUARANTEES

On May 11, 1995, the Company entered into a Loan and Security Agreement with
Century Business Credit Corporation ("Century") for a revolving credit facility
of $2,000,000.  On April 27, 1995, the Company issued 500,000 shares of
restricted Common Stock to each of Aaron R. Brown and Stephen J. Parker in
consideration for their limited personal guarantee given to Century equal to 25%
of the indebtedness incurred with Century.  In connection with this transaction
Messrs. Brown and Parker also terminated 420,000 stock options.  After review of
the transaction by a Special Committee appointed by the Board of Directors, the
issuance of the restricted stock and the cancellation of options were rescinded.
In their place, the Company issued to each of Messrs. Brown and Parker warrants
to purchase 600,000 shares of Common Stock in consideration for the limited
personal guarantees given by each in connection with the credit facility.  Each
warrant issued in the transaction entitled the holder to purchase shares of
Common Stock at a price of $1.0625 per share until May 11, 2000.  Messrs. Brown
and Parker exercised 31,000 warrants each during 1997 for total consideration of
$65,875, and exercised 569,000 warrants each during 1998 for total consideration
of $1,209,125.  The stock issued upon exercise of the warrants is restricted
stock under the federal securities laws.


INDEMNIFICATION ARRANGEMENTS

The Company is a party to indemnification agreements with two of its directors,
Aaron R. Brown and Stephen J. Parker, dated August 1990.  In addition, the
Company has entered into an indemnification agreement with Kevin O'Hare, a
former executive officer of the Company, dated July, 1997.  In general, the
indemnification agreements obligate the Company to indemnify each of Messrs.
Brown, Parker and O'Hare against the liabilities and expenses incurred by them
in acting as a director or officer of the Company to the maximum extent allowed
by law.  The Company, together with Messrs. Parker, Brown and O'Hare, have been
sued by the Company's former president for various claims asserted by the
plaintiff in connection with his termination of employment with the Company on
December 30, 1996.  The Company and the individual defendants have selected
counsel to defend the action.  The Board of Directors of the Company has
authorized the Company to advance the expenses of the individual defendants
incurred in defending this action upon the receipt of an undertaking from each
of them to repay the amounts so advanced in the event it is determined that they
are not entitled to indemnification under applicable law.

                                       25
<PAGE>
 
SALES AGENCY

Mr. Goldberg acts as a sub-agent for the Company and is the co-owner of Goldberg
& Associates, a company that acts as an agent for the Company in the sale of the
Company's products and services.  During 1998, the Company paid Mr. Goldberg and
such company a total of $84,569 in commissions for their services as the
Company's sales agents.


PRIVATE PLACEMENT

On March 23, 1999, the Company through a private placement transaction, issued
900,000 shares of common stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, for an aggregate purchase price of $1,530,000 or
$1.70 per share.  The proceeds of the issuance will be used for general working
capital.  The terms of such transaction were negotiated between the Company and
Gold & Appel Transfer, S.A. on an arms length basis, with Mr. Anderson
abstaining from all negotiations and approvals.

                                       26
<PAGE>
 
                                    PART IV
                                    ==== ==
                                        

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

(a)  Documents filed as part of this Annual Report on Form 10-K:

     (1)  Financial Statements
          --------------------

          See "Index To Consolidated Financial Statements and Financial
          Statement Schedules" on page F-i herein.


     (2) Financial Statement Schedules required to be filed by Item 8 on this
         --------------------------------------------------------------------
         form.
         -----

         See "Index To Consolidated Financial Statements and Financial
         Statement Schedules" on page F-i herein.


(b)  Reports on Form 8-K:

     (1) On December 10, 1998, the Company filed Form 8-K regarding the annual
         meeting of shareholders and the voting results of the elected Board of
         Directors.

     (2) On September 1, 1998, the Company filed Form 8-K regarding the
         resignation of a Former President and Chief Executive Officer as well
         as the repurchase of shares of common stock of the Company.

     (3) On June 16, 1998, the Company filed Form 8-K regarding its compliance
         with the continued listing requirements of the Nasdaq Small Cap
         Market.

                                       27
<PAGE>
 
(c)   Exhibits


Exhibit No.  Description
-----------  -----------

      3.1    Certificate of Incorporation of Registrant*
      3.2    Amendment to Certificate of Incorporation*
      3.3    By-Laws of Registrant*
      4.1    Specimen Common Share Certificate*
     10.1    DSC Marketing Services Supply Agreement**
     10.2    Key Employees Incentive Stock Option Plan**
     10.3    Employee Compensation Stock Option Plan**
     10.4    Agreement of Lease for 3 Parkway, Philadelphia, PA**
     10.6    Employment Agreement dated December 23, 1993, between US Wats, Inc.
             and Stephen J.  Parker* * *
     10.7    Loan and Security Agreement between US Wats, Inc. and Century
             Business Credit Corporation dated May 11, 1995****
     10.8    Employment Agreements dated February 25, 1997, between US Wats,
             Inc. and David B. Hurwitz, Kevin M. O'Hare and Mark A. Mendes*****
     10.9    Employment Agreement dated March 3, 1997, between US Wats, Inc. and
             Christopher J. Shannon.
     10.10   Termination Agreement dated September 30, 1997, between US Wats,
             Inc. and Kevin M. O'Hare.
     10.11   Termination Agreement dated October 15, 1997 between US Wats, Inc.
             and Mark A. Mendes
     10.12   Termination Agreement dated October 17, 1997, between US Wats, Inc.
             and Christopher J. Shannon
     10.13   Severance, General Release, and Cooperation Agreement dated August
             21, 1998, between US Wats, Inc. and Stephen Parker******
     10.14   Stock Repurchase Agreement dated August 21, 1998, between US Wats,
             Inc. and Stephen Parker******

     *       Filed as an exhibit with corresponding Exhibit No. to Registrant's
             post effective amendment No. 1 to Registration Statement on Form S-
             18, or previous Annual Report Form 10-K.
     **      Incorporated by reference to the December 31, 1992 Form 10-K
     ***     Incorporated by reference to the December 31, 1993 Form 10-K
     ****    Incorporated by reference to the June 30, 1995 Form 10-Q
     *****   Incorporated by reference to the February 25, 1997 Form 8-K
     ******  Incorporated by reference to the September 1, 1998 Form 8-K

                                       28
<PAGE>
 
                                  SIGNATURES


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



                                 US WATS, INC.
                                 (Registrant)

                         By:    /s/  Michael McAnulty
                               ----------------------------------
                               Michael McAnulty
 

                         Date:  March 31, 1999



Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.



SIGNATURE                TITLE                                  DATE
---------                -----                                  ----

 
/s/  David B. Hurwitz    President and Chief Executive Officer  March 31, 1999
-----------------------
David B. Hurwitz
 
/s/  Michael McAnulty    Chief Financial Officer and Treasurer  March 31, 1999
-----------------------
Michael McAnulty
 
/s/  Walt Anderson       Chairman of the Board                  March 31, 1999
-----------------------
Walt Anderson

                                       29
<PAGE>
 
                        US WATS, INC.  AND SUBSIDIARIES
                  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
                 YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996

                                        
                                                                      Page (s)
                                                                      --------

CONSOLIDATED FINANCIAL STATEMENTS:
 
Independent Auditors' Report                                             F-1
 
Consolidated Balance Sheets
     December 31, 1998 and 1997                                      F-2 to F-3
 
Consolidated Statements of Operations
     Years ended December 31, 1998, 1997, and 1996                       F-4
 
Consolidated Statements of Common Shareholders' Equity (Deficiency)
     Years ended December 31, 1998, 1997, and 1996                   F-5 to F-7
 
Consolidated Statements of Cash Flows~
     Years ended December 31, 1998, 1997, and 1996                       F-8
 
Notes to Consolidated Financial Statements                           F-9 to F-21

Financial Statement Schedule
- Schedule II - - Valuation and Qualifying Accounts                      F-22

                                      F-i
<PAGE>
 
INDEPENDENT AUDITORS' REPORT

Board of Directors and Shareholders
US Wats, Inc.
Bensalem, Pennsylvania

We have audited the accompanying consolidated balance sheets of US Wats, Inc.
and subsidiaries as of December 31, 1998 and 1997, and the related consolidated
statements of operations, common shareholders' equity (deficiency), and cash
flows for each of the three years in the period ended December 31, 1998.  Our
audits also included the financial statement schedule listed in the Index at
Item 14(a)(2).  These financial statements and financial statement schedule are
the responsibility of the Company's management.  Our responsibility is to
express an opinion on these financial statements and financial statement
schedule 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 US Wats, Inc. and subsidiaries as
of December 31, 1998 and 1997, and the results of their operations and cash
flows for each of the three years in the period ended December 31, 1998, in
conformity with generally accepted accounting principles.  Also, in our opinion,
such financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly in all
material respects the information set forth therein.

The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern.  As discussed in Note 3 to
the consolidated financial statements, the Company's net loss, negative working
capital and negative cash flows from operations raise substantial doubt about
its ability to continue as a going concern.  Management's plans concerning these
matters are also described in Note 3.  The consolidated financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.



DELOITTE & TOUCHE LLP
Philadelphia, Pennsylvania

March 30, 1999

                                      F-1
<PAGE>
 
                         US WATS, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
 
 
                                                         December 31,
                                                    ----------------------
                                                       1998        1997
                                                    ----------  ----------
<S>                                                 <C>         <C>
 
ASSETS
------
 
Current Assets
      Cash and cash equivalents                     $1,665,485  $1,588,267
      Accounts receivable, net of allowance for
      doubtful accounts of $934,624 for 1998 and
      $1,498,749 for 1997                            6,165,896   6,899,082
      Prepaid expenses and other                       166,977     108,683
                                                    ----------  ----------
 
         Total Current Assets                        7,998,358   8,596,032
                                                    ----------  ----------
 
Property and Equipment
      Telecommunications equipment                   5,031,047   3,881,857
      Equipment                                      1,690,490   1,579,435
      Software                                         652,422     647,797
      Office furniture and fixtures                    157,006     155,553
      Leasehold improvements                            46,671      36,432
                                                    ----------  ----------
                                                     7,577,636   6,301,074
Less accumulated depreciation and amortization       4,708,113   3,286,435
                                                    ----------  ----------
 
    Total Property and Equipment                     2,869,523   3,014,639
                                                    ----------  ----------
 
Other assets, principally deposits - net               153,583     202,804
                                                    ----------  ----------
 
        Total                                      $11,021,464 $11,813,475
                                                    ==========  ==========




The accompanying notes are an integral part of these consolidated financial statements
</TABLE> 
                                      F-2
<PAGE>
 
                        US WATS, INC.  AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
 
 
                                                                            December 31,
                                                                    ----------------------------
                                                                        1998           1997
                                                                    -------------  -------------
<S>                                                                 <C>            <C>
Liabilities and Shareholders' Equity (Deficiency)
-------------------------------------------------

Current Liabilities
  Note payable                                                       $ 1,121,341    $   690,826
  Capital lease obligations, current portion                             226,968        273,095
  Accounts payable                                                     4,372,548      6,975,779
  Accrued commissions                                                    891,318        943,556
  Accrued expenses and other                                             790,699      1,007,980
  State and Federal taxes payable                                        961,731      1,293,417
  Deferred revenue                                                         2,887         75,494
                                                                     -----------    -----------
 
   Total Current Liabilities                                           8,367,492     11,260,147
                                                                     -----------    -----------
 
Long-Term Liabilities
  Capital lease obligations, net of current portion                      149,792        380,260
                                                                     -----------    -----------
 
Commitments and Contingencies - see note 7
 
Redeemable preferred stock, $.01 par, authorized
  150,000 shares, issued and outstanding:
  30,000 shares in 1998 and 1997
  Redemption value: $11.00 per share                                     330,000        330,000
                                                                     -----------    -----------
 
Common Shareholders' Equity (Deficiency)
 Common Stock issuable                                                        --            166
Common stock, $.001 par, authorized
 30,000,000 shares; issued:
 20,077,144 shares in 1998 and
 17,654,100 shares in 1997                                                20,077         17,654
 Additional paid-in capital                                            9,514,075      5,328,982
 Accumulated Deficit                                                  (7,358,853)    (5,503,484)
                                                                     -----------    -----------
                                                                       2,175,299       (156,682)
 Common stock held in treasury
  (1,119,000 shares in 1998 and 250,000 shares in 1997), at cost          (1,119)          (250)
                                                                     -----------    -----------
 
                                                                       2,174,180       (156,932)
                                                                     -----------    -----------
 
    Total                                                            $11,021,464    $11,813,475
                                                                     ===========    ===========


   The accompanying notes are an integral part of these consolidated financial statements
</TABLE> 

                                      F-3
<PAGE>
 
                        US WATS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE> 
<CAPTION> 
                                                            Years Ended December  31,
                                                            ------------------------- 
                                                          1998           1997           1996
                                                         -----           ----            ----                       
<S>                                                  <C>            <C>            <C>
Revenues                                              $44,679,060    $56,466,698    $40,304,442
 
Cost of sales                                          31,789,200     41,511,542     26,802,398
                                                      -----------    -----------    -----------
 
Gross profit                                           12,889,860     14,955,156     13,502,044
 
Selling, general and administrative expenses           13,851,001     16,939,142     12,716,965
 
Provision for bad debts                                   788,493      1,465,248        479,208
                                                      -----------    -----------    -----------
 
(Loss) Income from operations                          (1,749,634)    (3,449,234)       305,871
 
Other income (expense)
      Interest income                                     164,180         71,921         62,732
      Interest expense                                   (232,915)      (322,508)      (272,978)
 
(Loss) Income before income tax expense (benefit)      (1,818,369)    (3,699,821)        95,625
 
Income tax expense                                         10,000             --          7,000
                                                      -----------    -----------    -----------
 
Net (loss) income                                      (1,828,369)    (3,699,821)        88,625
 
Preferred dividends and accretion                          27,000         57,000         27,000
                                                      -----------    -----------    -----------
 
Net (loss) income applicable to
      common shareholders                             $(1,855,369)   $(3,756,821)   $    61,625
                                                      ===========    ===========    ===========
 
Net loss per share
      applicable to common shareholders                     $(.10)         $(.23)  $         --          
                                                      ===========    ===========    =========== 
                                                                                   
 
Weighted average number of shares outstanding          18,785,656     16,084,971     15,877,900
                                                      ===========    ===========    ===========
 

 The accompanying notes are an integral part of these consolidated financial statements
</TABLE> 
                                      F-4
<PAGE>
 
                         US WATS, INC. AND SUBSIDIARIES
      CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS' EQUITY (DEFICIENCY)
                          YEAR ENDED DECEMBER 31, 1998
                                        
<TABLE>
                                           Common     Common    Add'l                        Treasury   Treasury   Shareholders'  
                            Common Stock   Par Value  Stock     Paid-In                      Stock      Stock At   Equity         
Description                 Shares Issued    $  .001  Payable   Capital       Deficit        Shares     Cost       (Deficiency)   
--------------------------  -------------    -------  -------   -----------   ------------   ---------  --------   -------------  
<S>                         <C>            <C>        <C>       <C>           <C>            <C>        <C>        <C>
Balance, December 31, 1997     17,654,100    $17,654  $   166    $5,328,982   $ (5,503,484)    250,000  $   (250)  $    (156,932)

Net Loss                               --         --       --            --     (1,828,369)         --        --      (1,828,369)
 
Short-Swing Profit                                         --     2,430,979             --          --        --       2,430,979
 Proceeds

Exercise of Employee Stock      1,068,984      1,069              1,403,422             --          --        --       1,404,491
 Options

Exercise of Warrants            1,188,000      1,188              1,259,419                                            1,260,607

Common Stock Issued               166,060        166    $(166)                          --          --        --

Options Issued for              
 Consulting Services                                                133,204                                              133,204 
                                                                                                                                 
Repurchase of Common Stock                                       (1,041,931)                   869,000   $  (869)     (1,042,800) 
                                
Cash Dividends on                                                                  (27,000)                              (27,000)
 Preferred                                                                     -----------                           ----------- 
 Stock ($.90 per share)
                               ----------    -------    -----   -----------    -----------   ---------   -------     -----------
Balance, December 31, 1998     20,077,144    $20,077    $   0   $ 9,514,075    $(7,358,853)  1,119,000   $(1,119)    $ 2,174,180
                               ==========    =======    =====   ===========    ===========   =========   =======     ===========


                      The accompanying notes are an integral part of these consolidated financial statements
</TABLE>

                                      F-5
<PAGE>
 
                         US WATS, INC. AND SUBSIDIARIES
             CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS' EQUITY
                          YEAR ENDED DECEMBER 31, 1997

                                        
<TABLE>
<S>                         <C>            <C>        <C>      <C>           <C>            <C>       <C>        <C>
                                                                                                                               
                                           Common     Common   Add'l                        Treasury  Treasury   Shareholders' 
                            Common Stock   Par Value  Stock    Paid-In                      Stock     Stock At   Equity        
Description                 Shares Issued    $  .001  Payable  Capital       Deficit        Shares    Cost       (Deficiency)  
--------------------------  -------------    -------  -------  -----------   ------------   --------  --------   ------------- 
Balance, December 31, 1996     15,902,100    $15,902       --   $2,623,350    $(1,776,663)   250,000     $(250)    $   862,339
Net Loss                               --         --       --           --     (3,699,821)        --        --      (3,699,821)
Private Placement               1,590,000      1,590       --    2,298,410             --         --        --       2,300,000
Exercise of Employee Stock        100,000        100       --      110,575             --         --        --         110,675
   Options
Exercise of Warrants               62,000         62       --       65,813             --         --        --          65,875
Common Stock to be Issued              --         --     $166      209,834             --         --        --         210,000
Options Issued for                     --         --       --       51,000             --         --        --          51,000
 Consulting
     Services
Accretion in Value of                  --         --       --      (30,000)            --         --        --         (30,000)
     Preferred Stock
Cash Dividends on                                                                 (27,000)                             (27,000)
 Preferred                                                                    
   Stock ($.90 per share)
                               ----------   --------  -------   ----------    -----------   --------  ---------     ----------
Balance, December 31, 1997     17,654,100    $17,654     $166   $5,328,982    $(5,503,484)   250,000     $(250)    $  (156,932)
                               ==========    =======  =======   ==========    ===========   ========  ========     ===========



                      The accompanying notes are an integral part of these consolidated financial statements
</TABLE>

                                      F-6
<PAGE>
 
                         US WATS, INC. AND SUBSIDIARIES
      CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS' EQUITY (DEFICIENCY)
                          YEAR ENDED DECEMBER 31, 1996
<TABLE>
<CAPTION>
 
 
                                                
                              Common Stock    Common         Add'l                            Treasury   Treasury    
                                Shares       Par Value      Paid-In                           Stock at    Stock     Shareholders'  
Description                     issued       $  .001         Capital          Deficit          Shares      Cost        Equity
---------------------------   ----------    ----------    ------------      ------------      -------     -------     ----------
<S>                          <C>            <C>           <C>               <C>              <C>          <C>         <C> 
Balance, December 31, 1995   15,852,100        $15,852      $2,573,400       $(1,838,288)     250,000       $(250)      $750,714
                                                                                                                   
Net Income                           --             --              --            88,625           --          --         88,625
                                                                                                                   
Exercise of Employee Stock                                                                                         
 Options                         50,000             50          49,950                --           --          --         50,000
                                                                                                                   
Cash Dividends on Preferred                                                                                        
  Stock, December 1, 1996                                                                                          
  ($.90 per share)                   --             --              --           (27,000)          --          --        (27,000)
                             ----------     ----------    ------------      ------------      -------     -------       --------
                                                                                                                   
Balance, December 31, 1996   15,902,100        $15,902      $2,623,350       $(1,776,663)     250,000       $(250)      $862,339
                             ==========     ==========    ============      ============      =======     =======       ========


                      The accompanying notes are an integral part of these consolidated financial statements
</TABLE>

                                      F-7
<PAGE>
 
                         US WATS, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOW
<TABLE>
<CAPTION>
 
                                                                              Years Ended December 31,
                                                                             -------------------------
                                                                         1998          1997          1996
                                                                    -------------  ------------  ------------
<S>                                                                 <C>            <C>           <C>
OPERATING ACTIVITIES:                                             
      Net income (loss) before preferred dividends                   $(1,828,369)  $(3,699,821)  $    88,625
      Adjustment to reconcile net income (loss) to                
      net cash provided by (used-in) operating activities         
          Stock and stock options issued for services                    133,204       201,000            --
              Depreciation and amortization                            1,439,171     1,010,186       930,293
              Provision for bad debts                                    788,493     1,465,248       479,208
              Write-off of fixed assets                                       --            --            --
              Changes in assets and liabilities which provided    
              (used) cash:                                        
               Accounts receivable                                       (55,307)   (1,850,431)   (2,093,041)
                    Prepaid expenses and other                           (58,294)       28,642       (30,134)
                    Other assets                                          (8,272)       94,554        24,332
                    Deferred revenue                                     (72,607)      (40,728)     (255,569)
                    Accounts payable and accrued expenses             (2,872,750)    1,077,445     2,153,891
                    State & Federal Taxes payable                       (331,686)      330,045       488,360
                                                                     -----------   -----------   -----------
                                                                  
      Net cash provided by (used in) operating activities             (2,866,417)   (1,383,860)    1,785,965
                                                                     -----------   -----------   -----------
                                                                  
INVESTING ACTIVITIES:                                             
      Purchase of property and equipment                              (1,276,562)     (395,491)     (864,304)
      Investment in internet service provider                             40,000            --       (40,000)
                                                                     -----------   -----------   -----------
                                                                  
     Net cash used in investing activities                            (1,236,562)     (395,491)     (904,304)
                                                                     -----------   -----------   -----------
                                                                  
FINANCING ACTIVITIES:                                             
      Proceeds from private placement                                         --     2,300,000            --
      Proceeds from stock option and warrant exercises                 2,665,098       236,550        50,000
      Proceeds from short swing profits                                2,430,979            --            --
      Repurchase of common stock                                      (1,042,800)           --            --
     (Decrease) increase in notes payable net                            430,515      (506,034)       21,696
      Repayment of capital lease obligations                            (276,595)      (50,341)     (152,005)
      Preferred stock dividend                                           (27,000)      (27,000)      (27,000)
      Payment of loan acquisition costs                                       --       (40,743)           --
                                                                     -----------   -----------   -----------
                                                                  
      Net cash (used in) provided by financing activities              4,180,197     1,912,432      (107,309)
                                                                     -----------   -----------   -----------
                                                                  
Net increase (decrease) in cash and cash equivalents                      77,218       133,081       774,352
                                                                  
Beginning cash and cash equivalents                                    1,588,267     1,455,186       680,834
                                                                     -----------   -----------   -----------
                                                                  
Ending cash and cash equivalents                                     $ 1,665,485   $ 1,588,267   $ 1,455,186
                                                                     ===========   ===========   ===========
 
                      The accompanying notes are an integral part of these consolidated financial statements
</TABLE>

                                      F-8
<PAGE>
 
                        US WATS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                        

1.  BACKGROUND
--------------

US WATS, Inc. (the "Company" or "USW") is a switch-based interexchange carrier
providing long distance telephone communications services primarily to small and
medium-size business customers. The Company also provides inbound-800 long
distance services, as well as other telecommunications services such as travel
cards (calling cards), cellular, paging, internet service, dedicated access,
data services, pre-paid calling cards (debit cards), international callback, and
carrier termination services. The Company uses its own switches and facilities
to originate, transport and terminate calls for customers generally located in
the Mid-Atlantic region and California (on-net areas). For calls originating or
terminating outside the Company's own network (off-net area), the Company
utilizes the services provided by other long distance companies. Substantially
all of the Company's revenues are earned from its customers located on the East
Coast.


2.  SUMMARY OF SIGNIFICANT ACCOUNTING  POLICIES
-----------------------------------------------

PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of the Company and
its four wholly-owned subsidiaries, USW Corporation, USW Enterprises, Inc.,
Carriers Group, Inc. and US Wats of Virginia Inc. after elimination of all
inter-company accounts, transactions and profits.

BUSINESS SEGMENTS

In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information."  This statement establishes standards for
the reporting of information about operating segments on an annual basis and is
effective for fiscal years beginning after December 15, 1997. The Company's
operations have been aggregated into a single reportable segment, as permitted
under SFAS No. 131, since management has chosen not to organize the Company
around products and services, geographic areas, regulatory environments,
economic characteristics, or types of customers.

REVENUE RECOGNITION

The Company recognizes revenue based upon the customer's usage of services. The
Company bills its customers for service on a monthly basis.  However, in some
instances, it bills certain customers on a more frequent basis.

CASH AND CASH EQUIVALENTS

The Company considers cash in bank and repurchase agreements with a maturity of
three months or less when purchased as cash and cash equivalents.

At certain times during the year, the Company has balances in its operating
accounts that in the aggregate exceed the $100,000 Federal Deposit Insurance
Corporation insurance limit.

                                      F-9
<PAGE>
 
PROPERTY AND EQUIPMENT

Property and equipment are recorded at cost. Depreciation is calculated for
financial reporting purposes using the straight-line method over the estimated
useful lives of the assets:

          Telecommunications equipment .....................7 years
          Furniture fixtures and other......................5 years

The Company intends to replace its Dex 400 switch in Philadelphia by no later
than the end of the second quarter of 1999 as a result of the switch's capacity
limitations and lack of Year 2000 compliance. Therefore, the Company has changed
the estimated remaining life of all the related fixed assets associated with
this switch and as a result has accelerated its depreciation by approximately
$393,000 in the second half of 1998 and will accelerate its depreciation by
approximately $105,000 in the first quarter of 1999. During 1998, the Company 
acquired the replacement switch at a cost of approximately $1,062,000, which is 
included in telecommunications equipment at December 31, 1998. Upon completion 
of installation, which is anticipated to occur during the second quarter of 
1999, the Company will commence depreciating the new switch.

Depreciation and amortization expense of property, plant and equipment for 1998,
1997, and 1996, was $1,439,171, $1,010,186, and $930,293, respectively.

DEFERRED FINANCING COSTS

Loan origination costs are amortized over the term of the related loan, and are
included in other assets.

ACCOUNTS PAYABLE

Accounts payable includes the cost of access charges due local telephone
companies and long distance transport purchased from long distance carriers.

MARKETING

All costs related to marketing and advertising the Company's products and
services are expensed in the period incurred.

USE OF ESTIMATES

The preparation of the Consolidated 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.

INCOME TAXES

The Company accounts for income taxes in accordance with Statement of Financial
Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes (See Note 6).

                                      F-10
<PAGE>
 
Income (Loss) per Common Share Applicable to Common Shareholders

Income (loss) per common share applicable to common shareholders is computed by
dividing net income (loss), after deduction of preferred stock dividends, by the
weighted average number of common shares outstanding during the period.

In February 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per
Share," which was adopted by the Company effective for the year ended December
31, 1997, as required by the statement.   For the years ended December 31, 1998,
1997, and 1996, the Company's potential common stock equivalents have either an
antidilutive or have no effect on income (loss) per share applicable to common
shareholders and, therefore, diluted income (loss) per common share applicable
to common shareholders has not been presented.

The following table summarizes those securities that could potentially dilute
income (loss) per common share applicable to common shareholders in the future
that were not included in determining the fully diluted income (loss) per common
share applicable to common shareholders as there is either no effect or the
effect is antidilutive.

<TABLE>
<CAPTION>
                                                                 Years Ended December 31,
Potential Common Shares resulting from:                     1998           1997           1996
                                                        -------------  -------------  -------------
 
<S>                                                     <C>            <C>            <C>
Stock Options  (see Note 10)                                  589,785      1,206,691         60,799
 
Stock Warrants  (see Note 10)                                       0        624,822         23,801
 
Cumulative, Convertible, Redeemable Preferred Stock                                   
(see Note 9)                                                  300,000        300,000        300,000
                                                              -------      ---------        -------  
                                                                                           
                                                              889,785      2,131,513        384,600
                                                              =======      =========        ======= 
                                                                                            
</TABLE>
FAIR VALUE OF FINANCIAL INSTRUMENTS

The fair value of the Company's financial instruments such as accounts
receivable, accounts payable, and note payable approximate their carrying
amounts.

CARRYING VALUE OF LONG-TERM ASSETS

The Company evaluates the carrying value of long-term assets, including
property, plant and equipment, and other intangibles, based upon current and
anticipated undiscounted cash flows, and recognizes an impairment when such
estimated cash flows are less than the carrying value of the asset.  Measurement
of the amount of impairment, if any, is based upon the difference between
carrying value and fair value.

NEW ACCOUNTING PRONOUNCEMENTS

In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities.  This statement establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities.  It requires that an entity recognize
all derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value.  The Company is not
required to adopt this standard until fiscal 1999.  At this time, the Company
has not determined the impact this standard will have on the Company's financial
statements.

                                      F-11
<PAGE>
 
RECLASSIFICATION OF ACCOUNTS

Certain reclassifications have been made to conform prior years' balances to the
current year presentation.


3. LIQUIDITY AND CONTINUATION OF BUSINESS
-----------------------------------------

The consolidated financial statements of the Company have been prepared on a
going-concern basis, which contemplates the continuation of operations,
realization of assets and liquidation of liabilities in the ordinary course of
business. The Company incurred a net loss applicable to common shareholders of
$1,855,369 during the year ended December 31, 1998 and had negative cash flow
from operating activities of $2,866,417. At December 31, 1998 the Company had a
net working capital deficit of $369,134 and an accumulated deficit of
$7,358,853. In addition, the Company was not in compliance with several of its
covenants in its Loan and Security Agreement with Century Business Credit
Corporation, however, the Company received a waiver related to such non-
compliance. Such conditions raise substantial doubt about the Company's ability
to continue as a going concern. The accompanying financial statements do not
include any adjustments that might be necessary should the Company be unable to
continue as a going concern.

The Company plans to focus on growing its revenue base through the addition of
profitable customers and decreasing its network costs. The Company intends to
reduce its network costs by obtaining more favorable pricing from suppliers and
by forming strategic alliances with certain similarly situated companies,
inducing the Company's sales agents to continue higher revenue production at
better margins.  Additionally, the Company intends to resell local access
service to its current and prospective business customers in six Bell Atlantic
states under its favorable interconnection agreements currently not being
utilized.

On March 23, 1999, the Company through a private placement transaction, issued
900,000 shares of common stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, for an aggregate purchase price of $1,530,000 or
$1.70 per share.  The proceeds of the issuance will be used for general working
capital.  The terms of such transaction were negotiated between the Company and
Gold & Appel Transfer, S.A. on an arms length basis, with Mr. Anderson
abstaining from all negotiations and approvals.

Management will focus on obtaining additional financing or possibly raising
additional equity through private placement, in order to ensure adequate funding
is available to support operations, if necessary. The Company's ability to
operate beyond the immediate future is dependent upon its ability to achieve
levels of revenues to support the Company's cost structure, decrease its network
costs, maintain adequate financing, and generate sufficient cash flow from
operations to meet its operating needs. However, no assurance can be given that
the Company will be successful in its efforts to implement its plans and achieve
a level of profitability.


4.  NOTE PAYABLE
----------------

On May 11, 1995, the Company entered into a Loan and Security Agreement with
Century Business Credit Corporation for a revolving credit facility of
$2,000,000.  The loan was established for an initial period of two years, and
was automatically renewed for two successive years and expires on May 11, 1999.
Interest on the loan is currently calculated at prime plus 3 3/4%(11 1/2% at
December 31, 1998) with a minimum loan value of $750,000. The outstanding
balance as of December 31, 1998 was $1,121,000. The loan is collateralized by
accounts receivable and fixed and intangible assets of the Company.

The loan agreement contains covenants and restrictions which, among other
things, require maintenance of certain subjective financial performance criteria
and restrict encumbrance of assets, creation of indebtedness and places
limitations on annual capital expenditures.  The Company was not in compliance
with several of its covenants in the Loan and Security Agreement, including
covenants pertaining to certain subjective 

                                      F-12
<PAGE>
 
financial performance criteria, however, the Company received a waiver related
to such conditions of non-compliance at December 31, 1998. In exchange for
warrants to purchase 600,000 shares of Common Stock each, an executive officer
and a board member both provided limited personal guarantees in connection with
the credit facility. (See Note 10)

The Company is currently negotiating the terms for the renewal of three
successive one year periods with Century Business Credit Corporation to begin on
May 11, 1999.  Interest for the new term is expected to be at a lower rate.  The
renewal period will also include a revolving $2,000,000 credit facility with a
minimum loan value of $750,000.  The Company anticipates that the new term will
not require any limited personal guarantees.


5.  OBLIGATIONS UNDER CAPITAL LEASES
------------------------------------

Property under capital leases is recorded at the lesser of the present value of
the minimum lease payments or its fair value at inception. The Company leases
various equipment under three-to-five-year noncancellable leases which expire at
various dates through 2000.

The leases carry interest rates ranging from approximately 9.0% to approximately
13.9% and are collateralized by the equipment purchased. The future minimum
lease payments for the next five years and related lease obligation balances as
of December 31, 1998 are as follows:


                    1999                   265,156
                    2000                   162,251
                                          --------
                                     
                    TOTAL                 $427,407
                                          ========
<TABLE> 
<CAPTION> 
 
 
                                                                   1998       1997
                                                                ---------   --------
 <S>                                                           <C>          <C>                                
  Aggregate capital lease obligation
   as of the year ended December 31                              $427,407   $774,921
  Less--amounts representing interest                              50,647    121,566
                                                                 --------   --------
  Present value of net minimum payments under capital leases      376,760    653,355
  Less--current portion of capital lease obligations              226,968    273,095
                                                                 --------   --------
   Capital lease obligations, net of current portion             $149,792   $380,260
                                                                 ========   ========
 
</TABLE>



The following is an analysis of property under capital leases:

                                          1998        1997
                                       ----------  -----------
 
Telecommunications Equipment           $1,405,151   $1,405,151
Office Equipment                           57,300       57,300
                                       ----------   ----------
     TOTAL                              1,462,451    1,462,451
 
Less Accumulated Amortization             645,226      434,783
                                       ----------   ----------
     Net Assets Under Capital Lease    $  817,225   $1,027,668
                                       ==========   ==========
 

                                      F-13
<PAGE>
 
Amortization of assets under capital leases charged to operations and included
in depreciation expense was $210,443, $210,443 and $149,523 in 1998, 1997, and
1996 respectively.


6.  INCOME TAXES
----------------

The net deferred tax asset at December 31 includes the following:
 
                                                  1998          1997
                                              ------------  ------------
 
Deferred Tax Asset                            $ 3,323,000   $ 2,295,000
Deferred Tax Liability                           (168,000)     (359,000)
Valuation Allowance for Deferred Tax Asset     (3,155,000)   (1,936,000)
                                              -----------   -----------
                                              $        --   $        --
                                              ===========   ===========

The utilization of the deferred tax asset depends on the Company's ability to
earn taxable income in the future. Although estimates are subject to change,
management was not able to determine that utilization of the deferred tax asset
is likely. Accordingly, a valuation allowance has been provided for the entire
deferred tax asset. The tax effect of major temporary differences that gave rise
to the Company's deferred tax assets and liabilities at December 31 are as
follows:
 
 
                                                  1998          1997
                                              ------------  ------------
 
      Net Operating Loss and Carryforwards    $ 2,270,000   $ 1,441,000
      Allowance for Doubtful Accounts             893,000       659,000
      Legal and Commission Reserves               157,000       195,000
      Charitable Contributions                      3,000
      Depreciation                               (168,000)     (359,000)
                                              -----------   -----------
      Net Deferred Tax Asset                    3,155,000   $ 1,936,000
                                              -----------   -----------
      Valuation Allowance                      (3,155,000)   (1,936,000)
                                              -----------   -----------
      Total                                   $        --   $        --
                                              ===========   ===========
 
The provision for income tax expense (benefit) for the years ended December 31,
consisted of the following amounts:
 
 
                                    1998      1997      1996
                                 ----------  -------  --------
Current tax expense (benefit)
 Federal                            $10,000   $   --    $7,000
 State                                   --       --        --
                                 ----------   ------  --------
                                         --       --     7,000
                                                              
Deferred tax expense                                          
  Federal                                --       --        --
  State                                  --       --        --
                                 ----------   ------  --------
                                    $10,000   $   --    $7,000
                                 ==========   ======  ======== 
 

                                      F-14
<PAGE>
 
The differences between the Company's income tax expense (benefit) and income
tax expense (benefit) computed using the U.S. Federal Income tax rate were as
follows:
<TABLE>
<CAPTION>
 
 
                                  1998                   1997                 1996
                                              % of                 % of                 % of
                                            pretax                 pretax              pretax
                                 Amount     income      Amount     income    Amount    income
<S>                           <C>           <C>      <C>           <C>      <C>        <C>
Computed "expected" income
    tax expense (benefit)     $(1,209,000)   (34.0)  $(1,257,900)   (34.0)  $ 29,500     34.0
Valuation allowance             1,219,000     34.5     1,250,600     33.8    (30,500)   (35.1)
Other                                   0        0         7,300       .2      8,000      9.2
                              -----------    -----   -----------    -----   --------    -----
Actual income tax
    expense (benefit)         $    10,000       .5   $        --       --   $  7,000      8.1
                              ===========    =====   ===========    =====   ========    =====
</TABLE>

The Company has available approximately $5,146,300 of net operating loss carry
forwards which may be applied against future federal taxable income. These carry
forwards begin to expire in 2005.


7.  COMMITMENTS AND CONTINGENCIES
---------------------------------

The Company has a long term contract for the purchase of 1+, 800, and Private
lines services over a 42 month period, expiring in November 1999.  The contract
provides for a minimum monthly commitment of $250,000 and an aggregate
commitment of $9,000,000 over the contract life.  The Company has met its
monthly commitments through December 1998 and has fully satisfied the aggregate 
amount.

The Company leases certain offices and equipment. Future annual minimum lease
payments under the significant agreements are as follows for the years ended
December 31:
<TABLE>
<CAPTION>
 
<S>                               <C>
                    1999             439,211
                    2000             425,425
                    2001             296,169
                    2002             132,366
                    2003              68,637
                    thereafter       211,888
                                  ----------
                      TOTAL       $1,573,696
                                  ==========
</TABLE>
Rent expense incurred for operating leases was approximately $492,789, $488,436,
and $422,896 in 1998, 1997, and 1996, respectively.

The Company had entered into employment agreements with certain of its Executive
Officers. At December 31, 1998, the total minimum commitment level over the next
three years is approximately $210,000.

The Company entered into a contract in December 1996 with its Chairman for
consulting services.  The total minimum aggregate commitment level over the
remaining four years of the contract as of December 31, 1998 is approximately
$500,000.

                                      F-15
<PAGE>
 
The Company entered into an agreement with a long distance carrier effective
August 25, 1995 for that carrier to provide network design, network operation
and network management of the Company's switch in Oakland, CA.  The agreement
specified certain incentive bonuses, payable in common stock, for the carrier
based on traffic levels of the Oakland switch.  Based on levels reached during
the two year term of the agreement which ended August 25, 1997, the Company
issued the carrier 106,060 shares of common stock in 1998.  The fair value of
the shares was charged to Selling, General and Administrative Expense in 1997.
The agreement also specified incentives for certain stock option grants.  In
1998, 100,000 options were awarded at a purchase price of $2.375 per share. (See
note 10)


8.   PENSION PLANS
------------------

The Company sponsors a 401(K) Pension and Profit Sharing Plan for all employees.
The Company has elected not to match any employee contributions or make any
profit sharing contributions to the plan.


9.   PREFERRED STOCK
--------------------

REDEEMABLE PREFERRED:

The Company has outstanding cumulative, convertible, redeemable preferred stock
which is convertible at the option of respective shareholders thereof, into ten
(10) common shares at a conversion price of one dollar ($1.00) each.

At any time after September 1, 1996, the Company, at the option of its Board of
Directors, may redeem part or all of the preferred shares outstanding at $11.00
each plus unpaid and accumulated dividends. At December 31, 1998, the maximum
aggregate redemption value is $330,000 and there were no unpaid accumulated
dividends. The preferred stock is mandatorily redeemable in cash on January 2,
2049 at $11.00 per share. Dividends on the preferred stock are payable in cash
only at a rate of 9% per annum on December 1, March 1, June 1, and September 1.

PREFERRED STOCK:

In July 1994, the shareholders approved an amendment to the Company's
Certificate of Incorporation to authorize 850,000 shares of par value $.01 per
share preferred stock.  No shares were issued as of December 31, 1998.


10.  COMMON STOCK, STOCK OPTIONS AND WARRANTS
---------------------------------------------

Under the Company's stock option plans, options may be granted to officers and
employees of the Company and its subsidiaries.  No option may be granted for a
term in excess of ten years from the date of grant.  As of December 31, 1998,
1,473,300 of the outstanding stock options were exercisable under the plans.
The exercise prices of the outstanding options represented the fair market value
at dates of grant.

                                      F-16
<PAGE>
 
A summary of the Company's stock option plans activity for common shares for the
three years ended December 31, 1998 follows:

<TABLE> 
<CAPTION> 
 
                                                                         Weighted     
                                                   Stock Options         Average 
                                 Number             Price Range          Exercise 
                               of Shares             Per Share            Price   
                              -----------         ---------------      -----------
<S>                           <C>             <C>                       <C>        
Outstanding 12/31/95            4,251,000         $0.75 to $2.00          $1.19    
 Granted                        2,045,000         $1.00 to $2.25          $1.52    
 Exercised                        (50,000)             $1.00              $1.00    
 Terminated                    (1,770,000)        $0.75 to $1.25          $ .97    
                               ----------         --------------          -----    
Outstanding 12/31/96            4,476,000         $1.00 to $2.25          $1.43    
 Granted                        1,610,000         $1.00 to $1.91          $1.27    
 Exercised                       (160,000)        $1.00 to $1.44          $1.07    
 Terminated                    (3,483,166)        $1.00 to $2.25          $1.48    
                               ----------         --------------          -----    
Outstanding 12/31/97            2,442,834         $1.00 to $2.25          $1.28    
     Granted                      516,750         $1.19 to $2.38          $1.20    
     Exercised                 (1,068,984)        $1.00 to $1.53          $1.31    
     Terminated                   (37,300)        $1.00 to $2.00          $1.33    
                               ----------         --------------          -----    
Outstanding 12/31/98            1,853,300         $1.00 to $2.38          $1.28    
                               ==========         ==============          =====   
</TABLE>                                                                       

<TABLE> 
<CAPTION> 
                                      Options Outstanding                           Options Exercisable
                      ------------------------------------------------------  -----------------------------
                                        Weighted                                                 Weighted
                                         Average      Weighted Average                            Average
   Range of                             Exercise     Remaining Contractual                        Exercise
Exercised Prices        Outstanding      Price          Life in Years           Exercisable        Price
----------------        -----------    -----------   ----------------------    --------------    ----------
<S>                     <C>            <C>           <C>                        <C>              <C> 
$1.00 - $1.03             658,000         1.02                     1.99            658,000          1.02
$1.19 - $1.40             922,000         1.24                     2.73            552,500          1.23
$1.50 - $1.75              46,800         1.64                     2.39             36,800          1.63
$2.00 - $2.38             226,500         2.17                     1.62            226,000          2.17
                        -----------    --------     --------------------     --------------      ----------                        
                        1,853,300       $ 1.28                     2.33          1,473,300       $  1.29
                        ===========    ========     ====================     ==============    ==========
</TABLE> 

EMPLOYEE STOCK OPTIONS

The Company accounts for stock options issued to employees in accordance with
Accounting Principles Board Opinion No. 25, under which compensation cost is
recognized based on the difference, if any, between the fair value of the
Company's stock at the time of option grant and the amount the employee must pay
to acquire the stock.  The Company's options have been issued at fair market
value at the time of grant.  Had compensation cost for the incentive and
nonqualifed options been determined consistent with Statement of Financial
Accounting Standards No. 123, Accounting for Stock - Based Compensation (SFAS
123), the Company's pro forma net loss and net loss per share for the years
ended December 31 are as follows:
 
<TABLE> 
<CAPTION> 
                                            1998           1997          1996    
                                        -------------  ------------  ------------
<S>                                      <C>           <C>           <C> 
Reported Net (Loss) Income               $(1,855,369)  $(3,756,821)  $    61,625 
Proforma Net Loss                        $(2,040,115)  $(4,454,993)  $  (288,493)
Reported Net Income (Loss) Per Share     $     (0.10)  $     (0.23)  $        -- 
Proforma Net Loss Per Share              $     (0.11)  $     (0.28)  $     (0.02) 
</TABLE> 

In accordance with the requirements of SFAS 123, this method of accounting has
not been applied to options granted prior to the fiscal year beginning January
1, 1995.  The resulting pro forma compensation cost may not be representative of
that to be expected in future years.

The weighted fair value of options granted during Fiscal 1998,1997 and 1996 was
$.69, $.75 and $.55 respectively. The fair values of each stock option grant is
estimated on the date of grant using the Black-Scholes option pricing model with
the following weighted average assumptions used for grants in 1998, 1997 and
1996: risk-free interest rates of 4.526%, 6.5% and 6.5%, respectively expected
dividend yields of 0%, expected lives ranging from three to five years from the
date of grant, and expected price volatility between 60% and 80% for the options
granted in 1998, 1997 and 1996.

                                      F-17
<PAGE>
 
In May 1995, the Company agreed to issue to each of two directors/officers of
the Company 600,000 Warrants to purchase Common Stock, in consideration for
limited personal guarantees to be provided in connection with the revolving
credit facility.  Each Warrant entitled the holder to purchase one share of
Common Stock of the Company at a price of $1.0625 per share until May, 2000.  In
September 1997, each of the two directors/officers exercised 31,000 warrants
resulting in an additional amount of $62 and $65,813 added to Common Stock and
paid in capital, respectively.  In April 1998, each of the two former
directors/officers exercised the remaining 569,000 warrants resulting in an
additional amount of $1,138 and $1,207,987 added to Common Stock and paid in
capital, respectively.

THIRD PARTY STOCK OPTIONS

The Company accounts for stock options issued to outside consultants in
accordance with SFAS 123, under which compensation expense is recognized based
on the difference, if any, between the fair value of the award or the goods or
services received, whichever is more reliably measurable.  The Company has
measured the options based on the fair value of the award and the amount that
the outside consultant must pay to acquire the stock at the date of grant due to
its inability to reliably measure the fair value of the goods or services.

In May 1997, the Company agreed to issue to an independent contractor, 50,000
warrants to purchase Common Stock.  Each warrant entitles the holder to purchase
one share of Common Stock of the Company at a price of $1.03 per share until May
2002. In 1997, the Company recorded the related consulting fees as an expense in
the amount of $51,000 representing the estimated fair value of the options in
accordance with SFAS 123. In May 1998, the independent contractor exercised all
50,000 warrants resulting in an additional amount of $50 and $51,450 added to
Common Stock and paid in capital, respectively. There are no outstanding
warrants remaining as of December 31, 1998.

During 1998, the Company issued 143,750 options to purchase Common Stock to
three independent contractors.  The options entitle one contractor to purchase
100,000 shares at $2.375 per share, another contractor to purchase 25,000 shares
at $1.1875 per share and the last contractor to purchase 18,750 shares at
$1.1875 per share.  In 1998, the Company recorded approximately $133,000 in
selling, general and administrative expenses associated with these options.


11.  CASH FLOW INFORMATION
--------------------------

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

The Company made cash payments for interest of $232,915, $322,508, and $272,978,
for the years ended December 31, 1998, 1997, and 1996, respectively. The Company
made cash payments for income taxes of $10,000, $0, and $0, for the years ended
December 31, 1998, 1997,  and 1996, respectively.

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES

Redeemable Preferred Stock accreted in value by $30,000 in the year ended
December 31, 1997.

During the years ended December 31, 1998, 1997, and 1996, the Company acquired
approximately $0, $176,000, and $124,000, respectively of telephone
communications and other equipment with capital leases. The lease agreements
were financed over three and five year periods.

                                      F-18
<PAGE>
 
12.  LITIGATION
---------------

On June 13, 1997, Mark Scully, a former President and Chief Operating Officer
of the Company, filed a complaint against the Company, Kevin O'Hare, Aaron Brown
and Stephen Parker in the United States District Court for the Eastern District
of Pennsylvania.  Mr. Scully asserts various claims in connection with his
termination of employment with the Company on December 30, 1996.  In particular,
he alleges, among other things, breach of contract in connection with the
termination of certain stock options, breach of the alleged contract for
employment, breach of an asserted duty of good faith and fair dealing,
fraudulent and negligent misrepresentation, and civil conspiracy.  Mr. Scully
alleges damages of at least $1.6 million, plus attorneys' fees, costs and other
disbursements and the cost of COBRA payments and interest; $1 million of the
alleged damages claimed are punitive.  The Company contests the allegations of
the complaint and intends to vigorously defend against the action.  The case was
tried to the Court sitting without a jury on December 14-16, 1998.  The parties
recently filed post-trial memorandum and are awaiting the decision of the Court.

The Company is party, in the ordinary course of business, to other litigation
involving services rendered, contract claims and other miscellaneous causes of
action arising from its business.  The Company has established reserves relating
to its legal claims and believes that potential liabilities in excess of those
recorded will not have a material adverse effect on the Company's Consolidated
Financial Statements, however, there can be no assurances to this effect.


13.  RELATED PARTY TRANSACTIONS
-------------------------------

INDEMNIFICATION ARRANGEMENTS

The Company is party to indemnification agreements with two of its directors,
Aaron R. Brown and Stephen J. Parker, dated August 1990. In addition, the
Company has entered into an indemnification agreement with Kevin O'Hare, a
former executive officer of the Company, dated July, 1997. In general, the
indemnification agreements obligate the Company to indemnify each of Messrs.
Brown, Parker and O'Hare against the liabilities and expenses incurred by them
in acting as a director or officer of the Company to the maximum extent allowed
by law. As stated above, the Company, together with Messrs. Parker, Brown and
O'Hare, have been sued by a former president for various claims asserted by the
plaintiff in connection with his termination of employment with the Company on
December 30, 1996. The Company and the individual defendants have selected
counsel to defend the action. The Board of Directors has authorized the Company
to advance the expenses of the individual defendants incurred in defending this
action upon the receipt of an undertaking from each of them to repay the amounts
so advanced in the event it is determined that they are not entitled to
indemnification under applicable law. As of December 31, 1998, no amounts had
been advanced by the Company under such agreements. (See Note 12)

SALES AGENCY

Mr. Goldberg, a director of the Company, acts as a sub-agent for the Company and
is the co-owner of Goldberg & Associates, a company that acts as an agent for
the Company in the sale of products and services. During 1998 the Company paid
Mr. Goldberg and such company a total of $84,569 in commissions for their
services as sales agents.

                                      F-19
<PAGE>
 
SHORT SWING PROFITS

During 1998, Mr. Anderson, a significant shareholder and current Chairman of the
Board of Directors, was required to remit short swing profits of approximately
$2,481,000 to the Company as a result of a violation of Section 16(b) of the
Securities Exchange Act of 1934. The Company has recorded such proceeds net of
related attorney's fees as additional paid in capital in 1998.

PRIVATE PLACEMENT

On March 23, 1999, the Company through a private placement transaction, issued
900,000 shares of common stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, for an aggregate purchase price of $1,530,000 or
$1.70 per share.  The proceeds of the issuance will be used for general working
capital.  The terms of such transaction were negotiated between the Company and
Gold & Appel Transfer, S.A. on an arms length basis, with Mr. Anderson
abstaining from all negotiations and approvals.

CHANGES IN MANAGEMENT

Effective August 21, 1998, Stephen Parker, President and Chief Executive
Officer, terminated his employment with the Company.  Mr. Parker was immediately
replaced by Aaron Brown as interim President and Chief Executive Officer.  Upon
termination Mr. Parker received severance pay of approximately $300,000.


14.  ABORTED MERGER COSTS
-------------------------

On October 28, 1997, the Company entered into an Agreement and Plan of Merger
with ACC Corp. and a wholly-owned subsidiary of ACC Corp., whereby US Wats would
become a wholly-owned subsidiary of ACC Corp. The merger was subject to the
satisfaction of certain conditions, including that the merger be treated as a
pooling of interests.  Costs associated with the merger of $567,000 were
incurred by the Company prior to December 31, 1997.  In 1998, the Company
incurred approximately $125,000 in expenses associated with the merger and are
included in Selling, General, and Administrative expenses in the Company's
Statement of Operations.  On March 11, 1998, the Company announced an agreement
with ACC Corp. for mutual termination of the Agreement and Plan of Merger, by
and among US Wats, ACC Corp. and a subsidiary of ACC Corp.

In 1998, the Company incurred approximately $256,000 in legal, accounting and
consulting fees associated with various other potential strategic alternatives.
In addition, in the first quarter of 1999, the Company has incurred
approximately $120,000 associated with potential strategic alternatives.

                                      F-20
<PAGE>

15. Other Sales Information
    -----------------------

Net sales information by the Company's product groups for the years ended 
December 31 are summarized as follows:

<TABLE> 
<CAPTION> 
                                                 1998                      1997                   1996
                                         -------------------       ------------------     -------------------
                                            Amount        %          Amount        %        Amount        %
                                         ------------   ----       ------------  ----     ------------  -----
<S>                                      <C>            <C>        <C>           <C>      <C>           <C> 
Domestic 1+                               $20,105,578    45        $20,892,678    37      $15,718,732    39
International                              10,276,183    23         17,504,676    31        9,673,066    24  
Inbound                                     6,701,859    15          8,470,005    15        6,448,711    16
Wireless                                    1,787,162     4          2,258,668     4        2,821,311     7
Domestic Carrier Termination                5,808,278    13          7,340,671    13        5,642,622    14
                                          -----------   ----       -----------   ----     -----------   ----
   Total                                  $44,679,060   100%       $56,466,698   100%     $40,304,442   100%
                                          ===========   ====       ===========   ====     ===========   ====
</TABLE> 


                                     F-21

<PAGE>
 
 
                                 US WATS, INC.
                Schedule II  Valuation and Qualifying Accounts

<TABLE> 
<CAPTION> 
---------------------------------------------------------------------------------------------------------------------
COL. A                                     COL. B           COL. C            COL. D           COL. E        COL. F
---------------------------------------------------------------------------------------------------------------------
DECRIPTION                               BALANCE AT                         CHARGED TO      DEDUCTIONS-   BALANCE AT
                                          BEGINNING       CHARGED TO      OTHER ACCOUNTS-     ACCOUNTS      END OF
                                          OF PERIOD         EXPENSE         RECOVERIES      WRITTEN OFF     PERIOD
---------------------------------------------------------------------------------------------------------------------
<S>                                      <C>          <C>                 <C>               <C>            <C>
Period ended 12/31/98
---------------------
 
ALLOWANCE FOR DOUBTFUL
  ACCOUNTS-                               
  ACCOUNTS RECEIVABLE                    $1,498,749          $  788,493      $(18,763)     $(1,333,855)   $  934,624
                                         ----------------------------------------------------------------------------
Period ended 12/31/97
---------------------
 
ALLOWANCE FOR DOUBTFUL
  ACCOUNTS-                               
  ACCOUNTS RECEIVABLE                    $  672,058          $1,465,248      $ 93,343      $  (731,900)   $1,498,749
                                         ----------------------------------------------------------------------------
Period ended 12/31/96
---------------------
 
ALLOWANCE FOR DOUBTFUL
  ACCOUNTS-                               
  ACCOUNTS RECEIVABLE                    $  268,921          $  479,209      $137,532      $  (213,604)   $  672,058
                                         ----------------------------------------------------------------------------
</TABLE>

                                     F-22