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


                                   FORM 10-K

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

                     For the Year Ended December 31, 1996

                        Commission File Number 1-10367


              ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

              DELAWARE                                 71-0675758
   (State or other jurisdiction of       (I.R.S. Employer Identification No.)
    incorporation or organization)

       206  1/2 E. EMMA AVENUE
       P.O. BOX 1237                                     72765
       SPRINGDALE, ARKANSAS                            (Zip Code)
(Address of Principal Executive Office)

Registrant's telephone number, including Area Code:  (501)750-1299

Securities Registered Pursuant to Section 12(b) of the Act:


                         Class A Common Stock, $.01 par value

                         Redeemable Class B Warrants


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 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.  YES: [X]  NO: [_]

Aggregate market value of voting stock held by non-affiliates of the registrant
at April 14, 1997: $2,328,302

Number of shares of the common stock outstanding at April 14, 1997:
                                              Class A - 19,201,148
                                              Class B -  1,465,530
<PAGE>
 
                                    PART I

ITEM 1.    BUSINESS

GENERAL

Advanced Environmental Recycling Technologies, Inc., ("AERT" or the "Company")
was founded in 1988 by the Brooks family and associates of Springdale, Arkansas.
Since inception, the Company has developed, patented, and commercialized several
new technologies and products which significantly advances state-of-the-art
reclamation of polyethylene plastic scrap and related manufacturing processes.
The Company utilizes its proprietary technologies to produce a growing line of
moisture-resistant and dimensionally stable, engineered composite building
materials. Since inception to December 31, 1996, the Company has generated net
sales of $18,936,984, as component parts primarily into the U.S. residential
homebuilding market. The Company is currently comprised of two separate, yet
interrelated manufacturing facilities; the Composites Manufacturing Unit located
in Junction, Texas, which manufactures and markets unique engineered composite
building materials made from reclaimed plastics and by-product wood fibers, and
the Plastics Reclamation Unit located in Rogers, Arkansas, which reclaims waste
plastics, processing various LDPE and HDPE materials that are used as feedstocks
in the composite manufacturing process.

AERT's advanced composite materials exhibit numerous advantages over traditional
wood and synthetic materials. These engineered composite materials are
competitively priced, and through independent testing, have been shown not to
rot, crack, warp or absorb moisture as compared to wood. In addition, the
products are impervious to insects, do not require chemical or preservative
treatments, and exhibit superior fire retardency as compared to competitive
grades of wood. They can be welded and fused by heat, nailed, screwed, sawed, or
drilled, and with minimal additional machining, can be formed into any desired
shape. The Company markets its engineered composite building materials under the
trade names MOISTURESHIELD(TM), LIFECYCLE(TM), and CHOICEDEK(TM) and markets
these products into three areas; 1) the door and window component market, 2) the
heavy industrial flooring market, and 3) the high-end residential and commercial
decking market. The Company's MOISTURESHIELD(TM) and CHOICEDEK(TM) products are
now rapidly gaining increased market acceptance in the growing field of
engineered wood products.

The Company employs a four-part business strategy: (1) it utilizes low-cost
waste products and internally-produced products as raw materials; (2) it
configures its production facilities so that it can economically manufacture a
broad range of products on the same equipment in short production runs; (3) it
maintains a high level of technical and product support for its customers and
places a major emphasis on quality control and consistency in regard to its
products; and (4) its marketing program identifies and sells to niche markets
with defined needs in which the Company believes it can be prominent or
dominant.  The Company markets its products through direct customer
relationships utilizing management and internal sales personnel, and places a
high emphasis on maintaining strong working relationships with its customers.

                                       1
<PAGE>
 
THE COMPOSITES UNIT

The Company's Composites Manufacturing Unit located in Junction, Texas
manufactures and markets its moisture-resistant composite building materials
under the trade names MOISTURESHIELD(TM), LIFECYCLE(TM), and CHOICEDEK(TM).  The
composite materials are hard, dense, short-grained substances with a dark,
speckled surface appearance.  Because of their plastic content, the composites
can be engineered for moisture resistance, do not require preservative or
chemical treatments like traditional wood, can be designed and extruded to
customer specifications to minimize waste, and are less subject to rotting,
cracking, warping, insect infestation and water absorption than conventional
wood materials.  Because of the wood fiber content, composites are less subject
to thermal contraction or expansion and display greater dimensional stability
than conventional plastic materials for such applications.  The composites are
denser than the straight-grained, clear grades of wood from western United
States forests traditionally used in the building applications for which AERT's
products compete.

The composites manufacturing process involves proprietary technologies and
specialized manufacturing equipment, custom-built or modified for the Company's
purposes.  It utilizes recycled plastics and wood-filler materials and, in
certain cases, special additives or virgin plastics in varying mixtures which
can be formulated based on the customer's desired end-product characteristics.
A key advantage of the Company's process is the ability to utilize plentiful,
low-cost raw material components, encapsulate the wood fibers in the plastic and
create a consistent material, free of foreign matter, which can be extruded into
a desired shape while the end product maintains many properties similar to
traditional wood materials.

The Composite Manufacturing Unit is comprised of a wood fiber raw material
processing department, a composite extrusion department, a millwork and
fabrication department, and a priming and paint department.  The raw materials
processing department consists of cedar fiber cleaning, drying, grinding and
storage equipment; the extrusion department consists of three extrusion and
downstream production lines; the millwork department consists of two molding and
end-work lines; and the painting department consists of inspection, preparation
and a painting and drying line.  The Company is currently in process of
upgrading the painting department with a larger and improved painting system,
which should come on line during the second quarter of 1997.  This line is
designed to enhance the quality of the surface finish and allow the company to
introduce an additional high end product line in the near future.

In May 1995, the Company entered into an exclusive marketing and distribution
agreement with a division of Weyerhaeuser, Inc. ("Weyerhaeuser") for sales of
its LIFECYCLE(TM), line of extruded decking components, which are primarily
targeted towards the high-end residential housing market. Weyerhaeuser currently
markets the product under the Company's trade-name, CHOICEDEK(TM), in a limited
number of its 80 distribution and reload centers primarily in the southwest,
west coast, and western mountain regions of the United States. The Company
intends to continue to grow and add additional Weyerhaeuser distribution as
production increases.

Due to increased composite sales demands, the Company is currently working to
expand its composite manufacturing capacity by the addition of a fourth
extrusion line in the near future.  The Company is also working to establishing
an additional composite manufacturing capability in conjunction with Sutton
Engineered Wood Products near Harrison, Arkansas.

                                       2
<PAGE>
 
THE PLASTICS RECLAMATION UNIT

The Plastics Reclamation Unit located in Rogers, Arkansas was initially
established to develop plastic recycling technology primarily to serve as a
dependable, cost-effective source of plastic raw material for the Composites
Manufacturing Unit.  The Company began activities at its Plastics Reclamation
Unit in 1990.  Since that time, the Company has further developed and patented
its proprietary waste plastics reclamation technologies which allows it to
recover waste plastics from the by-product of paper recycling mills, as well as
certain waste plastic from post-consumer or industrial plastic films.  See " -
Supply and Pricing of Raw Materials".  Secondary fiber recovery mills recycle
paper and polyethylene-coated paperboard to recover the paper fiber through a
process known as hydropulping.  The by-product of the hydropulping process is a
water-saturated mixture of polyethylene and unrecovered paper fiber, which most
such mills currently dispose of without further processing.  Using certain
plastics recycling technologies, which such paper recycling companies do not
generally have available, the Company has been able to economically recover
polyethylene suitable for use in its composite manufacturing process.

In 1991, while continuing to develop its initial plastic recycling technology,
the Company entered into a technology development agreement with The Dow
Chemical Company for the purpose of further developing and commercializing the
Company's plastic reclamation technology for additional applications of
polyethylene films.  The Company received an initial 10 million pounds market
development order from Dow in 1992 for recycled plastic.  However, when federal
recycling legislation and market development waned for recycled plastic, that
order was restructured in 1994 allowing the Company to significantly reduce
indebtedness.  Pursuant to the restructuring, Dow forgave approximately $879,000
in debt from the Company in lieu of purchasing the remaining portion of the
recycled plastic.  Following  the restructuring and completion of the Dow
contract, the Company began utilizing production capacity not required for
processing raw materials for the Composites Manufacturing Unit to produce other
types of materials for sale to manufacturers of grocery bags, trash bags, and
other manufacturers of plastic goods desiring recycled content in their
products.

Through 1995, the Company's plastic reclamation facility was involved in sales
of recycled plastics to third party film manufacturers.  The materials desired
by these customers required substantial processing beyond that necessary to
produce raw materials for the composites facility and sufficient efficiencies of
scale were never attained.  This, coupled with increased sales of the Company's
composite products, and the composites division's increased raw-material
requirements, prompted the Company, in the first quarter of 1996, to discontinue
reclamation of plastics for sale to third-parties and dedicate all of the
plastic facility's production to providing materials to the Junction operation.
In connection with this restructuring of the plastics reclamation plant, the
Company exchanged certain equipment,  previously utilized to produce plastics
for sale to third-parties, for other equipment which was utilized to produce
raw-materials and for additional equipment necessary to complete the
installation of a third production line at the Company's composite facility

The Company experienced a series of extensive fires that caused substantial
damage during the last half of 1996 at its Rogers, Arkansas plastic reclamation
facility.  These fires in September and December of 1996 set back the Company's
plastic reclamation program and limited composite sales growth.  The Company is
currently rebuilding said facility and has begun establishing a national supply
network for polyethylene.  These fires have been determined to be arson by
authorities and an investigation is ongoing.

SUPPLY AND PRICING OF RAW MATERIALS

The Company's composites are currently manufactured from cedar fiber,
polyethylene industrial and post-consumer film scrap and ground industrial and
post-consumer high-density polyethylene containers as well as 

                                       3
<PAGE>
 
other sources of consistent polyethylene waste products. AERT has entered into
informal supply agreements for the cedar fiber and a portion of the waste
plastics used in its composite manufacturing process, although it is the
Company's intention to enter into additional supply agreements in the future.
The Company currently purchases raw materials from sources, which it believes
are dependable and adequate for its short-term manufacturing requirements, and
the Company believes suitable alternative sources are available. Additional raw
material supply sources of both plastic and wood fiber will be required for the
Company to continue to increase composite production and sales. However, a
significant disruption of supply arrangements, a reduction in raw material
consistency or quality or significant increases in raw material prices could
have a material adverse effect on AERT's operations as recently experienced with
the Rogers, Arkansas fires.

     Cedar Fiber.  The composite facility is located near four cedar mills which
extract cedar oil for perfumes and industrial detergents and dispose of the
cedar fiber as a by-product of their operations.  It is also sold in some
instances as a horse stable bedding, or a drilling mud bridging agent.  The
Company, in the past, has purchased all of the wood fiber required for its
manufacturing purposes from these mills.  Although the Company believes it has
access to sufficient supplies of cedar fiber to supply its initial customer
requirements, the Company has manufactured its composite material with other
types of wood fibers.  The Company has commenced a testing program with hardwood
waste, and believes that a number of substitute wood fibers could be
satisfactorily used in its manufacturing process and that other sources are
currently available.  The Company may in the future, begin manufacturing a
portion of its OEM products with wood fibers other than cedar.  The pending
Sutton Engineered Wood Products will focus primarily on raw material wood fiber
sources other than cedar.

     Recycled Plastics.  The cost of recycled waste plastics for use in the
composites manufacturing process has been subject to significant market and
quality fluctuations over the past several years and the Company has experienced
supply problems associated with contaminated plastics in the past.  In an effort
to reduce its exposure to price volatility, inconsistent quality, and potential
supply disruptions, the Company in 1990 developed its own patented plastic
recycling technologies and established the waste Plastics Reclamation Unit in
Rogers, Arkansas to assure itself of a cleaner, more dependable, and consistent
supply of plastic raw material for its composite manufacturing operations.  The
Company has also recently established several additional plastic supply sourcing
relationships in order to broaden its sources of supply.

The Company's plastics manufacturing processes primarily focus on recycling the
following polyethylene films for use in the composites manufacturing process:

     -    Low Density Polyethylene ("LDPE") poly coatings or linings from
          recycled bleached food-board, which are generated from the
          hydropulping process;
     -    High Density Polyethylene ("HDPE") and Low Linear Density Polyethylene
          ("LLDPE") mixed plastic grocery bags from supermarket and store
          collection programs; and
     -    HDPE ground container material.

These films are highly contaminated with paper and other non-plastic materials
which makes them less desirable for traditional plastic uses, and thus lessens
their value to producers of recycled plastics.  However, plastic used for the
Company's Composites Manufacturing Unit does not require the purity, extensive
cleaning, additional washing and melt filtration associated with conventional
plastics, and can be processed faster and more economically.  Further, the
contaminated plastics are acquired by the Company at minimal costs, primarily
only the freight charges.  By focusing on contaminated plastics, the Company is
able to process these materials through its Plastics Reclamation Unit and
produce an acceptable lower-cost feed stock for the composites facility.  The
Company believes that it has adequate and reliable sources of LDPE hydropulp and
HDPE/LLDPE mixed plastic grocery bags for the foreseeable future once its Rogers
plastic reclamation facility recommences 

                                       4
<PAGE>
 
operations. The Company also from time to time purchases plastic, if available
at reasonable costs and quality, from outside sources, such as brokers or other
plastic recyclers, to supplement the above described sources.
 
MARKETING AND SALES

The Company has directed its initial marketing activities to specialized market
segments in the building and construction industry in which cost and physical
characteristics place AERT's composite products, such as the subsurface
component pieces of standard door and window products, at a competitive
advantage over alternative conventional materials and in which the current
weaknesses of composites (for example, certain of its strength and aesthetic
characteristics) are not critical disadvantages.  The Company has developed an
extensive customer base in the national door and window market, and with
Weyerhaeuser BMD, primarily through members of management, and strives to
maintain strong customer relationships.

To the extent a prospective customer currently uses wood for such component
pieces, the Company emphasizes the "value-added" potential of its
MOISTURESHIELD(TM) composite product which, unlike competing wood products, can
be engineered to incorporate certain desired end-product characteristics. The
Company also calls the prospective customer's attention to the savings in time
and expense that can be achieved by designing into the equipment used in the
extrusion process much of the millwork required in the customer's finished
product. In addition, the Company emphasizes the customer's avoidance of the
chemical treatments and in plant volatile organic compounds requirements often
necessary to give competing wood products rot resistance and durability and the
customer's avoidance of the substantial scrap wood or sawdust waste-product
typically generated in the sawing and milling process. The Company also stresses
the additional durability and performance of its products, which allows its
customers to extend the lifetime or warranties of their products.

MOISTURESHIELD(TM) composites have been previously marketed primarily to
companies that manufacture products for use by the construction industry in new
home construction and home improvement work. The construction industry is
subject to significant fluctuations in activity and periodic downturns caused by
general economic conditions. Reductions in construction activity could have an
adverse effect on the demand for AERT composites; however, the Company believes
that its market diversification program will reduce the effects that
fluctuations in construction activity would have on the Company. The Company
focuses heavily on products for the home improvement market, which often tends
to increase in activity when housing starts decline, and the Company is further
expanded its marketing focus and increasing its decking distribution with its
CHOICEDEK(TM) products through Weyerhaeuser to accommodate a wider range of
applications in order to avoid being totally dependent on one industry.

In May 1995, the Company entered into an exclusive marketing and distribution
agreement with a division of Weyerhaeuser for sales of its LIFECYCLE(TM) line of
extruded decking components, which are primarily targeted towards the high-end
residential housing market. Weyerhaeuser currently markets the product under the
Company's trade-name, CHOICEDEK(TM), in a limited number of its distribution and
reload centers throughout the United States and Canada. The Company intends to
further increase distribution and add additional markets during 1997 while
continuing to increase sales in its initial decking markets. Weyerhaeuser
markets CHOICEDEK(TM) primarily through independent contractor oriented lumber
dealers. CHOICEDEK(TM) is promoted through displays at regional and local home
and lawn and garden shows as well as store demonstration displays, and will soon
be marketed via a web site on the internet. The internet site will target high
end contractors and architects.

The Company currently maintains a concentrated customer base.  The Company is
unable to predict the future size of the markets for its composite building
products, however, the Company believes that the national door 

                                       5
<PAGE>
 
and window and residential decking material markets are significant. The Company
believes that it can further penetrate these markets and/or expand sales to its
existing customer base if the Company's goals for increased production capacity
and efficiency are achieved. By focusing its marketing strategy on a limited
number of large door and window companies, and by initiating sales of its new
decking products through the Weyerhaeuser marketing and distribution agreement,
the Company believes it can increase market penetration and sales without
significantly increasing administrative overhead. To a lesser extent, the
Company's marketing focus also utilizes outside commissioned sales
representatives for a portion of its door and window and decking customers.

REDUCTIONS IN CONSTRUCTION ACTIVITY; INTEREST RATE SENSITIVITY

AERT composites will be marketed primarily to companies that manufacture
products for use by the construction industry in new home construction and home
improvement work.  The construction industry is subject to significant
fluctuations in activity and to periodic downturns caused by general economic
conditions.  Increased interest rates can lead to reduced homebuilding activity.
Reductions in construction activity could necessarily have an adverse effect on
the demand for AERT composites.  The Company, therefore, places a major emphasis
on components for customers in the home improvement market.  However, the
Company has recently expanded its marketing focus to accommodate a wider range
of products and applications, and is continuing to increase market distribution.

INDUSTRY STANDARDS

ASTM and certain industry trade organizations have established general standards
and methods for measuring the characteristics of specific building materials.
Users of building materials (and frequently, issuers of building codes)
generally specify that the building materials comply with such standards
relative to the proposed applications.  In regard to decking, many areas require
independent testing of specific test criteria in order to qualify for building
code approval.  The Company has generated a substantial amount of independent
test data regarding its products and has developed an extensive field history in
conjunction with positive customer satisfaction for its components through its
large OEM customers.  In addition, the Company has submitted its decking
products to extensive independent testing by certified laboratories.  The
Company has submitted its decking to and successfully passed numerous extensive
testing parameters.  However, the Company has not to date submitted such
independent testing to an evaluation service and received a BOCA (blanket
building code approval) rating for its decking products.  The Company currently
submits its testing data and allows the user to determine suitability for the
application.  The lack of such a standard (and the independent assurance of
extensive testing, quality control and performance capability which compliance
with accepted standards typically provide), may limit the market potential of
the Company's decking materials in certain areas and make potential purchasers
of such building materials reluctant to use them until independent certification
is granted by a universally recognized approval agency.

The Company has accumulated significant product test data and begun the internal
preparation of proposed guidelines for wood-plastic composite materials for
certain decking construction applications for submission and evaluation for an
independent BOCA approval rating.  The Company intends to submit its application
in the near future.  The consideration and evaluation of proposed testing
standards for BOCA is sometimes a lengthy process, typically requiring several
years at a minimum.  The Company may also have to submit to additional
independent testing to gain approval.  Management believes the Company's decking
products can meet and conform to nationally recognized BOCA performance
standards and intends to obtain an independent BOCA approval rating in the
future for its decking products.

                                       6
<PAGE>
 
COMPETITION

In seeking to introduce MOISTURESHIELD(TM) and CHOICEDEK(TM) composites as
alternative building materials to high grade western pine and other woods,
aluminum, high-performance plastics and other construction materials, the
Company competes with major forestry product companies, aluminum fabricating
companies, and major plastic and petrochemical companies. The conventional
material manufacturers with which the Company must compete have, in many cases,
long-established ties to the building and construction industry and have proven
well-accepted products.

Many large competitors also have research and development budgets, marketing
staffs and financial and other resources, which far surpass the resources of the
Company.  There can be no assurance that such competitors will not attempt to
develop and introduce similar recycled composite materials.  The Company must
also compete in the building materials market with certain other plastics
recyclers currently manufacturing recycled materials intended for similar
building material applications, including decking and fencing.  None of such
recyclers, to the Company's knowledge, have achieved significant commercial
acceptance to date, however, Mobil Oil Company entered the market in 1992 with a
new composite products division and a decking and fencing product called
Timbrex, which was recently renamed Trex.  Mobil initiated a large national
marketing and advertising program, attained significant distribution in the
decking market and is a significant competitor in recycled plastic products.
Mobil has challenged and invalidated four AERT composite patents, and is
continuing to assert a claim for substantial attorney's fees against the
Company.  See (Item 3.  "Legal Proceedings").  However, the U.S. Court of
Appeals recently restored the validity of two of the four patents in suit.
Mobil also recently divested this division and reportedly sold it to a group of
Trex managers.  The new company is called The Trex Co., LLC.  Therefore, as of
this date, it appears Mobil Oil is no longer in this business, nor is it a
competitor of the Company.

As the Company has developed its own plastics reclamation technologies, it has
in certain instances been required to compete for raw materials with other
plastics recyclers, or plastic resin producers, most of which are far larger and
better established than the Company.  However, management believes that its
focus towards sources of contaminated polyethylene films that it recycles and
uses in its composites business are less attractive to most producers of
recycled plastics.  As a result, the Company has not historically experienced
significant competition for such raw materials.  Further, the Company believes
that the plastics reclamation processes it has developed for its composite
manufacturing business are targeted to the waste management needs of particular
industrial waste generators, to plastic film wastes and to other plastic waste
generators, whose potential as a recycling source is not being utilized to a
significant extent by current plastics recyclers, rather than to post-consumer,
source-separated plastic containers recycling processes, in which a
substantially greater number of plastics recyclers compete for plastic waste
materials.  As it grows, the Company now expects to encounter new entrants into
the composites or plastics reclamation business which could effect the Company's
source of raw materials supply and who may have substantially greater financial
and other resources than the Company and which may include beverage bottlers,
distributors and retailers as well as  forestry product producers, petrochemical
and other companies.  For example, The Trex Co., LLC now competing with the
Company for certain raw materials in connection with the production of its Trex
product described above.

PATENTED AND PROPRIETARY TECHNOLOGY

The Company's composite manufacturing process and its development efforts in
connection with waste plastics reclamation technologies involve patents and many
trade secrets which are considered proprietary by the Company, as well as
certain methods, processes and equipment designs for which the Company has
sought additional patent protection.  The Company has taken measures, which are
designed to safeguard its trade secrets 

                                       7
<PAGE>
 
by, among other things, entering into confidentiality and nondisclosure
agreements. Should the Company's trade secrets be disclosed notwithstanding
these efforts, the business and prospects of the Company could be materially and
adversely affected. The Company has filed seventeen patent applications and have
received issuance from the United States Patent and Trademark Office for
thirteen patents, five of which relate to the Company's composite materials
manufacturing operations and eight of which relate to its waste plastics
reclamation technologies. The patent applications recently allowed relate to the
Company's extrusion process, extrusion apparatus, and its continuous down
streaming cooling and forming conveyor system, and its plastic reclamation
process and equipment. In February 1994, in litigation with Mobil Oil
Corporation, a Delaware jury returned a verdict that four AERT patents on its
composite product technology were invalid. (See Item 3. "Legal Proceedings").
The Company's additional pending applications relate to additional manufacturing
apparatus, the composite product composition and technology involving its film
reclamation processes. There can be no assurance such additional patents will be
allowed, or if allowed that they will not be challenged and invalidated. The
cost of patent protection, and in particular, patent litigation is extremely
high. The Company intends to take other steps reasonably necessary in the future
to protect its existing technology and any technology, which may be subsequently
developed. The Company may license its technologies to industrial users in the
future if licensing terms can be agreed upon and if the Company believes it can
preserve adequate demand for its own products.

EMPLOYEES

At December 31, 1996, the Company employed 142 full-time personnel, 15 of whom
are executive or office personnel and 127 of whom are full-time factory
personnel.  The Company, from time-to-time, employs additional persons on a
part-time basis in its manufacturing operations.  The Company anticipates that
as its business expands it will employ additional management and factory
personnel.

                                       8
<PAGE>
 
ITEM  2.  PROPERTY

The Company conducts its composite products manufacturing operations from a
49,000 square foot manufacturing and storage facility on a seven-acre site in
Junction, Texas.  The grounds and a 10,500 square foot building are leased from
Marjorie S. Brooks, a major shareholder, under an agreement which expires April
30, 2001.  The Company owns the building improvements located on the site and
currently pays a monthly rent of $1,519 for the lease.  The Company believes
that the Junction facility is currently suitable for its composite materials
manufacturing requirements, however, the Company is evaluating ways to establish
additional composite capacity.

The Company's plastic reclamation facility is located in Rogers, Arkansas, where
the Company leases 17,000 square feet for its manufacturing and warehouse
facility and adjacent office space.  This facility is being occupied under the
provisions of a production lease which expires January 1, 1997 and contains five
automatic renewal options of one year each.  The lease agreement does not
require any minimum lease payments, but requires payments based on plant
production at a rate of $.02 per pound.  This rental arrangement will remain in
effect for any such renewal periods as well.  The Company paid rent of $114,907
for this facility during the year ended December 31, 1996.

The Company's corporate offices are located in a 800 square foot leased office
in Sprindale, Arkansas.  The lease provides for a rental amount of $400 per
month and is renewable on a month to month basis.

ITEM  3.  LEGAL PROCEEDINGS

On June 9, 1992, Mobil Oil Corporation ("Mobil") commenced an action against the
Company in the United States District Court for the District of Delaware
entitled Mobil Oil Corporation v. Advanced Environmental Recycling Technologies,
         -----------------------------------------------------------------------
Inc.  In its complaint, Mobil sought entry of a declaratory judgment that:  (a)
----                                                                           
AERT is without right or authority to threaten suit against Mobil or its
customers for alleged infringement of AERT patents; (b) The AERT patents are
invalid and unenforceable, and (c) Mobil has not infringed the AERT patents
through any products or method.  Mobil seeks no monetary damages in this suit,
but does seek reimbursement of its attorneys' fees.

On December 8, 1992, the Company answered Mobil's Complaint.  In its Answer, the
Company denied Mobil's claims and asserted counterclaims against Mobil and three
Mobil executives for:  (1) an illegal combination or contract in restraint of
trade in violation of federal antitrust laws; (2) a pattern of intentional
misconduct constituting an attempt to monopolize in violation of federal
antitrust laws; (3) breach of a confidential relationship between Mobil and the
Company; and (4) unfair competition.  The Company sought monetary damages,
punitive damages and injunctive relief.  Mobil filed an answer to AERT's
counterclaims, denying any liability.  The Delaware Court then bifurcated the
trial into patent and non-patent issues and ordered the patent issues tried
first.

In February 1994, after a trial on the patent issues, a Delaware jury returned a
verdict that four AERT patents on its composite product technology were invalid.
The jury also determined that Mobil had not infringed two of the four patents
which AERT had asserted against Mobil.  The jury verdict answered a number of
interrogatories on the factual issues, and rendered advisory findings for the
Court on Mobil's allegation that AERT had obtained its patents by inequitable
conduct.  Thereafter, the Judge adopted the jury's advisory findings on
inequitable conduct and held that each of the four AERT patents were
unenforceable for failure to disclose certain alleged prior art to the patent
office during patent prosecution.

                                       9
<PAGE>
 
Because of the nature of certain of the jury verdict interrogatory responses,
AERT's counsel concluded that the verdict was adversely affected by improper
conduct by Mobil counsel during trial, and false statements of law and fact made
during closing argument, that caused the jury to misapply the law on inequitable
conduct and to render clearly erroneous findings.  Consequently, AERT moved for
a new trial.  That motion was denied.  The Company's additional post-trial
motions were also denied by the Delaware Court.  On March 14, 1995, the Company
filed a sealed motion with the Court based upon newly discovered evidence which
alleges prejudicial misconduct by Mobil prior to the trial.  The motion also
brings to the Court's attention, evidence which the Company believes was
intentionally withheld from it in direct defiance of the Delaware Court's
January 4, 1994 Motion to Compel, prior to the trial.  It also brings to the
Court's attention, an official government safety approval document which was
altered prior to submission to AERT during pre-trial discovery, which also
relates to a portion of the alleged withheld discovery documentation.  The
motion seeks further discovery into Mobil's misconduct, and a new trial.  In
December 1995, the Company also moved to supplement its pending March 14, 1995
Motion with additional tampered evidence and discovery misconduct by Mobil.  The
March 14, 1995 motion is currently stayed before the Delaware Court.  The
Company filed an appeal with the U.S. Court of Appeals on July 10, 1995 on the
initial trial arguments.  In January 1996, oral arguments were presented before
the U.S. Court of Appeals.  On June, 1996, the U.S. Court of Appeals reversed a
portion of the earlier ruling and restored the validity of two of the four
patents in suit. The court let stand a portion of the earlier ruling that two of
the patents were invalid, and that Mobil did not infringe.  The Company did not
further appeal this issue to the Supreme Court. Should the Delaware Court deny
the Company's pending Prejudicial Misconduct Motion, the Company intends to
follow-up with an additional appeal on these issues.  Should the Court not rule
in favor of the Company on such motions, all appellate processes available will
be pursued.  There can be no assurance that the Company will receive a more
favorable outcome upon appeal.

In August 1994, Mobil filed a motion seeking an award of attorneys' fees and
costs in the amount of $2.7 million.  On November 1, 1994, the Court ruled that
the motion was premature and will not be considered at the present time.  In
January 1995, Mobil renewed its Motion for Attorneys' Fees.  In April 1995, the
Court requested AERT to respond to Mobil's Motion.  The Motion is currently
stayed.  With the recent appeals court ruling upholding the invalidity of two
patents and the ruling of inequitable conduct, the Company has been advised that
if and when the court decides to entertain Mobil's motion for the attorney's
fees, and if and when Mobil decides to submit documentation and substantiate its
claim, that the Company could face possible risk from an adverse decision
from the court by awarding a portion of said fees to Mobil. The Company has been
advised that it could face an aggressive challenge against it for a significant
portion of said $2.7 million attorney's fees in an attempt to end this
litigation prior to the companies prejudicial misconduct motion or pending
counterclaims against Mobil being heard. The Company will vigorously defend
against Mobil's claim for attorneys' fees and costs, however, there can be no
assurances as to the outcome of this litigation. The Company believes that the
Mobil motion for attorney's fees and the AERT prejudicial misconduct motion for
a new trial could be addressed sometime during 1997 by the Delaware Court. The 
Company has not recorded any liability related to such litigation at December 
31, 1996.

The Company feels it is also important to note that Mobil has recently divested
itself of the Trex division and reportedly sold it to members of the Trex
management group, several members of which have been involved in the litigation
against the Company.  With Mobil no longer involved with the business and
apparently no longer a competitor, the Company is evaluating the current legal
situation.

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

There were no matters submitted by the Company to a vote of security holders
during the quarter ended December 31, 1996.

                                       10
<PAGE>
 
                                    PART II

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

As of April 15, 1997, the Company's Class A Common Stock and the Company's
Redeemable Class B Warrants are traded in the over-the-counter market and are
listed on NASDAQ under the symbols AERTA and AERTZ, respectively.  In order to
remain listed on NASDAQ, the Company is required to meet certain criteria
("Maintenance Standards") established by NASDAQ.  One such Maintenance Standard
is a minimum bid price of $1.00 per share.  If the bid price per share goes
below $1.00, the security can remain on NASDAQ if the market value of the public
float (the aggregate market value of voting stock held by nonaffiliates) remains
at $1 million and the capital and surplus of the issuer is $2 million.  As of
December 31, 1996, the Company's bid price per share was below $1.00 and the
Company had total stockholders' equity of approximately $3.1 million. Unaudited
results subsequent to December 31, 1996, indicate that losses are continuing and
that the Company continues to have negative cash flows from operating
activities.  Although the Company continues to seek to raise capital from equity
sources, there can be no assurance that the Company will be able to maintain its
listing on NASDAQ.

The following table sets forth the ranges of high and low bid prices (as
reported by NASDAQ) of the Company's Class A Common Stock and Redeemable Class B
Warrants, for the years ended December 31, 1994, 1995 and 1996.  The quotations
represent prices between dealers and do not include retail markup, markdown or
commission, and do not necessarily represent actual transactions.

<TABLE>
<CAPTION>
                                                 Class A          Class B 
                                               Common Stock      Warrants 
                                               High    Low       High  Low
                                               -----  -----      ----  ---
<S>                                            <C>    <C>        <C>   <C>
Fiscal 1994                                                               
    First Quarter                               2.19    .50       .13  .03
    Second Quarter                               .88    .44       .03  .03
    Third Quarter                                .50    .19       .03  .03
    Fourth Quarter                               .56    .25       .06  .03
 Fiscal 1995                                                              
    First Quarter                                .53    .32       .06  .03
    Second Quarter                              2.06    .34        .*   .*
    Third Quarter                               2.00   1.00       .56  .13
    Fourth Quarter                              1.50    .94       .25  .09
 Fiscal 1996                                                              
    First Quarter                               1.31    .75       .19  .13
    Second Quarter                              1.63    .97       .38  .13
    Third Quarter                               1.00    .75       .13  .06
    Fourth Quarter                               .94    .34       .25  .06 
</TABLE> 

* - No established public trading market.

As of April 15, 1997, there were 1,552 record holders of Class A Common Stock
and 11 record holders of Class B Common Stock.  The number of beneficial owners
of the Class A Common Stock at April 15, 1997 is not known; however, based on
inquiries to certain brokers, management believes the number of the beneficial
owners of Class A Common Stock at April 15, 1997 was in excess of 5,000.

                                       11
<PAGE>
 
ITEM 6.      SELECTED FINANCIAL DATA

The following tables set forth selected historical data for the Company for the
years ended December 31, 1992 through 1996.  For the year ended December 31,
1996, the data was obtained from the Company financial statements contained in
this document at pages F-1 through F-24.  Data for the periods prior to December
31, 1996 was obtained from Item 6 of the Company's Annual Report or Form 10-K
for the year ended December 31, 1995.

STATEMENTS OF OPERATIONS DATA:
 
<TABLE> 
<CAPTION> 
                                             YEAR ENDED      YEAR ENDED      YEAR ENDED      YEAR ENDED      YEAR ENDED
                                          DEC. 31, 1996   DEC. 31, 1995   DEC. 31, 1994   DEC. 31, 1993   DEC. 31, 1992
                                          --------------  --------------  --------------  --------------  -------------- 
<S>                                       <C>             <C>             <C>             <C>             <C>
Sales                                        $ 6,950,219    $  5,581,172     $ 3,675,018     $ 2,043,476     $   559,886
                                             -----------    ------------     -----------     -----------     -----------
Net Loss before                          
extraordinary                            
gain                                          (2,933,698)     (2,756,263)     (2,970,135)     (3,692,773)     (3,241,158)

Extraordinary                            
gain                                              36,666               -         879,373               -               -
                                             -----------    ------------     -----------     -----------     ----------- 
Net Loss                                      (2,897,032)     (2,756,263)     (2,090,762)     (3,692,773)     (3,241,158)
                                             ===========    ============     ===========     ===========     ===========
Net Loss before                          
extraordinary gain per common share                 (.15)           (.17)           (.21)           (.34)           (.34) 
                                         
Extraordinary gain per common share                    -               -             .06               -               -
                                             -----------    ------------     -----------     -----------     ----------- 
Net Loss Per common                      
share/(1)/                                          (.15)           (.17)           (.15)           (.34)           (.34)
                                             ===========    ============     ===========     ===========     ===========
                                         
Weighted Average Number of Shares        
Outstanding/(1)/                              19,134,484      15,779,721      14,166,869      10,853,938       9,579,858
</TABLE>

                                       12
<PAGE>
 
BALANCE SHEET DATA:

<TABLE> 
<CAPTION> 
                                          DEC. 31, 1996     DEC. 31, 1995     DEC. 31, 1994     DEC. 31, 1993     DEC. 31, 1992
                                          --------------    --------------    --------------    --------------    -------------- 
<S>                                       <C>               <C>               <C>               <C>               <C> 
WORKING CAPITAL (DEFICIT)                     $(892,995)      $(1,556,805)       $ (599,753)       $ (701,142)        $  812,199
TOTAL ASSETS                                   6,725,599         7,357,742         8,781,907         9,146,981         9,925,393
LONG-TERM DEBT, LESS CURRENT MATURITIES          955,776         1,266,642         1,844,597           892,294           598,129
TOTAL LIABILITIES                              3,623,170         3,643,999         3,335,459         3,010,529         1,698,484
STOCK SUBSCRIPTION                                     -                 -                 -         1,000,000                 -
STOCKHOLDERS' EQUITY                          $3,102,379       $ 3,713,743        $5,446,448        $5,136,452        $8,226,909
</TABLE>

(1) The net loss per share of common stock is based on the combined weighted
average of shares of Class A and Class B Common Stock outstanding during the
period.  For purposes of such calculation, the 5,625,000 shares of Class B
Common Stock which were placed in escrow in connection with the public offering
in November 1989 (common stock equivalents) were not considered as outstanding
after the date of the public offering since they were contingently cancelable if
certain conditions did not occur.  On March 31, 1995, all shares of Class B
common stock held in escrow were canceled.

                                       13
<PAGE>
 
ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

Results of Operations
---------------------

Year Ended December 31, 1996 Compared To Year Ended December 31, 1995
---------------------------------------------------------------------

Net sales increased to $6,950,219 for the year ended December 31, 1996, which
represented an increase of $1,369,047 or 25% over the year ended December 31,
1995. 1996 composite sales consisted of door and window component sales of
$4,633,720, decking material sales of $1,935,849, industrial flooring sales of
$367,490, and other sales of $13,160. This compares with 1995 composite sales of
$3,770,569 for door and window components, $762,179 for decking sales, $395,252
for industrial flooring sales, and other sales of $653,172.

The increase in composite sales was primarily attributable to the addition of a
third extrusion line and related manufacturing equipment expansion which started
production during mid 1996. Although production and sales increased over prior
years, the Company was restrained in its attempt to further increase sales and
supply its customer commitments due to production limitations and inefficiencies
at the Junction, Texas composites facility. In addition, the Company experienced
significant raw material problems with its plastic supplies, created when the
Company had to purchase all plastic from outside vendors due to the extensive
fires experienced at the Rogers plastic reclamation facility in September and
December of 1996. Both fires were deemed arson by authorities. Members of
management voluntarily submitted to and passed polygraph tests after the
December fire. 

The claim regarding the September fire was settled in late 1996 for
approximately $379,000 and the Rogers plastic reclamation operation recommenced
in late November. On December 15, 1996, the undamaged portion of the Rogers
facility was then set fire and the manufacturing portion experienced extensive
damage closing the facility. As of this date, the Company has submitted a claim
for damages of $1.95 million dollars and has received a $350,000 advance from
the insurance company. The Company intends to rebuild the Rogers facility and
resume operations during the first half of 1997 and hopes to settle the second
fire claim in the near future. Although the Company has established alternate
supply sources and is currently meeting its customers minimum requirements, it
will require the Rogers facility to provide the quality, consistency, and the
volume of plastic required for the Company to continue to increase composite
sales to a level required to attain profitability.

Cost of goods sold was $7,822,154 for 1996 compared to $6,183,924 for 1995.
The increase in cost of goods sold was primarily attributed to increased sales
and increased raw material and labor costs associated with the less than
desirable operating efficiencies at the Junction facility.   The Company's
material and labor costs were adversely impacted by the quality and consistency
of the outside vendor plastic raw material that it has had to utilize and
increase purchases for due to the Rogers fires.  In addition, these costs 
increased in both real dollars and as a percent of sales due to the excessive 
scrap rates and the inefficient utilization of the regrindable scrap.
Significant categories are as follows:

                                       14
<PAGE>
 
<TABLE>
<CAPTION>
               Expense Category                         1996        1995
               ----------------                         ----        ----
               <S>                                  <C>          <C>
               Payroll and payroll taxes            $3,043,797   $2,169,987
               Depreciation                          1,194,406    1,043,804
               Raw Materials                         1,077,054      858,058
               Other                                 2,506,897    2,112,075
                                                    ----------   ----------
               Total                                $7,822,154   $6,183,924
                                                    ==========   ==========
</TABLE>

Selling, General and Administrative expenses during 1996 were $1,687,697
compared to $1,356,244 for 1995.  The increase in Selling, General and
Administrative expenses is primarily attributable to increased salaries and
professional fees.  In addition, the Company began a more extensive marketing
program for its ChoiceDek(TM) products with the goal of increasing distribution
and sales. As decking distribution increases, additional marketing expense will
be incurred to further support increased sales levels.

The net loss for 1996 was $2,897,032 or a net loss per weighted average common
share outstanding of $.15.  This compares to a loss of $2,756,263 or a net loss
per weighted average common share outstanding of $.17 for 1995. The 1996 loss
did include a one-time charge of $129,767 which related to a write off of
damaged equipment and leasehold improvements lost in the December fire in
Rogers.

Through 1995, the Company's plastics reclamation facility was involved in sales
of recycled plastics to third-party film manufacturers.  The materials desired
by these customers required substantial processing beyond that necessary to
produce raw materials for the composites facility and efficiencies of scale were
never attained.  This, coupled with increased sales of the Company's composite
products and accordingly, the composites division's increased raw material
requirements prompted the Company, in the first quarter of 1996, to discontinue
reclamation of plastics for sale to third-parties and dedicate all of the
plastic facility's production to providing materials to the Junction operation.
In connection with this restructuring of the plastics reclamation plant, the
Company exchanged certain equipment, previously utilized to produce plastics for
sale to third parties, for other equipment which was utilized to produce raw-
materials, and for additional equipment necessary to complete the installation
of a third production line at the Company's composite facility.

Composites sales for 1996 were limited by equipment and manufacturing problems
caused by tramp metal getting into both the extrusion systems and raw material
processing systems during the second half of 1996.  This evaded the Company's
cleaning and safety systems and resulted in downtime, maintenance and repair
costs, and increased scrap rates.  Law enforcement agencies are currently
investigating whether these incidents were intentional.  The Company has taken
additional security measures, including installation of surveillance cameras,
and the addition of on-site security personnel which are intended to better
protect the Company's facilities, however, there can be no assurance that such
incidents will not continue to adversely impact the Company's operations.

                                       15
<PAGE>
 
The Company has recently been put on notice and advised by its current fire
insurance carrier that due to the significant amount of loss from the two
Rogers, Arkansas fires experienced during the second half of 1996 that it had
chosen not to renew the Company's fire insurance policy when it expires in May
1997.  The Company's insurance agent has begun searching for alternative
coverage and has notified the Company that several other insurance carriers are
interested in bidding on insuring the Company's facilities provided that 24 hour
security is maintained and automatic fire protection devices are installed
around heat sources.  The Company has been advised that its deductible will most
likely be increased above the current $25,000 amount.  Although, the Company
believes that under the above mentioned conditions it can obtain insurance, as
of this date it has not yet been renewed.  Therefore, at present there can be no
assurance that it can receive fire insurance coverage, or if it does receive
coverage that it will be economical or cost effective.

Although the Company believes that reduced operating losses will continue into
the 1st Quarter of 1997, substantial reductions of unit production costs are
expected as a result of increased automation and streamlining of the Company's
operation in Junction, Texas.  The Company has also restructured its operations
management regarding the composites division, bringing in a new Chief Operating
Officer in February of 1997 to focus on improving production efficiencies and
reducing manufacturing costs.

Year Ended December 31, 1995 Compared To Year Ended December 31, 1994
---------------------------------------------------------------------

Net sales increased 52% from $3,675,018 for the year ended December 31, 1994 to
$5,581,172 for the year ended December 31, 1995.  This increase is attributable
to significant increases in sales of the Company's Composite Product division.
Composite product sales of $4,532,748 for 1995 represented a 49% increase over
the $3,049,013 in sales for 1994.

Increased sales volume from the composite manufacturing unit was the result of
sales to new customers.  The price decrease in the Company's composite products
was attributable to a significant decrease in the price of competing wood
products.  Additionally, composites sales were affected by a drop-off in U.S.
residential construction starts in February and March 1995, which resulted in
slower door and window sales in the first and second quarter.

Sales of recycled plastics were $1,048,424 in 1995 compared to $626,005 in 1994.
The increase in recycled plastics was primarily attributable to increased sales
prices and increased short-term demand for recycled plastics due to higher
prices of virgin resins during the first half of 1995.  Sales dropped
significantly beginning in the third quarter of 1995 due to the loss of a
substantial customer.

Cost of goods sold for the year-ended December 31, 1995 was $6,183,924 compared
to $4,921,378 for 1994 which reflects an increase of $1,262,546.  The most
significant reason for this increase was increased production and sales of the
composite products division.  Significant expense categories were as follows:

                                       16
<PAGE>
 
<TABLE>
<CAPTION>
               Expense Category                         1995         1994
               ----------------                         ----         ----
               <S>                                  <C>          <C>
               Payroll and payroll taxes            $2,169,987   $2,016,991
               Depreciation                          1,043,804      865,195
               Raw Materials                           858,058      545,507
               Other                                 2,112,075    1,493,685
                                                    ----------   ----------
               Total                                $6,183,924   $4,921,378
                                                    ==========   ==========
</TABLE>

Selling and Administrative Costs decreased slightly from $1,513,254 for the
year-ended December 31, 1994 to $1,356,244 for 1995.  The decrease is Selling,
General and Administrative and is primarily attributed to decreased legal
expenses.

In March 1994, Dow Chemical and the Company reached an agreement whereby Dow
Chemical's obligation to purchase material from the Company (10 million pounds
of the Company's recycled plastic bag film resins) was terminated.  In
consideration for this release, Dow forgave the repayment of the $456,158
outstanding advance payment.  In addition, Dow Chemical paid the Dow Credit
Corporation and forgave the Company's outstanding balance of $359,998 principal
plus accrued interest under a loan agreement between Dow Credit and the Company.
Further provisions of the agreement include the contribution in the amount of
$50,000 of Dow-owned laboratory equipment to the Company and continued technical
assistance from Dow Chemical.  Accordingly, the Company has recognized an
extraordinary gain primarily from the retirement of debt in the amount of
$879,373.

The net loss for the year ended December 31, 1995 was $2,756,263, or $.17 per
share.  This compares with a loss of $2,090,762, or $.15 per share, for the year
ended December 31, 1994.

Liquidity and Capital Resources
-------------------------------

At December 31, 1996, the Company had a working capital deficit of $892,995
compared to a working capital deficit of $1,566,805 at December 31, 1995.  The
decreased deficit is primarily attributable to the Company's 1996 recording of a
receivable from the insurance company regarding the Rogers fire at book value,
which management believes is less than replacement cost and re-capitalization
efforts through private placements of Class A common stock.  Cash and cash
equivalents increased $67,406 in 1996.  Significant components of that increase
were: (i) cash used in operating activities of $1,161,077, which consisted of
the net loss for the period of $2,897,032 reduced by depreciation and
amortization of $1,212,323, loss on disposition of equipment of $178,061, and
other sources of cash of $345,571; (ii) cash used in investing activities of
$830,328, and (iii) cash provided by financing activities of $1,922,812.
Payments on notes during the period were $732,011 and proceeds from the
issuance's of notes amounted to $369,155. At December 31, 1996, the Company had
notes payable in the amount of $1,722,679, of which $705,344 were current notes
payable or current portion of long-term debt.  On November 1, 1995, the Major
Stockholders and certain non-affiliated shareholders exercised 1,630,496 Class F
Warrants.  The proceeds from the exercise of these warrants, which amounted to
$994,603, reduced the working capital deficit of the Company and were used to
reduce current liabilities.  In January 1996, the major stockholder exercised
500,000 Class F Warrants which provided an additional $305,000 which reduced
current liabilities and the working capital deficit of the Company.

During the second quarter of 1996 the Company began an expansion project at the
Junction, Texas facility and added a third extrusion line in an attempt to
positively address increasing sales and a growing customer order backlog.  The
Company expended approximately $800,000 which is still ongoing into 1997.  To
finance this expansion in addition to providing additional working capital the
Company completed a private placement offering in June of 1996 to qualified
foreign investors under Regulation S of the Securities Act of 1993 with the

                                       17
<PAGE>
 
issuance of 1,666,893 shares of Class A Common Stock.  Net offering proceeds
consisted of $1,146,000 in cash.  As part of the offering, the Company has
issued 242,878 Class I Warrants to the Stock Placement Distributor.  The Class I
Warrants expire three years from the date of issue and are exercisable at prices
from $0.9375 to $1.125 per share of  Class A Common Stock for each Class I
Warrant exercised.

In May 1996, the Company completed a Private Placement Offering with the 
issuance of 338,624 shares of Class A Common Stock. Net offering proceeds 
consisted of $200,000 in cash.

During September 1996, the Company received $500,000 in cash relating to an
offering to qualified foreign investors under Regulation S of the Securities Act
of 1993 with the issuance of the 762,194  shares of Class A Common Stock
completed in October 1996.  In December 1996, the Company received $185,000 in
cash relating to an offering to qualified foreign investors under Regulation S
of the Securities Act of 1993 with the issuance of 228,571 Class A Common Stock
completed in December 1996 and the remaining shares to be issued in 1997.

The Company maintains an accounts receivable factoring agreement for up to
$700,000 through an affiliated company of a related party.  The terms of this
agreement call for the factor to advance 99.12% of the total of invoices
presented by the Company and for the Company to indemnify the factor against
loss of the amounts advanced. At December 31, 1996, $712 was available to factor
additional receivables. The Company also secured a line of credit from the Major
Stockholders during 1994 which provided approximately $981,000 of additional
cash for general corporate purposes through January 1995. In February 1995, this
obligation was restructured, converting the amount previously advanced as of
that date ($1,566,903) into long-term note payable and providing an additional
$433,097 revolving line of credit to be available as needed. As of December 31,
1996, the total amount of the line was available.

Due to the Rogers fires, and to increasing customer demand, the Company must now
rebuild the Rogers facility in conjunction with further expansion of its
composite facilities during 1997. The Company is currently planning to upgrade
its finishing and paint department in Junction, Texas and add a fourth extrusion
line during 1997. The Company currently intends to obtain approximately $2.2
million in financing through a preferred stock placement to institutional
investors. The preferred shares will pay a 10% dividend and will be convertible
into Class A common stock. The Company will file a registration statement under
Regulation D with the Securities and Exchange Commission. The Company believes
that if it can improve the production rates and efficiencies it is experiencing
as of the date of this filing in conjunction with rebuilding its Rogers Plastic
Reclamation Facility and further improve production efficiencies, it will be
able to achieve a level of operations in periods subsequent to the first quarter
of 1997 and thereafter which will significantly reduce or eliminate the need for
additional sources of capital to support its operations. Management believes
that increased sales obtained with a third composite line operating for a full
year and later fourth composites line to be completed by the third quarter 1997,
in conjunction with reduced plastics division costs will allow it to attain
profitability. As such, the Company believes it will be able to continue
operating as a going concern for at least the following twelve months. Continued
improvements in production efficiency and capacity as previously discussed will
be required for the Company to increase sales levels to those necessary to
attain profitable results of operations and provide funds to repay the Company's
outstanding obligations. There can be no assurance that such improvements in
production efficiency or capacity will be achieved by the Company.

While it is not anticipated that significant additional capital expenditures in
addition to those discussed above will be required during 1997, management is
currently evaluating plans to better position the Company to address potential
increasing sales opportunities on a timely basis. This could require significant
additional composite production capacity beyond that of the existing Junction
facility and require additional funds for capital expenditures. Therefore, the
Company has entered into a licensing and joint venture arrangement for
additional composite manufacturing capacity with Sutton Engineered Wood
Products. The Company has limited sources of equity financing other than
discussed above to fund any additional capital expenditures, if necessary. One
such source of financing could consist of certain of the Company's outstanding
warrants. The Company has currently outstanding, approximately 4.2 million Class
B Warrants with an exercise
                                       18
<PAGE>
 
price of $3.00. The expiration date of the Class B Warrants has been extended to
December 31, 1997. The Company also has outstanding 1,167,584 Private Placement
Warrants held by non-affiliated entities, which, if exercised by holders, could
generate equity capital for the Company (See Note 10 to the Financial
Statements). The receipt of additional funds by the Company upon exercise of any
such warrants, however, is subject to a number of contingencies, including, but
not limited to, (i) compliance with applicable federal and state securities
laws, (ii) the desire and ability of the holders to exercise their warrants,
(iii) the market price of the Company's stock, and (iv) status of the Company's
business.

The foregoing plan is not intended to satisfy the long-term cash needs of the
Company; rather the plan assumes that the Company will achieve and maintain
positive operating cash flows throughout the future.  There can be no assurance
that the Company will be able to maintain its current operating levels or
achieve increased production volumes and sales levels or that the Company could
obtain additional capital resources to support manufacturing operations if
required.

If the Company is unable to achieve and maintain a successful level of
operations in the near future or unable to secure additional debt or equity
financing to provide support to ongoing operations, or were it to be assessed
the Mobil legal claims described in Note 14 to the financial statements, it is
likely the Company will be unable to continue as a going concern.  (See Note 2
to the accompanying financial statements)


ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The response to this item is submitted in a separate section of this report.


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

There have been no disagreements on accounting and financial disclosures with
accountants during the periods reported upon herein.

                                       19
<PAGE>
 
                                   PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The directors and executive officers of the Company are as follows:

<TABLE>
<CAPTION>
     NAME                      AGE          POSITION
     ----                      ---          --------
     <S>                       <C>          <C>
     Sal Miwa                  40           Chairman of the Board
     Stephen W. Brooks         40           Chief Executive Officer and Director
     Joe G. Brooks             41           President and Director
     Grant Martin              49           Chief Operating Officer
     Phillip W. Hyde           56           Vice President of Composites
     Marjorie S. Brooks        61           Director
     Jerry B. Burkett          41           Director
     Dr. James H. Culp         51           Director and Special Board Assistant
                                            to the CEO
</TABLE>

Chairman of the Board and Chief Executive Officer Jim G. Brooks passed away
unexpectedly on January 16, 1996.

On January 30, 1996, Sal Miwa was elected as its Chairman by the Company's Board
of Directors to serve the remaining term of the late Jim Brooks.  Mr. Miwa has
been an outside director of the Company for the past two years.  Sal Miwa is
President of Optro-Mechanics (USA) Corporation, an import-export firm located in
Pearl River, New York.  For the past 15 years he has been engaged in various
international businesses and serves as a director and an officer of various
other family owned businesses located in U.S., Japan, and Europe.  He received
his Science Master degree in Aerospace Engineering from the Massachusetts
Institute of Technology.

Stephen W. Brooks was appointed to the Board of Directors of the Company on
January 30, 1996 and elected Chief Executive Officer on August 26, 1996.  Mr.
Brooks is President of Razorback Farms, Inc., a Springdale, Arkansas based firm
that specializes in vegetables for processing.  Mr. Brooks also serves on the
Boards of Razorback Farms, Inc. and The Ozark Food Processors Association.

Joe G. Brooks has served as President, Chief Executive Officer (until September
28, 1993) and a director since the Company's inception in December 1988.  From
July 1985 to December 1988, Mr. Brooks also served as President and a director
of Juniper Products, Inc. (July 1985 - February 1987) and served as an
independent consultant to Juniper Industries, Inc. (February 1987 - December
1988), artificial firelog manufacturing entities in Junction, Texas.  See
"Certain Transactions."  From October 1984 to July 1985, Mr. Brooks served as
President of Southern Minerals and Fibers, Inc. ("SMF"), a producer of drilling
mud and fluid additives.

J. Grant Martin joined the Company on February 24, 1996.  As Chief Operating
Officer, he assumes day-to-day control and operating responsibilities over the
Company's composite manufacturing facility in Junction, Texas.  Mr. Martin has
extensive technical and manufacturing experience with companies in the United
States and overseas.  Mr. Martin was previously employed as Vice-President of
operations of a large Texas manufacturing facility and prior to that served as a
Vice-President of Operations for a national engineering testing company.

Marjorie S. Brooks served as Secretary and Treasurer and a director since the
Company's inception in December 1988.  On March 9, 1993, Mrs. Brooks submitted
her resignation as a director for personal health reasons.  Mrs. Brooks also
serves as a director of Juniper Industries, Inc. and Razorback Farms, Inc., has
served as Secretary 

                                       20
<PAGE>
 
and Treasurer of the Brooks Investment Co., a holding company for the Brooks'
family investments, for more than the past thirty years, and has served as
President of Haskell Foods, Inc. from 1981 to the present.

Jerry B. Burkett was appointed to the Board of Directors of the Company on May
17, 1993.  Mr. Burkett has been a rice and grain farmer since 1979 and has been
a principal in other closely held businesses.  He is currently the President of
the Arkansas County Farm Bureau.

Dr. Culp received a B.S. Degree in Chemistry from the University of Alabama and
Ph.D. Degree in Analytical and Nuclear Chemistry from Texas A&M University.  Dr.
Culp was an Assistance Professor at Texas A&M University Chemical Oceanography
for two years before joining The Dow Chemical Company.  Dr. Culp worked at Dow
in research, manufacturing, business development, and supply chain for 23 years.
His last responsibility at Dow was North American Supply Chain Director for
Engineering Thermoplastics and North American Recycle Plastics Director.  Dr.
Culp retired from Dow in April, 1996.  He joined the AERT Board as Director of
Technology in July, 1996 and joined AERT as Special Board Assistant to the Chief
Executive Officer in October, 1996.

Joe G. Brooks and Stephen W. Brooks are brothers and are sons of  Marjorie S.
Brooks.  There are no other familial relationships between the current directors
and executive officers.

Each of the Company's directors have been elected to serve until the next annual
meeting of stockholders or until their successors are elected and qualified.
Officers serve at the discretion of the Board of Directors.

The Audit Committee of the Board of Directors consists of Jerry B. Burkett
(Chairman), Joe G. Brooks, and Sal Miwa.  The Audit Committee recommends
engagement of the Company's independent accountants and is primarily responsible
for approving the services performed by the Company's independent accountants
and for reviewing and evaluating the Company's accounting principles and its
system of internal accounting controls.

The Stock Option Committee, consists of Jerry B. Burkett (Chairman), Sal Miwa,
and Marjorie S. Brooks.  The Stock Option Committee administers the Company's
stock option plans on behalf of the Board of Directors and approves stock
options granted thereunder.

                                       21
<PAGE>
 
ITEM 11.  EXECUTIVE COMPENSATION

The following table sets forth the aggregate cash compensation paid by the
Company during the three years ended December 31, 1996 to each executive officer
of the Company whose aggregate cash compensation exceeded $100,000, and to the
chief executive officer.



                          SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
           Annual Compensation                                 Long-Term Compensation
           -------------------                                 ----------------------
                                                                       Awards                              Payouts
                                                                       ------                              -------

                                                             Restricted      Securities              Long-term
Name and                                         Other      Annual Stock     Underlying              Incentive     All Other
Principal Position          Year       Salary    Bonus      Compensation       Awards      Options    Payouts     Compensation
------------------          ----       ------    -----      ------------       ------      -------    -------     ------------
<S>                         <C>        <C>       <C>        <C>              <C>           <C>       <C>          <C>
Stephen W. Brooks           1996         $0       $0             $0              $0            0         $0            $0
Jim G. Brooks,              1995         $0       $0             $0              $0            0         $0            $0
Chief Executive             1994         $0       $0             $0              $0         500,000      $0            $0
Officer (9/28/93)                                                                              0 
and Chairman of                                          
the Board of
Directors
</TABLE>


          AGGREGATED OPTION EXERCISES IN YEAR ENDED DECEMBER 31, 1995
                    AND OPTION VALUES AT DECEMBER 31, 1996

<TABLE>
<CAPTION>
                                                 Number of               Value of Unexercised       
                    Number of                    Unexercised Options     In-the-Money Options     
                    Shares                       at December 31, 1995    at December 31, 1995     
                    Acquired        Value        Exercisable/            Exercisable/             
Name                on Exercise     Realized     Unexercisable           Unexercisable             
-----------------------------------------------------------------------------------------------
<S>                 <C>             <C>          <C>                     <C>
Stephen W. Brooks       0             $0         25,000/25,000               $0/$0
</TABLE>
                                        
                                        

                                       22
<PAGE>
 
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

The Board of Directors of the Company does not currently maintain a Compensation
Committee.  Accordingly, the Board of Directors, as a whole, reviews and acts
upon personnel policies and executive compensation matters.  Joe G. Brooks and
Stephen W. Brooks serve as executive officers of the Company; however such
individuals do not participate in compensation decisions or in forming
compensation policies in which they have a personal interest, nor do they vote
on any such matter.

LIMITED LIABILITY OF OFFICERS AND DIRECTORS

The Delaware Supreme Court has held that a director's duty of care to a
corporation and its stockholders requires the exercise of an informed business
judgment.  Having become informed of all material information reasonably
available to them, directors must act with requisite care in the discharge of
their duties.  The Delaware General Corporation law permits a corporation
through its Certificate of Incorporation to exonerate its directors from
personal liability to the corporation or its stockholders for monetary damages
for breach of the fiduciary duty of care as a director, with certain exceptions.
The exceptions include a breach of the director's duty of loyalty, acts or
omissions not in good faith or which involve intentional misconduct or knowing
violations of law, improper declarations of dividends and transactions from
which the directors derived an improper personal benefit.  The Company's
Certificate of Incorporation exonerates its directors, acting in such capacity,
from monetary liability to the extent permitted by this statutory provision.
The limitation of liability provision does not eliminate a stockholder's right
to seek nonmonetary, equitable remedies such as injunction or rescission to
redress an action taken by directors.  However, as a practical matter, equitable
remedies may not be available in all situations and there may be instances in
which no effective remedy is available.

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

The following table sets forth, as of December 31, 1996, certain information
with regard to the beneficial ownership of the Company's capital stock by each
holder of 5% or more of the outstanding stock, by each director of the Company,
and by all officers and directors as a group:

<TABLE>
<CAPTION>
========================================================================================================================
Name and Address                  Title of          Number of Shares        Percentage of Class       Percentage of     
of Beneficial Owner               Class(1)         of Common Stock(2)        Outstanding (2)(9)     Voting Power (2)(9) 
-------------------               --------         ------------------        ------------------     ------------------   
------------------------------------------------------------------------------------------------------------------------   
<S>                               <C>              <C>                       <C>                    <C>                 
Marjorie S. Brooks                Class A               9,525,331 (3)               26.7%                 38.4%         
P.O. Box 1237                     Class B                 837,588 (4)               57.2%                               
Springdale, AR  72764                                                                                                   
------------------------------------------------------------------------------------------------------------------------       
Joe G. Brooks                     Class A                  505,601(5)                1.4%                  5.1%         
950 North 2nd Street              Class B                  266,896                  18.2%                               
Rogers, AR  72756                                                                                                       
------------------------------------------------------------------------------------------------------------------------   
J. Douglas Brooks                 Class A                  429,666(6)                1.2%                  3.0%         
950 North 2nd Street              Class B                  131,051                   8.9%                               
Rogers, AR  72756                                                                                                       
------------------------------------------------------------------------------------------------------------------------   
Jerry B. Burkett                  Class A                   84,000(7)                *                     *         
1908 Oak                          Class B                   33,311                   *                     
Stuttgart, AR  72160                                                                                                    
------------------------------------------------------------------------------------------------------------------------   
Sal Miwa                          Class A                   53,000(8)                *                     *          
One Blue Hill Plaza, Suite 815
Pearl River, NY  10965-8667
------------------------------------------------------------------------------------------------------------------------    
Stephen W. Brooks                 Class A                   326,616                  1.0%                  2.2%
P.O. Box 291                      Class B                    89,311                  6.1%
Springdale, AR 72765
------------------------------------------------------------------------------------------------------------------------    
All officers and directors        Class A                10,924,214                 30.6%                 44.6%
as a group (six persons)          Class B                 1,358,157                 92.7%
------------------------------------------------------------------------------------------------------------------------   
* Less than 1%
========================================================================================================================
</TABLE>

(1)  The Class B Common Stock is substantially identical to the Class A Common
Stock, except that each share of Class B Common Stock has five votes per share
and each share of Class A Common Stock has one vote per share.

(2)  Beneficial ownership of shares determined in accordance with Rule 13d-
3(d)(1) of the Exchange Act and includes shares underlying outstanding warrants
and options which the named individual has the right to acquire within sixty
days of December 31, 1995.

                                       24
<PAGE>
 
(3)  Includes 4,023,715 shares owned directly, 200,000 shares issuable upon
exercise of stock options, 3,000 shares issuable upon exercise of Class B
Warrants, 325,000 shares issuable upon exercise of Class C Warrants issued in
connection with a $225,000 Bridge Note purchased in 1993, 5,306,304 shares
issuable upon exercise of Class F and Class G Warrants issued in connection with
a private placement of Class A Common Stock in May of 1994 and 2,000,000 shares
issuable upon exercise of Class H Warrants.

(4)  Includes 403,946 shares owned directly by Mrs. Brooks and 433,642 shares
owned by two corporations controlled by Mr. and Mrs. Brooks. (Razorback Farms,
Inc. is the record owner of 312,320 shares and SMF is the record owner of
121,322 shares, representing approximately 21.3% and 8.3%, respectively, of the
Class B Common Stock).  Excludes additional shares owned by adult children of
Mr. and Mrs. Brooks, including Joe G. Brooks and J. Douglas Brooks, as to which
she disclaims a beneficial interest.

(5)  Includes 86,552 shares owned directly, 3,000 shares owned as custodian for
Mr. Brook's minor child, 43,500 shares issuable upon exercise of Class B
Warrants owned directly and as custodian for Mr. Brook's minor child and 33,333
shares issuable upon exercise of stock options.

(6)  Includes 34,997 shares owned directly, 7,620 shares issuable upon exercise
of Class B Warrants and 33,333 shares issuable upon exercise of stock options.

(7)  Includes 3,000 shares owned directly, 2,000 shares owned by Mr. Burkett as
custodian for his minor child, 10,000 shares owned by a partnership controlled
by Mr. Burkett, 19,000 shares issuable upon exercise of Class B Warrants
directly and indirectly owned by Mr. Burkett and 50,000 shares issuable upon
exercise of stock options.

(8)  Includes 3,000 shares owned directly and 50,000 shares issuable upon
exercise of stock options.

(9)  Calculated based on 35,736,853 shares outstanding as of December 31, 1996,
which includes 15,070,175 shares which any person has the right to acquire
through the exercise of options and warrants within 60 days of December 31,
1995.

At April 15, 1997, there were 19,201,148 shares of Class A Common Stock and
1,465,530 shares of Class B Common Stock issued and outstanding.  At that date,
the directors and officers as a group directly owned shares representing
approximately 49.6% of the votes entitled to be cast upon matters submitted to a
vote of the Company's stockholders, and Marjorie S. Brooks and corporations
controlled by her owned shares representing approximately 38.4% of the votes
entitled to be cast and may be in a position to control the Company.

                                       25
<PAGE>
 
ESCROW SHARES

In connection with the Company's initial public offering, and at the request of
D.H. Blair, the underwriter in such offering, the holders of the Company's Class
B Common Stock agreed with the Company to place in escrow an aggregate of
5,625,000 shares of the Company's Class B Common Stock (the "Escrowed Shares")
pursuant to an escrow agreement with the Company and American Stock Transfer &
Trust Company as escrow agent.  Such shares were placed in escrow by each holder
of Class B Common Stock on a pro rate basis according to their respective
holdings.  Upon the occurrence of certain events, the Escrowed Shares were to be
released from escrow and returned to the Class B stockholders if during the
calendar year ended December 31, 1994 (1) the Company's minimum pretax income
was at $16 million or (2) the market price of the Company's Class A Common Stock
averaged in excess of $6.50 per share for twenty consecutive trading days.  The
Company did not achieve any of the above requirements, and, as such, the
Escrowed Shares were contributed to the Company's treasury on March 31, 1995 and
then canceled.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

On June 29, 1993 the Company circulated a private placement offering of up to
$1,200,000 in Bridge Notes and Class C Warrants.  The Notes are secured by
certain equipment of the Company's composite production division, bear interest
at the rate of 8% per annum, and mature June 29, 1994.  The face amount of each
Bridge Note is accompanied with an equal number of Class C Warrants which are
exercisable ratably into one share of Class A Common Stock at an exercise price
of $3.00 per share.  The Warrants expire on June 29, 1998.  Jim G. and Marjorie
Brooks participated in the Bridge Offering in the amount of $225,000.

In April 1994, the Company renewed an agreement with an affiliate whereby the
Company agreed to sell certain of its trade receivables which the affiliate
deems acceptable, up to $650,000 at any one time.  Upon acceptance of a sale of
a receivable, the affiliate will remit to the Company 100% of the receivable, as
defined in the agreement, and the Company shall remit to the affiliate .88% as a
factoring charge.  The Company will indemnify the affiliate for any loss arising
out of rejections or returns of any merchandise, or any claims asserted by the
Company's customers.  During 1995, the Company sold an aggregate of
approximately $5,852,000 in receivables under this agreement, of which $241,723
remains to be collected.  During 1994 and 1993, the Company sold an aggregate of
approximately $3,726,000 and $1,018,000, respectively, in receivables under this
agreement, none of which remains to be collected.  Costs of approximately
$51,000, $32,800 and $9,000 associated with the factoring agreement are included
in selling, production, general and administrative expenses at December 31,
1995, 1994 and 1993, respectively.

In July 1994, the Company obtained a $1,000,000 secured line of credit bearing
interest at the rate of 8.5% per annum from Jim G. and Marjorie S. Brooks at
December 31, 1994 the Brooks had advanced the $1,000,000 plus an additional
$411,903.  In February 1995, the line of credit was increased to $2,000,000 of
which $1,566,903 is a term-note to be amortized at 9.75% over five years
beginning April 1, 1995 and the balance of $433,097 is a revolving credit line
expiring in February 2000 available as needed by the Company.

                                       26
<PAGE>
 
                                    PART IV


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

     (a1), (a2), and (d).  The Financial Statements listed in the accompanying
Index to Financial Statements are filed as part of this report and such Index is
hereby incorporated by reference.  All schedules for which provision is made in
the applicable accounting regulation on the Securities and Exchange Commission
are not required under the related instructions or are inapplicable, and
therefore have been omitted.

     (a3) and (c).  The exhibits listed in the accompanying Index to Exhibits
are filed or incorporated by reference as part of this report and such Index is
hereby incorporated by reference.

     (b) No reports on Form 8-K were filed during the last quarter of the period
covered by this report.

                                       27
<PAGE>
 
                                  SIGNATURES

Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized, in the City of Springdale, State
of Arkansas, on the 15th day of April, 1997.


ADVANCED ENVIRONMENTAL RECYCLING
TECHNOLOGIES, INC.


BY: /S/ Joe G. Brooks                        /S/ Jake M. Bushey
------------------------------               -------------------------
  JOE G. BROOKS,                             JAKE M. BUSHEY,
  President                                  Corporate Controller

Date: April 15, 1997                         April 15, 1997
      --------------                         --------------

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

<TABLE>
<CAPTION>
Signature                    Title                                    Date          
---------                    -----                                    ----          
<S>                          <C>                                      <C>           
                                                                                    
/S/ Sal Miwa                 Chairman of the Board                    April 15, 1997
----------------------                                                               
SAL MIWA                                                                            
                                                                                    
                                                                                    
/S/ Joe G. Brooks            President and Director                   April 15, 1997
----------------------                                                               
JOE G. BROOKS                                                                       
                                                                                    
                                                                                    
/S/ Jerry B. Burkett         Director                                 April 15, 1997
----------------------                                                               
JERRY B. BURKETT                                                                    
                                                                                    
                                                                                    
/S/ Stephen W. Brooks        Chief Executive Officer and Director     April 15, 1997
----------------------
STEPHEN W. BROOKS                                                                   

                                                                                    
/S/ Marjorie S. Brooks       Director                                 April 15, 1997 
----------------------
MARJORIE S. BROOKS
</TABLE>

                                       28
<PAGE>
 
                                INDEX TO EXHIBITS
                                        
<TABLE>
<CAPTION>
                                                                                      Sequential
Exhibit No.    Description of Exhibit                                                Page Number 
-----------    ----------------------                                                -----------
<S>            <C>                                                                   <C> 
3.1            Certificate of Incorporation, including Certificate of       
               Amendment filed on June 12, 1989(a), and Certificate of      
               Amendment filed on August 22, 1989.(b)                       
3.2            Certificate of Designation of Class B Common Stock.(a)       
3.3            Bylaws of Registrant.(a)                                     
4.1            Form of Class A Common Stock Certificate.(c)                 
4.2            Form of Class B Common Stock Certificate.(a)                 
4.3            Form of Warrant Agreement with American Stock Transfer       
               & Trust Company, including Class A and Class B Common        
               Stock Purchase Warrants.(a)                                  
4.7            Form of Redeemable Class B Warrant Certificate.(c)           
4.8            Form of Class C Warrant Certificate.(h)                      
4.9            Form of Class D Warrant Certificate.(h)                      
4.10           Form of Class E Warrant Certificate.(h)                      
4.11           Form of Class F Warrant Certificate.(i)                      
4.12           Form of Class G Warrant Certificate.(i)                      
4.13           Form of Class H Warrant Certificate.(j)                      
4.14           Form of Class I Warrant Certificate.(k)                      
4.15           Form of Class J Warrant Certificate.(l)                      
4.16           Form of Class K Warrant Certificate.(m)                      
10.9           Form of Right of Refusal Agreement among Class B             
               Common Stockholders.(a)                                      
10.10          1989 Stock Option plan.(a)                                   
10.11          Form of Escrow Agreement with American Stock Transfer &      
               Trust Company.(c)                                            
10.15          Lease Agreement dated June 1, 1990 between the Registrant    
               and J's Feed, Inc. for the Registrant's plastics reclamation 
               facility.(e)                                                 
10.16          Loan Agreement dated June 13, 1991 with Dow Credit           
               Corporation.(f)                                              
10.16          Loan Agreement dated October 22, 1991 with Dow Credit        
               Corporation.(f)                                              
10.16          Loan Agreement with City of Rogers, arranged through         
               Arkansas Industrial Development Commission.(f)               
10.17          Lease Agreement dated June 15, 1992 between the Registrant and
               George's, Inc. for the Registrant's corporate office facility.(g)
10.18          Factoring Agreement dated April 30, 1993 between the Registrant
               and Brooks Investment Company.(h)
10.23          Private Placement Distribution Agreement dated September 23, 1993
               between the Registrant and Berkshire International Finance,
               Inc.(h)
10.26          Lease Agreement dated June 16, 1994 between Registrant and
               Marjorie S. Brooks.(i)
10.27          Line of Credit Promissory Note payable to Jim G. Brooks and
               Marjorie S. Brooks.(i)
10.28          Amended and Restated Stock Option Plan.(i)
</TABLE> 

                                       29
<PAGE>
 
<TABLE> 
<S>            <C> 
10.29          Non-Employee Director Stock Option Plan.(i)
10.30          Chairman Stock Option Plan.(i)
10.31          Factoring Agreement dated April 30, 1994 between the Registrant
               and Brooks Investment Company.(i)
</TABLE> 

_____________

*    The Registrant has no exhibits corresponding to Exhibits 1, 2, 5, 6, 7, 8,
     9, 11, through 23, or 26 through 29.
(a)  Contained in Exhibits to Registration Statement on Form S-1, No. 33-29595,
     filed June 28, 1989.
(b)  Contained in Exhibits to Amendment No. 1 to Registration Statement on Form
     S-1, No. 33-29595, filed August 24,1989.
(c)  Contained in Exhibits to Amendment No. 2 to Registration Statement on Form
     S-1, No. 33-29595, filed November 8, 1989.
(d)  Filed with Form 10-K for December 31, 1989.
(e)  Filed with Form 10-K for December 31, 1990.
(f)  Contained in Exhibits to Post Effective Amendment No. 1 to Registration
     Statement on Form S-1, No. 33-29593, filed December 24, 1991.
(g)  Filed with Form 10-K for December 31, 1992.
(h)  Filed with Form 10-K for December 31, 1992.
(i)  Filed herewith with Form 10-K for December 31, 1994.
(j)  Filed herewith with Form 10-K for December 31, 1996.
(k)  Filed herewith with Form 10-K for December 31, 1996.
(l)  Filed herewith with Form 10-K for December 31, 1996.
(m)  Filed herewith with Form 10-K for December 31, 1996.

                                       30
<PAGE>
 
                          ANNUAL REPORT ON FORM 10-K

                  ITEM 8, ITEM 14(A)(1) AND (2), (C) AND (D)

                         LIST OF FINANCIAL STATEMENTS

                               CERTAIN EXHIBITS

                         YEAR ENDED DECEMBER 31, 1996

              ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

                             SPRINGDALE, ARKANSAS

                                       31
<PAGE>
 
             ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC. 

                         INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                 Page
                                                                 ----
<S>                                                              <C>
Financial statements:
     Report of Independent Public Accountants                    F-2       
     Balance sheets                                              F-3 - F-4
     Statements of operations                                    F-5       
     Statements of stockholders' equity                          F-6 - F-7
     Statements of cash flows                                    F-8       
     Notes to financial statements                               F-9 - F-26
</TABLE>

                                       32
<PAGE>
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To the Board of Directors and Stockholders of
Advanced Environmental Recycling Technologies, Inc.:

We have audited the accompanying balance sheets of Advanced Environmental
Recycling Technologies, Inc. (a Delaware corporation), as of December 31, 1996
and 1995, and the related statements of operations, stockholders' equity and
cash flows for each of the three years in the period ended December 31, 1996.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Advanced Environmental
Recycling Technologies, Inc., as of December 31, 1996 and 1995, and the results
of its operations and its cash flows for each of the three years in the period
ended December 31, 1996, in conformity with generally accepted accounting
principles.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern.  As reflected in the accompanying
financial statements, the Company has not generated significant operating
revenues, has incurred net losses since inception, has a working capital deficit
at December 31, 1996, and is subject to certain claims in litigation as
discussed in Note 14.  Further, unaudited information subsequent to December 31,
1996 indicates that losses are continuing.  These factors, among others, as
discussed in Note 2, raise a substantial doubt about the ability of the Company
to continue as a going concern.  Management's plans in regard to these matters
are also described in Note 2.  The financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or the amount and classification of liabilities that might result should
the Company be unable to continue as a going concern.


                                                        /s/  ARTHUR ANDERSEN LLP


San Antonio, Texas
March 14, 1997

                                    33(F-2)
<PAGE>
 
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

BALANCE SHEETS

<TABLE>
<CAPTION>
                                                            ASSETS
                                                            ------
                                               December 31,         December 31,
                                                   1996                 1995
                                                   ----                 ----
<S>                                            <C>                  <C>
Current assets:
 Cash and cash equivalents                     $     82,756         $     15,350
 Receivables:
   Insurance                                      1,001,657                    -
   Trade                                              9,280               48,463
 Inventories                                        593,325              648,211
 Prepaid expenses and other                          87,381              108,528
                                               ------------         ------------
  Total current assets                            1,774,399              820,552
                                               ------------         ------------

Buildings and equipment,                     
  at cost, including construction                                     
  in progress of $838,709 (1996) and
  $22,946 (1995):
 Buildings                                          687,509              675,420
 Machinery and equipment                          6,791,709            7,985,870
 Transportation equipment                           135,527              112,411
 Office equipment                                   172,597              170,659
 Leasehold improvements                                   -              315,331
                                               ------------         ------------
                                                  7,787,342            9,259,691

 Less accumulated depreciation
  and amortization                                3,182,679            3,050,979
                                               ------------         ------------
  Net buildings and equipment                     4,604,663            6,208,712
                                               ------------         ------------
Other assets, at cost less                                                      
 accumulated amortization of                                                    
 $107,798 (1996) and $83,058 (1995)                 346,487              328,478
                                               ------------         ------------
Total assets                                   $  6,725,549         $  7,357,742
                                               ============         ============
</TABLE>

The accompanying notes to the financial statements should be read in conjunction
with these statements.

                                    34(F-3)
<PAGE>
 
                     LIABILITIES AND STOCKHOLDERS' EQUITY
                     ------------------------------------

<TABLE>
<CAPTION>
                                                            December 31,   December 31,
                                                                1996           1995    
                                                                ----           ----   
<S>                                                         <C>            <C>         
Current liabilities:                                                                   
 Accounts payable - trade                                   $  1,224,711   $  1,078,243
 Accounts payable - related parties                              468,715        362,155
 Current maturities of long-term debt                            705,344        755,576
Accrued liabilities                                              207,065        166,779
 Notes payable                                                    61,559         14,604
                                                            ------------   ------------
  Total current liabilities                                    2,667,394      2,377,357
                                                            ------------   ------------
Long-term debt, less current maturities -                                              
 Related parties                                                 799,554      1,102,554
 Other                                                           156,222        164,088
                                                            ------------   ------------
Total long-term debt                                             955,776      1,266,642
                                                            ------------   ------------
                                                                                      
Commitments and contingencies                                                          
                                                                                      
Stockholders' equity:                                                                  
 Preferred stock, $1 par value; 5,000,000                              -              -
  shares authorized, none issued                                                       
 Class A common stock, $.01 par value;                                                 
  50,000,000 shares authorized, 19,201,148 (1996)                192,012        156,929
  and 15,692,866 (1995) issued and outstanding                                         
 Class B convertible common stock, $.01 par value;                                     
  7,500,000 shares authorized, 1,465,530 (1996) and                                    
  1,465,530 (1995) issued and outstanding                         14,655         14,655
 Additional paid-in capital                                   21,533,450     19,282,865
 Accumulated deficit                                         (18,637,738)   (15,740,706)
                                                            ------------   ------------
 Total stockholders' equity                                    3,102,379      3,713,743                   
                                                            ------------   ------------
Total liabilities and stockholders' equity                  $  6,725,549   $  7,357,742
                                                            ============   ============
</TABLE>

The accompanying notes to the financial statements should be read in conjunction
with these statements.

                                    35(F-4)
<PAGE>
 
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
STATEMENTS OF OPERATIONS
 
<TABLE> 
<CAPTION> 
                                           Year ended     Year ended     Year ended
                                          December 31,   December 31,   December 31,
                                                1996           1995           1994
                                                ----           ----           ----
<S>                                       <C>            <C>            <C>
Sales                                      $ 6,950,219    $ 5,581,172    $ 3,675,018
 
Cost of Goods Sold                           7,822,154      6,183,924      4,921,378
                                             ---------      ---------      ---------

Gross Margin                                  (871,935)      (602,752)    (1,246,360)
                                                                                    
Loss on Disposal of Assets                     178,061        528,538              -
                                                                                    
Selling and Administrative Costs             1,687,697      1,356,244      1,513,254 
                                             ---------      ---------      --------- 

Operating Income (Loss)                     (2,737,693)    (2,487,534)    (2,759,614) 

Other Income (Expense):                     
 Other Income (Expense)                            599          1,098        (19,716)
 Interest Expense                             (196,604)      (269,827)      (190,805) 
                                             ---------      ---------      --------- 
                                              
Loss before extraordinary item              (2,933,698)    (2,756,263)    (2,970,135)   
                                                                                    
Extraordinary Gain                              36,666              -        879,373 
                                           -----------    -----------        -------
                                           
Net loss                                   $(2,897,032)   $(2,756,263)   $(2,090,762)
                                           ===========    ===========    ===========
 
Loss per share of common stock
 before extraordinary gain                       ($.15)         ($.17)         ($.21)
                                           ===========    ===========    ===========

Extraordinary gain per share of common
stock                                               -              -            $.06
                                           ===========    ===========    ===========
Net loss per share of
common stock                                     ($.15)         ($.17)         ($.15)
                                           ===========    ===========    ===========
Weighted average number of
 common shares outstanding                  19,134,484     15,779,721     14,166,869
                                           ===========    ===========    ===========
</TABLE>

The accompanying notes to the financial statements should be read in conjunction
with these statements.

                                    36(F-5)
<PAGE>
 
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                               Class A Common Stock    
                                               --------------------    
                                          Shares                 Amount
                                          ------                 ------
<S>                                     <C>                     <C>    
Balance - December 31, 1993             10,092,266              $100,923
                                                                       
Issuance of Class A                                                    
 Common stock                            3,945,772                39,457
Net loss for the year                                                  
 ended December 31, 1994                         -                     -
                                        ----------              --------
Balance - December 31, 1994             14,038,038              $140,380                               
                                        ==========              ========
Cancellation of 5,625,000               
 Shares of Class B Common Stock                  -                     -                               
Exercise of Stock Options                   24,332                   244                               
Exercise of Class F Warrants             1,630,496                16,305
Net loss for the year ended                                            
 December 31, 1995                               -                     -
                                        ----------              --------
Balance - December 31, 1995             15,692,866              $156,929                               
                                        ==========              ========
Exercise of Class F Warrants               500,000                 5,000
Net Proceeds from issuance of                                          
Class A Common Stock                     2,996,282                29,963
Exercise of Stock Options                   12,000                   120                               
Net loss for the year ended                                            
 December 31, 1996                               -                     -
                                        ----------              --------
Balance - December 31, 1996                                            
                                        19,201,148              $192,012
                                        ==========              ========
</TABLE>

The accompanying notes to the financial statements should be read in conjunction
with these statements.

                                    37(F-6)
<PAGE>
 
<TABLE>
<CAPTION>
                          Additional
                           Paid-in      Accumulated
 Class B Common Stock      Capital        Deficit        Total
 --------------------      -------        -------        -----
Shares          Amount
------          ------
<S>            <C>        <C>          <C>            <C>
 7,090,530     $ 70,905   $15,858,305  $(10,893,681)  $ 5,136,452          
                                                                        
                                                                        
         -            -     2,361,301             -     2,400,758       
                                                                        
         -            -             -    (2,090,762)   (2,090,762)      
----------     --------   -----------  ------------   -----------       
                                                                        
 7,090,530     $ 70,905   $18,219,606  $(12,984,443)  $ 5,446,448       
==========     ========   ===========  ============   ===========       
                                                                        
                                                                        
(5,625,000)     (56,250)       56,250             -             -       
         -            -        28,711             -        28,955       
         -            -       978,298             -       994,603       
                                                                        
         -            -             -    (2,756,263)   (2,756,263)      
----------     --------   -----------  ------------   -----------       
                                                                        
 1,465,530     $ 14,655   $19,282,865  $(15,740,706)  $ 3,713,743       
==========     ========   ===========  ============   ===========       
                                                                        
         -            -       300,000             -       305,000       
                                                                        
         -            -     1,942,785             -     1,972,748       
         -            -         7,800             -         7,920       
                                                                        
         -                               (2,897,032)   (2,897,032)      
----------     --------   -----------  ------------   -----------       
                                                                        
 1,465,530     $ 14,655   $21,533,450  $(18,637,738)  $ 3,102,379       
==========     ========   ===========  ============   ===========       
</TABLE>

                                    38(F-7)
<PAGE>
 
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.
 
STATEMENTS OF CASH FLOWS

<TABLE> 
<CAPTION> 
                                                             Year ended     Year ended     Year ended   
                                                            December 31,   December 31,   December 31, 
                                                                1996           1995           1994     
                                                            -------------  -------------  -------------
<S>                                                         <C>            <C>            <C>          
Cash flows from operating activities:                                                                  
 Net loss                                                    $(2,897,032)   $(2,756,263)   $(2,090,762)
Adjustments to reconcile net loss to net                                                               
  cash used in operating activities:                                                                   
 Depreciation and amortization                                 1,212,323      1,084,280        938,126 
 Amortization of other assets                                     24,740         23,257         20,223 
 Loss on disposition of equipment                                178,061        527,804         19,736 
 Increase in other assets                                        (42,749)       (38,130)       (49,624)
 Changes in operating assets & operating liabilities             400,246        671,536        223,648 
  Extraordinary gain                                             (36,666)             -       (879,373)
                                                             -----------    -----------    ----------- 
 Net cash used in operating activities                        (1,161,077)      (487,516)    (1,818,026)
                                                             -----------    -----------    ----------- 
Cash flows from investing activities:                                                                  
 Additions to buildings and equipment                         (1,073,409)      (248,603)      (835,921)
 Proceeds from sale of equipment                                       -          5,000         22,000 
 Insurance recoveries, net of fire related expenses              379,080              -        543,305 
                                                             -----------    -----------    ----------- 
 Net cash used in investing activities                          (694,329)      (243,603)      (270,616)
                                                             -----------    -----------    ----------- 
Cash flows from financing activities:                                                                  
 Prepaid Stock Subscriptions                                      85,000              -              - 
 Proceeds from issuance of notes                                 369,155      1,068,210      2,269,763 
 Payments on notes                                              (732,011)    (1,351,276)      (747,866)
 Proceeds from issuance of common stock                        1,887,748              -        380,341 
 Proceeds from warrant exercises, net                            305,000        994,603              - 
 Proceeds from exercise of stock options, net                      7,920         28,955              - 
                                                             -----------    -----------    ----------- 
 Net cash provided by financing                                1,922,812        740,492      1,902,238 
  activities                                                 -----------    -----------    ----------- 
Increase (decrease) in cash & cash equivalents                    67,406          9,373       (186,404)
Cash and cash equivalents:                                        15,350          5,977        192,381 
Beginning of period                                          -----------    -----------    ----------- 
End of period                                                $    82,756    $    15,350    $     5,977 
                                                             ===========    ===========    ===========  
</TABLE>

The accompanying notes to the financial statements should be read in conjunction
with these statements.

                                    39(F-8)
<PAGE>
 
ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS


Note 1:  Organization and description of the Company
----------------------------------------------------

Advanced Environmental Recycling Technologies, Inc. (the Company or AERT) has
developed and manufactures composite building material from waste plastic and
wood fiber waste for certain specialized applications in the construction
industry. The Company markets this material as a substitute for wood and plastic
filler materials for standard door frames, window sills, flooring, and decking.
The Company is comprised of two separate, yet interrelated manufacturing
facilities located in Junction, Texas and Rogers, Arkansas. The Company's
customers primarily consist of a number of regional and national door and window
manufacturers and Weyerhaeuser, the Company's primary decking customer.

The Company was initially capitalized on December 2, 1988, with a contribution
of machinery and equipment, plant facilities and technology, most of which was
used by certain members of management in an unsuccessful prior business. The
prior business was organized in June 1985 to manufacture artificial firelogs
using certain technology somewhat similar to that used in the Company's
manufacturing process. By 1986, the prior business had incurred substantial
losses from operations, had no further working capital resources and
discontinued its business. The initial contribution consisted of approximately
$3,000,000 in buildings, machinery and equipment, supplies and other tangible
assets, as well as technological rights and expertise. In connection with such
initial organization, the Company assumed $795,000 in bank indebtedness secured
by certain of the contributed assets. All such contributed amounts are reflected
in the accompanying financial statements at the contributor's book value.

For periods prior to 1995, the Company was a development stage enterprise whose
operations consisted primarily of design development and improvement of the
equipment and production process and initial marketing and determination of
product markets. Accordingly, the Company has reclassified certain prior period
amounts to conform to the current period presentation.


Note 2:  Future operations
--------------------------

The financial statements of the Company have been prepared on the basis of
accounting principles applicable to a going concern, which contemplates the
realization of assets and the satisfaction of liabilities in the normal course
of business. At December 31, 1996 the Company had a working capital deficit of
$892,995 and had incurred net losses of $2,897,032, $2,756,263, and $2,090,762
for the years ended December 31, 1996, 1995, and 1994, respectively. The Company
has incurred operating losses in each year since its inception and has never
operated at successful manufacturing levels over an extended period. Further,
unaudited information subsequent to December 31, 1996 indicates that losses are
continuing. Such continuing losses have primarily been caused by significant
problems in maintaining significant production volumes of products and in
producing products at economically feasible operating cost levels. There is no
assurance that the Company will be able to improve its

                                    40(F-9)
<PAGE>
 
manufacturing process and operating costs to the extent necessary to reach
successful operating levels.  Further, the Company has limited additional
financial resources available to support its operations and in the past few
years has, in large part, been supported by certain major shareholders.  There
is no commitment for such shareholders to continue such support beyond the
current line of credit.  The Company also has claims in litigation outstanding
against it as described in Note 14, the outcome of which is uncertain.  There
can be no assurance that the Company's financial resources (which at present are
limited to a $433,097 line of credit as described in Note 5) will be adequate to
support existing operations until such time, if ever, sales and manufacturing
levels are sufficient to generate positive cash flow from operations.  Further,
if the litigated claims discussed in Note 14 were to be assessed against the
Company, the Company would likely be unable to pay such claims.  These factors,
among others, raise substantial doubt concerning the ability of the Company to
continue as a going concern.  The financial statements do not include any 
adjustments relating to the recoverability and classification of recorded asset
amounts or the amount and classification of liabilities that might result should
the Company be unable to continue as a going concern. The ability of the Company
to continue as a going concern is dependent upon the ongoing support of its
stockholders, investors, customers and creditors and its ability to successfully
mass produce and market its products at economically feasible levels.

The Company has developed, and is currently implementing, a production plan
which Management believes will provide for better operating efficiencies and
correct the production problems encountered in the past. Such plan includes
increasing production capacity, changes to production management, further
automation of the production process and better utilization of regrindable
scrap. The Company is also seeking to raise approximately $2.2 million in an
offering of preferred stock, and believes that such capital will be sufficient
to support the Company until such time as the Company achieves positive cash
flow from operations. However, it is possible additional financial resources may
be necessary to fund maturities of debt and other obligations as they come due.
There is no assurance the Company will be able to correct prior production
problems and, improve operating efficiencies or that the Company will be
successful in securing sufficient capital resources to support the Company until
such time, if ever, the Company is able to generate positive cash flow from
operations.

Effective October 1, 1995, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 121, Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to Be Disposed Of. SFAS No. 121 requires an assessment of
the recoverability of the Company's investment in long-lived assets to be held
and used in operations whenever events or circumstances indicate that their
carrying amounts may not be recoverable. Such assessment requires that the
future cash-flows associated with the long-lived assets be estimated over their
remaining useful lives and an impairment loss recognized when the future cash-
flows are less than the carrying value of such assets.

The Company has assessed the recoverability of its investment in long-lived
assets to be held and used in operations under the guidelines set forth in SFAS
No. 121 and determined that no impairment loss was required as of December 31,
1996.  Such assessment required the Company to make certain estimates of future
production volumes and costs and future sales volumes and prices which are
expected to occur over the remaining useful lives of its long-lived assets.
(Such long-lived assets primarily consist of the Company's Rogers and Junction
manufacturing facilities.)  The Company's estimates of these factors are based
upon management's belief that future production volumes will significantly
increase over previous historical production levels achieved by the Company's
manufacturing facilities and that future production costs per unit will also
significantly decrease below previous historical cost levels.  As disclosed in
Note 15, the Company  intends to rebuild the Rogers plastics reclamation
facility and believes that no significant production problems will recur at

                                   41(F-10)
<PAGE>
 
its Junction composite manufacturing facility. As such, management of the
Company believes a reasonable basis exists for the use of such future estimates
which are significantly better than past historical performance.

Although the Company believes it has a reasonable basis for its estimates of
future production volumes and costs and future sales volumes and prices, it is
reasonably possible that the Company's actual performance could materially
differ from such estimates.  Management expects that the Company's performance
during the last nine months of 1997 will provide additional evidence to confirm
or disprove such future estimates.  Management also believes that if such
estimates are not confirmed, revisions to such estimates could result in a
material impairment loss on its long-lived assets constituting all or a material
portion of the carrying value of the Company's Rogers and Junction manufacturing
facilities which was $4,604,663 at December 31, 1996.

Note 3:  Significant accounting policies
----------------------------------------

     Statements of Cash Flows
     ------------------------

In order to determine net cash used in operating activities, net loss has been
adjusted by, among other things, changes in operating assets and operating
liabilities, excluding changes in cash and cash equivalents, current maturities
of long-term debt, and advances from affiliates included in notes payable -
related parties.  Those changes, shown as an (increase) decrease in current
assets and an increase (decrease) in current liabilities, are as follows:

<TABLE>
<CAPTION>
                                 Year ended     Year ended    Year ended
                                 December 31,   December 31,  December 31,
                                    1996           1995          1994
                                    ----           ----          ----
<S>                              <C>            <C>           <C>
Receivables                       $ 39,186       $ 12,457     $  83,709
Inventories                         (2,114)        62,483      (266,964)
Prepaid expenses and other          69,860          4,990       (11,198)
Accounts payable -
 trade & related parties           253,028        568,718       273,795
Accrued liabilities                 40,286         22,888       147,164
Other                                    -              -        (2,858)
                                  --------       --------     ---------
 
                                  $400,246       $671,536     $ 223,648
                                  ========       ========     =========

<CAPTION> 
                                 Year ended     Year ended    Year ended
                                 December 31,   December 31,  December 31,
                                    1996           1995          1994
                                    ----           ----          ----
 <S>                             <C>            <C>           <C>
 Cash paid for interest           $168,322       $301,192     $  35,794
 Cash paid for taxes                     -              -             -
</TABLE>

SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCIANG ACTIVITIES:
Insurance proceeds due for fire losses of 
 buildings and equipment                                  $1,001,660
Additions to buildings and equipment paid 
 directly by insurance company                                83,842
Note payable for finacing of insurance policies               48,713

The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.

                                   42(F-11)
<PAGE>
 
     Buildings and Equipment
     -----------------------

Buildings and equipment contributed to the Company in exchange for Class B
Common Stock are carried at the contributor's historical book value. Property
additions and betterments include capitalized interest and acquisition,
construction and administrative costs allocable to construction projects and
property purchases. Gains or losses on sales or other dispositions of property
are credited or charged to income.

Provision for depreciation of buildings and equipment is provided on a straight-
line basis for buildings and leasehold improvements, transportation equipment
and office equipment over the lesser of the estimated useful life of the asset
or the term of the lease. During 1996 the Company changed depreciation methods
for machinery and equipment from units of production to straight-line. The
change in methods had no material impact for the periods presented. Estimated
useful lives are: buildings and leasehold improvements - 6 to 20 years,
transportation equipment - 3 to 5 years, office equipment - 5 years and
machinery and equipment - 7 to 12 years (see note 2).

     Inventories
     -----------

Inventories are stated at the lower of cost (first-in, first-out method) or
market.  Inventories consisted of the following:

<TABLE>
<CAPTION>
                             December 31,  December 31,
                                1996          1995
                                ----          ----
<S>                          <C>           <C>
Raw materials                $210,483      $133,781
Work in process               351,477       451,369
Finished goods                 31,365        63,061
                             --------      --------
                             $593,325      $648,211
                             ========      ========
</TABLE>

     Other assets
     ------------

Other assets consist primarily of the costs for the preparation of patent
applications of $332,596, net at December 31, 1996 which are amortized using the
straight-line method over 17 years.  Also included in other assets are deposits
of $13,891.

     Use of estimates
     ----------------

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

                                   43(F-12)
<PAGE>
 
     Recently Issued Accounting Standards
     ------------------------------------

SFAS No. 123, "Accounting for Stock-Based-Compensation," issued by the FASB in
October 1995, encourages but does not require companies to measure and recognize
in their financial statements a compensation cost for stock-based employee
compensation plans based on the 'fair value' method of accounting set forth in
the statement. The Company has chosen to continue to account for its stock
option plans and other stock-based compensation using the "intrinsic value"
method of accounting set forth in Accounting Principles Board ("APB") Opinion
No. 25, "Accounting for Stock Issued to Employees," and related interpretations.
Accordingly, compensation cost for stock options is measured as the excess, if
any, of the quoted market price of the Company's common stock at the date of the
grant over the amount an employee must pay to acquire the stock.

Had compensation cost for the Company's stock option plans and other stock-based
compensation been determined consistent with SFAS No. 123, the Company's net 
loss and net loss per share of common stock would have been increased to the 
following pro forma amounts:
                                                    1996            1995
                                                    ----            ----
Net Loss                As Reported             (2,897,032)     (2,756,263)
                        Pro Forma               (4,140,251)     (3,217,929)
Net Loss per share of 
 common stock           As Reported                   (.15)           (.17)
                        Pro Forma                     (.22)           (.20)

Because the SFAS No. 123 method of accounting has not been applied to awards 
granted prior to January 1, 1995, the resulting pro forma compensation cost may 
not be representative of that expected in future years. 

In June 1996, the Financial Accounting Standards Board ("FASB") issued SFAS No. 
125, "Accounting for Transfers and Servicing of Financial Assets and 
Extinguishments of Liabilities." This statement provides accounting and 
reporting standards for, among other things, the transfer and servicing of 
financial assets, such as factoring receivables with recourse and will require 
the Company to classify its financial assets pledged as collateral separately 
in the financial statements.. This statement is effective for transactions 
occurring after December 31, 1996, and is to be applied prospectively. Earlier 
or retroactive application is not permitted. In December 1996, the FASB issued 
SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of SFAS No. 
125," SFAS No. 127 moves forward some, but not all, of the provisions of SFAS 
No. 125 to December 31, 1997. The Company presently factors, with recourse, 
receivables to a related party (see Note 4).

In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share." SFAS No. 
128 replaces the presentation of Primary Earnings Per Share (EPS) with Basic EPS
and requires dual presentation of Basic and Diluted EPS on the face of the 
statements of operations and requires a reconciliation of the numerator and 
denominator of the Basic EPS computation to the numerator and denominator of the
Diluted EPS computation. Basic EPS excludes dilution and is computed by dividing
income available to common stockholders by the weighted-average number of common
shares outstanding for the period. Diluted EPS reflects the potential dilution 
that could occur if securities or other contracts to issue common stock were 
exercised or converted into common stock or resulted in the issuance of common 
stock that then shared in the earnings of the Company. Diluted EPS is computed 
similarly to Fully Diluted EPS pursuant to Accounting Principles Board Opinion 
No. 15, "Earnings Per Share," SFAS No. 128 is effective for financial statements
issued after December 15, 1997, and earlier application is not permitted. SFAS 
No. 128 requires restatement of all prior-period EPS data presented. 

Concentrations of Credit Risk
-----------------------------

The Company's revenues are derived principally from a number of regional and
national door and window manufacturers and Weyerhaeuser, the Company's primary
decking customer.  This industry concentration has the potential to impact the
Company's exposure to credit risk because the customers may be similarly
affected by changes in economic or other conditions in the construction
industry.

                                   44(F-13)
<PAGE>
 
Disclosure About Fair Value of Financial Instruments
----------------------------------------------------

The following methods and assumptions were used to estimate the fair value of
each class of financial instrument held by the Company:

Current assets and current liabilities: The carrying value approximates fair
value due to the short maturity of those items.

Long-term debt: The fair value of the Company's long-term debt has been
estimated by the Company based upon each obligation's characteristics, including
remaining maturities, interest rate, credit rating, collateral and amortization
schedule.  The carrying amount approximates fair value.

Note 4:  Receivables
--------------------

During 1996, the Company recorded Bad Debt Expense of $35,476 for uncollectible
amounts previously factored by the Company.  At December 31, 1996 the Company
had $35,476 recorded as accounts payable to a related party for the
uncollectible amounts.

In April 1994, the Company renewed an agreement with an affiliate whereby the
Company agreed to sell certain of its trade receivables which the affiliate
deems acceptable, up to $700,000 at any one time. Upon acceptance of a sale of a
receivable, the affiliate will remit to the Company 100% of the receivable, as
defined in the agreement, and the Company shall remit to the affiliate .88% as a
factoring charge. The Company will indemnify the affiliate for any loss arising
out of rejections or returns of any merchandise, or any claims asserted by the
Company's customers. During 1996, the Company sold an aggregate of approximately
$7,317,000 in receivables under this agreement, of which $504,665 remains to be
collected as of December 31, 1996. During 1995 and 1994, the Company sold an
aggregate of approximately $5,852,000 and $3,726,000, respectively, in
receivables under this agreement, none of which remains to be collected. Costs
of approximately $61,555, $51,000 and $32,800 associated with the factoring
agreement are included in selling and administrative costs at December 31, 1996,
1995, and 1994, respectively.

Note 5:  Notes payable - related parties
----------------------------------------

In July 1994, the Company obtained a $1,000,000 line of credit financing
agreement with Jim G. and Marjorie S. Brooks.  The credit line is secured by
substantially all of the assets of the Company and accrues interest at a rate of
8.5% per annum.  Proceeds from the line of credit were used to redeem certain
outstanding notes payable to related parties and provide working capital for
Company operations.   In February 1995, the line of credit was increased to
$2,000,000 of which $1,566,903 is a term note to be amortized at 9 3/4% over
five years beginning April 1, 1995 and the balance of $433,097 is a revolving
credit line to be available as needed by the Company.  At December 31, 1996 and
1995 the Company had no amounts outstanding under this line and $433,097 was
available for future borrowings.  This revolving line of credit expires in
February 2000.

                                   45(F-14)
<PAGE>
 
Note 6:  Long-term debt
-----------------------


Long-term debt as of December 31, 1996 and December 31, 1995, consisted of the
following:

<TABLE>
<CAPTION>
                                                                          1996          1995
                                                                          ----          ---- 
<S>                                                                  <C>          <C>
Note payable, payable on demand, otherwise, due in 23-
monthly installments of $10,156 plus interest at prime plus 
two percent (10.50% at December 31, 1996) beginning
September 1, 1996; monthly installments of $15,354 including 
interest at 10.75% secured by certain manufacturing 
equipment, inventories and receivables.  (See Note 12)               $  200,999   $  324,970
 
 
Note payable, due in monthly installments of accrued
interest from January 1, 1995 through April 1, 1995,
And monthly installments of principal and interest beginning 
May 1, 1995 with the remaining balance due March 1, 1997, 
interest at 8%, secured by unescrowed shares of Class B Common
Stock owned by certain officers of the Company 
and certain manufacturing equipment.                                    130,536      213,769
 
Note payable, to a related party, due in 60-monthly                              
Installments of principal and interest, beginning 
April 1, 1995, interest at 9.75%.                                     1,174,283    1,399,245                
 
Note payable, accrued interest at 12% and principal are due            
and payable on January 1, 1998.                                         100,000           --
 
Other                                                    
                                                                         55,302       84,234
                                                                     ----------   ----------

Total                                                                 1,661,120    2,022,218

Less current maturities                                                (705,344)    (755,576)
Long-term debt, net of                                               ----------   ----------               

 current maturities                                                  $  955,776   $1,266,642    
                                                                     ==========   ==========                                 
</TABLE>

During 1996, the Company refinanced the lump sum payment due on September 1, 
1996 to Dow Credit Corporation of $253,878 to be paid in 18 monthly installments
of $15,354 including interest at 10.75%.

Subsequent to December 31, 1996 the Company refinanced the note payable due
March 1, 1997 with the terms of 24 monthly installments of $5,247 at 8%.

                                   46(F-15)
<PAGE>
 
The aggregate maturities of long-term debt as of December 31, 1996 are as
follows:

<TABLE>                                         
                    <S>       <C>                  
                    1997      $  705,344           
                    1998         482,896           
                    1999         373,617           
                    2000          99,263           
              Thereafter               -                 
                              ----------           
                              $1,661,120           
                              ==========            
</TABLE>

Note 7:  Stockholders' equity
-----------------------------

The Class A Common Stock and the Class B Common Stock are substantially similar
in all respects except that the Class B Common Stock has five votes per share
while the Class A Common Stock has one vote per share. Each share of Class B
Common Stock is convertible at any time at the holder's option to one share of
Class A Common Stock and, except in certain instances, is automatically
converted into one share of Class A Common Stock upon any sale or transfer.

On November 9, 1989, the Company completed a public offering of 1,250,000 units,
at a price to the public of $4.00 per unit.  In December 1989, the Company sold
an additional 100,000 units to the underwriter at the same price.  Each unit
consists of three shares of Class A Common Stock and three redeemable Class A
Warrants, which are separable and transferable immediately upon issuance.  Each
Class A Warrant entitles the holder to purchase a unit consisting of one share
of Class A Common Stock and one Class B Warrant at an exercise price of $2.00.
Each Class B Warrant entitles the holder to purchase one share of Class A Common
Stock at an exercise price of $3.00.  The Class A and Class B Warrants are
redeemable at $.05 per Warrant at the option of the Company if certain public
stock trading prices are achieved and were due to expire in November 1995.

In connection with the public offering, the Class B Stockholders placed in
escrow, on a pro rata basis, an aggregate of 5,625,000 shares of Class B Common
Stock.  The Class B Stockholders will continue to vote the escrow shares unless
such shares are canceled.  Upon the occurrence of certain events, escrow shares
will be released from escrow and returned to the Class B Stockholders if during
the calendar year ending December 31, 1994 (1) the Company's minimum pretax
income is at least $16 million or (2) the market price of the Company's Class A
Common Stock averages in excess of $6.50 per share for 20 consecutive trading
days.  The Company did not achieve any of the above requirements, and, as such,
the escrowed shares were contributed to the Company's treasury and then canceled
on March 31, 1995.

In March 1992, the Company issued notice of redemption of the aforementioned
Class A Warrants, of which approximately 4.3 million were outstanding on the
redemption date of April 27, 1992.  Prior to the redemption date, holders of
4,212,740 Class A Warrants exercised their warrants at $2.00 per warrant which
totaled $8,425,480  in warrant exercise proceeds.  Accordingly, the Company
issued 4,212,740 shares of Class A Common Stock and 4,212,740 Class B Warrants
to the exercisers of the Class A Warrants.  The remaining unexercised Class A
Warrants were redeemed at $0.05 per warrant.  During the fourth quarter of 1992,
holders of 300 Class B Warrants exercised their warrants at $3.00 per warrant.
In August 1996, the Company's Board of

                                   47(F-16)
<PAGE>
 
Directors approved a resolution extending the expiration date of the outstanding
Class B Warrants to January 1, 1998.  Under the provisions of SFAS No. 123, the
extension of the Class B warrants qualifies as a "Modification of Outstanding
Awards" and therefore has been included as a 1996 grant for purposes of SFAS No.
123.

On June 29, 1993, the Company circulated a private placement offering up to
$1,200,000 in Bridge Notes and Class C Warrants. The notes were secured by
certain equipment of the Company's composite products division, with accrued
interest at the rate of 8% per annum, and matured June 29, 1994. The face amount
of each Bridge Note was accompanied with an equal number of Class C Warrants
which are exercisable ratably into one share of Class A Common Stock at an
exercise price of $3.00 per share. The warrants expire on June 29, 1998. The
Company raised $650,000 and issued 650,000 Class C Warrants in connection with
this private placement offering. In May 1994, $600,000 of the Bridge Notes were
converted into Class A Common Stock as a portion of the Private Placement
Offering . In July 1994, the remaining $50,000 plus accrued interest was paid by
the Company.

In September 1993, the Company initiated an offering of up to $2,000,000 of
discounted gross offering proceeds of Class A Common Stock to qualified foreign
investors under Regulation S of the Securities Act of 1933. At December 31,
1993, 736,135 shares of such stock had been issued resulting in approximately
$602,000 net offering proceeds to the Company. In January 1994, an additional
450,000 shares were issued, resulting in approximately $344,000 net offering
proceeds to the Company. As a part of the offering, the Company has issued
168,501 Class D Warrants as of December 31, 1993 and an additional 38,250 Class
D Warrants during 1994 to the Stock Placement Distributor. The Class D Warrants
expire five years from the date of issue and are exercisable at a price of $1.50
per share of Class A Common Stock for each Class D Warrant exercised.

Also in connection with the Regulation S offering, the Company has reserved for
issuance one Class E Warrant for each two shares of Class A Common Stock
purchased by the aforementioned qualified foreign investors. The Class E
Warrants will be issued six months after the Class A Common shareholders' stock
acquisition date, provided that the shares of Class A Common Stock are still
owned by and registered in the name of the original purchaser as of such date.
The Class E Warrant will expire two years from the date of issue and will be
exercisable at $1.50 per share of Class A Common Stock for each Class E Warrant
exercised. As of December 31, 1996 no Class E Warrants have been exercised and
all such Warrants have expired.

In May 1994, the Company completed a Private Placement Offering at market price
to certain affiliated stockholders and bridge note holders with the issuance of
3,468,400 shares of Class A Common Stock, 3,468,400 Class F Warrants, and
3,468,400 Class G Warrants.  Net offering proceeds of approximately $2,065,000
consisted of $2,020,000 conversion of debt and accrued interest and $45,000 in
cash.  The Class F and Class G Warrants expire five years from the date of
issuance and are exercisable at a price of $.61 and $.92, respectively, per
share of Class A Common Stock for each Class F or Class G Warrants exercised.

In 1995, in connection with an extension of a line of credit to the Company by a
related party (see Note 5), the Company's Board of Directors authorized the
issuance of up to 2,000,000 Class H Warrants on a one-for-one basis for each
dollar advanced under the loan agreement and having an exercise price equal to
the per share market value of the Company's Class A Common Stock on the date of
such advances.  While no warrants have been issued as of the date of this
filing, all authorized Class H Warrants are currently issuable.  Upon issue, the
warrants will be exercisable at prices from $.39 to $.49 per share of Class A
Common Stock for each Class H

                                   48(F-17)
<PAGE>
 
Warrant exercised.  The Class H Warrants will expire in February 2005.

In May 1996, the Company completed a Private Placement Offering with the
issuance of 338,624 shares of Class A Common Stock. Net offering proceeds
consisted of $200,000 in cash.

In June 1996, the Company completed an offering to qualified foreign investors
under Regulation S of the Securities Act of 1933 with the issuance of 1,666,893
shares of Class A Common Stock. Net offering proceeds consisted of $1,146,000 in
cash. As part of the offering, the Company has issued 242,878 Class I Warrants
to the Stock Placement Distributor. The Class I Warrants expire three years from
the date of issue and are exercisable at prices ranging from $0.9375 to $1.125
per share of Class A Common Stock for each Class I Warrant exercised.

In September 1996, the Company received $500,000 in cash relating to an offering
to qualified foreign investors under Regulation S of the Securities Act of 1933
with the issuance of the 762,194 shares of Class A Common Stock completed in
October 1996.

In December 1996, the Company received $185,000 in cash relating to an offering
to qualified foreign investors under Regulation S of the Securities Act of 1933
with the issuance of 228,571 Class A Common Stock completed in December 1996 and
the remaining shares to be issued in 1997.

In December 1996, in connection with a note payable of $100,000 (see Note 6),
the Company authorized and issued two sets of Warrants, Class J for 200,000 and
Class K for 150,000.   Each Class J and Class K Warrant is exercisable on a one-
for-one basis with common stock.  Each Class J Warrant is exercisable at $.50
per share and each Class K Warrant is exercisable at $.75 per share.  Both Class
J and Class K warrants expire five year from the date of issuance.

The weighted-average fair value of warrants issued during 1996 and 1995 was
$0.21 and $0.24, respectively. The fair value of each warrant issued is
estimated on the date of issue using the Black-Scholes option pricing model with
the following weighted-average assumptions used for issuance in 1996 and 1995,
respectively: risk-free interest rates of 7.2 and 5.9 percent; expected lives of
1.5 an 3.0 years; and expected volatility of 112.6 and 72.2 percent. Since no
dividends are expected to be paid by the Company during the expected lives of
the warrants, a dividend yield of zero was used for purposes of computing the
fair value of the warrants.

                                   49(F-18)
<PAGE>
 
At December 31, 1996, the Company had Class A Common Stock reserved for issuance
as follows:

<TABLE>
<CAPTION>
                                                              
                                                      Weighted
                                 Class A              Average 
                               Common Stock           Exercise
                                 Reserved              Price  
                                 --------              -----
<S>                            <C>                    <C>     
Class B Warrants                  4,212,440              $3.00
Stock option plans (See Note 8)   2,600,000                  -
Class C Warrants                    650,000              $3.00
Class D Warrants                    206,751              $1.50
Class E Warrants                          -                  -
Class F Warrants                  1,337,904              $0.61
Class G Warrants                  3,468,400              $0.92
Class H Warrants                  2,000,000              $0.47
Class I Warrants                    242,878              $0.97
Class J Warrants                    200,000              $0.50
Class K Warrants                    150,000              $0.75
                                 ----------              -----
                                 15,068,373              $1.57 
                                 ==========              =====
</TABLE>

As of April 14, 1997, the Company's Class A Common Stock and the Company's
Redeemable Class B Warrants are traded in the over-the-counter market and are
listed on NASDAQ under the symbols AERTA and AERTZ, respectively.  In order to
remain listed on NASDAQ, the Company is required to meet certain criteria
("Maintenance Standards") established by NASDAQ.  One such Maintenance Standard
is a minimum bid price of $1.00 per share.  If the bid price per share goes
below $1.00, the security can remain on NASDAQ if the market value of the public
float (the aggregate market value of voting stock held by nonaffiliates) remains
at $1 million and the capital and surplus of the issuer is $2 million.  As of
December 31, 1996, the Company's bid price per share was below $1.00 and the
Company had total stockholders' equity of approximately $3.1 million. Unaudited
results subsequent to December 31, 1996 indicate that losses are continuing and
that the Company continues to have negative cash flows from operating
activities.  Although the Company continues to seek to raise capital from equity
sources, there can be no assurance that the Company will be able to maintain its
listing on NASDAQ.

                                   50(F-19)
<PAGE>
 
Note 8: Stock option plans
--------------------------

The Company's Stock Option Plans (the "1990 Plan" and the "1989 Plan") authorize
the issuance of a total of 1,500,000 shares of the Company's Class A Common
Stock to its directors, employees, and outside consultants. The option price of
the stock options awarded must be at least equal to the market value of the
Class A Common Stock on the date of grant. Stock options may not be granted to
an individual to the extent that in any calendar year in which options first
become exercisable, the shares subject to options first exercisable in such year
have a fair market value on the date of grant in excess of $100,000. Stock
options may not be granted after March 2000 and May 1999 for the 1990 Plan and
the 1989 Plan, respectively. No option may be outstanding for more than ten
years after its grant. The purpose of the Plans is to enable the Company to
encourage key employees, directors and outside consultants to contribute to the
success of the Company by granting such persons incentive stock options ("ISOs")
and/or non-incentive stock options ("nonqualified stock options"). The ISOs are
available for employees only.

In order to provide for disinterested administration of the Plans for purposes
of Rule 16b-3 under the Securities Exchange Act of 1934, the 1990 Plan also
provides that outside directors will automatically receive annual awards of
nonqualified stock options.

In June 1994, stockholders of the Company approved the adoption of the Amended
and Restated Stock Option Plan which superseded and replaced the Company's 1990
Stock Option Plan. The new Plan provides for the granting of options to purchase
up to 1,000,000 shares of the Company's Class A Common Stock by recipients of
incentive stock options or non-qualified stock options as granted by the
Company's Board of Directors. 406,000 options were granted from this plan during
1995.

The Company's stockholders also approved the Non-Employee Director Stock Option
Plan (the "Director Plan'). The Director Plan provides for the issuance of
options to purchase up to an aggregate of 500,000 shares of the Company's Class
A Common Stock to eligible outside directors of the Company. Each eligible
outside director will be granted options to purchase 25,000 shares of common
stock annually commencing in 1995 and each year thereafter. In April 1996,
25,000 such options were granted to each of the four outside directors serving
on the Board at that time.

Also in June 1994, stockholders of the Company approved the Chairman Stock
Option Plan (the "Chairman Plan"). The Chairman Plan provides that Jim G.
Brooks, the Company's Chairman and Chief Executive Officer be awarded a one-time
grant, effective May 1, 1994, to purchase 500,000 shares of the Company's Class
A Common Stock. The options granted are exercisable at $.63 per share and are
vested at the rate of 20% per year commencing on the first anniversary of the
grant date.

                                   51(F-20)
<PAGE>
 
A summary of the activity in the Company's Stock Option Plans during the years
ended December 31, 1996, 1995 and 1994 are as follows:

<TABLE>
<CAPTION>
 
                                         1996               1995                    1994
                                  ----------------------------------------------------------------------------
                                                Weighted              Weighted             Weighted
                                                Average               Average              Average
                                                Exercise              Exercise             Exercise
                                      Shares     Price      Shares     Price     Shares     Price
                                  ----------------------------------------------------------------------------
<S>                                 <C>         <C>       <C>         <C>        <C>       <C>
Outstanding at beginning of year    1,506,668      $1.21  1,068,000      $1.56    932,000     $1.69
Granted                               145,000      $0.84    481,000      $0.40    136,000     $0.71
Exercised                             (12,000)     $0.66    (24,332)     $1.19          -         -
Forfeited                            (310,668)     $0.70    (18,000)     $0.72          -         -
Expired                                     -          -          -          -          -         -
                                  ----------------------------------------------------------------------------
 
Outstanding at end of year          1,329,000      $1.30  1,506,668      $1.21  1,068,000     $1.56
</TABLE>

The weighted-average fair value of options granted during 1996 and 1995 was
$0.73 and $0.22, respectively.  The following table summarizes information about
stock options outstanding under the Company's Stock Option Plans as of December
31, 1996:

<TABLE>
<CAPTION>
                                           Options Outstanding           Options Exercisable                
                     --------------------------------------------------------------------------------------                
         Range                      Number        Wtd Avg      Wtd Avg         Number         Wtd Avg       
          of                      Outstanding    Remaining    Exercise       Exercisable      Exercise      
    Exercise Prices               at 12/31/96  Contract Life    Price        at 12/31/96       Price        
----------------------------------------------------------------------------------------------------------- 
    <S>                           <C>          <C>            <C>            <C>              <C>         
    $0.38 - $0.48                      281,000   9.0 years    $0.41           145,666          $0.43             
    $0.72 - $1.00                      298,334   7.9 years    $0.83           298,334          $0.83             
    $1.13 - $1.69                      416,000   5.9 years    $1.41           416,000          $1.41             
    $1.88 - $3.00                      333,666   5.4 years    $2.30           333,666          $2.30             
                     --------------------------------------------------------------------------------------
                                                                                                                 
    $0.38 -$3.00                     1,329,000   6.9 years    $1.30         1,193,666          $1.40             
</TABLE>

The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions used for grants in 1996 and 1995, respectively: risk-free interest
rates of 6.2 and 7.3 percent; expected lives of 3.0 and 3.8 years; and expected
volatility of 92.7 and 71.3 percent. Since no dividends are expected to be paid
by the Company during the expected lives of the options, a dividend yield of
zero was used for purposes of computing the fair value of the options.

                                   52(F-21)
<PAGE>
 
Note 9: Leases
--------------

At December 31, 1996, the Company was obligated under a non-cancelable sublease
with a principal stockholder for land and building where a production facility
is located. This lease has an expiration date of April 30, 2001, and rental
payments of $1,519 per month. The Company also leases a production facility
under an operating lease, which expired January 1, 1997 and contains five
automatic renewal options of one year each. The Company has executed the fourth
of the renewal options. This lease agreement does not require any minimum lease
payments but requires payments based on product shipments at a rate of $.02 per
pound. At December 31, 1996, the Company was obligated under various operating
leases covering certain equipment. Rent expense under operating leases for the
years ended December 31, 1996, 1995, and 1994 was $200,652, $200,417, and
$189,611, respectively. Future minimum lease payments required under operating
leases are as follows:

<TABLE>                                                   
     <S>                                          <C>     
     Fiscal Year                                          
       1997                                       $ 37,848
       1998                                         26,784
       1999                                         26,784
       2000                                         20,820
       thereafter                                    8,669
                                                  --------
     Total minimum payments required              $120,905
                                                  ======== 
</TABLE>

Note 10:  Income taxes
----------------------

Effective January 1, 1993, the Company adopted SFAS No. 109 "Accounting for
Income Taxes". The adoption of SFAS No. 109 had no effect on the Company's
financial position or results of operations, as the Company has generated book
and tax losses for the period from inception.

As of December 31, 1996, the Company had net operating loss carry forwards of
approximately $14 million for federal income tax purposes which are available to
reduce future taxable income and will expire in 2003 through 2011 if not
utilized and approximately $18.6 million for financial reporting purposes. For
federal income tax purposes, the Company deferred for future amortization start-
up costs in the amount of $9.4 million. Such costs, which have been expensed for
financial reporting purposes, are being amortized for tax purposes over five
years.

                                   53(F-22)
<PAGE>
 
The tax effects of significant temporary differences representing deferred
income tax assets and liabilities are as follows:

<TABLE>
<CAPTION>
                                         December 31,   December 31,   December 31,
                                             1996           1995           1994
                                             ----           ----           -----
<S>                                      <C>            <C>            <C>
Deferred income tax assets-
 Deferred start-up costs                  $ 1,540,000    $ 2,200,000    $ 2,550,000
 Net operating loss carry forward           4,885,000      3,300,000      1,244,000
 Valuation allowance                       (5,845,000)    (4,800,000)    (3,130,000)
                                          -----------    -----------    -----------
     Total deferred income tax assets     $   580,000    $   700,000    $   664,000
                                          ===========    ===========    ===========
Deferred income tax liabilities-
 Depreciation                             $   580,000    $   700,000    $   664,000
                                          -----------    -----------    -----------
     Total deferred income tax
      liabilities                         $   580,000    $   700,000    $   664,000
                                          ===========    ===========    ===========
</TABLE>

As the Company has generated net operating losses since its inception and there
is no assurance of future income, a valuation allowance of $5,845,000 has been
established at December 31, 1996 to recognize its deferred tax assets only to
the extent of its deferred tax liabilities. The Company will continue to
evaluate the necessity for such valuation allowance in the future.

Note 11:  Significant customer
------------------------------

During the year ended December 31, 1996, the Company had $2,193,507 in sales to
a single customer which represented 32% of total sales. Sales to this customer
for the years ended December 31, 1995 and 1994 were $2,189,073 (39%) and
$2,487,802 (68%), respectively. Additionally, the Company had sales of
$1,935,849 to another customer, which represents 28% of total sales for the year
ended December 31, 1996. Sales to this customer in 1995 were $653,412, which
represented 12% of total sales for the year ended December 31, 1995.

Note 12: Dow Chemical Debt Retirement
-------------------------------------

On March 18, 1994, Dow Chemical and the Company reached an agreement whereby Dow
Chemical's obligation to purchase material from the Company (10 million pounds
of the Company's recycled plastic bag film resins) was terminated. In
consideration for this release, Dow forgave the repayment of the $456,158
outstanding advance payment.

In addition, Dow Chemical paid the Dow Credit Corporation and forgave the
Company's outstanding balance of $359,998 principal plus accrued interest under
the loan agreement dated October 22, 1991, amended as of January 23, 1993,
between Dow Credit and the Company. Also the outstanding balance of $440,000
principal plus accrued interest due Dow Credit under the loan agreement dated
June 13, 1991, amended as of January 1, 1993 between Dow Credit and the Company
was restructured whereby the Company will repay the entire principal balance due
plus accrued interest. (See Note 6).

                                   54(F-23)
<PAGE>
 
Further provisions of the agreement include the contribution in the amount of
$50,000 of Dow-owned laboratory equipment to the Company and continued technical
assistance from Dow Chemical. Accordingly, the Company has recognized an
extraordinary gain primarily from the retirement of debt in the amount of
$879,373 in the accompanying statement of operations.

Note 13:  Net loss per share of common stock
--------------------------------------------

The net loss per share of common stock was based on the combined weighted
average number of shares of Class A and Class B Common Stock outstanding during
the period. For purposes of such calculation, the 5,625,000 shares of Class B
Common Stock which were placed in escrow in connection with the public offering
and subsequently canceled were not considered as outstanding after the date of
the public offering as the effect of such inclusion would be dilutive to the net
loss per share calculation. Further, the Company's other common stock
equivalents (options which accompanied the subordinated notes, Class A, B, C, D,
E, F, G, H, I, J, and K Warrants issued or contingently issuable, and the stock
options) have a dilutive effect on the loss per share calculation and,
accordingly, were also excluded.

Had the May 1994 conversion of the various debt instruments into 3,468,400
shares of Class A Common Stock as discussed in Note 7 occurred effective at the
later of the original issue date of the converted debt instruments or January 1,
1994, the net loss per share of common stock would have been $(.13) for the year
ended December 31, 1994.

Note 14: Commitments and contingencies
--------------------------------------

On June 9, 1992, Mobil Oil Corporation ("Mobil") commenced an action against the
Company in the United States District Court for the District of Delaware
entitled Mobil Oil Corporation v. Advanced Environmental Recycling Technologies,
         -----------------------------------------------------------------------
Inc.  In its complaint, Mobil sought entry of a declaratory judgment that:  (a)
----                                                                           
AERT is without right or authority to threaten suit against Mobil or its
customers for alleged infringement of AERT patents; (b) The AERT patents are
invalid and unenforceable, and (c) Mobil has not infringed the AERT patents
through any products or method.  Mobil seeks no monetary damages in this suit,
but does seek reimbursement of its attorneys' fees.

On December 8, 1992, the Company answered Mobil's Complaint. In its Answer, the
Company denied Mobil's claims and asserted counterclaims against Mobil and three
Mobil executives for: (1) an illegal combination or contract in restraint of
trade in violation of federal antitrust laws; (2) a pattern of intentional
misconduct constituting an attempt to monopolize in violation of federal
antitrust laws; (3) breach of a confidential relationship between Mobil and the
Company; and (4) unfair competition. The Company sought monetary damages,
punitive damages and injunctive relief. Mobil filed an answer to AERT's
counterclaims, denying any liability. The Delaware Court then bifurcated the
trial into patent and non-patent issues and ordered the patent issues tried
first.

In February 1994, after a trial on the patent issues, a Delaware jury returned a
verdict that four AERT patents on its composite product technology were invalid.
The jury also determined that Mobil had not infringed two of the four patents
which AERT had asserted against Mobil.  The jury verdict answered a number of
interrogatories on

                                   55(F-24)
<PAGE>
 
the factual issues, and rendered advisory findings for the Court on Mobil's
allegation that AERT had obtained its patents by inequitable conduct.
Thereafter, the Judge adopted the jury's advisory findings on inequitable
conduct and held that each of the four AERT patents were unenforceable for
failure to disclose certain alleged prior to the patent office during patent
prosecution.

Because of the nature of certain of the jury verdict interrogatory responses,
AERT's counsel concluded that the verdict was adversely affected by improper
conduct by Mobil counsel during trial, and false statements of law and fact made
during closing argument, that caused the jury to misapply the law on inequitable
conduct and to render clearly erroneous findings. Consequently, AERT moved for a
new trial. That motion was denied. The Company's additional post-trial motions
were also denied by the Delaware Court. On March 14, 1995, the Company filed a
sealed motion with the Court based upon newly discovered evidence which alleges
prejudicial misconduct by Mobil prior to the trial. The motion also brings to
the Court's attention, evidence which the Company believes was intentionally
withheld from it in direct defiance of the Delaware Court's January 4, 1994
Motion to Compel, prior to the trial. It also brings to the Court's attention,
an official government safety approval document which was altered prior to
submission to AERT during pre-trial discovery, which also relates to a portion
of the alleged withheld discovery documentation. The motion seeks further
discovery into Mobil's misconduct, and a new trial. In December 1995, the
Company also moved to supplement its pending March 14, 1995 Motion with
additional tampered evidence and discovery misconduct by Mobil. Although the
March 14, 1995 Motion is still pending before the Delaware Court, the Company
filed an appeal with the U.S. Court of Appeals on July 10, 1995 on the initial
trial arguments. In January 1996, oral arguments were presented before the U.S.
Court of Appeals. Should the Delaware Court deny the Company's pending
Prejudicial Misconduct Motion, the Company intends to follow-up with an
additional appeal on these issues. Should the Court not rule in favor of the
Company on such motions, all appellate processes available will be pursued.
There can be no assurance that the Company will receive a more favorable outcome
upon appeal.

In August 1994, Mobil filed a motion seeking an award of attorneys' fees and
costs in the amount of $2.7 million. On November 1, 1994, the Court ruled that
the motion was premature and will not be considered at the present time. In
January 1995, Mobil renewed its Motion for Attorneys' Fees. In April 1995, the
Court requested AERT to respond to Mobil's Motion. The Motion is currently
pending. With the recent appeals court ruling upholding the invalidity of two
patents and the ruling of inequitable conduct, the Company has been advised that
if and when the court decides to entertain Mobil's motion for the attorney's
fees, and if and when Mobil decides to submit documentation and substantiate its
claim, that the Company could face possible risk from an adverse decision from
the court by awarding a portion of said fees to Mobil. The Company has been
advised that it could face an aggressive challenge against it for a significant
portion of said $2.7 million attorney's fees in an attempt to end this
litigation prior to the companies prejudicial misconduct motion or pending
counterclaims against Mobil being heard. The Company will vigorously defend
against Mobil's claim for attorneys' fees and costs, however, there can be no
assurances as to the outcome of this litigation. The Company has not recorded
any liability related to such litigation at December 31, 1996.

                                   56(F-25)
<PAGE>
 
Note 15: Accounting for Rogers Plastic Reclamation Facility Fires
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During 1996, the Company experienced two fires at the Rogers Plastic Reclamation
Facility. In September, the Company experienced an extraordinary gain of $67,100
relating to the insurance proceeds for the loss of finished goods inventory 
destroyed. In addition, the final settlement of the insurance claim relating to 
the capital equipment destroyed in the September fire resulted in a gain of 
$167,034. 

In connection with the December fire, the Company has recorded an extraordinary
loss at December 31, 1996 of $130,368 and a receivable from the insurance
company in the amount of $1,101,657, which represents the difference between the
net book value of equipment lost in the December fire which the Company expects
to be reimbursed for by insurance proceeds. As of December 31, 1996, $100,000
had been collected from the insurance company. The total claim amount is in
excess of $1.95 million.

The impact of the extraordinary gain on the net loss per share of common stock
was immaterial.

The Company has recently been put on notice and advised by its current fire 
insurance carrier that due to the significant amount of loss from the two 
Rogers, Arkansas fires experienced during the second half of 1996 that it had 
chosen not to renew the Company's fire insurance policy when it expires in May 
1997. The Company's insurance carriers are interested in bidding on insuring the
Company's facilities provided that 24 hour security is maintained and automatic 
fire protection devices are installed around heat sources. The Company has been 
advised that its deductible will most likely be increased above the current 
$25,000 amount. Although the Company believes that under the above mentioned 
conditions it can obtain insurance, as of this date it has not yet been renewed.
Therefore, at present there can be no assurance that it can receive fire 
insurance coverage, or if it does receive coverage that it will be economical or
cost effective.

                                   57(F-26)