<PAGE>   1
 
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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
 
                                   FORM 10-K
(MARK ONE)
      [X]        ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
                     OF THE SECURITIES EXCHANGE ACT OF 1934
 
                   FOR THE FISCAL YEAR ENDED JANUARY 26, 1997
 
                                       OR
 
      [ ]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
                     OF THE SECURITIES EXCHANGE ACT OF 1934
 
               FOR THE TRANSITION PERIOD FROM        TO        .
 
                         COMMISSION FILE NUMBER 1-13740
 
                              BORDERS GROUP, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
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<C>                                            <C>
                  DELAWARE                                      38-3196915
       (STATE OR OTHER JURISDICTION OF                       (I.R.S. EMPLOYER
       INCORPORATION OR ORGANIZATION)                       IDENTIFICATION NO.)
</TABLE>
 
              500 EAST WASHINGTON STREET, ANN ARBOR, MICHIGAN 48104
             (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)      (ZIP CODE)
 
                                 (313) 913-1100
              (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
 
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                                                             NAME OF EXCHANGE
               TITLE OF CLASS                               ON WHICH REGISTERED
               --------------                               -------------------
<C>                                            <C>
       COMMON STOCK ($.001 PAR VALUE)                     NEW YORK STOCK EXCHANGE
</TABLE>
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
 
                                      NONE
 
INDICATE BY CHECK MARK WHETHER THE REGISTRANT: (1) HAS FILED ALL REPORTS
REQUIRED TO BE FILED BY SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE
REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH
FILING REQUIREMENTS FOR THE PAST 90 DAYS.  YES [X]   NO [ ]
 
INDICATE BY CHECK MARK IF DISCLOSURE OF DELINQUENT FILERS PURSUANT TO ITEM 405
OF REGULATION S-K IS NOT CONTAINED HEREIN, AND WILL NOT BE CONTAINED, TO THE
BEST OF REGISTRANT'S KNOWLEDGE, IN DEFINITIVE PROXY OR INFORMATION STATEMENTS
INCORPORATED BY REFERENCE IN PART III OF THIS FORM 10-K OR ANY AMENDMENT TO THIS
FORM 10-K
 
THE AGGREGATE MARKET VALUE OF THE VOTING STOCK HELD BY NON-AFFILIATES OF THE
REGISTRANT WAS APPROXIMATELY $1,495,460,897 BASED UPON THE CLOSING MARKET PRICE
OF $20.625 PER SHARE OF COMMON STOCK ON THE NEW YORK STOCK EXCHANGE AS OF APRIL
4, 1997.
 
NUMBER OF SHARES OF $.001 PAR VALUE COMMON STOCK OUTSTANDING AS OF APRIL 4,
1997: 75,897,031
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
PORTIONS OF THE REGISTRANT'S PROXY STATEMENT FOR THE MAY 15, 1997 ANNUAL MEETING
OF STOCKHOLDERS ARE INCORPORATED BY REFERENCE INTO PART III.
 
                THE EXHIBIT INDEX IS LOCATED ON PAGE 43 HEREOF.
 
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                              BORDERS GROUP, INC.
                                     INDEX
 
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<CAPTION>
                                                                            PAGE
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                                    PART I
Item 1.     Business....................................................      1
Item 2.     Properties..................................................      6
Item 3.     Legal Proceedings...........................................      7
Item 4.     Submission of Matters to a Vote of Security Holders.........      7
                                   PART II
Item 5.     Market for Registrant's Common Equity and Related
            Stockholder Matters.........................................      8
Item 6.     Selected Financial Data.....................................      9
Item 7.     Management's Discussion and Analysis of Financial Condition
            and
            Results of Operation........................................     10
Item 8.     Financial Statements and Supplementary Data.................     18
Item 9.     Changes in and Disagreements With Accountants on Accounting
            and Financial Disclosure....................................     34
                                   PART III
Item 10.    Directors and Executive Officers of the Registrant..........     34
Item 11.    Executive Compensation......................................     37
Item 12.    Security Ownership of Certain Beneficial Owners and
            Management..................................................     37
Item 13.    Certain Relationships and Related Transactions..............     37
                                   PART IV
Item 14.    Exhibits, Financial Statement Schedules, and Reports on Form
            8-K.........................................................     38
</TABLE>
<PAGE>   3
 
                                     PART I
 
ITEM 1. BUSINESS
 
GENERAL
 
     The Company, through its subsidiaries, Borders, Inc. ("Borders"), Walden
Book Company, Inc. ("Walden") is the second largest operator of book superstores
and the largest operator of mall-based bookstores in the United States based
upon both sales and number of stores. At March 23, 1997, the Company operated
142 large format books and music superstores and 16 book superstores under the
Borders name, 936 mall-based and other bookstores primarily under the
Waldenbooks name and 3 music superstores under the Planet Music name. The
Company had consolidated net sales of approximately $2.0 billion in 1996 and
$1.8 billion in 1995. References herein to years are to fiscal years of the
Company which currently end in January of the following calendar year.
 
     Borders is a premier operator of books and music superstores, offering
customers selection and service that the Company believes to be superior to
other book superstore operators. A key element of the Company's strategy is to
continue its growth and increase its profitability through the ongoing rapid
expansion of its Borders books and music superstore operations. In 1996, the
Company opened 41 new Borders books and music superstores. Borders superstore
operations achieved compound annual growth in net sales for the three years
ended January 26, 1997 of 63.1% and attained comparable store sales growth in
1996 of 9.9%. Borders superstores achieved average sales per square foot of $259
and average sales per superstore of $7.2 million in 1996, each of which the
Company believes to be higher than the comparable figures of any publicly
reporting book superstore operator.
 
     Each Borders superstore offers customers a vast assortment of books,
superior customer service, value pricing and an inviting and comfortable
environment designed to encourage browsing. A Borders superstore typically
carries the broadest selection of book titles in its market. Each Borders
superstore carries an average of 128,000 book SKUs, ranging from 85,000 SKUs to
170,000 SKUs, across numerous categories, including many hard-to-find titles. As
of March 23, 1997, 142 of the 158 Borders superstores were in a books and music
format, which also features an extensive selection of pre-recorded music, with
an emphasis on hard-to-find recordings and categories such as jazz, classical
and foreign music, and a broad assortment of pre-recorded videotapes, focusing
primarily on classic movies and hard-to-find titles. Each book and music
superstore carries approximately 50,000 SKUs of music and 9,300 SKUs of
videotapes. As of March 23, 1997, 152 of the 158 Borders superstores featured an
espresso bar.
 
     Over the past two decades, Borders has developed what it believes is the
most sophisticated inventory management system in the retail book industry. The
inventory management system includes a centrally controlled "expert" system that
uses artificial intelligence principles to forecast sales and recommend
inventory levels for each book in each store. Management believes that Borders'
inventory management system, which reflects both overall sales trends and local
buying patterns, results in higher in-stock positions, a broader selection of
book titles, and increased inventory turnover, sales per store and sales per
square foot, while simultaneously reducing costs to thereby provide Borders
stores with a more productive inventory assortment. As a result, management
believes this proprietary system has been a principal reason for Borders'
superior performance. The Company is adapting certain aspects of the system for
use in its mall-based business where appropriate, and believes that over the
long term it will enable the Company to offer a more productive assortment of
inventory throughout its operations.
 
     The Borders books and music superstores average 27,700 square feet,
including approximately 8,500 square feet devoted to music, approximately 400
square feet devoted to videos and approximately 1,500 square feet devoted to the
espresso bar. The remaining book superstores generally range in size from
approximately 12,000 square feet to approximately 20,700 square feet. Stores
opened in fiscal 1996 averaged 27,000 square feet. Each store is distinctive in
appearance and architecture and is designed to complement its local
surroundings, although Borders utilizes certain standardized specifications to
increase the speed and lower the cost of new store openings.
 
                                        1
<PAGE>   4
 
     Walden is the leading operator of mall-based bookstores in terms of sales
and number of stores, offering customers a convenient source for new releases,
hardcover and paperback bestsellers, selected children's books and a standard
selection of business, cooking, reference and general interest books. Walden has
a well established name and reputation and generates cash flow that the Company
plans to use in large part toward financing the Company's superstore growth.
"Waldenbooks" average approximately 3,300 square feet and typically carry
between 15,000 and 25,000 titles.
 
     In addition to its traditional mall format described above, Walden operates
an alternative mall-based bookstore utilizing a large format. This addresses the
desires of some developers to include a larger format bookstore in malls,
including, in many cases, where developers plan to include only one bookstore in
a mall, and is designed to take advantage of what management believes is the
desire by mall customers in some markets for greater selection and service. The
larger format consists of approximately 6,000 to 8,000 square feet and carries
between 43,000 and 48,000 titles. As of March 23, 1997, 93 of the larger format
stores had been opened.
 
DISTRIBUTION
 
     Borders. Borders believes that its centralized distribution system,
combined with Borders' use of its proprietary "expert" system to manage
inventory at the distribution center, significantly enhances its ability to
manage inventory on a store-by-store basis. Books are shipped directly from the
publishers to one of Borders' distribution centers, located in Harrisburg,
Pennsylvania; Reno, Nevada; Ann Arbor, Michigan and Indianapolis, Indiana.
Approximately 95% of the books carried by Borders are processed through its
distribution facilities, with the majority of the balance shipped directly to
Borders' stores from seven wholesalers. At each distribution facility, employees
process the merchandise from the publishers and write out claims for short
orders, damaged books, incorrect shipments and incorrect billings. Employees
also label books with proprietary bar code stickers identifying the book title,
price and subject area. During the non-holiday selling season, approximately 85%
to 90% of the trade inventory that arrives from publishers is processed within
48 hours for shipment to the stores. Newly released titles and rush orders are
processed within 24 hours. A small percentage of books ordered by local stores
is ordered from independent distributors, generally for special orders. Borders
purchases 85% of music directly from certain manufacturers and utilizes Borders'
own distribution centers to ship a majority of its music inventory to its
stores.
 
     In general, books can be returned to their publishers at cost. Borders
stores return books to the Company's centralized returns center in Nashville,
Tennessee to be processed for return to the publishers. Borders believes that
its returns to publishers are substantially lower than the industry average, due
to the sophistication of its inventory management system. As a result, Borders
is able to reduce its handling, carrying and freight expenses. In general,
Borders has limited rights to return music and videos to its distributor.
 
     Walden. Approximately 64% of the number of books carried by Walden's stores
are shipped to one of Walden's two distribution centers, located in Ontario,
California and Nashville, Tennessee. Walden also utilizes the Company's
Nashville, Tennessee returns center facility. Walden continues to use Ingram, a
major book wholesaler, to supplement its distribution centers.
 
COMPETITION
 
     The retail book business is highly competitive. Competition within the
retail book industry is fragmented with Borders facing direct competition from
other superstores, such as Barnes & Noble, Books-A-Million, Crown Books and
Media Play. Approximately 87% of Borders superstores currently face direct
competition from other large format book superstores. Walden faces direct
competition from the B. Dalton division of Barnes & Noble, Inc., as well as
regional chains and superstores. In addition, Borders and Walden compete with
each other, as well as specialty retail stores that offer books in a particular
area of specialty, independent single store operators, variety discounters, drug
stores, warehouse clubs, mail order clubs and mass merchandisers. In the future,
Borders and Walden may face additional competition from other categories of
retailers entering the retail book market, in particular music retailers.
 
                                        2
<PAGE>   5
 
     The music and video businesses are also highly competitive and Borders
faces competition from large established music chains, such as Tower Records and
the Musicland and Media Play divisions of Musicland Stores Corporation (which
also sell videos), established video chains, such as Blockbuster and Suncoast
Motion Picture Company (a division of Musicland Stores Corporation), as well as
specialty retail stores, video rental stores, variety discounters, warehouse
clubs and mass merchandisers (such as Best Buy), some of which may have greater
financial or other resources than the Company. In addition, consumers receive
television and mail order offers and have access to mail order clubs. The
largest mail order clubs are affiliated with major manufacturers of pre-recorded
music and may have advantageous marketing relationships with their affiliates.
 
     Recently the internet has emerged as an avenue for retailing in all media
categories that the Company carries. In particular, the retailing of books over
the internet is developing rapidly. Competitors on the internet include Amazon,
Barnes & Noble and others. The Company does not believe that sales to date on
the internet have materially affected the Company's sales, but internet sales
may become more significant over time. The Company is developing its own vehicle
for retailing over the internet which it expects to be in operation within a
year.
 
CREDIT FACILITY
 
     The Credit Facility was established pursuant to the Credit Agreement, dated
as of March 28, 1995 (the "Credit Agreement"), by and among the Company,
Borders, Walden and Planet Music, as both joint borrowers and cross guarantors,
the lenders party thereto, PNC, as administrative agent and First Chicago, as
syndication agent.
 
     General. The Credit Agreement currently provides for borrowings in a
principal amount of up to $300 million at any one time, which includes
sub-limits for discretionary lines of credit and letters of credit. The Credit
Agreement expires on March 27, 2000. Borrowings under the Credit Agreement are
referred to herein as the "Loans".
 
     Interest. The Company may elect to have the Loans bear interest at the Base
Rate or Euro-Rate. The Base Rate is a fluctuating rate per annum equal to the
greater of (i) the interest rate per annum announced from time to time by the
administrative agent at its principal office as its then prime rate or (ii) the
Federal Funds Effective Rate (as defined in the Credit Agreement) plus 1/2% per
annum. The Euro-Rate is a rate per annum equal to (a) the interest rate
determined by dividing (i) the London Interbank Offered Rate by (ii) one minus
the Euro-Rate Reserve Percentage (which in general is equal to the maximum
percentage reserve requirements with respect to eurocurrency funding), plus (b)
the Euro-Rate Margin (as defined in the Credit Agreement).
 
     Repayment. Subject to the provisions of the Credit Agreement, the Company
may, from time to time, borrow, repay and reborrow under the Credit Agreement.
The entire unpaid balance may be prepaid at any time without penalty, and is
payable on March 27, 2000.
 
     Covenants. The Credit Agreement contains financial covenants relating to
the maintenance of a minimum fixed charge coverage ratio, a maximum leverage
ratio and a minimum tangible net worth. The Credit Agreement also contains
restrictive covenants pertaining to the management and operation of the Company.
These covenants include, among others, significant limitations on indebtedness
(with an exception for certain permitted indebtedness necessary to satisfy
note-put agreements relating to certain mortgage pass-through certificates for
which certain Borders' leases serve as collateral), liens, contingent
obligations, loans and investments, dividends and distributions, liquidations,
mergers, consolidations, disposition of assets or subsidiaries, transactions
with affiliates, fundamental corporate changes, and capital expenditures and
repurchase of its common stock in excess of $50 million.
 
     Events of Default. The Credit Agreement provides for events of default
customary in facilities of this type, including: (i) failure to make payments
when due; (ii) breach of any representations and warranties; (iii) breach of
covenants; (iv) default under any agreement relating to indebtedness for
borrowed money in excess of $5.0 million in the aggregate; (v) bankruptcy
defaults; (vi) judgments in excess of $5.0 million;
 
                                        3
<PAGE>   6
 
(vii) ERISA defaults; (viii) solvency defaults; (ix) change in control defaults;
and (x) certain events that individually or in the aggregate could reasonably be
expected to have a material adverse effect.
 
LEASE FACILITY
 
     On November 26, 1995, the Company entered into a five year, $150 million
lease financing facility ("the Lease Facility") to finance new stores and other
property through operating leases. The Facility will provide financing to
Lessors through loans from a third party lender for up to 95% of a project cost.
It is expected that Lessors will make equity contributions approximating 5% of
each project. Independent of its obligations as lessee, the Company guarantees
payment when due of all amounts required to be paid to the third party lender.
The principal amounts guaranteed are limited to approximately 89% of the
original cost of a project, so long as the Company is not in default under the
lease relating to such project. Events of default are similar in nature to the
Credit Agreement. As of March 23, 1997 approximately 11% of Borders store
locations were financed through the Facility. Upon the refinancing of the
amounts outstanding under the Lease Facility, rental expense for locations
leased thereunder could be adversely affected.
 
ASSOCIATES
 
     As of March 23, 1997, the Company had a total of approximately 12,500
full-time associates and approximately 10,300 part-time associates. When hiring
new associates, the Company considers a number of factors, including education
and experience, personality, orientation towards customer service and, in the
case of Borders, performance on Borders' written examination. All new associates
participate in a training program that provides up to two weeks of in-store
training in all aspects of customer service and selling, including title
searches for in-stock and in-print merchandise, merchandising, sorting,
operation of POS terminals and store policies and procedures. The Company
believes that its relations with its associates are generally good. The
Company's associates are not represented by unions except that, during 1996, the
associates of three Borders stores elected to be represented by the United Food
and Commercial Workers International Union (UFCW). To date, no agreement has
been reached by the Company and the UFCW with respect to any of the three
stores.
 
TRADEMARKS AND SERVICE MARKS
 
     Borders(R), Borders Book Shop(R), and Borders Books & Music(R), among other
marks, are all registered trademarks and service marks used by Borders.
Brentano's(R), Coopersmith's(R), Longmeadow Press(R), Waldenbooks(R),
Waldenbooks Preferred Reader(R), Waldenkids(R) and Waldensoftware(R), among
other marks, are all registered trademarks and service marks used by Walden.
Planet Music(SM), among other marks, is a trademark and service mark of Planet
Music. The Borders and Walden service marks are used as trade names in
connection with their business operations.
 
SEASONALITY
 
     The Company's business is highly seasonal, with sales generally highest in
the fourth quarter and lowest in the first quarter. Moreover, the Company has
experienced losses in the first three quarters of each year. During 1996,
approximately 37.1% of the Company's sales and approximately 108.3% of the
Company's operating income were generated in the fourth quarter. The Company's
results of operations depend significantly upon the holiday selling season in
the fourth quarter; less than satisfactory net sales for such period could have
a material adverse effect on the Company's financial condition or results of
operations for the year and may not be sufficient to cover losses incurred in
the first three quarters of the year. The Company's expansion program generally
is weighted with store openings in the second half of the fiscal year. In the
future, changes in the number and timing of store openings, or other factors,
may result in different seasonality trends. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Seasonality".
 
                                        4
<PAGE>   7
 
RELATIONSHIP WITH KMART
 
     General. The Company was formerly a subsidiary of Kmart; Kmart currently
owns no shares of Common Stock.
 
     Kmart and the Company continue to have the following contractual
relationships.
 
     Tax Allocation and Indemnification Agreement. Prior to the completion of
its initial public offering ("the IPO"), the Company was included in the
consolidated federal income tax returns of Kmart and filed on a combined basis
with Kmart in certain states. Pursuant to a tax allocation and indemnification
agreement between the Company and Kmart (the "Tax Allocation Agreement") the
Company will remain obligated to pay to Kmart any income taxes the Company would
have had to pay if it had filed separate tax returns for the tax period
beginning on January 26, 1995, and ending on June 1, 1995, the date of the
consummation of the IPO (to the extent that it has not previously paid such
amounts to Kmart). In addition, if the tax liability attributable to the Company
for any previous tax period during which the Company was included in a
consolidated federal income tax return filed by Kmart or a combined state return
is adjusted as a result of an action of a taxing authority or a court, then the
Company will pay to Kmart the amount of any increase in such liability and Kmart
will pay to the Company the amount of any decrease in such liability (in either
case together with interest and penalties). The Company's tax liability for
previous years will not be affected by any increase or decrease in Kmart's tax
liability if such increase or decrease is not directly attributable to the
Company. After completion of the IPO, the Company continued to be subject under
existing federal regulations to several liability for the consolidated federal
income taxes for any tax year in which it was a member of any consolidated group
of which Kmart was the common parent. Pursuant to the Tax Allocation Agreement,
however, Kmart agreed to indemnify the Company for any federal income tax
liability of Kmart or any of its subsidiaries (other than that which is
attributable to the Company) that the Company could be required to pay and the
Company agreed to indemnify Kmart for any of the Company's separate company
taxes.
 
     Lease Guaranty Agreement. Approximately 39 of Borders' leases for its
retail stores have been guaranteed by Kmart, on either a full or limited basis.
Limited guarantees generally provide for the release of Kmart's guarantee upon
satisfaction by Borders of certain financial requirements specified in the
guarantee. Under the terms of a lease guaranty, indemnification and
reimbursement agreement entered into upon completion of the IPO (the "Lease
Guaranty Agreement"), until termination of all of the lease guarantees, except
during such time as the Company achieves and maintains the investment grade
status specified in the Lease Guaranty Agreement, the Company will be subject to
certain covenants and restrictive covenants under the Lease Guaranty Agreement
including restrictions on indebtedness, dividends, mergers and certain liens.
 
     Under the terms of the Lease Guaranty Agreement, the underlying leases will
be transferable by Borders, subject to a right of first refusal in favor of
Kmart with respect to sites within a three-mile radius of a Kmart store and,
with respect to all other sites, a right of first offer in favor of Kmart. The
Company and Borders are required to indemnify Kmart with respect to (i) any
liabilities Kmart may incur under the lease guarantees, except those liabilities
arising from the gross negligence or willful misconduct of Kmart, and (ii) any
losses incurred by Kmart after taking possession of any particular premises,
except to the extent such losses arise solely from the acts or omissions of
Kmart. Under the terms of the Lease Guaranty Agreement, in the event of (i) the
Company's or Borders' failure to provide any required indemnity, (ii) a knowing
and material violation of the limitations on transfers of guaranteed leases set
forth in the agreement, (iii) a breach of any of the financial covenants
described above or (iv) certain events of bankruptcy, Kmart will have the right
to assume any or all of the guaranteed leases and to take possession of all of
the premises underlying such guaranteed leases; provided, that in the event of a
failure or failures to provide required indemnities, the remedy of taking
possession of all of the premises underlying the guaranteed leases may be
exercised only if such failures relate to aggregate liability of $10.0 million
or more and only if Kmart has provided 100 days' prior written notice. In the
event of a failure to provide required indemnities resulting in losses of more
than the equivalent of two months rent under a particular lease but less than
$10.0 million, Kmart may exercise such remedy of possession as to the premises
underlying the guaranteed lease or leases to which the failure to provide the
indemnity relates and one additional premise for each such premises to which the
failure relates, up to a
 
                                        5
<PAGE>   8
 
maximum, in any event, of five additional premises, and thereafter, with respect
to such additional premises, Kmart remedies and indemnification rights shall
terminate. In the event of a failure to provide required indemnities resulting
in liabilities of less than the equivalent of two months rent under a particular
lease, Kmart may exercise such remedy of possession only as to the premises
underlying the guaranteed lease or leases to which the failure to provide the
indemnity relates. The Lease Guaranty Agreement will remain in effect until the
expiration of all lease guarantees, which the Company believes will be on or
after November 2019.
 
ITEM 2. PROPERTIES
 
     Borders. Borders operated 158 stores in 36 states and the District of
Columbia at March 23, 1997. Borders leases all of its stores. Borders' store
leases have an average initial term of 15 to 20 years with several five-year
renewal options. At March 23, 1997, the average unexpired term under Borders'
158 existing store leases was 14.3 years prior to the exercise of any options.
 
     The Company has leased its corporate headquarters in Ann Arbor, Michigan
and all distribution centers located in Harrisburg, Pennsylvania; Indianapolis,
Indiana; Reno, Nevada; Columbus, Ohio and Ann Arbor, Michigan.
 
     Walden. Walden operates 936 stores in all 50 states as of March 23, 1997.
Walden leases all of its stores. Walden's store leases have an average term of
10 years. At present, the average unexpired term under Walden's 936 existing
store leases is approximately 4.7 years. The terms of Walden's mall-based
bookstores leases for its 936 leased bookstores open as of March 23, 1997 expire
as follows:
 
<TABLE>
<CAPTION>
     LEASE TERMS TO EXPIRE DURING
12 MONTHS ENDING ON OR ABOUT JANUARY 31    NUMBER OF MALL STORES
---------------------------------------    ---------------------
<S>                                        <C>
1997...................................             228
1998...................................             112
1999...................................             103
2000 and later.........................             493
</TABLE>
 
     Walden leases both of its distribution facilities located in Ontario,
California and Nashville, Tennessee. The California facility has approximately
237,600 square feet dedicated to distribution and warehousing and approximately
9,400 square feet dedicated to corporate offices and general administration. The
Tennessee facility has approximately 494,500 square feet dedicated to
distribution and warehousing and approximately 25,500 square feet dedicated to
corporate offices and general administration. The Company relocated its
Waldenbooks headquarters during 1995 in order to better coordinate its
operations with Borders and allow for streamlining and combination of certain
management and administrative functions. On December 5, 1995, Walden completed
the sale of its previous corporate headquarters facility located in Stamford,
Connecticut.
 
     Planet Music. Planet Music operates stores in 3 states at March 23, 1997.
Planet Music leases all of its stores under operating leases with terms ranging
from one to 13 years. The average remaining lease term for Planet Music leases
is six years.
 
ITEM 3. LEGAL PROCEEDINGS
 
     The Company is from time to time involved in or affected by litigation
incidental to the conduct of its respective businesses. The Company believes
that no currently pending litigation to which it is a party will have a material
adverse effect on its liquidity, financial position or results of operations.
 
     On March 9, 1995, a grand jury sitting in the Southern District of New York
issued a subpoena (the "Subpoena") to Walden seeking the production of certain
documents relating to Walden's store closing program in connection with an
investigation being conducted by the Antitrust division of the Department of
Justice. On April 1, 1997, the Department of Justice advised Walden that the
investigation had been closed.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     Not applicable.
 
                                        6
<PAGE>   9
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
     The following table sets forth, for the fiscal quarters indicated, the high
and low closing market prices for the Common Stock on the New York Stock
Exchange (after the effect of the 2-for-1 stock split, effective, March 1,
1997).
 
<TABLE>
<CAPTION>
                                                               HIGH       LOW
                                                               ----       ---
<S>                                                           <C>       <C>
FISCAL QUARTER 1995
     Second Quarter (from May 25, 1995).....................  $ 8.56    $ 6.94
     Third Quarter..........................................  $10.75    $ 8.06
     Fourth Quarter.........................................  $10.19    $ 7.63
FISCAL QUARTER 1996
     First Quarter..........................................  $16.69    $ 9.75
     Second Quarter.........................................  $18.69    $14.32
     Third Quarter..........................................  $19.63    $15.38
     Fourth Quarter.........................................  $19.25    $15.07
</TABLE>
 
     The Common Stock is traded on the New York Stock Exchange.
 
     As of April 4, 1997, the Common Stock was held by approximately 3,125
holders of record.
 
     The Company currently intends to retain its earnings to finance future
growth and therefore does not anticipate paying any cash dividends in the
foreseeable future. The declaration and payment of dividends, if any, is subject
to the discretion of the Board and to certain limitations under the General
Corporation Law of the State of Delaware. In addition, the Credit Facility and
the Lease Facility prohibit the Company from paying any dividends. The Lease
Guaranty Agreement between the Company, Borders and Kmart restricts the
Company's ability to pay dividends, unless no defaults exist under any
indebtedness of the Company and such payments do not exceed the sum of 50% of
cumulative consolidated net income since the Company's initial public offering
of common stock, which was completed on June 1, 1995, and certain proceeds
received from the sale of capital stock. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources".
 
                                        7
<PAGE>   10
 
ITEM 6. SELECTED FINANCIAL DATA
 
     The information set forth below should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," and the Company's consolidated financial statements and the notes
thereto.
 
<TABLE>
<CAPTION>
                                                                       FISCAL YEAR ENDED
                                            -----------------------------------------------------------------------
                                             JAN. 26,       JAN. 28,       JAN. 22,       JAN. 23,       JAN. 24,
                                               1997          1996(1)         1995           1994          1993(2)
                                             --------       --------       --------       --------       --------
                                                          (DOLLARS IN MILLIONS EXCEPT PER SHARE DATA)
<S>                                         <C>            <C>            <C>            <C>            <C>
STATEMENT OF OPERATIONS DATA
Superstore sales........................     $  979.1       $  717.5       $  425.5       $  224.8       $   56.0
Mall bookstore sales....................        979.7        1,031.5        1,085.5        1,145.8        1,127.7
                                             --------       --------       --------       --------       --------
     Total sales........................     $1,958.8       $1,749.0       $1,511.0       $1,370.6       $1,183.7
Operating income before restructuring
  provision, goodwill writedowns and FAS
  121...................................     $  103.1       $   64.5       $   50.2       $   49.9       $   42.2
Restructuring provision.................           --             --            6.4          142.8             --
Goodwill writedowns.....................           --          201.8             --             --             --
FAS 121 impairment......................           --           63.1             --             --             --
Operating income (loss).................     $  103.1       $ (200.4)      $   43.8       $  (92.9)      $   42.2
Net income (loss).......................     $   57.9       $ (211.1)      $   20.9       $  (61.2)      $   23.1
Earnings (loss) per common
  share(3)(4)...........................     $   0.70       $  (2.53)      $   0.24             --             --
Earnings per common share before
  restructuring provision, goodwill
  writedowns and FAS 121(3)(4)..........     $   0.70       $   0.42       $   0.32             --             --
Weighted average common shares
  outstanding (in thousands)(4).........       82,554         83,358         87,140             --             --
 
END OF PERIOD BALANCE SHEET DATA
Working capital.........................     $  211.9       $  197.3       $  258.0       $   72.4       $  119.5
Total assets............................      1,211.0        1,052.3        1,355.9        1,006.3          872.2
Short-term borrowings...................         30.0           60.0             --             --             --
Long-term debt and capital lease
  obligation, including current portion,
  and redeemable preferred stock........          6.7            8.6           21.1           11.1            9.8
Shares subject to repurchase............         34.1             --             --             --             --
Stockholders' equity....................        511.4          472.0          726.3          457.5          521.1
</TABLE>
 
-------------------------
(1) The Company's 1995 fiscal year consisted of 53 weeks.
 
(2) Data for 1992 include results of Borders from October 30, 1992, the date of
    the Kmart Acquisition. The Company's 1992 fiscal year consisted of 51 weeks
    due to a change in reporting period. Sales for the 52nd week, which would
    have been included in 1992 results of operations had this change not
    occurred, totaled $18.
 
(3) Earnings (loss) per common share as of January 28, 1996 and January 22, 1995
    are pro forma.
 
(4) Weighted average common shares outstanding and earnings (loss) per common
    share include the effect of the 2-for-1 stock split, effective March 11,
    1997, for all periods presented.
 
                                        8
<PAGE>   11
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS
 
GENERAL
 
     The Company, through its subsidiaries, is the second largest operator of
book superstores and the largest operator of mall-based bookstores in the United
States based upon both sales and number of stores. At January 26, 1997, the
Company operated 157 superstores under the Borders name, 961 mall-based and
other bookstores primarily under the Waldenbooks name and 4 Planet Music
superstores. The Company is a holding company and does not have any significant
assets or liabilities, other than all of the outstanding common stock of
Borders, Walden and Planet Music.
 
     The Company's business strategy is to continue its growth and increase its
profitability through (i) the continued expansion and refinement of its Borders
superstore operation, (ii) the continued focus on core operations and on cost
reductions in its mall-based bookstore operations and (iii) the realization of
synergies and economies of scale through a combination of certain of its books
and music operations. The Company's 1996 fiscal year consisted of the 52 weeks
ended January 26, 1997. The Company's 1995 fiscal year consisted of 53 weeks
ended January 28, 1996. The Company's 1994 fiscal year consisted of the 52 weeks
ended January 22, 1995. References herein to years are to the Company's fiscal
years which currently end on the Sunday immediately preceding the last Wednesday
in January of the following calendar year.
 
2-FOR-1 STOCK SPLIT
 
     Effective March 11, 1997, the Company effected a 2-for-1 split of its
common stock in the form of a 100% stock dividend. The number of shares
outstanding and per share information have been restated for all periods
presented as if the split took place at the beginning of each period.
 
INITIAL PUBLIC OFFERING AND PURCHASE OF COMMON STOCK FROM KMART
 
     The Company sold 25,062,322 shares of common stock in the IPO, which was
completed on June 1, 1995, the net proceeds of which were paid to Kmart. In
addition, as part of the IPO, Kmart sold 46,747,678 shares of common stock it
previously owned, thereby reducing its interest in the Company to 13%. The
Company did not receive any proceeds from the sale of common stock by Kmart. On
August 15, 1995, the Company completed a transaction to purchase and retire the
remaining 10,771,460 shares of common stock owned by Kmart at a price of $6.75
per share.
 
                                        9
<PAGE>   12
 
RESULTS OF OPERATIONS
 
     The following table presents the Company's statement of operations data, as
a percentage of sales, for the three most recent fiscal years.
 
<TABLE>
<CAPTION>
                                                              JANUARY 26,   JANUARY 28,   JANUARY 22,
                                                                 1997          1996          1995
                                                              -----------   -----------   -----------
<S>                                                           <C>           <C>           <C>
RESULTS OF OPERATIONS
Sales.......................................................     100.0%        100.0%        100.0%
Cost of merchandise sold (includes occupancy)...............      73.4          74.5          74.6
                                                                 -----         -----         -----
Gross margin................................................      26.6          25.5          25.4
Selling, general and administrative expenses................      20.9          21.4          22.1
Pre-opening expense.........................................       0.4           0.4           0.3
Goodwill amortization.......................................        --           0.2           0.5
Operating losses from stores identified for closure.........        --          (0.2)         (0.8)
                                                                 -----         -----         -----
Operating income before restructuring provision, goodwill
  writedowns and FAS 121....................................       5.3           3.7           3.3
Restructuring provision.....................................        --            --           0.4
Goodwill writedowns.........................................        --          11.5            --
FAS 121 impairment..........................................        --           3.6            --
                                                                 -----         -----         -----
Operating income (loss).....................................       5.3         (11.4)          2.9
Interest expense............................................       0.4           0.3           0.1
                                                                 -----         -----         -----
Income (loss) before income tax.............................       4.9         (11.7)          2.8
Income tax provision........................................       1.9           0.4           1.4
                                                                 -----         -----         -----
Net income (loss)...........................................       3.0%        (12.1)%         1.4%
                                                                 -----         -----         -----
Net income excluding goodwill writedown, FAS 121 and
  restructuring provision...................................       3.0%          2.0%          1.9%
                                                                 -----         -----         -----
STORE ACTIVITY
Borders Superstores
  Beginning number of stores................................       116            75            44
  Openings..................................................        41            41            31
                                                                 -----         -----         -----
  Ending number of stores...................................       157           116            75
                                                                 -----         -----         -----
Walden Mall Bookstores
  Beginning number of stores................................       992         1,102         1,159
  Openings..................................................         9             5            11
  Closings..................................................       (40)         (115)          (68)
                                                                 -----         -----         -----
  Ending number of stores...................................       961           992         1,102
                                                                 -----         -----         -----
CD Superstores/Planet Music Superstores
  Beginning number of stores................................         9            10             6
  Openings..................................................        --            --             4
  Closings..................................................        (5)           (1)           --
                                                                 -----         -----         -----
  Ending number of stores...................................         4             9            10
                                                                 -----         -----         -----
</TABLE>
 
                                       10
<PAGE>   13
 
FISCAL YEARS ENDED JANUARY 26, 1997 AND JANUARY 28, 1996
 
     Sales for the year ended January 26, 1997 were $1,958.8 million, reflecting
a 12% increase over the $1,749.0 million in sales achieved in 1995. Both the
higher number of Borders superstores and Borders' 9.9% comparable store sales
increase contributed to the growth, which was partially offset by store closings
at Waldenbooks. The Walden comparable store sales increase of 0.1% reflects flat
mall traffic levels and the impact of increased superstore competition offset by
the benefit of new merchandising initiatives. Walden also experienced a benefit
from a larger number of seasonal calendar kiosks introduced in malls with
existing Walden stores and stores expanded to a larger format.
 
     Gross margin as a percent of sales rose, from 25.5% in 1995 to 26.6% in
1996. The increase in gross margin percentage reflects the impact of
consolidated distribution operations and improved buying and sales mix resulting
in higher initial product margin, reduced depreciation as a result of the fourth
quarter 1995 SFAS 121 write-off and tighter control of inventory shrinkage.
 
     As a percentage of sales, SG&A for 1996 was 20.9%, or 0.5% less than the
21.4% of sales in the corresponding period of 1995. The 0.5% decrease is due
largely to the leveraging of corporate overhead over the Company's expanding
sales base, as well as headcount reductions and related wage savings resulting
from the move of the Waldenbooks headquarters from Stamford, Connecticut to Ann
Arbor, Michigan.
 
     Pre-opening expense in 1996 was $7.2 million as compared to $7.3 million in
1995. Pre-opening expense per store varies primarily as a result of differing
levels of grand opening advertising, depending on the presence of the Company in
the market, and differing levels of labor costs associated with opening the
store. The Company opened 41 Borders superstores and 9 Waldenbooks mall-based
stores in 1996 as compared to 41 Borders superstores and 5 Waldenbooks
mall-based stores in 1995.
 
     Goodwill amortization was $1.1 million in 1996, as compared to $3.7 million
in 1995. The decrease in goodwill amortization of $2.6 million is a result of
the lower goodwill balance due to the noncash writedowns of goodwill in 1995.
(See "Goodwill Writedown.")
 
     Operating income before goodwill writedown and FAS 121 was $103.1 million
or 5.3% of sales in 1996, as compared to $64.5 million or 3.7% of sales in 1995.
 
     Interest expense was $7.0 million in 1996, as compared to $4.6 million for
the same period in 1995. The Company incurred full-year, pre-tax interest
expense of $4.5 million in 1996 versus $2.3 million in 1995 as a result of the
purchase of Kmart's remaining interest in the Company in August 1995.
 
     Income tax expense in 1996 was $38.2 million as compared to $6.1 million in
1995. The effective tax rate for both periods differed from the statutory rate
primarily as a result of non-deductible goodwill amortization and writedown and
the FAS 121 charge. Excluding the non-recurring charges, goodwill amortization
and writedown and a portion of the FAS 121 charge, the Company's effective tax
rate was 39.8% in 1996 as compared to 38.6% in 1995. The increase in effective
rate is due primarily to a higher marginal rate applied to a greater level of
1996 pre-tax income versus 1995.
 
     As a result of the foregoing, net income for the year ended January 26,
1997 was $57.9 million as compared to $35.3 million for the year ended January
28, 1996, excluding non-recurring charges for the goodwill write-down and the
effect of the adoption of FAS 121.
 
FISCAL YEARS ENDED JANUARY 28, 1996 AND JANUARY 22, 1995
 
     Sales for the year ended January 28, 1996 were $1,749.0 million, reflecting
a 16% increase over the $1,511.0 million in sales achieved in 1994. Both the
higher number of Borders superstores and Borders' 9.6% comparable store sales
increase contributed to the growth, which was partially offset by store closings
and negative comparable store sales of 2.3% at Waldenbooks. The Walden
comparable store sales decrease reflects continuing sluggish mall traffic and
increased competition from superstores, offset by an increase from a larger
number of calendar kiosks introduced in malls with existing Walden stores and
stores expanded to a larger format.
 
                                       11
<PAGE>   14
 
     Gross margin as a percent of sales rose, from 25.4% in 1994 to 25.5% in
1995. The increase in gross margin percentage reflects lower occupancy as a
percent of sales of the Borders superstores offset in part by the continuing
impact of music sales, which have a lower gross margin, as an increasing
percentage of the Company's total sales. Rapid expansion of the Company's books
and music superstore business has resulted in a relatively immature superstore
base, with 64% of all books and books and music superstores in operation less
than two years as of January 28, 1996. Management expects that continued
expansion of the superstore base as well as general maturation of the superstore
operations will allow for increased operating leverage and potentially higher
operating margins.
 
     As a percentage of sales, SG&A for 1995 was 21.4%, or 0.7% less than the
22.1% of sales in the corresponding period of 1994. The 0.7% decrease is due
largely to the leveraging of corporate overhead over the Company's expanding
sales base, as well as headcount reductions and related wage savings resulting
from the move of the Waldenbooks headquarters from Stamford, Connecticut to Ann
Arbor, Michigan. The Company also incurred a charge of $8.1 million in 1994,
associated with Borders stock appreciation rights, which was not repeated in
1995.
 
     Pre-opening expense in 1995 was $7.3 million as compared to $5.7 million in
1994. Pre-opening expense per store varies primarily as a result of differing
levels of grand opening advertising, depending on the presence of the Company in
the market, and differing levels of labor costs associated with opening the
store. The Company opened 41 Borders superstores and 5 Waldenbooks mall-based
stores in 1995 as compared to 31 Borders superstores and 11 Waldenbooks
mall-based stores in 1994.
 
     Excluding the non-recurring goodwill writedowns of $201.8 million, goodwill
amortization was $3.7 million in 1995 as compared to $7.4 million in 1994. The
decrease in goodwill amortization of $3.7 million is a result of the lower
goodwill balance due to the noncash writedown of goodwill. (See "Goodwill
Writedown.")
 
     Operating income before restructuring provision, goodwill writedown and FAS
121 was $64.5 million or 3.7% of sales in 1995, as compared to $50.2 million or
3.3% of sales in 1994.
 
     Interest expense was $4.6 million in 1995, as compared to $1.0 million for
the same period in 1994. Net cash transfers between the Company and Kmart
through October 23, 1994 have been reflected in the Company's historical
financial statements as equity transactions. Accordingly, the Company's
operating results for periods prior to that date do not reflect interest expense
on intercompany transactions. Additionally, the Company incurred pre-tax
interest expense of $2.3 million in 1995, relating to the purchase of Kmart's
remaining interest in the Company.
 
     Income tax expense in 1995 was $6.1 million, as compared to $21.9 million
in 1994. The effective tax rate for both periods differed from the statutory
rate primarily as a result of non-deductible goodwill amortization and writedown
and the FAS 121 charge. Excluding the non-recurring charges, goodwill
amortization and writedown and a portion of the FAS 121 charge, the Company's
effective tax rate was 38.6% in 1995 as compared to 42.3% in 1994.
 
     As a result of the foregoing, net income for the year ended January 28,
1996, excluding non-recurring charges for the goodwill writedown and the effect
of the adoption of FAS 121, was $35.3 million as compared to $28.3 million,
excluding non-recurring charges in 1994.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     The Company's principal capital requirements are to fund working capital
needs, the opening of new stores and the refurbishment and expansion of existing
stores.
 
     Net cash provided by operations in 1996 was $101.0 million, as compared to
$11.7 million in 1995. The current year activity primarily reflects income
before non-cash charges for depreciation and amortization and increases in taxes
payable as a result of timing of estimated payments offset by cash used for
inventories as a result of store expansion at Borders. Inventory net of accounts
payable increased primarily due to 41 new Borders stores.
 
                                       12
<PAGE>   15
 
     Net cash used for investing was primarily for capital expenditures for new
stores and, in 1994, the acquisition of Planet Music. Capital expenditures in
1996 reflect the opening of 41 new superstores and 9 new Waldenbooks stores and
the addition of the Columbus distribution center. Capital expenditures in 1995
also included expenditures for the Company's combined headquarters facilities
and data processing equipment. Capital expenditures for stores in 1994 reflect
the opening of 44 new stores (33 superstores and 11 mall-based stores),
conversion of two Walden-owned superstores to Borders books and music
superstores, the relocation of three book superstores, expansions of 20 stores
(five superstores and 15 mall-based stores), and capital expenditures on stores
scheduled to open in early 1995.
 
     Net cash used for financing in 1996 was $2.0 million, resulting primarily
from net repayments of borrowings under the credit facility, offset by cash
received for construction funding, the issuance of Company stock under the
Company's employee benefit plans, and the sale of put options on the Company's
common stock. Net cash used for financing in 1995 was $130.4 million, which
resulted from net borrowings under the credit facility, offset by cash used for
the repayment of borrowings from Kmart and the purchase of Kmart's remaining
interest in the Company.
 
     The Company expects capital expenditures to be approximately $100 million
in 1997. The Company currently plans to open approximately 40 Borders
superstores and 25 new, expanded or relocated Waldenbooks mall stores in 1997.
Average cash requirements for the opening of a prototype Borders books and music
superstore are $2.9 million, representing capital expenditures of $1.5 million,
inventory requirements, net of related accounts payable, of $1.25 million and
$0.15 million of pre-opening costs. Average cash requirements to open a new or
expanded Waldenbooks store range from $0.4 million to $0.7 million, depending on
the size and format of the store. The Company plans to lease new store locations
predominantly under operating leases.
 
     The Company anticipates that planned closings of Walden stores will
decrease Walden's annual working capital requirements. On a consolidated basis,
the Company expects its working capital requirements to increase as a result of
its expansion program for its Borders books and music superstores.
 
     The Company plans to execute its expansion plans for its Borders
superstores principally with funds generated from operations and financing
through the lease facility in 1997 and beyond. In the event that working capital
requirements are in excess of operating cash flows and lease financing, the
Company may fund such excess with borrowings under the credit facility. The
Company believes funds generated from operations, borrowings under the credit
facility and financing through the lease facility will be sufficient to fund its
anticipated capital requirements for at least the next two to three years.
 
     In 1996, the Company announced its intention to repurchase up to $50
million of its common stock from time to time. Funds for such purchases would be
from borrowings under the credit facility.
 
     In 1995, the Company entered into a $300 million, five-year working capital
line of credit with a syndicate of banks. The Company had $30.0 million in
outstanding borrowings under the credit facility at January 26, 1997. In 1995,
the Company also entered into a five-year $150 million lease financing facility
to finance new stores and other property through operating leases. The lease
facility provides financing to Lessors through loans from a third-party lender
for up to 95% of a project cost. Lessors generally will make equity
contributions approximating 5% of each project. Independent of its obligations
as lessee, the Company guarantees payment when due of all amounts required to be
paid to the third-party lender. The principal amount guaranteed is limited to
approximately 89% of the original cost of a project, so long as the Company is
not in default under the lease relating to such project. There were 28
properties financed through the lease facility, with a financed value of $102.6
million at January 26, 1997. Management believes that the rental payments for
properties financed through the lease facility may be lower than those which the
Company could obtain elsewhere due to, among other factors, (i) the lower
borrowing rates available to the Company's landlords under the facility, and
(ii) the fact that rental payments for properties financed through the facility
do not include amortization of the principal amounts of the landlords'
indebtedness related to the properties. Rental payments relating to such
properties will be adjusted when permanent financing is obtained to reflect the
interest rates available at the time of the refinancing and the amortization of
principal.
 
                                       13
<PAGE>   16
 
     During 1994, the Company entered into agreements in which leases with
respect to four Borders' locations serve as collateral for certain mortgage
pass-thru certificates. These mortgage pass-thru certificates include a
provision requiring the Company to repurchase the underlying mortgage notes in
certain events, including the failure by the Company to make payments of rent
under the related leases, the failure by Kmart to maintain required investment
grade ratings or the termination of the guarantee by Kmart of the Company's
obligations under the related leases (which would require mutual consent of
Kmart and Borders). In the event the Company is required to repurchase all of
the underlying mortgage notes, the Company would be obligated to pay
approximately $36.6 million. The Company would expect to fund this obligation
through its line of credit. Since February 1995, Kmart has failed to maintain
investment grade ratings and, therefore, these notes are now subject to put by
the holder. To date, the holder has not exercised its right to put the notes.
 
     In addition to the contingent repurchase obligations described above,
leases relating to two other Borders locations served as collateral for certain
mortgage pass-thru certificates. On March 11, 1996, Kmart was required to
repurchase the underlying notes. The Company purchased the notes from Kmart for
approximately $12.1 on June 18, 1996, which fully satisfied the Company's
contingent obligation.
 
     The Company does not believe that the note purchase has had a material
effect on the Company's financial position or earnings.
 
1995 ACCOUNTING CHANGES
 
     Goodwill Writedown -- Prior to completion of the IPO, the Company, as a
subsidiary of Kmart, followed the accounting policies established by Kmart for
its consolidated group and, accordingly, evaluated the overall recoverability of
goodwill using projected undiscounted cash flows. At April 23, 1995, such
goodwill aggregated $257.6 million, net of accumulated amortization of $38.6
million.
 
     The sale of common stock in the IPO generated net proceeds that were less
than the historical book value of the Company, resulting in Kmart taking a write
off of its investment in the Company in the amount of $185.0 million. As a
result, the Company re-evaluated its accounting policy regarding goodwill
impairment and adopted a new policy for recognition and measurement of goodwill
impairment based on a fair value approach. The Company believes fair value is a
preferable method to assess goodwill as it believes that the value at which the
individual businesses could be bought and sold in an arm's length transaction
between a willing buyer and seller is the most objective evidence and,
therefore, the most relevant measure of their value. This change in the method
of evaluating the recoverability of goodwill resulted in the recording of a
pre-tax charge to operations of $182.0 million in the second quarter of 1995.
During the fourth quarter of 1995, the Company took an additional charge of
$19.8 million. The charges aggregated $132.2 million for Borders, $16.2 million
for Planet Music and $53.4 million for Waldenbooks. As of January 28, 1996, all
goodwill relating to Waldenbooks and Planet Music had been written-off.
 
     This change resulted in a reduction of $5.9 million and $1.5 million of
goodwill amortization expense on an annual and quarterly basis, respectively.
Earnings per share in 1996 and prospectively will be improved by approximately
$0.07 on an annual basis. In 1995, the partial-year effect of the accounting
change excluding the one-time charge was $3.9 million, or approximately $0.05
per share.
 
     The Company's fair value methodology is applied to each of its businesses
on a separate basis. When evaluating the need to record a goodwill impairment,
the Company will evaluate whether there have been any temporary or permanent
impairments, and will record appropriate charges (if any) to operations for
permanent impairments in fair value. The Company will evaluate Borders for
impairment every quarter. Since all goodwill related to the Walden and Planet
businesses has been written-off, no further evaluations for impairment will be
necessary. There was no goodwill impairment required in 1996.
 
     FAS No. 121. -- Accounting for Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of (FAS 121)
 
     The Company adopted FAS 121, effective as of the fourth quarter of 1995.
The carrying value of long-lived assets and certain identifiable intangible
assets will be evaluated whenever changes in circumstances indicate the carrying
amount of such assets may not be recoverable. In performing such reviews for
 
                                       14
<PAGE>   17
 
recoverability, the Company compares the expected cash flows to the carrying
value of long-lived assets and identifiable intangibles. If the expected future
cash flows are less than the carrying amount of such assets, the Company
recognizes an impairment loss for the difference between the carrying amount and
their estimated fair value. Fair value is estimated using expected future cash
flows. If an asset being tested for recoverability was acquired in a business
combination accounted for using the purchase method, the goodwill that arose in
that transaction is allocated to the assets being tested for recoverability.
This change resulted in a pre-tax charge of $63.1 million to operations in the
fourth quarter of 1995. The charge consisted of $42.1 million for leasehold
improvements and furniture and fixtures of Waldenbook stores, $14.5 million for
goodwill relating to such stores and $6.5 million for leasehold improvements and
furniture and fixtures of Planet Music. The impairment relating to Waldenbooks
resulted principally from declining mall traffic and increasing superstore
competition. Planet Music also faces intense competition from superstores,
resulting in declining gross margins. As a result of this charge, depreciation
and amortization expense was reduced by approximately $5.1 million after-tax or
$0.06 per share ($0.07 including the effects of the fourth quarter goodwill
writedown previously discussed) in 1996 and on a declining basis for the next
several years. No writedowns of long-lived assets were required in 1996.
 
1993 RESTRUCTURING PLAN
 
     In 1993, the Company implemented a restructuring plan to close 187
underperforming Walden stores and to combine certain distribution and
headquarters functions of Borders and Walden, and recorded a provision of $142.8
million to provide for the estimated costs of implementing the plan. The
restructuring provision included provisions for store closures of $101.5
million, combination of certain Borders and Walden functions of $35.8 million
and reengineering programs of $5.5 million. As of January 26, 1997, the
combination of operations and the store closure program was substantially
complete.
 
     Walden continues to evaluate the operating performance of its stores and
intends to aggressively identify stores which do not meet its performance and
return criteria. Based upon this ongoing evaluation, the Company may identify
additional stores which it decides to close in future periods.
 
                                       15
<PAGE>   18
 
SEASONALITY
 
     The Company's business is highly seasonal, with sales significantly higher
and all operating profit realized during the fourth quarter, which includes the
Christmas selling season.
<TABLE>
<CAPTION>
                                                                      FISCAL 1996 QUARTER ENDED
                                                                --------------------------------------
                                                                APRIL      JULY     OCTOBER    JANUARY
                                                                -----      ----     -------    -------
                                                                        (DOLLARS IN MILLIONS)
<S>                                                             <C>       <C>       <C>        <C>
SALES.......................................................    $404.0    $414.3    $413.5     $727.0
Operating income (loss).....................................      (3.7)     (2.0)     (2.9)     111.7
% of full year:
  Sales.....................................................      20.6%     21.2%     21.1%      37.1%
  Operating income (loss)...................................      (3.6)     (1.9)     (2.8)     108.3
 
<CAPTION>
                                                                      FISCAL 1995 QUARTER ENDED
                                                                --------------------------------------
<S>                                                             <C>       <C>       <C>        <C>
SALES.......................................................    $353.6    $363.8    $362.1     $669.5
Operating income (loss) (excluding goodwill writedowns and
  FAS 121)..................................................      (8.8)     (7.7)     (8.0)      89.0
% of full year:
  Sales.....................................................      20.2%     20.8%     20.7%      38.3%
  Operating income (loss) (excluding goodwill writedowns and
     FAS 121)...............................................     (13.6)    (11.9)    (12.4)     137.9
<CAPTION>
                                                                      FISCAL 1994 QUARTER ENDED
                                                                --------------------------------------
<S>                                                             <C>       <C>       <C>        <C>
SALES.......................................................    $302.8    $325.6    $323.1     $559.5
Operating income (loss) (excluding restructuring
  provision)................................................      (4.4)     (3.4)     (0.2)      58.2
% of full year:
  Sales.....................................................      20.0%     21.6%     21.4%      37.0%
  Operating income (loss) (excluding restructuring
     provision).............................................      (8.7)     (6.8)     (0.4)     115.9
</TABLE>
 
EFFECTS OF INFLATION
 
     The Company's management does not believe inflation has had a material
impact on its operating results or financial position for the periods presented.
 
EFFECTS OF COMPLIANCE WITH ENVIRONMENTAL PROTECTION PROVISIONS
 
     Compliance with federal, state and local provisions which have been enacted
or adopted regulating the discharge of materials into the environment, or
otherwise relating to the protection of the environment, has not had, and is not
expected to have, a material effect on the liquidity, financial position,
results of operations or competitive position of the Company.
 
                                       16
<PAGE>   19
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
                         INDEX TO FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
                                                                PAGE
                                                                ----
<S>                                                             <C>
Consolidated Statements of Operations for the fiscal years
  ended January 26, 1997, January 28, 1996 and January 22,
  1995......................................................      19
Consolidated Balance Sheets as of January 26, 1997 and
  January 28, 1996..........................................      20
Consolidated Statements of Cash Flows for the fiscal years
  ended January 26, 1997, January 28, 1996 and January 22,
  1995......................................................      21
Consolidated Statement of Stockholder's Equity for the
  fiscal year ended January 26, 1997 and January 28, 1996...      22
Notes to Consolidated Financial Statements..................      23
Report of Independent Accountants...........................      33
</TABLE>
 
                                       17
<PAGE>   20
 
                              BORDERS GROUP, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                              JANUARY 26,   JANUARY 28,   JANUARY 22,
                                                                 1997          1996          1995
                                                              -----------   -----------   -----------
                                                                    (DOLLARS IN MILLIONS EXCEPT
                                                                      PER COMMON SHARE DATA)
<S>                                                           <C>           <C>           <C>
Sales.......................................................   $1,958.8      $1,749.0      $1,511.0
Cost of Merchandise Sold (Includes Occupancy)...............    1,437.8       1,302.3       1,127.1
                                                               --------      --------      --------
Gross Margin................................................      521.0         446.7         383.9
Selling, General and Administrative Expenses................      409.6         374.5         333.3
Pre-opening Expense.........................................        7.2           7.3           5.7
Goodwill Amortization and Writedowns........................        1.1         205.5           7.4
FAS 121 Impairment..........................................         --          63.1            --
Operating Losses of Stores Identified for Closure...........         --          (3.3)        (12.7)
Restructuring Provision.....................................         --            --           6.4
                                                               --------      --------      --------
Operating Income (Loss).....................................      103.1        (200.4)         43.8
Interest Expense............................................        7.0           4.6           1.0
                                                               --------      --------      --------
Income (Loss) before Income Tax.............................       96.1        (205.0)         42.8
Income Tax Provision........................................       38.2           6.1          21.9
                                                               --------      --------      --------
Net Income (Loss)...........................................   $   57.9      $ (211.1)     $   20.9
                                                               ========      ========      ========
Earnings (Loss) per Common Share Data -- Unaudited and Pro
  Forma for 1995 and 1994 (Note 3):
  Earnings (Loss) per Common Share..........................   $   0.70      $  (2.53)     $   0.24
                                                               ========      ========      ========
  Weighted Average Common Shares Outstanding (In
     Thousands).............................................     82,554        83,358        87,140
                                                               ========      ========      ========
</TABLE>
 
          See accompanying Notes to Consolidated Financial Statements.
 
                                       18
<PAGE>   21
 
                              BORDERS GROUP, INC.
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                                  FISCAL YEAR ENDED
                                                              --------------------------
                                                              JANUARY 26,    JANUARY 28,
                                                                 1997           1996
                                                              -----------    -----------
                                                                 (DOLLARS IN MILLIONS
                                                                EXCEPT SHARE AMOUNTS)
<S>                                                           <C>            <C>
ASSETS
Current Assets:
  Cash and cash equivalents.................................   $   42.6       $   36.5
  Merchandise inventories...................................      737.5          637.5
  Accounts receivable and other current assets..............       44.1           34.0
  Property held for resale..................................        8.1           28.7
  Deferred income taxes.....................................       14.1            3.5
                                                               --------       --------
       Total Current Assets.................................      846.4          740.2
Property and equipment, net.................................      289.2          243.5
Other assets................................................       18.4            6.3
Deferred income taxes.......................................       18.5           22.7
Goodwill, net of accumulated amortization of $41.5 and
  $40.4, respectively.......................................       38.5           39.6
                                                               --------       --------
                                                               $1,211.0       $1,052.3
                                                               ========       ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
  Short-term borrowing and current portion of long-term
     debt...................................................   $   30.5       $   60.5
  Trade accounts payable....................................      350.1          304.8
  Accrued payroll and other liabilities.....................      197.8          164.0
  Taxes, including income taxes.............................       56.1           13.6
                                                               --------       --------
       Total current liabilities............................      634.5          542.9
Long-term debt and capital lease obligations................        6.2            8.1
Other long-term liabilities.................................       24.8           29.3
Commitments and contingencies (Note 10).....................         --             --
                                                               --------       --------
       Total liabilities....................................      665.5          580.3
                                                               --------       --------
Shares subject to repurchase (Note 10)......................       34.1             --
                                                               --------       --------
Stockholders' Equity:
  Common stock, par value $.001 per share; 200,000,000
     shares authorized; 75,858,016 and 75,317,984 shares
     issued and outstanding at January 26, 1997 and January
     28, 1996, respectively.................................        0.1             --
Additional paid-in capital..................................      648.0          669.2
Deferred compensation and officer receivables...............       (0.8)          (3.4)
Accumulated deficit.........................................     (135.9)        (193.8)
                                                               --------       --------
       Total Stockholders' Equity...........................      511.4          472.0
                                                               --------       --------
                                                               $1,211.0       $1,052.3
                                                               ========       ========
</TABLE>
 
          See accompanying Notes to Consolidated Financial Statements.
 
                                       19
<PAGE>   22
 
                              BORDERS GROUP, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                                            FISCAL YEAR ENDED
                                                              ---------------------------------------------
                                                              JANUARY 26,      JANUARY 28,      JANUARY 22,
                                                                 1997             1996             1995
                                                              -----------      -----------      -----------
                                                                          (DOLLARS IN MILLIONS)
<S>                                                           <C>              <C>              <C>
Cash provided by (used for):
  Operations
  Net income (loss).......................................      $  57.9          $(211.1)         $  20.9
  Adjustments to reconcile net income (loss) to operating
     cash flows:
     Restructuring provision..............................           --               --              6.4
     Depreciation and amortization........................         42.9             42.0             45.6
     Goodwill writedown...................................           --            201.8               --
     FAS 121 impairment...................................           --             63.1               --
     Loss on disposal of property and equipment...........           --              1.8              5.3
     Deferred income taxes................................         (6.4)            (0.4)            22.3
     Increase (decrease) in other long-term assets and
       liabilities........................................        (16.0)           (14.6)             8.3
     Other -- net.........................................           --              1.5               --
  Cash provided by (used for) current assets and current
     liabilities:
     Increase in inventories..............................       (100.0)          (109.7)           (88.8)
     Decrease in property held for resale.................           --             (7.0)              --
     Decrease in restructuring reserve....................         (2.1)           (38.0)           (38.2)
     Increase in accounts payable.........................         45.3             33.6             10.5
     Increase (decrease) in taxes payable.................         44.2              7.6             (1.3)
     Other -- net.........................................         35.2             41.1            (17.5)
                                                                -------          -------          -------
     Net cash provided by (used for) operations...........        101.0             11.7            (26.5)
                                                                -------          -------          -------
  Investing
  Capital expenditures....................................        (97.2)          (116.0)          (123.0)
  Purchase of Planet Music................................           --               --            (12.3)
  Proceeds from sale of property and equipment............          4.7             34.2              3.4
  Other...................................................         (0.4)              --               --
                                                                -------          -------          -------
     Net cash used for investing..........................        (92.9)           (81.8)          (131.9)
                                                                -------          -------          -------
  Financing
  Repayment of long-term debt and capital lease
     obligations..........................................         (2.0)            (7.2)            (2.2)
  Proceeds from sale of put options.......................          4.5               --               --
  Proceeds (advances) for construction funding............         19.8             (9.6)             8.0
  Proceeds from initial public offering...................           --            248.0               --
  Proceeds from (repayments to) Kmart.....................           --           (360.0)           112.0
  Net funding from credit facility........................        (30.0)            60.0               --
  Issuance of common stock................................          5.7             11.1               --
  Purchase of shares held by Kmart........................           --            (72.7)              --
  Net equity transactions with Kmart......................           --               --            247.4
                                                                -------          -------          -------
     Net cash provided by (used for) financing............         (2.0)          (130.4)           365.2
                                                                -------          -------          -------
Net increase (decrease) in cash and equivalents...........          6.1           (200.5)           206.8
Cash and equivalents at beginning of year.................         36.5            237.0             30.2
                                                                -------          -------          -------
Cash and equivalents at end of year.......................      $  42.6          $  36.5          $ 237.0
                                                                =======          =======          =======
Supplemental cash flow disclosures:
  Interest paid...........................................      $   9.8          $   3.9          $   1.0
  Income taxes paid.......................................          5.9             13.7              5.3
  Non-cash investing and financing activities:
     Preferred stock issued for Planet Music
       acquisition........................................           --               --              5.2
</TABLE>
 
          See accompanying Notes to Consolidated Financial Statements.
 
                                       20
<PAGE>   23
 
                              BORDERS GROUP, INC.
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
                                                          DEFERRED                        RETAINED
                                     COMMON STOCK       COMPENSATION                      EARNINGS
                                 --------------------   AND OFFICER      ADDITIONAL      ACCUMULATED
                                   SHARES      AMOUNT   RECEIVABLES    PAID-IN CAPITAL     DEFICIT     TOTAL
                                   ------      ------   ------------   ---------------   -----------   -----
                                                  (DOLLARS IN MILLIONS EXCEPT SHARE AMOUNTS)
<S>                              <C>           <C>      <C>            <C>               <C>           <C>
Balance at January 23, 1994....           --    $ --       $  --           $   --          $    --     $457.5
Formation of the Company.......   57,519,138      --          --            460.7             (3.2)        --
Net equity transactions with
  Kmart........................           --      --          --            248.0               --      248.0
Dividends accrued on redeemable
  Preferred Stock..............           --      --          --               --             (0.1)      (0.1)
Net income.....................           --      --          --               --             20.9       20.9
                                 -----------    ----       -----           ------          -------     ------
Balance at January 22, 1995....   57,519,138    $ --       $  --           $708.7          $  17.6     $726.3
                                 ===========    ====       =====           ======          =======     ======
Conversion of mandatorily
  redeemable Series A Preferred
  Stock........................      846,660      --          --              5.6               --        5.6
Dividends accrued on
  mandatorily redeemable Series
  A Preferred Stock............           --      --          --               --             (0.3)      (0.3)
Net loss.......................           --      --          --               --           (211.1)    (211.1)
Purchase of stock held by
  Kmart........................  (10,771,460)     --          --            (72.7)              --      (72.7)
Shares sold by the Company in
  the Offering (Note 2)........   25,062,322      --          --               --               --         --
Issuance of common stock.......    2,661,324      --        (3.4)            14.5               --       11.1
Conversion of SAR's to
  options......................           --      --          --             13.1               --       13.1
                                 -----------    ----       -----           ------          -------     ------
Balance at January 28, 1996....   75,317,984    $ --       $(3.4)          $669.2          $(193.8)    $472.0
                                 ===========    ====       =====           ======          =======     ======
Net income.....................           --      --          --               --             57.9       57.9
Issuance of Common Stock.......      540,032      --          --              5.7               --        5.7
Stock split....................           --     0.1          --               --             (0.1)        --
Tax benefit of equity
  compensation.................           --      --          --              2.7               --        2.7
Issuance of put options:
  Receipt of premium...........           --      --          --              4.5               --        4.5
  Shares subject to
     repurchase................           --      --          --            (34.1)              --      (34.1)
Payment of receivables and
  deferred compensation........           --      --         2.6               --               --        2.6
                                 -----------    ----       -----           ------          -------     ------
Balance at January 26, 1997....   75,858,016    $0.1       $(0.8)          $648.0          $(135.9)    $511.4
                                 ===========    ====       =====           ======          =======     ======
</TABLE>
 
          See accompanying Notes to Consolidated Financial Statements.
 
                                       21
<PAGE>   24
 
                              BORDERS GROUP, INC.
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               (DOLLARS IN MILLIONS EXCEPT PER COMMON SHARE DATA)
 
NOTE 1 -- ORGANIZATION AND BASIS OF PRESENTATION
 
     Borders Group, Inc. (the Company) owns all of the outstanding common stock
of Borders, Inc. (Borders), Walden Book Company, Inc. (Walden) and Planet Music,
Inc. (Planet Music). At January 26, 1997, the Company operated 157 Borders
superstores, 961 Waldenbooks stores and 4 Planet Music superstores in the United
States.
 
NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES
 
     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
 
     The Company's significant accounting policies, which conform to generally
accepted accounting principles applied on a consistent basis between years,
except for the items discussed herein, are described below.
 
     Fiscal Year: The Company's fiscal year ends on the Sunday immediately
preceding the last Wednesday in January. Fiscal 1996 consisted of 52 weeks and
ended on January 26, 1997. Fiscal 1995 consisted of 53 weeks and ended on
January 28, 1996. Fiscal 1994 consisted of 52 weeks and ended on January 22,
1995.
 
     Cash and Equivalents: Cash and equivalents include short-term investments
with original maturities of 90 days or less.
 
     Inventories: Merchandise inventories are valued on a first-in, first-out
(FIFO) basis at the lower of cost or market using the retail inventory method.
The Company includes certain distribution and other expenses in its inventory
costs.
 
     Property and Equipment: Property and equipment are recorded at cost,
including capitalized interest, and depreciated over their estimated useful
lives on a straight-line basis for financial statement purposes and on
accelerated methods for income tax purposes. Most store properties are leased
and improvements are amortized over the term of the lease, generally over 10 to
15 years. Other annual rates used in computing depreciation for financial
statement purposes are 2% to 3% for buildings and 10% to 20% for other fixtures
and equipment. Amortization of assets under capital lease is included in
depreciation expense.
 
     Expenditures for properties, primarily self-developed locations which the
Company intends to sell and lease back within one year, are included in property
held for resale.
 
     Income Taxes: The Company accounts for income taxes in accordance with
Statement of Financial Accounting Standards No. 109 (FAS 109). FAS 109 requires
that deferred taxes be provided on temporary differences between the book and
tax basis of assets and liabilities. In addition, the standard requires
adjustment of deferred tax balances to reflect enacted changes in statutory
income tax rates.
 
     Goodwill: Goodwill is amortized over 40 years on a straight-line basis. The
Company evaluates the recoverability of goodwill using a fair value methodology
on a quarterly basis. See Note 4 -- Accounting for Goodwill.
 
     Financial Instruments: The recorded values of the Company's financial
instruments, which include accounts receivable and accounts payable, approximate
their fair values.
 
     2-for-1 Stock Split: In January 1997, the Company's Board of Directors
approved a 2-for-1 stock split on the Company's common stock, effective March
11, 1997. All references to the number of shares outstanding
 
                                       22
<PAGE>   25
 
                              BORDERS GROUP, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
and per share information for all periods presented have been restated as if the
2-for-1 stock split was effective at the beginning of 1994.
 
     Pre-Opening and Closing Costs: Costs associated with the opening of a new
store are expensed during the first full fiscal month of the store's operations.
When the decision to close a store is made, the Company provides for the future
net lease obligation, nonrecoverable investment in fixed assets and other
expenses directly related to discontinuance of operations. Prior to 1995,
estimated operating losses until the store closure date were also included in
the provision for store closings.
 
     Preferred Reader Program: Walden sells memberships in its Preferred Reader
Program, which offers members discounts on purchases and other benefits.
Membership fees are deferred and recognized over the 12-month membership period.
 
     Equity-Based Compensation: The Company has elected to continue to account
for equity-based compensation under the guidance of APB No. 25. See Note 15 for
discussion of the pro forma net income calculated under FAS No. 123.
 
NOTE 3 -- INITIAL PUBLIC OFFERING OF COMMON STOCK
 
     The Company was formed in August 1994 as a wholly-owned subsidiary of Kmart
Corporation. On June 1, 1995, the Company sold 25,062,322 shares of common stock
in an initial public offering of common stock (the Offering), the net proceeds
of which were paid to Kmart. In addition, as part of the Offering, Kmart sold
46,747,678 shares of common stock it previously owned, thereby reducing its
interest in the Company to 13%. The Company did not receive any proceeds from
the sale of common stock by Kmart. On August 15, 1995, the Company completed a
transaction to purchase and retire the remaining 10,771,460 shares of common
stock owned by Kmart at a price of $6.75 per share.
 
     Pro forma weighted average shares outstanding are calculated as follows
(thousands):
 
<TABLE>
<CAPTION>
                                                               1995     1994
                                                               ----     ----
                                                                (UNAUDITED)
<S>                                                           <C>      <C>
Shares issued upon formation of the Company.................  57,520   57,520
Shares sold by the Company in the Offering..................  25,062   25,062
Shares issued upon completion of the Offering...............   2,810    2,810
Shares issued subsequent to the Offering....................     290       --
Purchase of Kmart's remaining interest......................  (4,684)      --
Common stock equivalents....................................   2,360    1,748
                                                              ------   ------
Pro forma weighted average common shares outstanding........  83,358   87,140
                                                              ======   ======
</TABLE>
 
     The unaudited pro forma earnings per common share data are based on actual
common shares outstanding after the Offering, after the effect of the 2-for-1
stock split, and assume the Offering took place at the beginning of 1994.
 
NOTE 4 -- ACCOUNTING FOR GOODWILL
 
     Prior to completion of the Offering, the Company, as a subsidiary of Kmart,
followed the accounting policies established by Kmart for its consolidated group
and, accordingly, evaluated the overall recoverability of goodwill using
projected undiscounted cash flows. At April 23, 1995, such goodwill aggregated
$257.6, net of accumulated amortization of $38.6.
 
     The sale of common stock in the Offering generated net proceeds that were
less than the historical book value of the Company, resulting in Kmart taking a
write-off of its investment in the Company in the amount of $185.0. Subsequent
trading activity in the Company's common stock immediately after the Offering
did not
 
                                       23
<PAGE>   26
 
                              BORDERS GROUP, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
result in any meaningful appreciation in value. As a result, the Company
reevaluated its accounting policy regarding goodwill impairment and adopted a
new policy for recognition and measurement of goodwill impairment based on a
fair value approach. The Company believes fair value is a preferable method to
assess goodwill as it believes that the value at which the individual businesses
could be bought and sold in an arms length transaction between a willing buyer
and seller is the most objective evidence and, therefore, the most relevant
measure of their value. This change in the method of evaluating the
recoverability of goodwill resulted in the recording of a pre-tax charge to
operations of $182.0 in the second quarter of 1995. During the fourth quarter of
1995, the Company took an additional charge of $19.8 for Waldenbooks. The
charges aggregated $132.2 for Borders, $16.2 for Planet Music and $53.4 for
Waldenbooks. The charges for Waldenbooks and Planet Music represented all
existing goodwill relating to those businesses.
 
     The Company's fair value methodology is applied to each of its businesses
on a separate basis. In determining the fair value for a high growth retail
business, the median price/earnings (P/E) multiple for similar growth retail
companies has been calculated based upon actual quoted market prices per share
and analysts' consensus earnings estimates for these growth companies. This P/E
multiple has been applied to management's best estimates of the respective
earnings for Borders and Planet Music to arrive at an overall fair value of the
respective companies. The Company will continue to utilize the same basket of
high-growth retailers in order to determine this multiple for Borders provided
that there are no significant changes in the underlying characteristics of such
companies. With respect to Waldenbooks, given its retail market maturity, a
median earnings before depreciation and amortization, interest and taxes
(EBITDA) multiple for mature companies was applied to management's best estimate
of EBITDA to arrive at an overall fair value. Further, the calculation used by
the Company is net of transaction costs, which are estimated at 5.5% and consist
of assumed underwriting and other costs. In addition, when evaluating the need
to record a goodwill impairment, the Company will evaluate whether there have
been any temporary or permanent impairments, and will record appropriate charges
(if any) to operations for permanent impairments in fair value. The Company will
evaluate Borders for impairment every quarter, based on the above methodology.
Since all goodwill related to the Walden and Planet Music businesses has been
written-off, no further evaluations for impairment will be necessary. No
write-downs of goodwill were required in 1996.
 
NOTE 5 -- FAS NO. 121 -- ACCOUNTING FOR IMPAIRMENT OF LONG-LIVED ASSETS AND FOR
          LONG-LIVED ASSETS TO BE DISPOSED OF (FAS 121)
 
     The Company adopted FAS 121, effective as of the fourth quarter of 1995.
The carrying value of long-lived assets and certain identifiable intangible
assets will be evaluated whenever changes in circumstances indicate the carrying
amount of such assets may not be recoverable. In performing such reviews for
recoverability, the Company compares the expected cash flows to the carrying
value of long-lived assets and identifiable intangibles. If the expected future
cash flows are less than the carrying amount of such assets, the Company
recognizes an impairment loss for the difference between the carrying amount and
their estimated fair value. Fair value is estimated using expected discounted
future cash flows. If an asset being tested for recoverability was acquired in a
business combination accounted for using the purchase method, the goodwill that
arose in that transaction is allocated to the assets being tested for
recoverability. This change resulted in a pre-tax charge of $63.1 to operations
in the fourth quarter of 1995. The charge consisted of $42.1 for leasehold
improvements and furniture and fixtures of Waldenbook stores, $14.5 for goodwill
relating to such stores and $6.5 for leasehold improvements and furniture and
fixtures of Planet Music. The impairment relating to Waldenbooks resulted
principally from declining mall traffic and increasing superstore competition.
Planet Music also faces intense competition from superstores resulting in
declining gross margins. No writedowns of long-lived assets were required in
1996.
 
                                       24
<PAGE>   27
 
                              BORDERS GROUP, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
NOTE 6 -- RELATIONSHIP WITH KMART
 
     The Company's historical financial statements for periods prior to October
23, 1994 reflect funding provided by Kmart to the Company and its subsidiaries,
and net cash provided by the Company and its subsidiaries to Kmart, as
adjustments of Kmart's investment in the Company. Accordingly, no interest
expense or income on net cash transfers between the Company and Kmart prior to
October 23, 1994 is reflected in the Company's historical financial statements.
The Company incurred interest of $0.9 on its borrowings from Kmart for the
period from October 23, 1994 to January 22, 1995. In January 1995, the Company
began managing its own treasury functions. Net equity transactions with Kmart
were $248.0 in 1994.
 
NOTE 7 -- PROPERTY AND EQUIPMENT
 
     Property and equipment consists of the following:
 
<TABLE>
<CAPTION>
                                                                1996       1995
                                                                ----       ----
<S>                                                            <C>        <C>
Property and equipment:
  Land.....................................................    $    --    $   0.6
  Buildings................................................         --        2.7
  Leasehold improvements...................................      179.1      163.9
  Furniture and fixtures...................................      342.6      277.8
  Construction in progress.................................        2.6       17.0
                                                               -------    -------
                                                                 524.3      462.0
Less-accumulated depreciation and amortization.............     (235.1)    (218.5)
                                                               -------    -------
Property and equipment, net................................    $ 289.2    $ 243.5
                                                               =======    =======
</TABLE>
 
NOTE 8 -- RESTRUCTURING
 
     In 1993, the Company implemented a restructuring plan pursuant to which it
planned to close 187 underperforming Walden stores and to combine certain
distribution and headquarters functions of Borders and Walden. The Company
recorded a restructuring charge of $142.8 to provide for the estimated costs of
implementing the plan. The Company recorded an additional charge of $6.4 in the
fourth quarter of 1994 to reflect revised estimates of the cost of completing
the restructuring plan. This additional charge related to a writedown of the
Walden headquarters facility in Stamford, Connecticut to estimated net
realizable value and additional costs associated with relocating the Walden
headquarters to Ann Arbor, Michigan, offset in part by the reversal of amounts
accrued for 73 stores removed from the store closure program. As of January 26,
1997, the restructuring plan was substantially complete.
 
                                       25
<PAGE>   28
 
                              BORDERS GROUP, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
NOTE 9 -- INCOME TAXES
 
     The income tax provision consists of:
 
<TABLE>
<CAPTION>
                                                                1996        1995       1994
                                                                ----        ----       ----
<S>                                                             <C>        <C>         <C>
Current:
  Federal...................................................    $39.5      $  7.5      $ 0.6
  State and local...........................................      4.9         0.3        0.4
Deferred:
  Restructuring reserve.....................................      2.1        17.6       21.5
  FAS 121 impairment........................................      4.4       (17.0)        --
  Deferred compensation.....................................     (1.0)       (0.5)      (3.0)
  Differences in book and tax depreciation..................      1.9         3.4       (0.8)
  Inventory valuation differences...........................     (4.1)       (3.6)       0.7
  Other.....................................................     (9.5)       (1.6)       2.5
                                                                -----      ------      -----
     Total Income Tax Provision.............................    $38.2      $  6.1      $21.9
                                                                =====      ======      =====
</TABLE>
 
     A reconciliation of the federal statutory rate to the Company's effective
tax rate follows:
 
<TABLE>
<CAPTION>
                                                 1996        1995       1994       1996      1995       1994
                                                 ----        ----       ----       ----      ----       ----
<S>                                              <C>        <C>         <C>        <C>       <C>        <C>
Federal statutory rate.......................    $33.3      $(71.8)     $15.0      35.0%     (35.0)%    35.0%
State and local taxes, net of federal tax
  benefit....................................      3.0         0.5        4.0       3.1        0.2       9.3
Goodwill amortization........................      0.4         1.3        2.4       0.4        0.6       5.6
Goodwill writedowns..........................       --        75.6         --        --       36.9        --
Other........................................      1.5         0.5        0.5       1.3        0.2       1.3
                                                 -----      ------      -----      ----      -----      ----
  Total income tax provision.................    $38.2      $  6.1      $21.9      39.8%       2.9 %    51.2%
                                                 =====      ======      =====      ====      =====      ====
</TABLE>
 
     Deferred tax assets and liabilities resulted from the following:
 
<TABLE>
<CAPTION>
                                                                JANUARY 26, 1997    JANUARY 28, 1996
                                                                ----------------    ----------------
<S>                                                             <C>                 <C>
Deferred tax assets:
  Federal benefit for state deferred taxes..................         $ 2.6               $ 1.5
  Accruals and other current liabilities....................          16.4                 7.6
  Restructuring reserve.....................................           1.7                 3.8
  Deferred revenue..........................................           6.8                 6.2
  Other long-term liabilities...............................           2.6                 3.4
  Deferred compensation.....................................           6.4                 5.4
  Deferred rent.............................................          10.7                 9.4
  FAS 121 impairment........................................          12.6                17.0
                                                                    ------              ------
     Total deferred tax assets..............................          59.8                54.3
                                                                    ------              ------
Deferred tax liabilities:
  Inventory.................................................          11.5                15.6
  Property and equipment....................................          14.3                12.4
  Other.....................................................           1.4                 0.1
                                                                    ------              ------
     Total deferred tax liabilities.........................          27.2                28.1
                                                                    ------              ------
     Net deferred tax assets................................         $32.6               $26.2
                                                                    ======              ======
</TABLE>
 
                                       26
<PAGE>   29
 
                              BORDERS GROUP, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
NOTE 10 -- COMMITMENTS AND CONTINGENCIES
 
     There are various claims, lawsuits and actions pending against the Company
and its subsidiaries that are incident to their operations. It is the opinion of
management that the ultimate resolution of these matters will not have a
material effect on the Company's liquidity, financial position or results of
operations.
 
     During 1994, the Company entered into agreements in which leases with
respect to four Borders' locations serve as collateral for certain mortgage
pass-thru certificates. These mortgage pass-thru certificates include a
provision requiring the Company to repurchase the underlying mortgage notes in
certain events, including the failure by the Company to make payments of rent
under the related leases, the failure by Kmart to maintain required investment
grade ratings or the termination of the guarantee by Kmart of the Company's
obligations under the related leases (which would require the mutual consent of
Kmart and Borders). In the event the Company is required to repurchase all of
the underlying mortgage notes, the Company would be obligated to pay
approximately $36.6. Since February 1995, Kmart has failed to maintain
investment grade ratings and, therefore, these notes are now subject to put by
the holder. To date, the holder has not exercised its rights to put the notes.
 
     In addition to the contingent repurchase obligations described above,
leases relating to two other Borders locations served as collateral for certain
mortgage pass-thru certificates. On March 11, 1996, Kmart was required to
repurchase the underlying notes. The Company purchased the notes from Kmart for
approximately $12.1 on June 18, 1996, which fully satisfied the Company's
contingent obligation. The Company does not believe the note purchase has had a
material effect on the Company's financial position or earnings.
 
     During December 1996, the Company sold one million put options on the
Company's common stock which have exercise prices of $33.50-$34.50
($16.75-$17.25 giving effect to the 2-for-1 stock split) per share and expire on
various dates between March 16, 1998 and April 15, 1998. The Company received
proceeds of $4.5 million upon sale of the puts. The put options give the holder
the right to, at the Company's option, a net cash settlement or share
repurchase. If settlement is required at expiration, the Company intends to
repurchase such shares. The total cash settlement that would be required if the
options were put would be $34.1, resulting in an effective repurchase price, net
of put proceeds of $29.63 ($14.82 giving effect to the 2-for-1 stock split) per
share. The $34.1 has been reclassified to Shares subject to repurchase on the
consolidated balance sheet.
 
NOTE 11 -- DEBT
 
     In March 1995, the Company entered into a credit agreement which provides a
$300, five-year working capital facility. Borrowings under the credit facility
bear interest at a base rate or an increment over LIBOR at the Company's option.
The credit agreement contains operating covenants which limit the Company's
ability to incur indebtedness, make acquisitions, dispose of assets and issue or
repurchase, in excess of $50 million, its common stock, pay dividends on its
common stock and require the Company to meet certain financial measures
regarding fixed charge coverage, leverage and tangible net worth. The Company
had borrowings outstanding under the credit facility of $30 at January 26, 1997.
At February 23, 1997, the Company had net borrowings of $70 outstanding under
the credit facility. The weighted average interest rate in 1996 and 1995 was
approximately 6.0% and 6.2%, respectively.
 
     The Company's long-term debt obligations consist of capital lease
liabilities at January 26, 1997, and also included mortgages of $1.8 as of
January 28, 1996. Scheduled principal payments and capitalized lease obligations
as of January 26, 1997 are as follows: 1997 -- $0.5; 1998 -- $0.3; 1999 -- $0.3;
2000 -- $0.3; 2001 -- $0.2; 2002 and, thereafter, -- $5.1.
 
                                       27
<PAGE>   30
 
                              BORDERS GROUP, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
NOTE 12 -- LEASES
 
     Operating Leases: The Company conducts operations primarily in leased
facilities. Store leases are generally for terms of 10 to 20 years. Borders'
leases generally contain multiple five-year renewal options which allow Borders
the option to extend the life of the leases up to 25 years beyond the initial
noncancellable term. Walden's leases generally do not contain renewal options.
Certain leases provide for additional rental payments based on a percentage of
sales in excess of a specified base. Also, certain leases provide for the
payment by the Company of executory costs (taxes, maintenance and insurance).
 
     Lease Commitments: Future minimum lease payments under operating leases at
January 26, 1997 total $171.0 in 1997, $163.8 in 1998, $156.8 in 1999, $146.9 in
2000, $132.8 in 2001, $931.2 in all later years and, in the aggregate, total
$1,702.5.
 
     Rental Expenses: A summary of operating lease rental expense and short-term
rentals follows:
 
<TABLE>
<CAPTION>
                                                         1996     1995     1994
                                                         ----     ----     ----
<S>                                                     <C>      <C>      <C>
RENTAL EXPENSES
  Minimum rentals.....................................  $163.8   $138.7   $120.9
  Percentage rentals..................................     3.3      5.1      5.5
                                                        ------   ------   ------
     Total............................................  $167.1   $143.8   $126.4
                                                        ======   ======   ======
</TABLE>
 
     Capitalized Leases: The Company accounts for one store and certain computer
equipment under capital leases. At January 26, 1997, the Company's commitments
under leases accounted for as capital leases aggregated $6.2.
 
     Lease Financing Facility: On November 26, 1995, the Company entered into a
five-year, $150 lease financing facility ("the Facility") to finance new stores
and other property through operating leases. The Facility will provide financing
to Lessors through loans from a third-party lender for up to 95% of a project
cost. It is expected that Lessors will make equity contributions approximating
5% of each project. Independent of its obligations as Lessee, the Company will
guarantee payment when due of all amounts required to be paid to the third-party
lender. The principal amount guaranteed will be limited to approximately 89% of
the original cost of a project, so long as the Company is not in default under
the lease relating to such project. There was $102.6 and $21.2 outstanding under
the Facility at January 26, 1997 and January 28, 1996, respectively, and $104.1
outstanding at February 23, 1997.
 
NOTE 13 -- EMPLOYEE BENEFIT PLANS
 
     Pension Plans: Effective February 28, 1995, Walden employees participating
in the Kmart pension plans became fully vested in their accumulated benefits
under the plans. Walden employees no longer accumulate benefits under the Kmart
pension plans subsequent to that date. The Company and Kmart have agreed that
all benefit obligations to Walden employees participating in the Kmart pension
plans will be borne by such plans without further expense charges to, or funding
obligation by, the Company. The Company recorded pension expense of $2.4 in 1994
related to the Kmart pension plans.
 
     Employee Savings Plan: Prior to February 28, 1995, employees of the Company
who met certain requirements as to age and service were eligible to participate
in Kmart's Employee Savings Plan (Kmart Savings Plan). Additionally, employees
of Borders who meet certain requirements as to age and service are eligible to
participate in the Company's Savings Plan. Effective February 28, 1995,
accumulated benefits of Company employees participating in the Kmart Savings
Plan were transferred to the Company Savings Plan and such employees ceased
participation in the Kmart Savings Plan. The Company's expense related to these
plans was $2.8, $2.3 and $2.3 for 1996, 1995 and 1994, respectively.
 
                                       28
<PAGE>   31
 
                              BORDERS GROUP, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
NOTE 14 -- STOCK-BASED BENEFIT PLANS
 
     Stock Option Plan: In February 1995, the Company adopted the 1995 Stock
Option Plan (the 1995 Plan) pursuant to which the Company may grant options to
purchase its common stock. With the exception of certain option grants described
below, the exercise price of options granted under the 1995 Plan will generally
not be less than the fair value per share of the Company's common stock; such
options will generally vest after three years and will generally be exercisable
up to five years from grant date. All Company stock option grants participate in
the 2-for-1 split of the Company's common stock. All information presented has
been restated for the 2-for-1 split.
 
     The Company has established a compensation philosophy that is designed to
foster a performance oriented, entrepreneurially-led ownership culture. The 1995
Plan is an integral part of the Company's employee ownership culture and
compensation program. Options have been granted under the 1995 Plan to all
full-time employees of the Company and its subsidiaries with six months or more
of service, consisting of approximately 11,000 employees. The Company's
executive compensation is heavily oriented toward equity incentives that
includes a combination of stock and options which require at least some annual
out-of-pocket investment in the business on the part of management. Restrictions
on the equity incentives promote a long-term focus on the part of management and
maximize retention of personnel. Management believes the equity incentives have
been integral to its success in meeting operating objectives and reducing
employee turnover since the Offering.
 
     In February 1995, the Company granted options to purchase 1,925,000 shares
of common stock at an exercise price of $7.50 per share pursuant to the 1995
Plan (the 1995 Options). These options vest after three years and are
exercisable for a period of five years from grant date.
 
     In February 1995, the Company granted to certain senior management
personnel options to purchase 4,866,867 restricted shares of common stock under
the 1995 Plan (the Management Options). The exercise price of these options was
generally $6.00 per share, representing a discount from fair value at date of
grant. Such options were exercisable only at the time of the Offering. Options
were exercised to purchase 1,974,000 shares of restricted stock in 1995.
Restricted shares of common stock purchased upon exercise of the Management
Options are restricted from sale or transfer for three years from the date the
options were exercised. The remaining options not exercised were forfeited.
 
     In February 1995, the Company also granted to certain senior management
personnel 951,340 options to purchase an additional share of common stock (the
Matching Options) for each restricted share of common stock purchased through
exercise of Management Options at the time of the Offering. The exercise price
of the Matching Options was generally $7.50 per share. Matching Options vest
after three years and expire five years after the grant date.
 
     On November 8, 1995, the Company granted approximately 6.8 million stock
options at an exercise price of $8.69 to approximately 2,400 employees pursuant
to the 1995 Plan. Generally, this grant was intended to represent a one-time
grant in lieu of annual grants for the next three years. The options vest at the
rate of 25% per year, beginning on November 8, 1998.
 
     In January and August 1996 and January 1997, the Company granted to more
than 10,000 individual store employees approximately 2,020,000 stock options in
aggregate at prevailing market prices at the time of grant. The options
generally vest 12 months from the grant date and expire 10 years from grant. In
addition, during 1996, the Company granted 1,150,000 stock options to 1,250
home-office employees. Generally, these grants were a one-time grant in lieu of
grants for the next three years for newly hired or promoted employees. The
options generally vest 20%-40% per year with final vesting in 2001 and expire 10
years from the grant date. The purpose of the option program is to promote stock
ownership and corresponding ownership behavior, for all full-time employees with
at least six months of service.
 
                                       29
<PAGE>   32
 
                              BORDERS GROUP, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     In addition, in January 1997, the Company granted 693,000 stock options
with an exercise price of $17.32 to certain senior management personnel. These
grants were in lieu of cash compensation for the following year and vest one
year from the date of grant with an expiration two and one-quarter years from
the grant date.
 
     The Company will recognize compensation expense for the difference between
the exercise price and the fair value per share at grant date of the Management
Options. Such expense will be recognized over the three-year vesting period.
 
     In connection with the Offering, the Company adopted a management stock
purchase plan (the Management Plan) and an employee stock purchase plan (the
Employee Plan). Under the Management Plan, the Company's senior management
personnel are required to use 20%, and may use up to 100%, of their annual
incentive bonuses to purchase restricted shares of the Company's common stock,
at a 20% discount from the fair value of the same number of unrestricted shares
of common stock. Restricted shares of common stock purchased under the
Management Plan will generally be restricted from sale or transfer for three
years from date of purchase. The Employee Plan allows the Company's associates
not covered under the Management Plan to purchase shares of the Company's common
stock at a 15% discount from their fair-market value.
 
     The Company will recognize compensation expense for the discount on
restricted shares of common stock purchased under the Management Plan. Such
discount will be recognized as expense on a straight-line basis over the
three-year period during which the shares are restricted from sale or transfer.
Compensation expense under the Management Plan aggregated $0.4 in 1996 and $0.2
in 1995. The Company is not required to record compensation expense with respect
to shares purchased under the Employee Plan.
 
     Stock Appreciation Rights: In connection with its acquisition by Kmart,
Borders established a stock appreciation rights (SARs) plan covering all
employees at that date; options outstanding at the acquisition date under
Borders' existing stock option plans were converted to SARs in connection with
the acquisition. Under the SARs plan, employees were entitled to receive a cash
payment per share equal to the excess of the fair value of a Borders' share over
the base price defined in the plan. In fiscal year 1994, the Company recorded
compensation expense of $8.1 million for the increase in the value of shares
subject to SARs over the related base price. In connection with the Offering,
substantially all remaining SARs were converted to options on the Company's
common stock.
 
     At January 26, 1997, the Company has 411,694 shares authorized for the
grant of stock options under the 1995 Plan.
 
     A summary of the information relative to the Company's stock option plans
follows:
 
<TABLE>
<CAPTION>
                                                                             WEIGHTED         WEIGHTED
                                                            NUMBER OF        AVERAGE        AVERAGE GRANT
                                                              SHARES      EXERCISE PRICE      DATE FMV
                                                            ---------     --------------    -------------
<S>                                                         <C>           <C>               <C>
STOCK OPTIONS
Outstanding at January 22, 1995
  Granted.................................................  20,087,188        $ 6.92            $2.87
  Exercised...............................................   1,984,656        $ 5.91            $0.65
  Forfeited...............................................   3,398,628        $ 6.09            $0.65
Outstanding at January 28, 1996...........................  14,703,904        $ 7.25            $3.68
  Granted.................................................   3,360,826        $16.00            $7.33
  Exercised...............................................     296,764        $ 5.44            $3.74
  Forfeited...............................................   1,581,242        $ 9.19            $3.97
Outstanding at January 26, 1997...........................  16,186,724        $ 8.92            $4.42
Exercisable at January 26, 1997...........................   2,277,784        $ 2.70            $4.71
</TABLE>
 
                                       30
<PAGE>   33
 
                              BORDERS GROUP, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     Certain options granted by the Company upon conversions of existing SARs at
the time of the IPO, were granted with exercise prices less than market value at
the date of the grant. The weighted average exercise price and weighted average
grant date fair value were $5.02 and $9.35, respectively for such grants.
 
<TABLE>
<CAPTION>
                                                                                              WEIGHTED
                                                                             WEIGHTED       AVERAGE FAIR
                                                            NUMBER OF        AVERAGE        MARKET VALUE
                                                              SHARES      PURCHASE PRICE      AT GRANT
                                                            ---------     --------------    ------------
<S>                                                         <C>           <C>               <C>
STOCK ISSUED UNDER STOCK PURCHASE PLANS
Management Plan
  1995....................................................      93,266        $ 7.13           $ 8.91
  1996....................................................      48,166        $ 9.33           $11.67
Employee Plan
  1995....................................................     494,458        $ 6.43           $ 7.56
  1996....................................................     196,064        $14.00           $16.48
</TABLE>
 
     Financial Accounting Standards Board Statement No. 123, "Accounting for
Stock-Based Compensation" (FAS 123) requires recognition of compensation expense
for stock options and other stock-based compensation for the fair value of the
instruments at date of grant. The Company has adopted the disclosure-only option
of FAS 123, for the 1996 fiscal year. The pro forma net income (loss) and pro
forma earnings (loss) per share had the Company adopted the fair-value
accounting provisions of FAS No. 123 would have been $50.8, $(220.6) and $20.9,
and $0.62, $(2.65) and $0.24 in 1996, 1995 and 1994, respectively.
 
                                       31
<PAGE>   34
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To the Stockholders and Board of Directors
of Borders Group, Inc.
 
     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, of cash flows and of
stockholders' equity present fairly, in all material respects, the financial
position of Borders Group, Inc. and its subsidiaries at January 26, 1997 and
January 28, 1996, and the results of their operations and their cash flows for
each of the three years in the period ended January 26, 1997, in conformity with
generally accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which 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, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
 
     As discussed in Note 4 and Note 5 to the consolidated financial statements,
the Company changed its accounting for goodwill impairment and adopted Statement
of Financial Accounting Standards No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," in 1995.
 
Price Waterhouse LLP
 
Detroit, Michigan
March 11, 1997
 
                                       32
<PAGE>   35
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
     Not Applicable.
 
                                    PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     Set forth below is certain information regarding the directors and
executive officers of the Company:
 
<TABLE>
<CAPTION>
                NAME                   AGE                           POSITION
                ----                   ---                           --------
<S>                                    <C>   <C>
Robert F. DiRomualdo.................  52    Chairman, Chief Executive Officer and Director
George R. Mrkonic....................  44    Vice Chairman and Director
Bruce A. Quinnell....................  48    President and Chief Operating Officer
Richard L. Flanagan..................  44    President Borders Store Operations
Kathryn L. Winkelhaus................  41    President Walden Store Operations
Timothy J. Hopkins...................  43    President Borders Group, Inc. Merchandising
Thomas D. Carney.....................  50    Vice President, General Counsel and Secretary
H. Kevin Rutherford..................  38    Vice President, Corporate Human Resources
Cedric J. Vanzura....................  33    Vice President, Planning and Finance, Treasurer
Philip C. Semprevivo.................  56    Vice President and Chief Information Officer
Kenneth E. Scheve....................  50    Vice President, Finance
Peter R. Formanek....................  53    Director
Brian P. Lamb........................  55    Director
Amy B. Lane..........................  44    Director
Larry Pollock........................  49    Director
Leonard A. Schlesinger...............  44    Director
</TABLE>
 
     The Company's Certificate provides, among other things, that the Board is
divided into three classes. Directors for each class will be elected at the
annual meeting of stockholders held in the year in which the term for such class
expires and will serve thereafter for three years. Directors hold office until
their successors are elected and qualified. However, if the shareholders of the
Company approve a proposal to be presented at the 1997 Annual Meeting, to
reincorporate the company in Michigan, all directors will be elected annually
for one year terms.
 
     Robert F. DiRomualdo has served as the Chairman and Chief Executive Officer
and a Director of the Company since its formation in August 1994. Prior to the
formation of the Company, Mr. DiRomualdo was President and Chief Executive
Officer of Borders from January 1989 to February 1994. From February 1994 to
August 1994, Mr. DiRomualdo was responsible for overall operations at Borders
and Walden.
 
     George R. Mrkonic has served as the Vice Chairman of the Company since
December 1994, and a Director since its formation in August 1994. He has also
served as President of the Company from December 1994 until January 1997. Prior
to joining the Company, Mr. Mrkonic served as Executive Vice President,
Specialty Retailing Group of Kmart Corporation, where he had overall
responsibility for the specialty retailing operations of Kmart including, among
others, Borders and Walden, from November 1990 to November 1994. Mr. Mrkonic is
also a director of Champion Enterprises, Inc., a manufacturer and seller of
manufactured homes and mid-sized buses and Comshare, Inc., which produces
computer software for business applications.
 
     Bruce A. Quinnell has served as President and Chief Operating Officer of
the Company since February 1997. Mr. Quinnell served as President and Chief
Operating Officer of Walden from November 1994 to February 1997. From January
1994 to November 1994, Mr. Quinnell held the position of Executive Vice
President and Chief Operating Officer of Walden. Prior to joining Walden, Mr.
Quinnell was Executive Vice President, Finance and Administration for PACE
Membership Warehouse, Inc., a former subsidiary of
 
                                       33
<PAGE>   36
 
Kmart, from October 1992 to January 1994. From September 1987 until October
1992, Mr. Quinnell was Chief Financial Officer of Dollar General Corp., a
general merchandise retailer.
 
     Richard L. Flanagan has served as President of Borders Store Operations
since February 1997. From February 1994 until February 1997, Mr. Flanagan served
as President and Chief Operating Officer of Borders. Prior thereto, Mr. Flanagan
served as Chief Financial Officer of Borders from April 1991 to February 1994.
From 1987 until April 1991, Mr. Flanagan was Vice President and Chief Financial
Officer of Ellwood Group, Inc., a steel manufacturer.
 
     Kathryn L. Winkelhaus has served as President of Walden Store Operations
since February 1997. From 1992 through 1997, Ms. Winkelhaus served as Sr. Vice
President, Store Operations for Walden. Ms. Winkelhaus has held several
positions of increasing levels of responsibility in store operations since
joining the company in 1979.
 
     Timothy J. Hopkins has served as Merchandising President of the Company
since February 1997. From 1995 to February 1997, Mr. Hopkins served as Sr. Vice
President, Merchandising and Marketing for Walden. Prior to joining the company,
Mr. Hopkins served as Vice President, International and also Vice President,
Merchandising with QVC Network from 1992 through 1995.
 
     Thomas D. Carney has been Vice President, General Counsel and Secretary of
the Company since December 1994. For more than five years prior to joining the
Company, Mr. Carney was a Partner at the law firm of Dickinson, Wright, Moon,
Van Dusen & Freeman in Detroit, Michigan.
 
     H. Kevin Rutherford has served as Vice President, Corporate Human Resources
for Borders Group Inc. since February 1997. From 1994 through February 1997, Mr.
Rutherford served as Vice President, Human Resources for Walden. Prior to
joining the company, Mr. Rutherford was Vice President, Human Resources for
Footaction USA, an athletic footwear retail subsidiary of Melville Corporation
from 1992 through 1994.
 
     Cedric J. Vanzura has been Vice President, Planning and Finance, Treasurer
since August 1996. From November 1994 until August 1996. Mr. Vanzura served as
Vice President, Group Planning and Resource Management. From May 1994 to
November 1994, Mr. Vanzura held the position of Director, Business Development,
Specialty Retail Group of Kmart. Prior to joining Kmart, from 1990 to 1994, Mr.
Vanzura was a Senior Consultant and then a Manager, Management Consulting, at
Deloitte & Touche Management Consulting.
 
     Philip C. Semprevivo has been Vice President and Chief Information Officer
of the Company since December 1994. Prior to joining the Company, Mr. Semprevivo
was an independent management consultant specializing in strategic information
technology planning and reengineering of business processes through the use of
information technology from 1988 to December 1994.
 
     Kenneth E. Scheve has served as Vice President Finance for Borders Group
Inc. since February 1997. From 1994 through February 1997, Mr. Scheve served as
Vice President, Finance for Walden. Prior to joining the company, Mr. Scheve
served as Director -- Internal Audit, Specialty Retailing Group of Kmart
Corporation from 1991 through 1994.
 
     Peter R. Formanek has served as a director of the Company since August,
1995. Mr. Formanek was co-founder of Autozone Inc., a retailer of aftermarket
automotive parts, and served as President and Chief Operating Officer of
Autozone, Inc. from 1986 until his retirement in May, 1994. He currently is a
director of The Perrigo Company, a manufacturer of store brand over-the-counter
drug and personal care products and vitamins.
 
     Brian P. Lamb has served as a director of the Company since August, 1995.
Mr. Lamb is Chairman, CEO and a director of C-SPAN, the Cable Satellite Public
Affairs Network which he founded in 1977.
 
     Amy B. Lane has served as a director of the Company since August, 1995. In
January 1997, Ms. Lane became Managing Director, Investment Banking Group, of
Merrill Lynch. From 1989 through 1996, she served as a Managing Director,
Corporate Finance, of Salomon Brothers Inc., including service as Co-Head of
Salomon Brothers Investment Banking Group covering the retail industry.
 
                                       34
<PAGE>   37
 
     Larry Pollock has served as a director of the Company since August, 1995.
In January 1997, Mr. Pollock became Executive Vice President and Chief Operating
Officer of HomePlace, Inc., a chain of home furnishings and housewares
superstores. From 1994 to 1996, he served as the President, Chief Operating
Officer and a director of Zale Corporation, a jewelry retailer. From 1990
through 1993, Mr. Pollock served as President and Chief Operating Officer of
Karten's Jewelers, Inc., a New England jewelry chain. Mr. Pollock is a partner
of Independent Group L.P., a privately-held radio broadcasting company based in
Cleveland, Ohio, and a director of New West Eyeworks, Inc., a retail optical
company.
 
     Leonard A. Schlesinger has served as a director of the Company since
August, 1995. Mr. Schlesinger is the George Fisher Baker, Jr. Professor of
Business Administration at the Harvard Business School. He has served as a
faculty member at the Harvard Business School for more than five years. Mr.
Schlesinger serves as a director of Limited, Inc., a specialty retailer and
Pegasystems, Inc., a customer service software company.
 
     Officers of the Company are elected on an annual basis and serve at the
discretion of the Board of Directors.
 
COMMITTEES
 
     The Audit Committee was established for the purpose of reviewing and making
recommendations regarding the Company's employment of independent accountants,
the annual audit of the Company's financial statements and the Company's
internal controls, accounting practices and policies. The current members of the
Audit Committee are Mr. Lamb and Ms. Lane.
 
     The Compensation Committee was established for the purpose of making
recommendations to the Board of Directors regarding the nature and amount of
compensation for executive officers of the Company. The Compensation Committee
also administers certain of the Company's employee benefit plans. The current
members of the Compensation Committee are Mr. Formanek, Mr. Pollock, and Mr.
Schlesinger.
 
COMPENSATION OF DIRECTORS
 
     Each director who is not an employee of the Company receives $25,000 in
restricted shares of Common Stock (the "Restricted Shares") paid and valued at
the beginning of the relevant calendar year. The restrictions on such Restricted
Shares will generally lapse one year from the date of grant. Each director who
is not an employee of the Company also receives $1,000 in value of Common Stock
for each board meeting attended, and $500 in Common Stock for each committee
meeting attended, paid and valued at the end of the calendar quarter in which
the meetings occurred. Such Common Stock cannot be sold until at least six
months after the date of grant.
 
     On the date of each of the Company's Annual Meetings, each eligible
director receives an option to purchase 10,000 shares of Common Stock of the
Company. The exercise price of options granted under the Plan is the fair market
value on the date of grant. To be eligible to receive option grants at the
Annual Meetings to be held in 1997, 1998 and 1999 and thereafter, a director
generally must have owned at least 10,000, 15,000 and 20,000 shares of Common
Stock, respectively, for the one-year period prior to the date of the meeting.
 
     Each option vests and becomes exercisable on the third anniversary of the
date of grant except that (i) an option is forfeited in its entirety if the
director ceases, at any time prior to his or her exercise of the option, to hold
the minimum number of shares that he or she was required to hold for the one
year period prior to the grant to be eligible therefor; (ii) all outstanding
options vest and become immediately exercisable in the event of a change in
control of the Company, and (iii) all options held by a director who has served
as a director for six years or more vest and become immediately exercisable as
of the date upon which he or she ceases to serve as a director.
 
     An option may be exercised only during the period that the optionee serves
as a director of the Company or within three months after termination of such
service and only if it is vested and has not expired at the time of termination.
However, if the director ceases to serve as such as a result of death or if the
individual has
 
                                       35
<PAGE>   38
 
served as a director of the Company for more than 10 years, such three month
period is extended to three years.
 
ITEM 11. EXECUTIVE COMPENSATION
 
     The information required by this Item 11 is incorporated herein by
reference to the information under the caption "Executive Compensation" in the
Proxy Statement for the Company's May 15, 1997 Annual Meeting of Stockholders.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     The information required by this Item 12 is incorporated herein by
reference to the information under the heading "Beneficial Ownership of Common
Stock" in the Proxy Statement for the Company's May 15, 1997 Annual Meeting of
Stockholders.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
 
     N/A
 
                                       36
<PAGE>   39
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
     (a) The following exhibits are filed herewith unless otherwise indicated:
 
<TABLE>
<CAPTION>
                                      DESCRIPTION
                                      -----------
<C>           <S>
 3.1(1)       Amended and Restated Certificate of Incorporation of the
              Borders Group, Inc.
 3.2(3)       Amendment to Restated Certificate of Incorporation of
              Borders Group, Inc.
 3.3(2)       Bylaws of the Borders Group, Inc.
10.1(1)       Stockholder Agreement dated as of February 17, 1995, between
              Borders Group, Inc. and Kmart Corporation.
10.2(2)       Employment Agreement dated as of February 1, 1995 between
              Borders Group, Inc. and Robert F. DiRomualdo.
10.3(1)       Employment Agreement dated as of November 15, 1994 among
              Borders Group, Inc., Walden Book Company, Inc. and George R.
              Mrkonic.
10.4(7)       Form of Severance Agreement.
10.5(1)       1992 Stock Appreciation Rights Plan of Borders, Inc.
10.8(1)       Borders Group, Inc. Stock Option Plan.
10.9(5)       First Amendment to the Borders Group, Inc. Stock Option
              Plan.
10.10(3)      Intercompany Agreement dated May 24, 1995 between Borders
              Group, Inc. and Kmart Corporation.
10.11(3)      Tax Allocation Agreement dated May 24, 1995 between Borders
              Group, Inc. and Kmart Corporation.
10.12(3)      Lease Guaranty Agreement dated May 24, 1995 between Borders
              Group, Inc. and Kmart Corporation.
10.14(2)      Management Stock Purchase Plan.
10.15(5)      First Amendment to the Management Stock Purchase Plan
10.16(2)      Employee Stock Purchase Plan
10.17(6)      First Amendment to the Employee Stock Purchase Plan
10.18(2)      Annual Incentive Bonus Plan.
10.19(2)      Director Stock Plan.
10.20(3)      Revolving Credit Facility Credit Agreement (the "Credit
              Agreement") dated as of March 28, 1995 by and among Borders
              Group, Inc., Borders, Inc., Walden Books Company, Inc. and
              Planet Music, Inc. and the lenders party thereto, and PNC
              BANK, National Association, as Administrative Agent and
              First National Bank of Chicago, as Syndication Agent.
10.21(4)      Amendment No. 1 and Consent to Credit Agreement among
              Borders Group, Inc., its subsidiaries and the lenders party
              thereto.
10.22(4)      Amendment No. 2 and Consent to Credit Agreement among
              Borders Group, Inc., its subsidiaries and the lenders Party
              thereto.
10.23(5)      Amendment No. 3 to the Credit Agreement among Borders Group,
              Inc., its subsidiaries and the lender Party thereto.
10.24(5)      Amendment No. 4 to the Credit Agreement among Borders Group,
              Inc., its subsidiaries and the lender Party thereto.
10.25(7)      Amendment No. 5 to the Credit Agreement among Borders Group,
              Inc., its subsidiaries and the lender Party thereto.
</TABLE>
 
                                       37
<PAGE>   40
<TABLE>
<CAPTION>
                                      DESCRIPTION
                                      -----------
<C>           <S>
10.26(5)      Consent dated October 20, 1995 under the Credit Agreement
              among Borders Group, Inc., its subsidiaries and the Lenders
              Party Thereto.
10.27(5)      Participation Agreement dated as of November 22, 1995 by and
              among Borders Group, Inc., its subsidiaries, Wilmington
              Trust Company, SAM Project Funding Corp. I, Bankers Trust
              Company, PNC Bank National Association and the Lenders Party
              Thereto, including exhibits thereto.
10.28(5)      Guarantee Agreement dated as of November 22, 1995 by and
              among Bankers Trust Company, Borders Group, Inc. and its
              subsidiaries, including exhibits thereto.
10.29(7)      First Amendment to the Guarantee Agreement dated as of
              February 9, 1996, by and among Borders Group, Inc. and its
              subsidiaries.
10.30(7)      Agreement dated April 19, 1996, between Borders Group, Inc.
              and Richard L. Flanagan.
10.31(7)      Agreement dated April 19, 1996, between Borders Group, Inc.
              and Bruce A. Quinnell.
10.32(7)      Agreement dated April 10, 1996, between Borders Group, Inc.
              and Philip C. Semprevivo.
10.33(8)      Amendment No. 6 and Consent to Credit Agreement among
              Borders Group Inc., its subsidiaries and the Lenders Party
              Thereto.
10.34(8)      Amendment No. 2 and Consent to the Guarantee by and among
              Bankers Trust Company, Borders Group, Inc. and its
              subsidiaries.
10.35(9)      Amendment No. 7 and Consent to Credit Agreement among
              Borders Group, Inc., its subsidiaries and Parties Thereto.
10.36         Amendment No. 8 and Consent to Credit Agreement among
              Borders Group, Inc., its subsidiaries and Parties Thereto.
11.1          Statement of Computation of Per Share Earnings.
18.1(3)       Letter of Price Waterhouse LLP dated July 17, 1995.
21.1          Subsidiaries of Registrant.
23.1          Consent of Price Waterhouse LLP
</TABLE>
 
-------------------------
(1) Incorporated by reference from the Company's Registration Statement on Form
    S-4 (File No. 33-90016).
 
(2) Incorporated by reference from the Company's Registration Statement on Form
    S-1 (File No. 33-90918).
 
(3) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the quarter (File No. 1-13740).
 
(4) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the quarter ended July 23, 1995 (File No. 1-13740).
 
(5) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the Quarter ended October 22, 1995. (File No. 1-13740).
 
(6) Incorporated by reference from the Company's Registration Statement on Form
    S-1 (File No. 33-80643).
 
(7) Incorporated by reference from the Company's Annual Report on Form 10-K for
    the year ended January 28, 1996 (File No. 1-13740).
 
(8) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the quarter ended July 28, 1996 (File No. 1-13740).
 
(9) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the quarter ended October 27, 1996 (File No. 1-13740).
 
     (b) Financial Statement Schedules:
 
     All financial statement schedules are omitted as they are not applicable or
the required information is included in the consolidated financial statements of
the Registrant.
 
                                       38
<PAGE>   41
 
                                   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.
 
                                          BORDERS GROUP, INC.
                                          (Registrant)
 
                                          By:    /s/ ROBERT F. DIROMUALDO
                                            ------------------------------------
                                                    Robert F. DiRomualdo
                                            Chairman and Chief Executive Officer
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
                        NAME                                        TITLE                      DATE
                        ----                                        -----                      ----
<C>                                                    <S>                                <C>
 
              /s/ ROBERT F. DIROMUALDO                 Chairman, Chief Executive          April 21, 1997
-----------------------------------------------------  Officer and Director
                Robert F. DiRomualdo
 
                /s/ GEORGE R. MRKONIC                  Vice Chairman and Director         April 21, 1997
-----------------------------------------------------  (Principal Financial and
                  George R. Mrkonic                    Accounting Officer)
 
                /s/ PETER R. FORMANEK                  Director                           April 21, 1997
-----------------------------------------------------
                  Peter R. Formanek
 
                                                       Director
-----------------------------------------------------
                    Brian P. Lamb
 
                   /s/ AMY B. LANE                     Director                           April 21, 1997
-----------------------------------------------------
                     Amy B. Lane
 
                  /s/ LARRY POLLOCK                    Director                           April 21, 1997
-----------------------------------------------------
                    Larry Pollock
 
             /s/ LEONARD A. SCHLESINGER                Director                           April 21, 1997
-----------------------------------------------------
               Leonard A. Schlesinger
</TABLE>
 
                                       39
<PAGE>   42
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                                  DESCRIPTION
-------                                 -----------
<C>             <S>
  3.1 (1)       Amended and Restated Certificate of Incorporation of the
                Borders Group, Inc.
  3.2 (3)       Amendment to Restated Certificate of Incorporation of
                Borders Group, Inc.
  3.3 (2)       Bylaws of the Borders Group, Inc.
 10.1 (1)       Stockholder Agreement dated as of February 17, 1995, between
                Borders Group, Inc. and Kmart Corporation.
 10.2 (2)       Employment Agreement dated as of February 1, 1995 between
                Borders Group, Inc. and Robert F. DiRomualdo.
 10.3 (1)       Employment Agreement dated as of November 15, 1994 among
                Borders Group, Inc., Walden Book Company, Inc. and George R.
                Mrkonic.
 10.4 (7)       Form of Severance Agreement.
 10.5 (1)       1992 Stock Appreciation Rights Plan of Borders, Inc.
 10.8 (1)       Borders Group, Inc. Stock Option Plan.
 10.9 (5)       First Amendment to the Borders Group, Inc. Stock Option
                Plan.
 10.10(3)       Intercompany Agreement dated May 24, 1995 between Borders
                Group, Inc. and Kmart Corporation.
 10.11(3)       Tax Allocation Agreement dated May 24, 1995 between Borders
                Group, Inc. and Kmart Corporation.
 10.12(3)       Lease Guaranty Agreement dated May 24, 1995 between Borders
                Group, Inc. and Kmart Corporation.
 10.14(2)       Management Stock Purchase Plan.
 10.15(5)       First Amendment to the Management Stock Purchase Plan
 10.16(2)       Employee Stock Purchase Plan
 10.17(6)       First Amendment to the Employee Stock Purchase Plan
 10.18(2)       Annual Incentive Bonus Plan.
 10.19(2)       Director Stock Plan.
 10.20(3)       Revolving Credit Facility Credit Agreement (the "Credit
                Agreement") dated as of March 28, 1995 by and among Borders
                Group, Inc., Borders, Inc., Walden Books Company, Inc. and
                Planet Music, Inc. and the lenders party thereto, and PNC
                BANK, National Association, as Administrative Agent and
                First National Bank of Chicago, as Syndication Agent.
 10.21(4)       Amendment No. 1 and Consent to Credit Agreement among
                Borders Group, Inc., its subsidiaries and the lenders party
                thereto.
 10.22(4)       Amendment No. 2 and Consent to Credit Agreement among
                Borders Group, Inc., its subsidiaries and the lenders Party
                thereto.
 10.23(5)       Amendment No. 3 to the Credit Agreement among Borders Group,
                Inc., its subsidiaries and the lender Party thereto.
 10.24(5)       Amendment No. 4 to the Credit Agreement among Borders Group,
                Inc., its subsidiaries and the lender Party thereto.
 10.25(7)       Amendment No. 5 to the Credit Agreement among Borders Group,
                Inc., its subsidiaries and the lender Party thereto.
 10.26(5)       Consent dated October 20, 1995 under the Credit Agreement
                among Borders Group, Inc., its subsidiaries and the Lenders
                Party Thereto.
</TABLE>
<PAGE>   43
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                                  DESCRIPTION
-------                                 -----------
<C>             <S>
 10.27(5)       Participation Agreement dated as of November 22, 1995 by and
                among Borders Group, Inc., its subsidiaries, Wilmington
                Trust Company, SAM Project Funding Corp. I, Bankers Trust
                Company, PNC Bank National Association and the Lenders Party
                Thereto, including exhibits thereto.
 10.28(5)       Guarantee Agreement dated as of November 22, 1995 by and
                among Bankers Trust Company, Borders Group, Inc. and its
                subsidiaries, including exhibits thereto.
 10.29(7)       First Amendment to the Guarantee Agreement dated as of
                February 9, 1996, by and among Borders Group, Inc. and its
                subsidiaries.
 10.30(7)       Agreement dated April 19, 1996, between Borders Group, Inc.
                and Richard L. Flanagan.
 10.31(7)       Agreement dated April 19, 1996, between Borders Group, Inc.
                and Bruce A. Quinnell.
 10.32(7)       Agreement dated April 10, 1996, between Borders Group, Inc.
                and Philip C. Semprevivo.
 10.33(8)       Amendment No. 6 and Consent to Credit Agreement among
                Borders Group Inc., its subsidiaries and the Lenders Party
                Thereto.
 10.34(8)       Amendment No. 2 and Consent to the Guarantee by and among
                Bankers Trust Company, Borders Group, Inc. and its
                subsidiaries.
 10.35(9)       Amendment No. 7 and Consent to Credit Agreement among
                Borders Group, Inc., its subsidiaries and Parties Thereto.
 10.36          Amendment No. 8 and Consent to Credit Agreement among
                Borders Group, Inc., its subsidiaries and Parties Thereto.
 11.1           Statement of Computation of Per Share Earnings.
 18.1 (3)       Letter of Price Waterhouse LLP dated July 17, 1995.
 21.1           Subsidiaries of Registrant.
 23.1           Consent of Price Waterhouse LLP
</TABLE>
 
-------------------------
(1) Incorporated by reference from the Company's Registration Statement on Form
    S-4 (File No. 33-90016).
 
(2) Incorporated by reference from the Company's Registration Statement on Form
    S-1 (File No. 33-90918).
 
(3) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the quarter (File No. 1-13740).
 
(4) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the quarter ended July 23, 1995 (File No. 1-13740).
 
(5) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the Quarter ended October 22, 1995. (File No. 1-13740).
 
(6) Incorporated by reference from the Company's Registration Statement on Form
    S-1 (File No. 33-80643).
 
(7) Incorporated by reference from the Company's Annual Report on Form 10-K for
    the year ended January 28, 1996 (File No. 1-13740).
 
(8) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the quarter ended July 28, 1996.
 
(9) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the quarter ended October 27, 1996 (File No. 1-13740).