<PAGE>   1

                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   FORM 10-KSB

[X] Annual Report Pursuant to Section 13 or 15(d) of The Securities
         Exchange Act of 1934

                   For the fiscal year ended December 31, 1997

[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
         Exchange Act of 1934

                         Commission file number 0-22250

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                 (Name of Small Business Issuer In Its Charter)

          DELAWARE                                     95-4592204
(State  or Other Jurisdiction                       (I.R.S. Employer
of Incorporation or Organization)                  Identification  No.)

                    6355 TOPANGA CANYON BOULEVARD, SUITE 120
                        WOODLAND HILLS, CALIFORNIA 91367
              (Address of Principal Executive Offices and Zip Code)

                                 (818) 615-1500
                (Issuer's telephone Number, Including Area Code)

       Securities registered under to Section 12(b) of the Exchange Act:

                                                Name of Each Exchange
    Title of Each Class                          on which Registered
COMMON STOCK, $.001 PAR VALUE                  AMERICAN STOCK EXCHANGE


       Securities registered under to Section 12(g) of the Exchange Act:

                                      NONE

         Check whether the issuer: (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for past 90 days.

                  Yes   /X/           No   / /

         Check if there is no disclosure of delinquent filers in response to
Item 405 of Regulation S-B is not contained in this form, and no disclosure will
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-KSB
or any amendment to this Form 10-KSB [X]

         The issuer's revenues for the fiscal year ended December 31, 1997 were
$2,481,000.

         At March 27, 1998 the aggregate market value of the voting stock held
by non-affiliates of the issuer was $15,489,245.

         At March 27, 1998 the issuer had 9,403,001 shares of Common Stock,
$0.001 par value, issued and outstanding.

         Transitional Small Business Disclosure Format (check one):
                  Yes   / /           No   /X/

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions of the issuer's Proxy Statement with respect to its 1998 Annual Meeting
of Stockholders, currently scheduled to be held on May 22, 1998, are
incorporated by reference into Part III of this Report.



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                                     PART I


ITEM 1.  DESCRIPTION OF BUSINESS.

HISTORY AND PRIOR ACTIVITIES

         Brilliant Digital Entertainment, Inc. ("Brilliant" or the "Company") is
a production and development studio introducing a new generation of digital
entertainment to be distributed over the Internet, on CD-ROM, as television
programming and for home video. The Company, headquartered in the United States,
was incorporated during July 1996. The Company was formed through the
combination of two businesses: Brilliant Interactive Ideas, Pty. Ltd. ("BII
Australia"), an entertainment software developer and producer; and Sega
Australia New Developments ("SAND"), a research and development operation for
leading edge software tools. Since its founding in September 1993, BII Australia
has developed and sold interactive education and entertainment CD-ROM titles
primarily for children.

         BII Australia became a wholly-owned subsidiary of the Company in August
1996 through the exchange of all 100,000 outstanding shares of BII Australia for
1,000,000 shares of Common Stock of the Company. In addition, on September 30,
1996 the Company acquired SAND. SAND was established during the second quarter
of 1994 by Sega Ozisoft Pty., Limited ("Sega Ozisoft"), one of the largest
publishers and distributors of entertainment software products in Australia and
New Zealand. Sega Ozisoft and BII Australia began working together during
November of 1994 to jointly continue the development of SAND's software tools.
BII Australia provided consulting advice regarding integration of individual
tool components, the required functionality of the tool suite and technical
issues impacting the use of text, sound, graphics and other special effects in
the development of an interactive digital entertainment product. BII Australia
and Sega Ozisoft formalized their relationship on January 17, 1996 with an
agreement through which BII Australia provided continued technical assistance
for the enhancement of SAND's software tools and in the development of the first
Multipath Movie product, which is based on the Australian comic strip character
"Cyberswine."

GENERAL

         Using its proprietary state-of-the-art software tools, the Company
produces Multipath(TM) Movies, which are three-dimensional digitally animated
stories each with up to hundreds of plot alternatives, or paths, leading to
multiple distinct conclusions that are influenced by the user. The Company's
Multipath Movies feature seamless interactivity leaving the plot and graphical
presentation of the story uninterrupted by the user's decisions. The Company
utilizes a single cost-efficient production process to produce multiple formats
of a particular Multipath Movie title for different distribution channels, such
as the Internet, CD-ROM or television programming. In addition, the Company has
developed a system that permits real time distribution of, and user interaction
with, its Multipath Movies over the Internet.

         As a key part of its strategy, the Company has secured quality content
for its Multipath Movies from a number of proven sources, including Superman
from D.C. Comics (a subsidiary of Warner Bros.), Xena: Warrior Princess and
Hercules & Xena the Animated Movie, each from Universal Studios, Ace Ventura
from Morgan Creek, Popeye from King Features Syndicate and the Choose Your Own
Nightmare series for kids from Bantam Doubleday Dell Books. The Company also
develops Multipath Movies based on internally-developed content. Further to its
strategy, the Company has entered into distribution agreements with key industry
participants Packard Bell NEC, CompuServe, and graphics acceleration hardware
manufacturers Matrox and S3.

         The Company's Multipath Movies combine the best qualities of
traditional filmed entertainment -- complex characters, stories and plots, with
the best of the traditional computer game -- interactivity. The Company's
Multipath Movies are designed to appeal to the entire home PC market, including
both the core gamer and the much larger segment of PC users not currently served
by traditional game developers. In order to offer digital entertainment products
with wide appeal, the Company is producing a variety of Multipath Movies
tailored to various demographic groups, such as its Storyteller(TM) Series in
which an animated storyteller narrates engaging interactive stories targeted at
children eight to twelve years of age and Multipath Movies for Kids(TM),
including Popeye, targeted to children as young as three years old. Multipath
Movies incorporate a number of features that the Company believes represent
significant technical enhancements over existing digital entertainment. For
example, animated characters created using the Company's tools appear humanlike
and have realistic features, facial expressions and mouth movements. Multipath
Movies also allow


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users to control characters' moods as opposed to only their actions. In
addition, a typical Multipath Movie will encourage viewers to interact with the
story seamlessly, influencing the plot without interrupting its flow or
graphical presentation.

         The Company's first Multipath Movie title, Cyberswine, was released at
the end of the fourth quarter of 1997. The Company expects to expand the release
of Cyberswine during the second quarter of 1998 through its distribution
agreement with Packard Bell NEC. Pursuant to additional distribution agreements,
Matrox is also bundling Cyberswine with its m3D line of 3D graphics acceleration
chip sets, and S3 may bundle Cyberswine with its graphics chip sets. The Company
has also entered into a distribution agreement with CompuServe through which the
Company is establishing its own Multipath Movie site on the CompuServe service
enabling each of CompuServe's subscribers in the United States to purchase
Cyberswine and other Multipath Movies. The Company intends to use its existing
and future distribution relationships for subsequent Multipath Movie titles that
are currently in production.

         Beginning in late 1998, the Company plans to release certain of its
Multipath Movies in non-interactive format as television broadcast/cable
programming and home video features. The Company intends to segment such
Multipath Movies into 30-minute episodes and, by packaging together multiple
episodes, can create a season-length series for the broadcast market. Similarly,
the Company intends to produce 80- to 120-minute animated features for the home
video market. The Company believes that it can produce Multipath Movies for
television programming and home video features at costs substantially below
typical industry costs. The Company intends to enter into joint ventures or
partnerships with film and television production companies to jointly develop
and release digital entertainment for the broadcast and home video markets
utilizing the Company's proprietary tools.

         Using its proprietary software tools in conjunction with the Company's
digital production and layup skills, the Company develops Multipath Movies in a
single production process. The Company has five proprietary software tools: (i)
ScripNav, a software tool that enables a script writer to write, review and
correct branching multipath scripts; (ii) TalkTrack, a software tool used to
synchronize facial expressions and mouth movements to voice soundtracks
automatically; (iii) SCuD Engine, a software system which collects and
integrates the output from all of the component tools to produce the Multipath
Movie; (iv) Mr. Copy, a new software tool that arranges, reorders and, using
licensed technology, compresses and decompresses audio and bit map files created
during the production of a Multipath Movie and optimally organizes the files for
use in playing the Multipath Movie; and (v) DigitalProjector, which contains all
the necessary elements to load and play a Multipath Movie. Utilizing its
proprietary software tools, the Company can produce each title in multiple
formats in a single cost-efficient production process, enabling the Company to
amortize its production costs across the revenue streams from each format. In
addition, the Company's TalkTrack tool allows for low-cost modification of
Multipath Movies to other languages without the awkward appearance of dubbed
movies. The Company's proprietary software tools and production process are
designed to emulate traditional film writing and production techniques and allow
screenwriters, directors and producers to develop Multipath Movies without any
detailed knowledge of computer programming or significant assistance from
expensive programming teams. The Company believes that the utilization of
existing entertainment resources will enable it to generate high-quality digital
entertainment at a low cost.

         The Company has significantly strengthened its title development and
production pipeline during 1997. As of March 27, 1998, the Company has completed
eleven episodes, as set forth below, and has 54 additional Multipath Movie
episodes in various stages of development and production. The Company plans to
complete an additional 20 episodes during 1998 and the balance of the current
production slate, or 34 episodes, during 1999. The Company plans to release
completed episodes based upon market conditions and other factors, including the
bundling and shipping schedules of its OEM distributors.


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<TABLE>
<CAPTION>
                                                            EPISODES IN
                                                            DEVELOPMENT       1997          1998         1999
TITLE                               CONTENT SOURCE         OR PRODUCTION   COMPLETIONS   COMPLETIONS   COMPLETIONS
-------------------------------  ------------------------  -------------   -----------   -----------   -----------
<S>                              <C>                       <C>             <C>           <C>           <C>
Cyberswine...................    Internally developed             2             5           --              2
Gravity Angels...............    Internally developed             8             1             4             4
Ten Weeks in the Head Bin....    Internally developed             4           --            --              4
Choose Your Own Nightmare....    Bantam Doubleday Dell           12             4             6             6
Popeye.......................    King Features Syndicate          2             1             2           --
Ace Ventura..................    Morgan Creek                     9           --              3             6
Xena: Warrior Princess.......    Universal Studios                9           --              3             6
Superman.....................    D.C. Comics                      8           --              2             6
                                                           -------------   -----------   -----------   -----------
    TOTAL....................                                    54            11            20            34
                                                           =============   ===========   ===========   ===========
</TABLE>

THE DIGITAL ENTERTAINMENT MARKET

         Digital entertainment is intended to combine the best elements of
filmed entertainment, creative artistry and engaging plotlines, in a multimedia
format complete with high-quality stereo sound, graphics and animation to
produce a realistic experience. Digital entertainment is created, stored and can
be distributed electronically. Examples of current digital entertainment
products include high-end computer games, virtual reality attractions, and
computer-animated television programs and feature films. Traditionally, digital
entertainment has been distributed on CD-ROM and game console cartridges.
Leading edge digital entertainment products are now also being released online
to capitalize on the tremendous current interest in the Internet and the World
Wide Web. In addition, digital entertainment products have recently been
released as broadcast television and cable programming, home videos, and even
full length feature movies, although on a limited basis.

         TECHNOLOGY AND DIGITAL ENTERTAINMENT

         The market for digital entertainment evolved and has grown dramatically
with the increasing proliferation and sophistication of personal computers and
game playing consoles, and with the widespread use of the Internet. Sales of
personal computers to home users have increased in recent years as a result of
declining prices and increased functionality of PCs. The number of multimedia
PCs used in homes worldwide is expected to grow from 40 million in 1996 to 67
million in 2000. These enhanced processing, graphics, sound, storage and
transmission capabilities have enabled PC users to more easily operate
multimedia software and digital entertainment products. In addition,
technological advances have enabled millions of consumers and businesses to
utilize the Internet, particularly the World Wide Web. International Data
Corporation estimates that World Wide Web users grew to approximately 35 million
by the end of 1996 and will grow to approximately 163 million by 2000.
Widespread use of the Internet has become possible with technological
improvements in data transmission, such as the development of more powerful data
servers and faster modems.

         The Company believes that the demand for digital entertainment will
continue to grow given the increasing multimedia capability of today's PCs, the
growing popularity of the Internet and the increasing ease in accessing the
Internet. Despite the technological advances that have been made in producing,
processing and delivering digital entertainment, the Company believes that the
consumer will expect digital entertainment products to have increasingly
sophisticated features, including more realistic graphics and special effects,
user control of more complicated or subtle character movements and real time
interactivity.

INTRODUCING THE MULTIPATH MOVIE

         The Company's Multipath Movies combine the best qualities of
traditional filmed entertainment -- complex characters, stories and plots, with
the best of traditional computer games -- interactivity. Multipath Movies are
three-dimensional, digitally animated stories with many plot alternatives, or
paths, that are influenced by user interaction throughout the story. The Company
is targeting a larger market than users of traditional computer games for its
Multipath Movie products; Multipath Movies will be as short as 30 minutes in
length so that users can enjoy them within a single sitting and will utilize
content that is designed to appeal to a wide variety of audiences.


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         Multipath Movies are unlike any other entertainment product known to
the Company. In contrast to existing compressed video interactive movies, the
action of a Multipath Movie does not stop while a user makes decisions. A user's
decisions are implemented seamlessly because the Company's proprietary
DigitalProjector has the technical ability to form and manipulate streams of
complex three-dimensional animated images in real time, sequentially, for the
duration of the movie. A Multipath Movie provides the user with up to hundreds
of plot branches leading to a number of different conclusions. The opening
scenes of each Multipath Movie will require limited interaction, which is
intended to introduce users to the story in a manner that builds user empathy
with the lead characters and teaches the user how to interact with a Multipath
Movie. Further into a Multipath Movie, the level of prompted interactivity will
increase and prompts are designed to become less direct and more intuitive.
Users interact with Multipath Movies by responding with a mouse, keyboard or
remote control device to decision points which affect the plot of a Multipath
Movie. Decision points are identified by indicators that include (i) on-screen
or dialogue prompts that manipulate the moods and personality profiles of the
main characters, which in turn produce new plot directions and story lines, (ii)
a character choice icon appearing at pre-scripted points where there is tension
between two characters or characters have differing opinions about an issue
which requires the viewer to make a supportive selection, and (iii) a mechanism
which inventories items a character has collected in prior scenes and provides
the user access to those items at set moments which in turn affect the action
and the outcome of a scene.

         For example, in viewing Cyberswine, the users' responses to prompts
determine a character's actions and affect the character's mood, thereby
influencing its future decisions. If the user elects not to respond at any given
prompt, the collective impact of the user's previous responses on the
character's mood will drive subsequent branching decisions. In Cyberswine, if a
user elects aggressive options in response to prompts, subsequent branching
decisions will be made automatically as if an aggressive response was given by
the user. Additionally, in Xena: Warrior Princess the Company plans to
incorporate an interface mechanism enabling users to make characters collect
items such as weapons, valuables or food that they can use in later scenes.

         The Multipath Movie allows the user to jump forward or reverse to
previously viewed scenes and, if desired, to select a different decision path.
The user can view the Multipath Movie from the perspective chosen by the
director or elect an almost infinite number of alternative camera angles. The
user can also control camera angles to search for information or clues that
might prove valuable in later scenes. In addition, users or their parents can
select an appropriate age rating (such as "G," "PG," or "R") and thereby limit
certain camera angles or scenes. Multipath Movies can also include a feature
enabling more than one user to interact with the characters of the Multipath
Movie.

         The Company plans to release Multipath Movies in the following formats:

         Retail CD-ROM Titles. The Company intends to produce versions of its
Multipath Movies in stand alone CD-ROM format for retail distribution.

         Bundled Titles with Online Capability: The Company is developing a
system that enables users to play Multipath Movies in real time over the
Internet through various online delivery systems. To date, low data transmission
rates have precluded real-time video viewing of digital entertainment over the
Internet, but the Company has developed a system permitting real-time online
interactivity with its Multipath Movies. As part of the Company's system, most
of the data necessary for viewing Multipath Movies is distributed on CD-ROM or
installed on PC hard drives by manufacturers. This data generally includes a
library of characters, scenes, graphics, sound and other components, as well as
DigitalProjector, which includes the architecture necessary for playing the
Multipath Movie and accessing the Internet for future episodes. Generally,
consumers will receive a preview or first episode of a Multipath Movie title
without being required to connect to the Internet. Because most of the data
necessary to play a Multipath Movie and future episodes is resident on the
CD-ROM or hard drive of the viewer's computer, a low-bit rate data stream can be
delivered via the Internet to provide the animation and storyline for future
episodes. The Company is currently also developing technology that will stream
animation messages as well as sound, which will then not be required to reside
on the user's CD-ROM or hard drive.

         Television Broadcast/Cable Programming and Home Video. The Company also
plans to release certain of its Multipath Movie titles in non-interactive
format, as television broadcast/cable programming and as home video features.
The Company intends to segment such Multipath Movies into episodes for sale into
the 30-minute broadcast and cable


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series market. By packaging together multiple episodes, the Company can create a
season-length series. Similarly, the Company plans to produce features from
certain Multipath Movies by selecting a predetermined plot ending and to market
these 80- to 120-minute features to home video publishers.

         MULTIPATH MOVIE CONTENT CATEGORIES

         The Company is developing a broad range of Multipath Movie titles
designed to appeal to viewers of varying ages and tastes. Much of the PC-based
digital entertainment developed to date has been designed for the dedicated
computer game player, typically an eight to 21-year-old male with substantial
free time and spending money who appreciates game playing complexities. The
Company's strategy is to develop and produce Multipath Movie titles based upon
various types of compelling content directed at discrete consumer categories.
Because internally-developed titles require significant time and expertise, the
Company intends to place even greater emphasis on licensed content in the
future. The Company is currently developing titles according to the following
categories:

         Multipath Movie Features. The Company's first Multipath Movie,
Cyberswine, was produced from original scripts developed by the Company, and is
loosely based on an Australian science fiction comic strip series. The Company
has certain royalty obligations on revenues derived from Cyberswine. The Company
is also developing various other titles for this category including the
internally generated series, Gravity Angels and Ten Weeks in the Head Bin, as
well as titles based on licensed content including Ace Ventura, Xena: Warrior
Princess and Superman. Additional titles in this category will be based on
science fiction, adventure, comedic and other types of underlying content and
may capitalize on popular and widely recognized film, television and comic strip
characters and personalities. The Company intends to investigate and pursue
content opportunities for this category that will continually broaden the appeal
of Multipath Movie features.

         Storyteller Series. The Company is also developing the Storyteller
Series, which is a series of Multipath Movies targeting children eight to twelve
years of age. The Storyteller Series will be based upon published children's
books and original stories. Initial titles in the Storyteller Series, including
Night of the Werewolf and Biting for Blood, will be based upon Bantam Doubleday
Dell's popular children's series, Choose Your Own Adventure, currently comprised
of approximately 181 titles, and Choose Your Own Nightmare, currently comprised
of approximately 18 titles. Each of these book series is written in a branching
format, in which the reader will skip to different pages or chapters of the book
depending upon responses to questions posed in the story. Because of the
branching nature of the Choose Your Own Adventure and Choose Your Own Nightmare
series, the Company believes that these stories are ideally suited to the
multipath format of the Storyteller Series. The Company introduced the
Storyteller Series at the end of the fourth quarter of 1997.

         Multipath Movies for Kids. The Company is developing Multipath Movies
for Kids for children three to twelve years of age. These titles will be
specifically designed to appeal to this age group by including more comic-like
characters and engaging music and sound effects. The first title, Quest for the
Woolly Mammoth, featuring Popeye, was completed at the end of the fourth quarter
of 1997.

INTERNET TICKETING

         The Company has also developed its own proprietary ticketing system to
collect revenue from its online users. The Company's ticketing system is
designed for compatibility with a wide variety of data storage and content
billing arrangements, and to provide added value for ISPs and allow customers to
be billed more easily under a variety of charging options. The Company's
ticketing system allows a viewer to purchase a "Movie Ticket." The Company's
proprietary ticketing system and multipath serving software currently reside on
restricted access servers at the facilities of Worldsite Networks ("Worldsite"),
and are maintained, upgraded and queried for reports by the Company via remote
access. Through the facilities of Worldsite, the Company (i) receives requests
from customers to purchase Tickets, (ii) receives, processes and transmits
credit card or other payment authorization sufficient to allow the Company to
receive payment of the price of each Ticket from the customer's bank, credit
card processor, ISP, debit account, or special purpose Internet charge or
payment account, (iii) delivers Tickets to customers, (iv) provides Multipath
Movie instructions after receipt, verification and cancellation of the
customer's Ticket and (v) collects and processes information relating to
customers for the benefit of the Company.


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THE PRODUCTION OF MULTIPATH MOVIES

         The production process for Multipath Movies consists of eight phases:
scripting, creative design, voice and sound, model and world building, texturing
and lighting, blocking/camera editing, special effects animation and the
generation of rendered output.

         The production of a Multipath Movie is very similar to the production
of a traditional film. Just as the traditional film director identifies
locations, builds sets and chooses actors, the digital Multipath Movie director
builds "worlds" and "models." In the same way that traditional filmed
entertainment directors give actors wardrobes and props, the Multipath Movie
director "textures" the models.

         The Multipath Movie production process, however, differs from the
traditional movie process in three important ways. First, the traditional
process is substantially more labor intensive, requiring large crews, artisans
and technicians to produce a final product. Once scenes are filmed and edited,
any reshoots require the re-assembling of actors and crews, which is not only
costly but often not feasible. Second, filming and editing in the traditional
film process are two separate functions that cannot be performed simultaneously.
Through digital production, a scene, or group of scenes, can be blocked,
animated and edited at the same time. As a result, the producer can immediately
view the scene and make any necessary changes while avoiding substantial costs
and logistical problems. Finally, the digital Multipath Movie process allows the
producer to easily substitute models and worlds, alter texturing and lighting,
alter the blocking and editing process and alter special effects. By clicking
the mouse, the director/scriptwriter can preview entire scenes, add/delete
characters and plots, and automatically change the appearance of a character or
object. Because the characters and sets are all digitally produced and then
animated by the Company's tools, set components (such as language on storefronts
and vehicles) and personal features such as skin tone and hair color only need
to be changed once to effect the desired change throughout the Multipath Movie.

         TECHNOLOGY; BRILLIANT'S SOFTWARE TOOLS AND PRODUCTION CAPABILITIES

         The Company has developed five proprietary software tools that enable
it to produce high-quality Multipath Movies: (i) ScripNav, a software tool that
enables a script writer to write, review and correct branching multipath
scripts; (ii) TalkTrack, a software tool used to synchronize facial expressions
and mouth movements to voice soundtracks automatically; (iii) SCuD Engine, a
software system which collects and integrates the output from all of the
component tools to produce the Multipath Movie; (iv) Mr. Copy, a new software
tool that arranges, reorders and, using licensed technology, compresses and
decompresses audio and bit map files created during the production of a
Multipath Movie and optimally organizes the files for use in playing the
Multipath Movie; and (v) DigitalProjector, which contains all the necessary
elements to load and play a Multipath Movie.

         ScripNav. ScripNav was developed specifically for the writing of
complex Multipath Movie scripts. A scriptwriter will use ScripNav to compose,
edit and finalize a script using a commercially available word processing
package. Then, the scriptwriter will insert various subplots into scenes in
order to adapt the script to the Multipath Movie format; the alternative
subplots, or paths, are based upon different temperaments of the lead character.
For example, if the character is angry, the character will approach the other
characters and the events in the scene in a much more aggressive and hostile
manner, which will, in turn, send the plot in the appropriate direction. By
inserting directional guides throughout the script, the scriptwriter is able to
create a script with multiple paths and endings based on a character's moods and
his or her interactions with the other characters. Once the script has been
developed in the Multipath Movie style, ScripNav enables the scriptwriter to
read, review and correct the script. ScripNav then corrects for syntax and
branching errors and allows the scriptwriter to review the multiple plots
produced. Lastly, ScripNav produces statistics that allow the scriptwriter to
identify scenes that either cannot or are unlikely to be reached through the
plot's development and, therefore, should be excluded from the final Multipath
Movie product.

         TalkTrack. TalkTrack automatically synchronizes a character's lip
movements with corresponding dialogue tracks by examining wave files and
generating output files that contain references to the appropriate mouth shapes.
The tool samples sounds and matches them to the most appropriate mouth shape,
and in the process, builds a library of correct sound samples with a direct
relationship to a correct mouth shape. As the Company creates more content, it
will build a


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library of improving sound and mouth shape matches. The Company believes that
TalkTrack is a more efficient and cost effective way to incorporate voice into
Multipath Movies than other existing sound tools. In addition, TalkTrack allows
for low cost modification of the Multipath Movies to any language without the
awkward appearance of dubbed movies. The sophistication of this tool was
significantly enhanced during 1997 by incorporation of improved voice sampling
techniques and database applications and by incorporating licensed lip
synchronization technology.

         SCuD Engine. SCuD Engine is the centerpiece of the Multipath Movie
development and production process. SCuD Engine is an object-oriented
environment that collects and integrates source files from ScripNav, graphics,
sound and TalkTrack tools and makes them available for layup and editing. SCuD
Engine provides a multi-window editing environment in which the developer can
preview, analyze and edit the final product. When a previously unedited scene is
opened, SCuD Engine retrieves the text for the scene from the script text file
of ScripNav and places the text in on-screen blocks or slots. The layup artist
can then view the descriptive or dialogue text while attaching imported
graphics, sound and other source material to that line of script. SCuD also
includes a Shot Based Editing System which enables multiple sets and or props to
be incorporated into one scene such that cuts and edits can take place in line
with a traditional film environment. For example, in Cyberswine the specific
scene data (sets and props) could be loaded into memory and then shown through
different camera positions. In Gravity Angels, data from a number of different
scenes (multiple scene sets and props) can be loaded into memory residing in an
'off' state until it needs to be used by the camera or editor at which state it
returns to an 'on' state. This substantially improves the visual richness of
scenes.

         Mr. Copy. The Company has recently developed Mr. Copy which builds,
integrates and allocates the final data files in composing a Multipath Movie to
be played on the DigitalProjector. Mr. Copy arranges, assembles and, using
licensed technology, compresses and decompresses thousands of audio and bit map
files that are created during the development of a Multipath Movie in a manner
that optimizes the playing of the title. Mr. Copy compresses files allowing up
to five hours of branching content to be captured in as little as 60 megabytes
of disk space, as compared with conventional technologies which presently would
require at least one gigabyte of storage.

         DigitalProjector. DigitalProjector contains all the necessary
components to load and play the final Multipath Movie product. DigitalProjector
is the software engine for any system that is being used to play the Multipath
Movie and is generally the only software tool that the Company must modify to
permit the Multipath Movie to be adapted to new platforms. The Company has
developed DigitalProjector for IBM-compatible PCs, and may develop
DigitalProjector for other platforms.

         In addition to its proprietary software tools and engines, the Company
uses certain commercially available sound and graphics tools in the Multipath
Movie production process. The Company's proprietary tools used in conjunction
with commercially available tools allow the developer to produce a high quality
Multipath Movie from the initial scripting stage to the generation of title
output.

         In order to further promote the Multipath Movie as a digital
entertainment format, the Company intends to release on a limited basis object
code versions of its software tools to selected entertainment production
companies and other entertainment professionals. The Company intends to release
these software tool sets through joint venture arrangements in which the Company
can control the proprietary value of the software tools and control their
dissemination. As part of these joint venture arrangements, the Company will
provide certain technical and production assistance, while deriving revenue from
a retained ownership interest in the Multipath Movie titles produced by the
joint venture partner. The Company will particularly target potential joint
venture partners with either the type and availability of content or other
creative and production skills that are well-suited to the software tools and
production of Multipath Movies. The Company believes that the availability and
use of the software tools by the entertainment community at large will stimulate
the overall level of interest in the Multipath Movie format and will increase
the number of available Multipath Movie titles, thereby helping to establish the
Multipath Movie format as a de facto standard. Additionally, the Company intends
to selectively adapt and enhance its tools to include features suggested by
entertainment production professionals.


                                       8

<PAGE>   9

SALES AND MARKETING

         The Company's sales and marketing program is designed to achieve
revenue growth, create and continue capturing new customers and promote the
ongoing growth of the Multipath Movie genre through various distribution methods
and promotional initiatives. In order to facilitate the broad acceptance of
Multipath Movies, the Company is pursuing a broad distribution strategy. The
Company is focusing on three primary channels in building broad distribution of
its product formats:

         CD-ROM Retail Channels and Direct-To-Retail. The Company is continuing
to establish a retail distribution program in which Multipath Movies will be
marketed through traditional software publishers and distributors nationwide. In
addition, the Company will seek to substantially broaden distribution in retail
and mass market outlets, including video retailers, during 1998. The Company
seeks to develop multiple arrangements without giving broad title exclusivity to
any particular publisher or distributor. To complement these arrangements, the
Company is also establishing a direct-to-retail program in which the Company
will enter into certain marketing and distribution agreements with selected
retailers with particular emphasis on national and regional computer, office and
mass merchants. The Company will outsource the logistical, shipping and
warehousing needs for its direct-to-retail program.

         Internet and Online Services. Given the importance of Internet and
online delivery in the overall success of the Multipath Movie format, the
Company believes that it is critical to make Multipath Movies available to as
many Internet and online service users as possible. Consequently, the Company
seeks to bundle its titles on various types of PC hardware. Through its
relationship with Packard Bell NEC, Packard Bell NEC is obligated to bundle the
Company's products on up to six million PCs shipped during a three-year period.
The Company will continue to pursue additional bundling arrangements with other
OEM manufacturers. To complement its title bundling arrangements, the Company is
also establishing a site for its Multipath Movies as part of the online service
offered by CompuServe, including a bulletin board, library and conferencing/chat
area. As part of this program, selected Multipath Movie titles will be
distributed to Compuserve users on CD-ROMs, which will allow them to purchase
Multipath Movies through this site.

         Television Broadcast/Cable Programming and Home Video. The Company
currently anticipates that it will begin to market its Multipath Movies as
television programming and home video features. Due to the episodic and serial
nature of its Multipath Movies, the Company's titles are easily adaptable to the
episodic television market. In addition, by grouping multiple episodes together,
the Company can also produce titles for the cable and direct to video markets.

INTERNATIONAL SALES AND MARKETING

         The Company's international sales and marketing strategy will be
managed from the United States and will be executed through a combination of
domestic and offshore efforts. The Company's strategy for international
distribution is to utilize exclusive arrangements for specific countries or
dedicated territories with distributors, which in management's opinion, are best
suited to direct the commercial launch and ongoing marketing support of products
in that country or territory. The Company believes that it will be able to
continue to capitalize on management's extensive network of international
relationships and background in the international distribution of CD-ROM
products. In 1997, the Company retained a managing director for Europe, based in
the United Kingdom. The Company is currently exploring possible product
development and distribution joint venture and strategic relationship
opportunities in Europe. The Company believes that product distribution in
Europe will require implementation of localized distribution strategies and
methods through established regional distributors. In addition, the Company
believes that greater emphasis on traditional retail distribution methods will
be required in Europe initially because of lower Internet usage rates in this
region.

         Given the global nature of the World Wide Web, the Company believes
that international markets represent a significant incremental opportunity for
its Multipath Movies delivered over the Internet. Utilizing its proprietary
TalkTrack technology, the Company believes it can deliver Multipath Movies in
foreign languages without significant logistical or cost issues. In particular,
the Company intends to initially explore opportunities in France and Germany.
Because the lip movements of the characters are automatically synchronized to
the dialogue track of the Multipath Movie, the Company has the ability to
downstream foreign-language versions to international online users of Multipath
Movies.


                                       9

<PAGE>   10

STRATEGIC, CONTENT AND DISTRIBUTION RELATIONSHIPS

         The Company has entered into various strategic relationships and other
arrangements to assist in the development, production and distribution of
Multipath Movies. These strategic relationships will be an integral element in
the execution of the Company's business strategy.

         Packard Bell NEC. The Company entered into an agreement with Packard
Bell NEC in September 1996 for Packard Bell NEC to bundle software for a
Multipath Movie title with 80% of the first 7.4 million multimedia equipped
personal computers shipped by Packard Bell NEC in the United States, Canada, the
United Kingdom, Australia, New Zealand and South Africa over a three-year period
which began in August of 1997 (the "Shipping Period"). The bundled software
allows the user to play or download Multipath Movies from an Internet site
established by the Company. The bundled software permits viewing of a preview or
the first episode of Cyberswine and includes a library of characters, scenes,
graphics, sound and other components permitting viewing of future episodes of
the title. The Company has the ability to periodically substitute other
Multipath Movie titles for the Cyberswine title initially bundled by Packard
Bell NEC. For a period ending two years following the expiration of the Shipping
Period, Packard Bell NEC has agreed to provide point of sale retail advertising
for the Multipath Movies distributed through Packard Bell NEC, and to create a
prominently displayed icon on the Packard Bell NEC screen display which, when
clicked, will enable the user to view a preview of the Multipath Movie and
purchase the entire Multipath Movie. Packard Bell NEC received warrants to
purchase 600,000 shares of the Company's Common Stock upon execution of the
agreement.

         Under the terms of a September 1997 agreement, the Company granted to
Packard Bell NEC the right to distribute a version of Cyberswine loaded on the
hard drives of Packard Bell NEC computers. Under the September 1997 agreement,
the Company will receive a percentage of future revenue from online end users,
for a portion of the Shipping Period, and a minimum fixed fee. The Company also
granted distribution rights to future Multipath Movie titles which become
available during a portion of the Shipping Period, for a percentage of future
revenues from end users. Upon expiration of this portion of the Shipping Period,
the Company will be entitled to all revenues that are derived from Multipath
Movies distributed pursuant to the September 1996 agreement. In connection with
this agreement, the Company granted to Packard Bell NEC warrants to purchase
200,000 shares of the Company's Common Stock.

         Morgan Creek Productions. The Company has entered into an agreement to
form a joint venture with Morgan Creek Interactive, a subsidiary of Morgan Creek
Productions. Morgan Creek is a principal developer and distributor of feature
films; past features include "Ace Ventura: Pet Detective," and "Ace Ventura:
When Nature Calls." The agreement provides that Morgan Creek will contribute to
the joint venture a nonexclusive license to two motion picture scripts for use
in the development of Multipath Movies to be distributed on CD-ROM for PCs and
over the Internet. The first project commenced under this agreement is a
thirteen episode comedy adventure series featuring the Ace Ventura character.
The Company is scripting three episodes of Ace Ventura, which it expects to
complete during 1998. The Company expects to complete scripting of an additional
six episodes during 1999. The rights granted by Morgan Creek under the agreement
do not extend to broadcast/cable television programming. Morgan Creek is
providing certain creative, direction and film development assistance to the
Company. The Company will be responsible for all development costs of the
Multipath Movies but will be entitled to recover such costs before Morgan Creek
will participate in any revenues generated from the Multipath Movies created by
the joint venture. The Company will also contribute to the joint venture a
nonexclusive license to the Company's DigitalProjector software tool solely for
use in connection with two Multipath Movies to be produced by the joint venture.
In exchange for the contribution of development content, Morgan Creek will
receive, following the Company's recovery of production costs and the Company's
recovery of its investment in the joint venture, a designated percentage of the
joint venture's revenues. Morgan Creek also received warrants to purchase 85,000
shares of the Company's Common Stock. The agreement provides that Morgan Creek
will own all intellectual property related to the content used in the Multipath
Movies created by the joint venture and will have the right to exploit such
content for other uses without any royalty obligation to the joint venture or
the Company, although the Company will retain all rights to the licensed
software tool.

         Bantam Doubleday Dell Books for Young Readers. The Company has entered
into an agreement (the "Bantam Agreement") with Bantam Doubleday Dell providing
the Company with an option to acquire exclusive worldwide interactive rights to
Bantam Doubleday Dell's "Choose Your Own Nightmare" and "Choose Your Own
Adventure" series of interactive books. The Company's option covers over 185
titles, plus any additional titles in each series published by


                                       10

<PAGE>   11

Bantam Doubleday Dell. The Company's rights include rights to adapt the licensed
titles to interactive format only and to deliver the products on CD-ROMs and via
the Internet. By exercising its option, the Company will be required to acquire
no less than 18 titles during the seven-year term of the Bantam Agreement.
Bantam Doubleday Dell will be entitled to receive a portion of the net proceeds
from sales of the licensed titles. Upon the Company's election of each of the
first 16 titles, in batches of four titles, the Company is required to pay
Bantam Doubleday Dell a nonrefundable advance against which royalties will be
applied. To date, the Company has exercised its option on 10 titles.

         King Features Syndicate. The Company has entered into an agreement with
King Features Syndicate providing the Company with the right to use its
character Popeye and related story characters in Multipath Movies for play on
PC-based CD-ROM products and over the Internet in countries where English is the
predominantly spoken language. The option includes the right to adapt licensed
titles for a number of Multipath Movies. The Company has paid King Features
Syndicate a cash advance against future royalties. If the Company meets certain
minimum earned royalty levels, the Company shall have the option to extend the
agreement for two years beyond its original three-year term which continues
until December 31, 1999.

         Universal Studios. The Company's agreement with Universal provides the
Company with the rights to use certain story scripts from the live action
television series Xena: Warrior Princess and animated character designs from the
direct-to-video motion picture Hercules & Xena the Animated Movie for use in the
production of Multipath Movies. The sale of Multipath Movie titles based on the
original plots can be made for the CD-ROM and DVD platforms and additional plots
can be distributed and sold via the Internet. The Company has paid Universal
Studios part of an advance against future royalty payments and guaranteed
minimum royalties. The initial term of this agreement continues until January
31, 2002.

         D.C. Comics (Warner Bros.). The Company's agreement with D.C. Comics
provides the Company with the rights to use the comic strip character "Superman"
in Multipath Movies which can be distributed on CD-ROM and DVD platforms, or via
the Internet. The Company has a guaranteed advance against royalties. The
Company is also obligated to pay D.C. Comics a certain percentage of net
advertising proceeds received from the sale of Multipath Movies based on the
Superman character. The initial term of the agreement continues until September
1, 2001.

         Crawford Productions. The Company has entered into a production joint
venture with Crawford Productions Pty., Ltd. ("Crawfords"), an Australian
television and production company, to develop two Multipath Movies. The Company
and Crawfords have not identified a mutually agreeable product for the joint
venture. Pursuant to the joint venture, Crawfords and the Company would each
fund one-half of the development budget of the joint venture. Crawfords would be
responsible for distributing broadcast and cable versions of the two Multipath
Movies and the Company would distribute the Multipath Movies in interactive
computer-based formats. Crawfords and the Company would equally divide all
proceeds from exploitation of the two Multipath Movies created by the joint
venture. There can be no assurance that the Company and Crawfords will reach
agreement on a project for the joint venture, or that the joint venture will
successfully produce a Multipath Movie.

         CompuServe. CompuServe has agreed to distribute the enabling software
and digital assets for the Company's Multipath Movies on CompuServe's CD-ROMs
sent to its members and prospective members. If CompuServe determines not to
distribute the enabling software and digital assets on its upgrade CD-ROMs, the
Company may terminate the agreement. The Company will establish a site providing
CompuServe users access to Multipath Movies. Through the site, CompuServe users
will be able to download files in order to view various Multipath Movies and
episodes. The site will also include a Forum consisting of a message board,
library and "chat" area. The site will be hosted by computer facilities provided
by CompuServe. Under the agreement, the Company will receive a portion of
Multipath Movie revenues, connect-time fees and advertising and sponsorship fees
generated by use of the Company's CompuServe site. The Company will also receive
"bounties" for CompuServe subscribers brought to CompuServe by the Company's
marketing efforts.

         Others. The Company has granted Matrox, a manufacturer of graphics
acceleration hardware, the right to place the first episode of Cyberswine on an
Internet enabled CD-ROM bundled with Matrox products. S3, a manufacturer of
graphics acceleration hardware, has entered into a two-year agreement with the
Company permitting, but not requiring, S3 to bundle Cyberswine on a CD-ROM
distributed with its three dimensional hardware products. The Company is also


                                       11

<PAGE>   12

actively pursuing additional bundling, distribution and licensing arrangements
pursuant to which Multipath Movies would be distributed through the original
equipment manufacturer and through specialty software and mass merchandiser
retail channels. There can be no assurance that the Company will successfully
conclude any such relationship, or that if concluded, such relationships will be
implemented in a manner that significantly increases Multipath Movie
distribution or revenues.

RESEARCH AND DEVELOPMENT

         The Company's research and development program is focused on: (i)
enhancing the Company's software tools to continually add features identified by
and of value to the creative and production entertainment communities, (ii)
developing enhanced Internet delivery capabilities for Multipath Movies, (iii)
improving the Company's proprietary object-oriented database to enhance facial
expressions and mouth movements of Multipath Movie characters, and (iv)
increasing the efficiency of its object-oriented production process. The
Company's research and development program includes development of a proprietary
object-oriented database intended to give Multipath Movie producers ready access
to the Company's database of objects, such as sets, props and characters, and
thereby increase production efficiencies. The Company is expending substantial
resources in its research and development facility in Australia, where it
maintains a staff of sixteen engineers. Research and development expenses for
the years ended December 31, 1996 and 1997 were $1,996,000 and $1,709,000,
respectively. Research and development expenses for 1996 include $1,350,000 of
in-process research and development costs incurred in connection with the SAND
acquisition in September 1996.

COMPETITION

         The markets for the Company's digital entertainment products are
intensely competitive, subject to rapid change and characterized by constant
demand for new product features at reduced prices and pressure to accelerate the
release of new products and product enhancements. The Company expects to compete
with computer graphics special effects firms, including Pixar, ILM, Digital
Domain, Sony ImageWorks, Pacific Data Images, Rhythm & Hues and Boss Film
Studios, Inc. The Company also expects to compete with firms producing CD-ROM
products such as Broderbund, GT Interactive, Electronic Arts, Learning Company,
CUC and large corporations, such as Disney and Microsoft, with substantial bases
of intellectual property content and substantial financial resources, who have
entered or announced their intention to enter the market for CD-ROM
entertainment products. Finally, the Company's Multipath Movies will compete
with traditional feature films and television programming produced by major
movie studios, including Disney, Warner Bros., Twentieth Century Fox, Paramount,
Sony, Lucasfilm, MCA Universal and MGM/UA, as well as numerous other independent
motion picture and television production companies. Several movie studios
already have developed their own internal computer animation capability and have
developed and released animated feature films or created computer animation for
special effects in animated films. The Company expects additional competition in
the animated feature film market from these and other movie studios. The Company
will also compete with movie studios for the acquisition of literary properties,
production financing, the services of performing artists, and the services of
other creative and technical personnel, particularly in the fields of animation
and technical direction.

PROPRIETARY RIGHTS

         The Company's success and ability to compete is dependent in part upon
its proprietary technology. The Company also relies on trademark, trade secret
and copyright laws to protect its technology, with the source code for the
Company's proprietary software being protected both as a trade secret and as a
copyrighted work. Also, it is the Company's policy that all employees and
third-party developers sign nondisclosure agreements. However, there can be no
assurance that such precautions will provide meaningful protection from
competition or that competitors will not be able to develop similar or superior
technology independently. Also, the Company has no license agreements with the
end users of its products and does not copy-protect its software, so it may be
possible for unauthorized third parties to copy the Company's products or to
reverse engineer or otherwise obtain and use information that the Company
regards as proprietary. Although the Company is not aware of unauthorized
copying of its products, if a significant amount of unauthorized copying of the
Company's products were to occur, the Company's business, operating results and
financial condition could be adversely affected. Furthermore, policing
unauthorized use of the Company's products is difficult and costly, and software
piracy can be expected to be a persistent problem. If litigation is necessary in
the future to enforce the Company's intellectual property rights, to protect the
Company's trade secrets or to determine the validity and scope


                                       12

<PAGE>   13

of the proprietary rights of others, such litigation could result in substantial
costs and diversion of resources and could have a material adverse effect on the
Company's business, operating results and financial condition. Ultimately, the
Company may be unable, for financial or other reasons, to enforce its rights
under intellectual property laws and the laws of certain countries in which the
Company's products are or may be distributed may not protect the Company's
products and intellectual rights to the same extent as the laws of the United
States.

         The Company believes that its products, including its suite of software
tools, do not infringe any valid existing proprietary rights of third parties.
Since the software tools used to create the Multipath Movies were developed by
SAND, a division of Sega Ozisoft, the Company relies entirely on the
representations of Sega Ozisoft contained in the SAND Acquisition Agreement
between BII-Australia and Sega Ozisoft that, to Sega Ozisoft's best knowledge,
the SAND technology and software acquired by the Company does not infringe the
proprietary rights of others. Additionally, although the Company has received no
communication from third parties alleging the infringement of proprietary rights
of such parties, there can be no assurance that third parties will not assert
infringement claims in the future. Any such third party claims, whether or not
meritorious, could result in costly litigation or require the Company to enter
into royalty or licensing agreements. There can be no assurance that any such
licenses would be available on acceptable terms, if at all, or that the Company
would prevail in any such litigation. If the Company were found to have
infringed upon the proprietary rights of third parties, it could be required to
pay damages, cease sales of the infringing products and redesign or discontinue
such products, any of which could have a material adverse effect on the
Company's business, operating results and financial condition.

EMPLOYEES

         At December 31, 1997 the Company had 74 full-time employees: 14 engaged
in research and development, 53 in production, five in general administration
and finance and two in sales and marketing. None of the employees of the Company
is covered by a collective bargaining agreement. The Company considers its
relationship with its employees to be good. The Company currently utilizes the
services of nine independent software developers pursuant to contractual
relationships.

         The Company intends to hire additional key personnel in the near
future. The Company's expansion may significantly strain the Company's
management, financial and other resources. Any failure to expand these areas in
an efficient manner could have a material adverse effect on the Company's
operating results.

         The Company believes its future success will depend in large part on
the Company's ability to recruit and retain qualified employees, particularly
those highly skilled design, process and test engineers involved in the
manufacture of existing systems and the development of new systems and
processes. The competition for such personnel is intense. There can be no
assurances that the Company will be successful in retaining or recruiting key
personnel. Three of the Company's employees, the Chairman and CEO, the CFO and
the Director of Licensing, are based in Los Angeles, California. All other
employees operate out of facilities located in Bondi Junction and Woollahra,
both suburbs of Sydney, Australia.


ITEM 2.  DESCRIPTION OF PROPERTIES.

PROPERTIES

         The Company's production facilities, consisting of approximately 8,500
square feet, are located in Bondi Junction, Australia. At December 31, 1997, the
research and development facilities, consisting of approximately 1,900 square
feet, were located in Woollahra, Australia. During January 1998, the Company
expanded its production facilities to approximately 12,800 square feet, and
moved and expanded its research and development division into facilities
consisting of approximately 3,300 square feet in Double Bay, Australia. The
current annual rental under the Bondi Junction lease is $163,000 and under the
Double Bay lease is $59,000. The Company also leases an office in Woodland
Hills, California for rent of approximately $69,000 per annum.


                                       13

<PAGE>   14

         The Company anticipates using up to $0.5 million during 1998 to expand
its current production studio in Bondi Junction and its research and development
facilities in Double Bay. The current facility is fully operational with six
sound studios and fifty four work stations for modeling and animation as well as
a number of additional work station seats for authors and graphic artists that
work on a contract basis. The Company anticipates expanding this studio to
accommodate additional sound studios and work stations. In addition, the Company
anticipates using up to $0.7 million in 1998 and 1999 to establish new
production facilities in California. It is anticipated that these facilities
will develop and produce titles with local joint venture partners and overflow
work from Australia. Research and development with respect to the continual
enhancements and upgrades of the Company's proprietary software tool suite will
be maintained in Double Bay.


ITEM 3.  LEGAL PROCEEDINGS.

         The Company is not involved in any litigation.


ITEM 4.  SUBMISSION OF MATTER TO A VOTE OF SECURITYHOLDERS.

         None.


                                       14

<PAGE>   15

                                     PART II


ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED MATTERS.

COMMON STOCK

         The Company's Common Stock commenced trading on the American Stock
Exchange on November 22, 1996 under the symbol "BDE." Prior to that time, there
was no public market for the Company's Common Stock. The following table sets
forth, for the periods indicated, certain high and low prices for the Common
Stock as reported by the American Stock Exchange.

<TABLE>
<CAPTION>
                                                                High             Low
                                                               -----            -----
<S>                                                            <C>              <C>
YEAR ENDED DECEMBER 31, 1996
     Fourth Quarter (beginning November 22, 1996) ..........   $5.13            $3.56

YEAR ENDED DECEMBER 31, 1997
     First Quarter .........................................    6.00             3.88
     Second Quarter ........................................    8.38             4.50
     Third Quarter .........................................    9.88             6.25
     Fourth Quarter ........................................    9.38             4.00
</TABLE>

         On March 27, 1998, the closing price of the Common Stock as reported on
the American Stock Exchange was $2.375 per share. As of March 27, 1998, there
were 20 holders of record of the Common Stock.

RECENT SALES OF UNREGISTERED SECURITIES

         In November 1997, the Company issued warrants to purchase 15,040 shares
of Common Stock at an exercise price of $5.50 per share to Chloe Holdings, Inc.
("Chloe") as partial consideration valued at $20,000 for services rendered in
connection with the Company's public offering in December 1997. The warrants
vest and become exercisable in December 1998 and expire on November 4, 2000.
Chloe covenanted that (i) it acquired the warrants for its own account with the
present intention of holding such warrants for investment purposes only and not
with a view to, or for sale in connection with, any distribution of such
warrants (other than a distribution in compliance with all applicable federal
and state securities laws); (ii) it is an experienced and sophisticated investor
and has such knowledge and experience in financial and business matters that it
is capable of evaluating the relative merits and the risks of an investment in
the warrants and of protecting its own interests in connection with the
transaction at issue; (iii) it is willing to bear and is capable of bearing the
economic risk of an investment in the warrants; and (iv) the Company made
available to it, prior to the date of the warrant agreement, the opportunity to
ask questions of the Company and its officers, and to receive from the Company
and its officers information concerning the terms and conditions of the warrant
and the warrant agreement and to obtain any additional information with respect
to the Company, its business, operations and prospects, as reasonably requested
by it; and (v) it is an "accredited investor" as that term is defined under Rule
501(a)(4) of Regulation D promulgated by the Commission under the Securities
Act. The issuance and sale of these securities was exempt from the registration
and prospectus delivery requirements of the Securities Act pursuant to Section
4(2) of the Securities Act (in accordance with Rule 506 of Regulation D) as a
transaction not involving any public offering.

DIVIDENDS

         The Company has never paid any dividends on its Common Stock. The
Company intends to retain any earnings for use in its business and does not
intend paying any cash dividends on its Common Stock in the foreseeable future.


                                       15

<PAGE>   16

ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS.

         The following discussion and analysis should be read together with the
Consolidated Financial Statements of the Company and notes thereto incorporated
elsewhere in this Form 10-KSB.

         This discussion summarizes the significant factors affecting the
consolidated operating results, financial condition and liquidity/cash flows of
the Company for the twelve, six and twelve month periods ended December 31,
1997, December 31, 1996 and June 30, 1996, respectively. Except for the
historical information contained herein, the matters discussed in this
Management's Discussion and Analysis of Financial Condition and Results of
Operations are forward looking statements that involve risks and uncertainties
and are based upon judgments concerning various factors that are beyond the
Company's control. Actual results could differ materially from those projected
in the forward looking statements as a result of, among other factors, the
factors set forth under the caption "Cautionary Statements and Risk Factors"
below.

OVERVIEW

         Brilliant is a production and development studio producing a new
generation of digital entertainment that is being distributed over the Internet
and on CD-ROM. The Company, headquartered in the United States, was incorporated
in July 1996. The Company was formed through the combination of two businesses:
Brilliant Interactive Ideas, Pty. Ltd. ("BII Australia"), an entertainment
software developer and producer; and Sega Australia New Developments ("SAND"), a
"skunk works" research and development operation for leading edge software
tools. BII Australia became a wholly owned subsidiary of the Company through the
exchange of all 100,000 outstanding shares of BII Australia for 1,000,000 shares
of Common Stock of the Company. In addition, the Company acquired SAND on
September 30, 1996. SAND was established during the second quarter of 1994 by
Sega Ozisoft Pty., Limited ("Sega Ozisoft"), one of the largest publishers and
distributors of entertainment software products in Australia and New Zealand,
the predecessor of which was co-founded by Mark Dyne and Kevin Bermeister.

         The Company's historical operations prior to September 1996 discussed
in this section reflect only the operations of BII Australia. Founded in
September 1993, BII Australia initially developed and sold interactive education
and entertainment CD-ROM titles primarily for children. With the completion of
the acquisition of SAND in September 1996, the nature of the Company's business
changed significantly. SAND is responsible for developing the Multipath Movie
suite of proprietary software tools, production process and first Multipath
Movie product. The Company is focusing its efforts on the development of the
Multipath Movie tools and production process, as well as the commercialization
of the Multipath Movie genre, and has substantially completed the phase-out of
its traditional CD-ROM business. As a result of this change in the Company's
business, the following discussion may not be representative of its future
operations. The Company changed its fiscal year end from June 30 to December 31,
effective December 31, 1996.

         The Company intends to generate a substantial majority of its future
revenue from the development, production, distribution, licensing and on-line
exhibition of Multipath Movies and other three-dimensional digitally created
entertainment. The Company launched the first of its Multipath Movie series,
Cyberswine, its Multipath Movie for Kids series, Popeye and the Quest for the
Woolly Mammoth, and the first two of its StoryTeller Series, Night of the
Werewolf and The Halloween Party, in the fourth quarter of 1997. The Company's
annual and quarterly revenue will depend upon the successful development,
distribution, timing and market acceptance of its interactive products and upon
the costs to distribute and promote these products. Specifically the revenues
derived from the production and distribution of the Company's Multipath Movies
will depend primarily on the acceptance by the market of the Multipath Movie
concept and the underlying content of the Multipath Movie, neither of which can
be predicted nor necessarily bear a direct correlation to the production or
distribution costs incurred. See "Cautionary Statements and Risk Factors -
Acceptance of Multipath Movie Concept; Successful Development of Multipath
Movies with Appealing Creative Content," and "Cautionary Statements and Risk
Factors - Dependence on Development of Additional Multipath Movies." The
commercial success of a Multipath Movie is also expected to depend upon
promotion and marketing, production costs, impact of competition and other
factors. Accordingly, the Company's annual and quarterly revenues are and will
be extremely difficult to forecast.

         The Company incurred significant operating expenses and development
costs as it continued development of its proprietary software tools and its
Multipath Movies and as it continued to expand in anticipation of growth. In
connection


                                       16

<PAGE>   17

with the Company's acquisition of SAND in September 1996, the Company expensed
$1,350,000 attributable to in-process research and development. Also, the
Company entered into strategic relationships with Packard Bell NEC and Morgan
Creek. In September 1996, the Company issued to Packard Bell NEC and Morgan
Creek warrants to purchase 600,000 and 85,000 shares of Common Stock,
respectively, which, based on the value of the warrants issued, resulted in a
$1,096,000 operating expense and a corresponding credit to equity. In September
1997, Packard Bell NEC was issued 200,000 warrants resulting in an expense of
$140,000 and a corresponding credit to equity, based on the value of the
warrants issued. The Company also incurred compensation expense of $125,000 in
connection with directors' stock options in November 1996. As a result of these
operating expenses and charges, the Company incurred a significant loss in the
six months ended December 31, 1996. During the year ended December 31, 1997, the
Company recognized revenue under its distribution agreement with Packard Bell
NEC. However, costs associated with development of its Multipath Movies resulted
in a net loss for the year ended December 31, 1997. See "Cautionary Statements
and Risk Factors - Limited Operating History; Uncertain Profitability."

RESULTS OF OPERATIONS

         Year Ended December 31, 1997 as Compared to Year Ended December 31,
1996

         Revenues. Revenues from the sale of Multipath Movies through retail
outlets are recognized when the product is shipped. Product returns or price
protection concessions that exceed the Company's reserves could materially
adversely affect the Company's business, operating results and financial
condition and could increase the magnitude of quarterly fluctuations in the
Company's operating and financial results. Furthermore, if the Company's
assessment of the creditworthiness of its customers receiving product on credit
proves incorrect, the Company could be required to significantly increase the
reserves previously established. There can be no assurance that such future
write-offs will not occur or that amounts written off will not have a material
adverse effect on the Company's business, results of operations and financial
condition.

         The Company enters into distribution contracts under which the Company
is entitled to fixed minimum guaranteed amounts. Where such amounts have not yet
been received, the minimum guaranteed amount is recognized as revenue when the
CD-ROM master is delivered to the distributor and the terms of the sale are
considered fixed. Revenues from the sale of electronic tickets to view Multipath
Movies over the Internet will be recognized when the tickets are sold.

         The Company historically has derived its revenues from royalties,
development fees and software sales. The Company licenses its traditional CD-ROM
products to publishers and distributors in exchange for non-refundable advances,
and royalties based on product sales. Royalties based on product sales are due
only to the extent revenues exceed any associated non-refundable royalty
advance. Royalties related to non-refundable advances are recognized when the
CD-ROM master is delivered to the licensees. Royalty revenues in excess of
non-refundable advances are recognized upon notification by the distributor that
a royalty has been earned by the Company. Development fees are paid by customers
in exchange for the Company's development of software packages in accordance
with customer specifications. The software development agreements generally
specify certain "milestones" which must be achieved throughout the development
process. As these milestones are achieved, the Company recognizes the portion of
the development fee allocated to each milestone. Software sales revenues are
recognized upon shipment of product. See Note 2 of Notes to Consolidated
Financial Statements.

         Revenues increased from $1,213,000 for the year ended December 31, 1996
to $2,481,000 for the year ended December 31, 1997. This represents an increase
of $1,268,000, or 105%. Revenues in 1997 included $1,973,000 of revenue
recognized when the Company and Packard Bell NEC entered into an agreement
which, among other things, granted to Packard Bell NEC the right to distribute a
version of Cyberswine loaded on the hard drives of Packard Bell NEC computers.
Packard Bell NEC committed that the shipments of computers with which the
Company's Multipath Movies will be bundled would occur over the 12 months
commencing on first shipment of Multipath Movies bundled with Packard Bell NEC
computers (which occurred in December, 1997), subject to certain limited time
extensions of the shipping period. Revenues in 1996 were generated from sales of
the Company's traditional CD-ROM products, a business which is being phased out.
Revenues in 1997 were adversely effected by delays in duplication, packaging and
distribution which caused the Company's first Multipath Movies, Cyberswine,
Popeye and the Quest for the Woolly Mammoth, Night of the Werewolf and The
Halloween Party to begin arriving at retailers at the end of December, after the
holiday selling season.


                                       17

<PAGE>   18

         As a result of delays in the commencement of the U.S. shipment of
personal computers upon which the Company's products are to be bundled, the
first U.S. Multipath Movie bundles are now expected to begin shipment during the
second quarter of 1998. Although this delay should not affect the number of
units to be shipped pursuant to the Company's bundling relationship with Packard
Bell NEC, it will impact the Company's 1998 revenues and earnings since users
will not be equipped to purchase on-line episodes over the Internet as early as
expected.

         Cost of revenues. Cost of revenues related to royalties consists
primarily of royalty obligations to third parties. Cost of revenues related to
development fees consists primarily of salaries, benefits and overhead
associated with the development of specific software products to customer
specifications, as well as costs of outside contractors engaged from time to
time in creating aspects of software products such as animation, voice recording
and music. Cost of revenues related to software sales consists primarily of
royalties to third parties and the direct costs and manufacturing overhead
required to reproduce and package software products. Cost of revenues decreased
from $458,000 for the year ended December 31, 1996 to $44,000 for the year ended
December 31, 1997. This represents a decrease of $414,000, or 90%. Cost of
revenues in 1996 include costs associated with development of the Company's
traditional CD-ROM products. During 1997, the costs associated with the
development of the Company's Multipath Movies were charged to research and
development expenses or capitalized, in accordance with Statement of Financial
Accounting Standards No. 86 ("SFAS No. 86"). See "-Accounting Treatment for
Development Costs and Research Expenditures."

         Sales and marketing. Sales and marketing expenses include primarily
costs for salaries, advertising, promotions, brochures, travel and trade shows.
Sales and marketing expenses decreased from $1,101,000 for the year ended
December 31, 1996 to $1,090,000 for the year ended December 31, 1997. Sales and
marketing expenses include expenses related to grants of warrants to Packard
Bell NEC of $140,000 in September 1997 and $960,000 in September 1996. Sales and
marketing expenses are expected to increase in future periods due to the
expansion of the Company's sales force.

         General and administrative. General and administrative expenses include
primarily salaries and benefits of management and administrative personnel,
rent, insurance costs and professional fees. General and administrative expenses
increased from $1,268,000 for the year ended December 31, 1996 to $2,217,000 for
the year ended December 31, 1997. The increase is attributable to increased
costs associated with the development of internal management and infrastructure
to support the Company's increased development activity, and other services.

         Research and development. Research and development expenses include
salaries and benefits of personnel conducting research and development of
software products. Research and development costs also include costs associated
with creating the Company's traditional CD-ROM software tools and the software
tools used to develop Multipath Movies. Research and development expenses
decreased from $1,996,000 for the year ended December 31, 1996 to $1,709,000 for
the year ended December 31, 1997. Research and development expenses for 1996
include $1,350,000 of in-process research and development costs incurred in
connection with the SAND acquisition in September 1996. Excluding this charge,
research and development expenses in 1996 were $646,000. Costs in 1997 include
continuing development of Multipath Movies and the Multipath Movie software
tools. In accordance with SFAS No. 86, the results of operations for the year
ended December 31, 1997 include in-process research and development expenses
incurred in connection with the development of the Multipath Movie and the
Company's proprietary software tools.

         The Company has chosen to focus on the development of Multipath Movies
for the PC and has deferred development for other platforms, including game
consoles, until warranted by market conditions. This focus allows the Company to
devote more of its resources to development of Multipath Movie technology and
development of additional titles. The Company believes that its decision will
have no adverse impact on revenues in the near or medium term.

         Depreciation. Depreciation expense relates to depreciation of fixed
assets such as computer equipment and cabling, furniture and fixtures and
leasehold improvements. These fixed assets are depreciated over their estimated
useful lives (up to four years) using the straight-line method. Depreciation
expense increased from $130,000 for the year ended December 31, 1996 to $214,000
for the year ended December 31, 1997, primarily attributable to additional
computer equipment put in place and leasehold improvements made during 1997.

         Other income and expense. Other income includes interest income and
expenses, gains and losses on foreign exchange transactions and export
development grants paid to BII Australia by the Australian Trade Commission for
BII


                                       18

<PAGE>   19

Australia's participation in certain export activities. Interest increased from
a net expense of $41,000 for the year ended December 31, 1996 to a net income of
$313,000 for the year ended December 31, 1997. These increases are due to the
higher cash balances as a result of the initial public offering in November
1996, the secondary offering in December 1997, and the repayment of all interest
bearing debt.

         Six Months Ended December 31, 1996 as Compared to Six Months Ended
December 31, 1995

         Revenues. Revenues decreased from $1,184,000 for the six months ended
December 31, 1995 to $350,000 for the six months ended December 31, 1996. This
represents a decrease of $834,000 or 70%, mainly attributable to decreased
royalty revenues as a result of a change in the Company's focus from development
of traditional CD-ROM products to the development of Multipath Movies.

         Cost of revenues. Cost of revenues decreased from $434,000 for the six
months ended December 31, 1995 to $186,000 for the six months ended December 31,
1996. This represents a decrease of $248,000, or 57%. Cost of revenues in the
1995 period included costs associated with development of the Company's own
titles. In the 1996 period, the Company reduced its development of traditional
CD-ROM product. Many of the costs associated with the development of software
for third parties were paid directly by the third parties.

         Sales and marketing. Sales and marketing expenses increased from
$35,000 for the six months ended December 31, 1995 to $970,000 for the six
months ended December 31, 1996. Sales and marketing expenses include expenses
related to the grant of warrants to Packard Bell NEC which was valued at
$960,000 in September 1996. The agreement with Packard Bell NEC requires Packard
Bell NEC to provide certain promotional services to the Company. Accordingly,
the expense associated with the warrants has been recorded as a sales and
marketing expense.

         General and administrative. General and administrative expenses
increased from $129,000 for the six months ended December 31, 1995 to $1,065,000
for the six months ended December 31, 1996. This increase is associated with
increased accounting, legal and consulting services provided to the Company and
the value of stock options granted during the period.

         Research and development. Research and development expenses increased
from $103,000 for the six months ended December 31, 1995 to $1,877,000 for the
six months ended December 31, 1996. Of this increase, $1,350,000 is attributable
to the in-process research and development costs incurred in connection with the
SAND acquisition.

         Depreciation. Depreciation expense increased from $46,000 for the six
months ended December 31, 1995 to $74,000 for the six months ended December 31,
1996. This increase is attributable to additional computer equipment put in
place during 1996.

         Other income and expense. Other income includes interest income and
gains on foreign exchange transactions. Interest income increased from $0 for
the six months ended December 31, 1995 to $41,000 for the six months ended
December 31, 1996 due to the higher cash balances as a result of the initial
public offering in November 1996. Interest expense relates mainly to interest on
the Company's loan from PIE, a significant shareholder. Interest expense
decreased from $64,000 for the six months ended December 31, 1995 to $54,000 for
the six months ended December 31, 1996. This decrease is due to a lower average
balance outstanding on the PIE loan during the six months ended December 31,
1996 as compared to the six months ended December 31, 1995.

         Fiscal Year Ended June 30, 1996 as Compared to Fiscal Year Ended June
30, 1995

         The Company experienced significant growth in fiscal year 1996.
Contracts with Packard Bell NEC and Ocean of America Inc. provided substantial
revenues in 1996, and the Company also entered into new agreements in 1996 to
develop software for other companies. In addition, the Company entered into new
marketing agreements for wider domestic and international sales of its products.
The Company's growth in 1996 resulted in increases in operating expenses,
although with the increased level of activity, the Company realized certain
operating efficiencies and economies of scale.

         Revenues. Revenues increased from $843,000 for the year ended June 30,
1995 to $2,054,000 for the year ended June 30, 1996. This represents an increase
of $1,211,000 or 144%. Royalties increased by $539,000, attributable to a
greater


                                       19

<PAGE>   20

number of completed software titles. Development fees increased by $497,000 as a
result of more software products being developed. Software sales revenues
increased by $175,000, also as a result of the greater number of completed
titles.

         Cost of Revenues. Cost of revenues increased from $656,000 for the year
ended June 30, 1995 to $739,000 for the year ended June 30, 1996. This
represents an increase of $83,000 or 13%, mainly attributable to a greater
number of titles in development. Although revenues almost doubled, costs of
revenues increased only slightly. The Company's gross profit margin increased
from 22% in 1995 to 64% in 1996, attributable to economies of scale and
increased operating efficiencies.

         Sales and Marketing. Sales and marketing expenses increased from
$116,000 for the year ended June 30, 1995 to $163,000 for the year ended June
30, 1996. This represents an increase of $47,000 or 41%, attributable primarily
to increases in the Company's sales and marketing efforts.

         General and Administrative. General and administrative expenses
increased from $224,000 for the year ended June 30, 1995 to $366,000 for the
year ended June 30, 1996. This represents an increase of $142,000 or 63%,
attributable primarily to increased staff and overhead to support the higher
level of production and sales activity.

         Research and Development. Research and development expenses decreased
slightly from $183,000 for the year ended June 30, 1995 to $174,000 for the year
ended June 30, 1996. This represents a decrease of $9,000 or 5%. The decrease is
due to the fact that the Company incurred lower development expenses in 1996 to
enhance software tools that were developed in 1995.

         Depreciation. Depreciation expense increased from $43,000 for the year
ended June 30, 1995 to $102,000 for the year ended June 30, 1996. This is
primarily due to increased computer equipment in place during 1996.

         Other Income and Expense. In fiscal year 1996, other income includes
$122,000, which represents an export market development grant paid to BII
Australia by the Australian Trade Commission for BII Australia's participation
in certain export activities. Interest expense relates mainly to interest on the
Company's loan from PIE, a significant stockholder. Interest expense increased
from $45,000 for the year ended June 30, 1995 to $95,000 for the year ended June
30, 1996. This represents an increase of $50,000 or 111%, resulting from higher
average outstanding borrowings from PIE in 1996 as compared to 1995.

         Pro forma net income (loss) per share. Pro forma net loss per share for
the fiscal year ended June 30, 1996 reflects the acquisition by the Company of
SAND, assumed to have taken place on July 1, 1995, in exchange for a $1,500,000
convertible promissory note. The purchase price has been allocated between
in-process research and development ($1,350,000) and other assets ($150,000).
This resulted in a pro forma charge to research and development expenses of
$1,350,000, including the pro forma consolidation of the operations of SAND. Pro
forma net loss per share for the fiscal year ended June 30, 1996 also reflects
the conversion of the SAND Note into 780,001 shares of Common Stock of the
Company. The unaudited consolidated pro forma financial data may not represent
the results of operations or financial position which actually would have been
obtained if those transactions had been completed as of the date indicated or
which may be obtained in the future.

FLUCTUATING OPERATING RESULTS

         Historically, the Company has experienced significant fluctuations in
its operating results from quarter to quarter and it expects these fluctuations
to continue in the future. For instance the Company had anticipated completing
foreign distribution and licensing relationships in the fourth quarter of 1997,
which are now expected to be completed in the first half of 1998. These
relationships were expected to generate substantial revenues in 1997.

         Also, as a result of delays in the commencement of U.S. shipments of
personal computers upon which the Company's products are bundled, the first U.S.
Multipath Movie bundles are now expected to begin shipment during the second
quarter of 1998. Although this delay does not affect the number of units to be
shipped pursuant to the Company's bundling relationship with Packard Bell NEC,
it will impact the Company's 1998 revenues and earnings since users will not be
equipped to purchase on-line episodes over the Internet as early as expected.


                                       20

<PAGE>   21

         Factors that may influence the Company's quarterly operating results
include customer demand for the Company's products, shipping schedules for PC
hardware with which Multipath Movies are bundled, introduction or enhancement of
products by the Company and its competitors, the ability of the Company to
produce and distribute retail packaged versions of Multipath Movies in advance
of peak retail selling seasons, the timing of releases of new products or
product enhancements by the Company and its competitors, introduction or
availability of new hardware, market acceptance of the Multipath Movies and
other new products, development and promotional expenses relating to the
introduction of new products or enhancements of existing products, reviews in
the industry press concerning the products of the Company or its competitors,
changes or anticipated changes in pricing by the Company or its competitors, mix
of distribution channels through which products are sold, mix of products sold,
product returns, the timing of orders from major customers, order cancellations,
delays in shipment and other developments and decisions including the timing and
extent of development expenditures, management's evaluation and judgment
regarding a title's acceptance, other unanticipated operating expenses and
general economic conditions.

         Additionally, a majority of the unit sales for a product typically
occurs in the quarter in which the product is introduced. As a result, the
Company's revenues may increase significantly in a quarter in which a major
product introduction occurs and may decline in following quarters. The Company's
revenues both domestically and internationally have varied significantly between
monthly and quarterly periods. Therefore, in the future, the operating results
for any quarter should not be taken as indicative of the results for any quarter
in subsequent periods.

         The Company's expense levels are, to a large extent, fixed. The Company
may be unable to adjust spending in a timely manner to compensate for any
revenue shortfall. As a result, any significant shortfall in revenue from the
Company's Multipath Movies would have an immediate material adverse effect on
the Company's business, operating results and financial condition. The Company
has increased its operating expenses to fund greater levels of Multipath Movie
production and research and development, increased marketing operations and
expanded distribution channels. As was the case during 1997, and as is expected
to be the case in at least the first and second quarters of 1998, to the extent
that such expenses precede or are not subsequently followed by increased
revenues, the Company's business, operating results and financial condition will
be materially adversely affected.

         The entertainment software business is highly seasonal. Typically, net
revenues are highest during the fourth calendar quarter (which includes the
holiday buying season), decline in the first calendar quarter and are lowest in
the second and third calendar quarters. This seasonal pattern is due primarily
to the increased demand for entertainment software products during the year-end
holiday buying season. As a result, a disproportionate share of the Company's
net revenues historically have been generated in the fourth quarter of the
Company's fiscal year. The Company expects its revenues and operating results
will continue to reflect these seasonal factors.

         The entertainment industry historically has been subject to substantial
cyclical variation, with consumer spending for entertainment products tending to
decline during recessionary periods. There can be no assurance that the Company
will be able to adjust its anticipated product development expenditures and
other expenses in the event of an economic downturn during such development.
Accordingly, if a recessionary period occurs, tending to result in decreased
sales of the Company's products, product development expenses likely will remain
constant and the Company's business, operating results and financial condition
could be materially adversely affected.

ACCOUNTING TREATMENT FOR DEVELOPMENT COSTS AND RESEARCH EXPENDITURES

         The Company's accounting policy follows SFAS No. 86, which provides for
the capitalization of certain software development costs once technological
feasibility is established. The capitalized costs are then amortized on a
straight-line basis over the estimated product life or on a ratio of current
revenues to total projected product revenues, whichever results in the greater
amortization amount. Prior to the establishment of technological feasibility,
these costs are expensed as incurred. Historically, the Company has expensed all
costs related to the development of both its software tools and Multipath Movie
titles. During the third quarter of 1997, the Company began capitalizing certain
development costs related to the production of Multipath Movies in accordance
with SFAS No. 86. In the future, if the Company incurs costs to develop digital
entertainment products for distribution as home video features or television
programming, such discrete costs may be capitalized and amortized in the
proportion that gross revenues realized bear to management's estimate of the
total gross revenues expected to be received, in accordance with Statement of
Financial Accounting Standards No. 53, "Financial


                                       21

<PAGE>   22

Reporting by Producers and Distributors of Motion Picture Films."

ACCOUNTING GUIDANCE FOR REVENUE RECOGNITION FOR SOFTWARE TRANSACTIONS

         The Company recognizes software revenue in accordance with AICPA
Statement of Position ("SOP") 91-1, "Software Revenue Recognition". The
Accounting Standards Executive Committee issued SOP 97-2, "Software Revenue
Recognition" in October 1997 effective for transactions entered into in fiscal
periods beginning after December 15, 1997. SOP 97-2 supersedes SOP 91-1 and
provides revised and expanded guidance on when revenue should be recognized and
in what amounts for licensing, selling, leasing, or otherwise marketing computer
software. The Company adopted SOP 97-2 in the first quarter of 1998. The
adoption of SOP 97-2 may materially affect the period in which revenues from
distribution contracts are recognized in the future, however, the potential
future impact cannot currently be determined .

LIQUIDITY AND CAPITAL RESOURCES

         As of December 31, 1997, the Company's principal source of liquidity
was approximately $12,300,000 in cash. Prior to the Company's initial public
offering in November 1996, a substantial portion of its operations were financed
through loans from two significant stockholders, PIE and Reefknot.

         In November 1996, the Company's initial public offering (the "Initial
Public Offering") of 2,000,000 shares of Common Stock at $5 per share provided
approximately $8,500,000 in cash after underwriters' discounts and commissions
and offering expenses. All loans from Reefknot and PIE were repaid from proceeds
of the initial public offering.

         On December 10, 1997, the Company closed a secondary offering (the
"Secondary Offering") of 2,500,000 shares of Common Stock at $5 per share,
2,200,000 of which were sold by the Company. The Secondary Offering resulted in
gross proceeds of approximately $9,800,000 in cash after underwriters' discounts
and commissions and offering expenses. Approximately $2,500,000 of the net
proceeds of the Initial Public Offering and all of the proceeds of the Secondary
Offering remain available for product development and working capital and
general corporate purposes.

         Net cash provided by operating activities during the year ended
December 31, 1996 was primarily attributable to revenues of $1,213,000. Net cash
used in operating activities during the year ended December 31, 1997 was
primarily attributable to a net loss of $2,305,000 and an increase in accounts
receivable of $1,986,000. Net cash used in investing activities in the year
ended December 31, 1997 was due primarily to the purchase of computer equipment.
Cash provided by financing activities in the years ended December 31, 1996 and
1997 were primarily attributable to the issuance of shares in the public
offerings of Common Stock.

         The Company has an obligation under its agreement with Morgan Creek to
fund entirely the development of two Multipath Movies, the first of which, Ace
Ventura, is currently under development. The Company has an obligation under its
joint venture agreement with Crawfords to jointly fund two Multipath Movies. To
date no projects have been identified for development by the parties. The
Company also is required to make minimum payments of $198,000 under various
licensing agreements. At December 31, 1997, the Company had rental commitment
for its offices and production facilities of $1,067,000

         The Company believes that current funds and cash generated from
operations will be sufficient to meet its anticipated cash needs for working
capital and capital expenditures for at least the next year but will not be
sufficient to permit completion of the entire slate of Multipath Movie episodes
estimated to be completed in 1998. See "Description of Business - General." The
Company intends to raise additional funds to permit completion of all 20 titles
scheduled for completion during 1998 through debt or equity financings or other
means. The Company is currently exploring alternatives to fulfill these
requirements. No assurance can be given that additional financing will be
available or that, if available, it can be obtained on terms favorable to the
Company and its stockholders. If the Company is unable to obtain additional
financing sufficient to fund the completion of all 20 titles scheduled for
completion in 1998, the Company anticipates that it may defer completion of
several titles. See "Cautionary Statements and Risk Factors - Future Capital
Needs; Uncertainty of Additional Funding."

CAUTIONARY STATEMENTS AND RISK FACTORS


                                       22

<PAGE>   23

         Several of the matters discussed in this document contain forward
looking statements that involve risks and uncertainties. Factors associated with
the forward looking statements which could cause actual results to differ
materially from those projected or forecast in the statements that appear below.
In addition to other information contained in this document, readers should
carefully consider the following cautionary statements and risks factors:

         Acceptance of Multipath Movie Concept; Successful Development of
Multipath Movies with Appealing Creative Content. The success of the Company's
Multipath Movie products will depend to a significant extent on acceptance by
the market of the Multipath Movie concept. The market for entertainment software
is emerging and is dependent upon a number of variables, including consumer
preferences, the installed base of personal computers and a sufficient number of
entertainment software titles to stimulate market development. Any competitive,
technological or other factor materially adversely affecting the introduction or
sale of personal computers or entertainment software would have a material
adverse effect on the Company. Because the market for entertainment software is
relatively small in comparison to the overall market for consumer software
products, it is impossible to predict with any degree of certainty the future
rate of growth, if any, and the size of the market for the Company's products.

         Each Multipath Movie will be an individual artistic work, and its
commercial success primarily will be determined by user reaction, which is
unpredictable. The Company introduced Cyberswine, its first Multipath Movie, at
the end of the fourth quarter of 1997. The commercial success of the Company's
Multipath Movies will depend on its ability to predict the type of content that
will appeal to a broad audience and to develop stories and characters that
capture the attention and imagination of the market. In addition, the success of
the Company's Multipath Movies will depend upon the Company's ability to develop
popular characters and to license recognized characters and properties from
third parties for its software titles. There can be no assurance that the
Company will be able to develop or license popular stories or characters. The
success of a Multipath Movie also depends upon the effectiveness of the
Company's marketing and successful introduction of the first Multipath Movie
through the Company's bundling relationship with Packard Bell NEC and the retail
channel, as well as the quality and acceptance of other competing programs
released into the market at or near the same time, critical reviews, the
availability of alternative forms of entertainment and leisure time activities,
general economic conditions and other tangible and intangible factors, all of
which can change and cannot be predicted with certainty. There can be no
assurance that the Company will be able to successfully introduce the Multipath
Movie through its bundling relationship with Packard Bell NEC, in the retail
channel or otherwise. Accordingly, there exists substantial risk that some or
all of the Company's Multipath Movies will not be commercially successful,
resulting in certain costs not being recouped or anticipated profits not being
realized. Further, the success of the Multipath Movie genre will substantially
depend on the market's reception of the first Multipath Movie. The failure of
the Company's initial Multipath Movie to achieve commercial success would damage
the ability of the Company to introduce additional titles. Accordingly, the
failure of any of the Company's Multipath Movies, and especially its first
Multipath Movie, to achieve commercial success, could have a material adverse
affect on the business, operating results and financial condition of the
Company.

Product Delays. The Company's current production schedules contemplate that it
will release a number of Multipath Movies in the fourth quarter of 1998 and
1999. As with any software product, however, until all aspects of the
development and initial distribution of a product are completed, there can be no
assurance of its release date. Release dates will vary depending on quality
assurance testing and other development factors. If the Company were unable to
commence volume shipments of a significant new product during the scheduled
quarter, its revenue and earnings would likely be materially and adversely
affected in that quarter. In the past, the Company has experienced significant
delays in the introduction of certain new products. For instance, delays in
duplication, packaging and distribution caused the Company's first Multipath
Movies, Cyberswine, Popeye and the Quest for the Woolly Mammoth, Night of the
Werewolf and The Halloween Party to begin arriving at retailers at the end of
December 1997, after the holiday selling season. It is likely in the future that
such delays will continue to occur and that certain new products will not be
released in accordance with the Company's internal development schedule or the
expectations of public market analysts and investors. A significant delay in the
introduction of, or the presence of a defect in, one or more new products could
have a material adverse affect on the ultimate success of such products and on
the Company's business, operating results and financial condition, particularly
in the quarter in which such products are scheduled to be completed.


                                       23

<PAGE>   24

         Limited Operating History; Uncertain Profitability. The Company was
founded in September 1993, and shipped its initial traditional CD-ROM product in
November 1994 and substantially curtailed this aspect of its business in 1996.
The Company acquired the software tools necessary to produce Multipath Movies in
August 1996 and has only recently introduced its first Multipath Movie. The
Company has only a limited operating history upon which an evaluation of the
Company and its prospects can be based.

         In the third quarter of 1997 the Company was profitable due to revenues
associated with its Packard Bell NEC bundling agreement. However, revenues in
the fourth quarter of 1997 were adversely affected by delays in duplication,
packaging and distribution which caused the Company's first Multipath Movies to
begin arriving at retailers at the end of December, after the the holiday
selling season. In addition, as a result of delays in the commencement of the
U.S. shipment of personal computers upon which the Company's products are
bundled, the first U.S. Multipath Movie bundles are now expected to begin
shipment during the second quarter of 1998. Although this delay should not
affect the number of units to be shipped pursuant to the Company's bundling
relationship with Packard Bell NEC, it will impact the Company's 1998 revenues
and earnings since users will not be equipped to purchase on-line episodes over
the Internet as early as expected. In order for the Company to achieve sustained
profitability, the Company must continue to enter into a variety of distribution
and revenue generating arrangements of this type, as well as arrangements with
Internet service providers, traditional CD-ROM publishers and retailers. There
can be no assurance that the Company will enter into any such arrangements, or
that the Company will be able to sustain quarterly profitability.

         Fluctuating Operating Results. The Company intends to generate a
substantial majority of its future revenue from the development and production
of Multipath Movies and other three-dimensional digitally created entertainment.
The Company commenced the launch of the first of its Multipath Movies,
Cyberswine, at the end of the fourth quarter of 1997. The Company also released
the first products in the Storyteller Series and Multipath Movies for Kids
series at that time. The Company's annual and quarterly revenue will depend upon
the successful development, timing and market acceptance of its interactive
products and upon the costs to distribute and promote these products.
Specifically, the revenues derived from the production and distribution of the
Company's Multipath Movies will depend primarily on the acceptance by the market
of the Multipath Movie concept and the underlying content of the Multipath
Movie, neither of which can be predicted nor necessarily bear a direct
correlation to the production or distribution costs incurred. See " - Acceptance
of Multipath Movie Concept; Successful Development of Multipath Movies with
Appealing Creative Content," and " - Dependence on Development of Additional
Multipath Movies." The commercial success of a film also depends upon promotion
and marketing, production costs, impact of competition and other factors. See
"Business - Competition." Accordingly, the Company's annual and quarterly
revenues are and will continue to be extremely difficult to forecast.

         Historically, the Company has experienced significant fluctuations in
its operating results from quarter to quarter and it expects these fluctuations
to continue in the future. Factors that may influence the Company's quarterly
operating results include customer demand for the Company's products, shipping
schedules for PC hardware with which Multipath Movies are bundled, introduction
or enhancement of products by the Company and its competitors, the ability of
the Company to produce and distribute retail packaged versions of Multipath
Movies in advance of peak retail selling seasons, the timing of releases of new
products or product enhancements by the Company and its competitors,
introduction or availability of new hardware, market acceptance of the Multipath
Movies and other new products, development and promotional expenses relating to
the introduction of new products or enhancements of existing products, reviews
in the industry press concerning the products of the Company or its competitors,
changes or anticipated changes in pricing by the Company or its competitors, mix
of distribution channels through which products are sold and the timing of
negotiation and completion of distribution arrangements, mix of products sold,
product returns, the timing of orders from major customers, order cancellations,
delays in shipment and other developments and decisions including the timing and
extent of development expenditures, management's evaluation and judgment
regarding a title's acceptance, other unanticipated operating expenses and
general economic conditions. Additionally, a majority of the unit sales for a
product typically occurs in the quarter in which the product is introduced. As a
result, the Company's revenues may increase significantly in a quarter in which
a major product introduction occurs and may decline in following quarters. The
Company's revenues both domestically and internationally have varied
significantly between monthly and quarterly periods. Therefore, in the future,
the operating results for any quarter should not be taken as indicative of the
results for any quarter in subsequent periods.


                                       24

<PAGE>   25

         The Company's expense levels are, to a large extent, fixed. The Company
may be unable to adjust spending in a timely manner to compensate for any
revenue shortfall. As a result, any significant shortfall in revenue from the
Company's Multipath Movies would have an immediate material adverse effect on
the Company's business, operating results and financial condition. The Company
plans to increase its operating expenses to fund greater levels of Multipath
Movie production and research and development, increased marketing operations
and expanded distribution channels. To the extent that such expenses precede or
are not subsequently followed by increased revenues, the Company's business,
operating results and financial condition will be materially adversely affected.

         The entertainment software business is highly seasonal. Typically, net
revenues are highest during the fourth calendar quarter (which includes the
holiday buying season), decline in the first calendar quarter and are lowest in
the second and third calendar quarters. This seasonal pattern is due primarily
to the increased demand for entertainment software products during the year-end
holiday buying season. As a result, a disproportionate share of the Company's
net revenues historically have been generated in the fourth quarter of the
Company's fiscal year. The Company expects its revenues and operating results
will continue to reflect these seasonal factors.

         The entertainment industry historically has been subject to substantial
cyclical variation, with consumer spending for entertainment products tending to
decline during recessionary periods. There can be no assurance that the Company
will be able to adjust its anticipated product development expenditures and
other expenses in the event of an economic downturn during such development.
Accordingly, if a recessionary period occurs, tending to result in decreased
sales of the Company's products, product development expenses likely will remain
constant and the Company's business, operating results and financial condition
could be materially adversely affected. See " -- Rapid Technological Change;
Changing Product Platforms and Formats."

         Due to all of the foregoing factors, it is also likely that in some
future periods the Company's operating results will be below the expectations of
public market analysts and investors. In such event, the price of the Company's
Common Stock would likely be materially adversely affected.

         Future Capital Needs; Uncertainty of Additional Funding. The Company's
future capital requirements will depend on many factors, including but not
limited to, the number of Multipath Movies developed, the cost of content
development, marketing and distribution, the size and timing of future
acquisitions, if any, and the availability of additional financing. The Company
anticipates that its existing funds will not be sufficient to fund completion of
the entire slate of 20 Multipath Movie episodes estimated to be completed in
1998, and intends to attempt to raise additional funds to permit completion of
all titles through debt or equity financings. No assurance can be given that
such additional financing will be available or that, if available, it can be
obtained on terms favorable to the Company and its stockholders. If the Company
is unable to obtain additional financing sufficient to fund the completion of
all titles scheduled for completion in 1998, the Company anticipates that it may
defer completion of several titles. In addition, any equity financing could
result in dilution to the Company's stockholders. The Company's inability to
obtain adequate funds would adversely affect the Company's operations and
ability to implement its strategy.

         Substantial Dependence Upon Third Parties. The Company depends
substantially upon third parties for several critical elements of its business
including the development and licensing of content and the distribution of its
products.

                  Dependence Upon Strategic and Licensing Relationships. The
Company has entered into strategic relationships with Packard Bell NEC, Morgan
Creek, CompuServe, S3 and Matrox as well as licensing arrangements with numerous
additional companies that own the stories underlying and/or characters in many
of the Company's current and planned products. The Company's business strategy
is based largely on its strategic and licensing relationships with these and
other companies and its ability to continue to enter into similar strategic and
licensing relationships in the future. In these relationships, mutual agreement
of the parties is generally required for significant matters, or approval of the
strategic partner or both parties is required to release products or to commence
distribution of products. For example, the Company will be dependent on Packard
Bell NEC and other OEMs to bundle Multipath Movies with their hardware products
as a significant element of the Company's launch of the Multipath Movie genre.
Packard Bell NEC's obligation to distribute such Multipath Movies will depend
upon Packard Bell NEC's acceptance of master CD-ROMs complying with the
Company's specifications. Consequently, Packard Bell NEC may, in the exercise of
its approval rights, delay the introduction of the Company's first Multipath
Movie. The Company is also unable to control, manage or accurately


                                       25

<PAGE>   26

predict the shipping schedules of Packard Bell NEC and other OEM distributors.
Delays in such shipping schedules or other distribution problems affecting OEM
distributors may materially adversely affect the Company's ability to release
its products. For instance, the Company expected Packard Bell NEC to commence
U.S. shipment of personal computers bundled with Cyberswine in January 1998. As
a result of delays in Packard Bell NEC's shipping schedules, the Company now
does not expect Packard Bell NEC to begin U.S. shipment of the Company's first
Multipath Movie bundles until the second quarter of 1998 and the Company can
give no assurance that Packard Bell NEC will achieve this schedule. Also, Morgan
Creek and many other content licensors have various creative controls and
approval rights pursuant to their joint venture agreements with the Company.
These creative controls and approval rights allow Morgan Creek as well as
content licensors to arbitrarily reject or delay the Multipath Movie productions
of the respective joint ventures. There can be no assurance that the Company
will not be subject to delays resulting from disagreements with or an inability
to obtain approvals from its strategic partners or that the Company will achieve
its objectives in respect of any or all of its strategic relationships or
continue to maintain and develop these or other strategic relationships, or that
licenses between the Company and any such third party will be renewed or
extended at their expiration dates. Many content licensors are also reluctant to
grant broad licenses covering multiple formats (e.g., a license covering both
Internet and television distribution rights) to companies without proven track
records in the television production business, and, where rights are available,
there is often significant competition for licenses. As a result of such
competition, and the reluctance by owners of content to grant broad licenses,
there can be no assurance that licensed content will be available to the Company
at prices, or upon terms or conditions acceptable to the Company or which permit
the Company to implement its strategy of producing Multipath Movies for multiple
formats. Delays resulting from disagreements with licensors or joint venture
partners or the Company's failure to renew or extend a key license, maintain any
of its strategic relationships or enter into new licenses and strategic
relationships on sound financial terms could materially adversely affect the
Company's business, operating results and financial condition.

                  Use of Independent Software Developers and Content Providers.
In addition to internally developing software and creating content, the Company
uses entertainment software created by independent software developers as well
as content developed by third parties. The Company has less control over the
scheduling and the quality of the software generated by independent contractors
than over that developed by its own employees. Additionally, the Company may not
be able to secure the services of talented content developers. The Company's
business and future operating results will depend in part on the Company's
continued ability to maintain relationships with skilled independent software
developers and content providers, and to enter into and renew product
development agreements with such developers. There can be no assurance that the
Company will be able to maintain such relationships or enter into and renew such
agreements.

         Dependence on Development of Additional Multipath Movies. The Company's
success will depend largely upon its ability in the future to continuously
develop new, commercially-successful Multipath Movie titles and to replace
revenues from Multipath Movie titles in the later stages of their life cycles.
If revenues from new products or other activities fail to replace declining
revenues from existing products, the Company's business, operations and
financial condition could be materially adversely affected. In addition, the
Company's success will depend upon its ability to develop popular characters and
to license recognized characters and properties from third parties for its
digital entertainment products. If the Company is unable to develop popular
characters or if the cost of licensing characters and properties from third
parties becomes prohibitive, the Company's business, operating results and
financial condition could be adversely affected. Also, the Company may from time
to time, enter into agreements with licensors of intellectual property that
involve advance payments of royalties and guaranteed minimum royalty payments.
If the sales volumes of products subject to such arrangements are not sufficient
to recover such advances and guarantees, the Company will be required to write
off unrecovered portions of such payments. If the Company is required to write
off a material portion of any advances, or ultimately accrue for the guarantees,
its business, operating results and financial condition could be materially
adversely affected.


                                       26

<PAGE>   27

         Risks Associated with Internet Delivery. The Company also intends to
distribute certain of its Multipath Movies through its Internet site and through
a site on the CompuServe online service. Accordingly, any system failure that
causes interruption or an increase in response time on the Company's Internet
site or the CompuServe site, could result in less traffic to and distribution of
Multipath Movies via the Internet and, if sustained or repeated, could reduce
the attractiveness of the Company's products. The Company is also dependent upon
Web browsers and Internet and online service providers to ensure user access to
its products. User acceptance with respect to payment methods over the Internet
may also create barriers to distribution of the Company's products through the
Internet. Any disruption in the Internet access provided to the Company's
Internet site or any failure by the Company's Internet site to handle higher
volumes of transactions could have a material adverse effect on the Company's
business, operating results and financial condition.

         The seamless appearance of Multipath Movies delivered over the Internet
requires that while a scene is being viewed, succeeding scenes must be
downloaded. This requires the use of 28.8 kilobits per second or faster modems,
computers equipped with high-speed Pentium (or equivalent) microprocessors, 24
megabytes of random access memory and appropriately configured operating
systems. These requirements generally are not satisfied by the majority of the
base of currently installed PCs. There can be no assurance that adequately
equipped and configured computers will become widespread prior to release of the
Company's Multipath Movies. Users of computers with less sophisticated PCs may
experience noticeable latencies or "lag times" between scene changes.
Additionally, the performance characteristics of Multipath Movies delivered via
the Internet may not equal those of Multipath Movies delivered solely on
CD-ROMs, particularly with respect to perceived seamlessness and sound quality.
Moreover, communications between the user and an Internet site delivering
Multipath Movies may require routing of Multipath Movie instructions through
several servers and may result in brief but noticeable lag times. Noticeable lag
times or negative comparisons to Multipath Movies distributed on CD-ROM may
reduce the attractiveness of online versions of the Multipath Movies.

         The Company presently serves its Multipath Movies delivered over the
Internet through a single vendor. Any significant interruption in service
provided by this vendor could interrupt sales and delivery of Multipath Movies
and materially adversely affect the Company's ability to conduct its business
and maintain customer satisfaction, and thereby materially adversely affect the
Company's business, operating results and financial condition.

         Risks Associated With Retail Distribution. The Company anticipates that
a significant proportion of sales of Multipath Movies will be made through
distributors and to retailers. The Company is currently expending significant
resources developing a retail sales channel. The expenditures associated with
this development are likely to precede the realization of significant sales
through this channel. Moreover, the Company has no prior experience in the
development or management of the retail channel or sales through such channel.
The competition for shelf space in retail stores is intense. To the extent that
the number of consumer software products and computer platforms increases, this
competition for shelf space may further intensify. The Company's products are
expected to constitute a small percentage of a retailer's sales volume, and
there can be no assurance that retailers will provide the Company's products
with adequate levels of shelf space and promotional support. Due to the
increased competition for limited retail shelf space and promotional resources,
retailers and distributors are increasingly in a better position to negotiate
favorable terms of sale, including price discounts and product return policies,
as well as cooperative market development funds. Increased competition could
result in loss of shelf space for, and reduction in sell-through of, the
Company's products at retail stores, as well as significant price competition,
any of which could adversely affect the Company's business, operating results
and financial condition.

         Retailers often require software publishers to pay fees in exchange for
preferred shelf space. The amounts paid to retailers by software publishers and
distributors for preferred shelf space are generally determined on a case by
case basis and there is, as of yet, no industry standard for determining such
fees, although larger publishers and distributors will likely have a competitive
advantage in this regard to the extent they have greater financial resources and
negotiating leverage.

         At the time of retail product shipment, the Company will establish
reserves, including reserves which estimate the potential for future returns
based on seasonal terms of sale and distributor and retailer inventories of the
Company's products, as well as other factors. The Company intends to recognize
revenue from the sale of its products upon shipment except for sales made to
certain distributors where the right of ownership does not pass at delivery.
Product


                                       27

<PAGE>   28

returns or price protection concessions that exceed the Company's reserves could
materially adversely affect the Company's business, operating results and
financial condition and could increase the magnitude of quarterly fluctuations
in the Company's operating and financial results. Furthermore, if the Company's
assessment of the creditworthiness of its customers receiving product on credit
proves incorrect, the Company could be required to significantly increase the
reserves previously established. There can be no assurance that such future
write-offs will not occur or that amounts written off will not have a material
adverse effect on the Company's business, results of operations and financial
condition.

         Manufacturing Risks. The production of the Company's Multipath Movies
for the retail distribution channel consists of pressing CD-ROM disks,
assembling purchased product components, printing product packaging and user
manuals and packaging finished products, all of which will be performed for the
Company by third party vendors in accordance with the Company's specifications
and forecasts. Currently, the Company will use primarily one vendor for each of
these services. While these services are available from multiple vendors and at
multiple sites, there can be no assurance that an interruption in the
manufacture of the Company's products could be remedied without undue delay and
without materially adversely affecting the Company's results of operations. The
Company does not have contractual agreements with any of its third party
vendors, which may result in an inability to secure adequate services in a
timely manner. Demand for the services of these vendors is also seasonal, with
peak demand, and service and production backlogs and delays occurring in
September, October and November of each year. The Company's retail Multipath
Movies must be manufactured, assembled, printed, packaged and shipped in this
environment of strained capacity and must compete for capacity and priority with
the CD-ROM products of many substantially larger competitors of the Company
which are able to wield substantially greater influence with the Company's
vendors than can currently be exerted by the Company. If the Company is unable
to secure adequate services to timely produce and deliver its products for
fourth quarter sales, the Company's business, operating results and financial
condition would be materially adversely effected.

         Software Tools and Product Development. The suite of software tools
that will enable the Company to create its Multipath Movie has been developed
over the past three years and additional refinement of these tools may be
necessary in order continue to enhance the Multipath Movie format. The Company
believes that its future success depends in large part upon the continuous
enhancement of the software tools used to create the Multipath Movie. If
problems in the development of the Company's software tools arise, no assurance
can be given that the Company will be able successfully remedy these problems.
Also, entertainment products as complex as those offered by the Company may
contain undetected errors or defects when first introduced or as new versions
are released. The Company has in the past discovered software errors in certain
of its new products and enhancements after their introduction. Although the
Company has not experienced material adverse effects resulting from any such
errors to date, there can be no assurance that errors or defects will not be
found in new products or releases after commencement of commercial shipments,
resulting in adverse product reviews and a loss of or delay in market
acceptance, which would have a material adverse effect upon the Company's
business, operating results and financial condition.

         Rapid Expansion and Management of Growth. Implementation of the
Company's business plan, including introduction and marketing of the Company's
Multipath Movies, management of the Company's joint venture with Morgan Creek,
management of the Company's strategic relationship with Packard Bell NEC,
negotiation of additional content licensing and distribution agreements,
management of Internet service providers, the expansion of the Company's studio
in Australia and the development of a new studio in California, and the general
strains of the Company's role of a public company have resulted in a significant
expansion of the Company and will require that the Company continue to
significantly expand its operations in all areas. This growth in the Company's
operations and activities has placed and will continue to place a significant
strain on the Company's management, operational, financial and accounting
resources. Successful management of the Company's operations will require the
Company to continue to implement and improve its financial and management
information systems. In addition, the restructuring of the Company and resulting
management and reporting of Australian operations and financial results from the
United States have placed and will continue to place an additional strain on the
Company's accounting and information systems resources. The Company's ability to
manage its future growth, if any, and to increase production levels and commence
marketing and distribution of its products will also require it to hire and
train new employees, including management and technical personnel, and motivate
and manage its new employees and integrate them into its overall operations and
culture. The Company recently has made additions to its management team and is
in the process of expanding its marketing and production staff, a process which
is expected


                                       28

<PAGE>   29

to continue. The Company's failure to manage implementation of its business plan
would have a material adverse effect on the Company's business, operating
results and financial condition.

         Risks Associated with Acquisitions. In the future, the Company may
acquire complementary companies, products or technologies, and from time to time
engages in discussions relating to possible acquisitions. Acquisitions involve
numerous risks, including adverse short-term effects on the combined business'
reported operating results, impairments of goodwill and other intangible assets,
the diversion of management's attention, the dependence on retention, hiring and
training of key personnel, the amortization of intangible assets and risks
associated with unanticipated problems or legal liabilities.

         Rapid Technological Change; Changing Product Platforms and Formats. The
entertainment software market and the PC industry in general are characterized
by rapid and significant technological developments and frequent changes in
computer operating environments. To compete successfully in these markets, the
Company must continually improve and enhance its existing products and
technologies and develop new products and technologies that incorporate
technological advances while remaining competitive in terms of performance and
price. The Company's success also will depend substantially upon its ability to
anticipate the emergence of, and to adapt its products to, popular platforms for
consumer software.

         The Company has designed its Multipath Movies for use with the
IBM-compatible PC. The Company intends to design future products for use with
new platforms which will require substantial investments in research and
development. Generally, such research and development efforts must occur one to
two years in advance of the widespread release or use of the platforms in order
to introduce products on a timely basis following the release of such platforms.
The research and development efforts in connection with games for certain
advanced and emerging platforms may require greater financial and technical
resources than currently possessed by the Company. In addition, there can be no
assurance that the new platforms for which the Company develops products will
achieve market acceptance and, as a result, there can be no assurance that the
Company's development efforts with respect to such new platforms will lead to
marketable products or products that generate sufficient revenues to offset the
research and development costs incurred in connection with their development.
Failure to develop products for new platforms that achieve significant market
acceptance would have a material adverse effect on the Company's business,
operating results and financial condition. There can be no assurance that
technological developments will not render certain of the Company's existing
products obsolete, that the Company will be able to adapt its products or
technologies to emerging hardware platforms, that the Company has chosen to
support platforms that ultimately will be successful or that the Company will be
able successfully to create software titles for such platforms in a timely
manner, or at all. See " - Software Tools and Product Development."

         Dependence on Key Personnel. The Company's success has and will
continue to depend to a significant extent upon certain key management, product
development and technical personnel, many of whom would be difficult to replace,
particularly Mark Dyne, its Chairman and Chief Executive Officer, and Kevin
Bermeister, its President. Although the Company has entered into employment
agreements with certain officers, such agreements are terminable upon 30 days
notice by either party. Accordingly, there can be no assurance that such
employees will continue to be available to the Company. The loss of the services
of one or more of these key employees could have a material adverse effect on
the Company and the Company's future success will depend in large part upon its
ability to attract, retain and motivate personnel with a variety of technical
and managerial skills, including software development and programming expertise.
Significant competition exists for such personnel and the companies with which
the Company competes are often larger and more established than the Company.
Additionally, there is currently an industry-wide shortage of technical
personnel which makes it more difficult to attract and retain such personnel.
There can be no assurance that the Company will be able to retain and motivate
its managerial and technical personnel or attract additional qualified members
to management or technical staff. The inability to attract and retain necessary
technical and managerial personnel could have a material and adverse effect upon
the Company's business, operating results and financial condition.

         Shared Responsibilities and Other Employment Commitments of Chief
Executive Officer and President. The Company's Chief Executive Officer and
Chairman, Mark Dyne, and its President, Kevin Bermeister, also serve as joint
managing directors of Sega Ozisoft Pty. Limited ("Sega Ozisoft") and other
businesses. Mark Dyne also serves as


                                       29

<PAGE>   30

Chairman of the Board of Tag-It Pacific, Inc. Kevin Bermeister also serves as
managing director of Sega Enterprises (Australia) Pty., Ltd. Although Messrs.
Dyne and Bermeister are active in the management of the Company, they are not
required to spend a certain amount of time at the Company nor are they able to
devote their full time and resources to the Company. Further, the Company does
not have employment agreements with either of Messrs. Dyne or Bermeister. There
can be no assurance that the inability of Messrs. Dyne and Bermeister to devote
their full time and resources to the Company will not adversely affect the
Company's business, operating results or financial condition.

         Conflicts of Interest. Certain of the Company's directors and officers
are directors or officers of potential competitors and/or strategic partners of
the Company. These relationships may give rise to conflicts of interest between
the Company, on the one hand, and one or more of the directors, or officers
and/or their affiliates, on the other hand. The Company's Certificate of
Incorporation provides that Mark Dyne and Kevin Bermeister are required to
present to the Company any corporate opportunities for the development of any
type of digital entertainment with the exception of opportunities for (i)
minority participation in the development of digital entertainment and (ii)
participation in the development by others of digital entertainment where
publishing and distribution rights for the product to be developed are offered
to Messrs. Dyne and/or Bermeister solely for Australia, New Zealand and/or
Southern Africa. The Company's Certificate of Incorporation provides that
Messrs. Dyne and Bermeister are not required to present to the Company any other
opportunities which potentially may be of benefit to the Company.

         Limited Proprietary Protection. The Company's success and ability to
compete is dependent in part upon its proprietary technology. The Company also
relies on trademark, trade secret and copyright laws to protect its technology,
with the source code for the Company's proprietary software being protected both
as a trade secret and as a copyrighted work. Also, it is the Company's policy
that all employees and third-party developers sign nondisclosure agreements.
However, there can be no assurance that such precautions will provide meaningful
protection from competition or that competitors will not be able to develop
similar or superior technology independently. Also, the Company has no license
agreements with the end users of its products and does not copy-protect its
software, so it may be possible for unauthorized third parties to copy the
Company's products or to reverse engineer or otherwise obtain and use
information that the Company regards as proprietary. Although the Company is not
aware of unauthorized copying of its products, if a significant amount of
unauthorized copying of the Company's products were to occur, the Company's
business, operating results and financial condition could be adversely affected.
Furthermore, policing unauthorized use of the Company's products is difficult
and costly, and software piracy can be expected to be a persistent problem. If
litigation is necessary in the future to enforce the Company's intellectual
property rights, to protect the Company's trade secrets or to determine the
validity and scope of the proprietary rights of others, such litigation could
result in substantial costs and diversion of resources and could have a material
adverse effect on the Company's business, operating results and financial
condition. Ultimately, the Company may be unable, for financial or other
reasons, to enforce its rights under intellectual property laws and the laws of
certain countries in which the Company's products are or may be distributed may
not protect the Company's products and intellectual rights to the same extent as
the laws of the United States.

         The Company believes that its products, including its suite of software
tools, do not infringe any valid existing proprietary rights of third parties.
Since the software tools used to create the Multipath Movies were developed by
SAND, a division of Sega Ozisoft, the Company relies entirely on the
representations of Sega Ozisoft contained in the SAND Acquisition Agreement
between BII Australia and Sega Ozisoft that, to Sega Ozisoft's best knowledge,
the SAND technology and software acquired by the Company does not infringe the
proprietary rights of others. Additionally, although the Company has received no
communication from third parties alleging the infringement of proprietary rights
of such parties, there can be no assurance that third parties will not assert
infringement claims in the future. Any such third party claims, whether or not
meritorious, could result in costly litigation or require the Company to enter
into royalty or licensing agreements. There can be no assurance that the Company
would prevail in any such litigation or that any such licenses would be
available on acceptable terms, if at all. If the Company were found to have
infringed upon the proprietary rights of third parties, it could be required to
pay damages, cease sales of the infringing products and redesign or discontinue
such products, any of which alternatives, individually or collectively could
have a material adverse effect on the Company's business, operating results and
financial condition.

         Volatility of Stock Price. The Company's Common Stock is traded on the
American Stock Exchange, and there has been substantial volatility in the market
price of the Common Stock. The trading price of the Common Stock has been and is
likely to continue to be subject to significant fluctuations in response to
variations in quarterly operating


                                       30

<PAGE>   31

results, the gain or loss of significant contracts, changes in management,
announcements of technological innovations or new products by the Company or its
competitors, legislative or regulatory changes, general trends in the industry,
recommendations by securities industry analysts and other events or factors. In
addition, the stock market has experienced extreme price and trading volume
fluctuations which have affected the market price of the common stock of many
technology companies in particular and which have at times been unrelated to
operating performance of the specific companies whose stock is affected. In
addition, in the past the Company has not experienced significant trading volume
in its Common Stock, has not been actively followed by stock market analysts and
has had limited market-making support from broker-dealers. If market-making
support does not continue at present or greater levels and/or the Company does
not continue to receive analyst coverage, the average trading volume in the
Common Stock may not increase or even sustain its current levels, in which case,
there can be no assurance that an adequate trading market will exist to sell
large positions in the Common Stock.

         Control by Existing Stockholders. As of December 31, 1997, the
Company's officers and directors and Sega Ozisoft, of which Messrs. Dyne and
Bermeister are directors and stockholders, owned approximately 30.6% of the
Company's outstanding shares. As a result, these stockholders are able to
control the Company and its operations, including the election of at least a
majority of the Company's Board of Directors and thus, the policies of the
Company. The voting power of these stockholders could also discourage potential
acquirors from seeking to acquire control of the Company through the purchase of
the Common Stock, which might have a depressive effect on the price of the
Common Stock.

         Effect of Certain Charter Provisions; Stockholder's Rights Plan;
Anti-Takeover Effects of Certificate of Incorporation, Bylaws and Delaware Law.
The Company's Board of Directors has the authority to issue up to 1,000,000
shares of Preferred Stock and to determine the price, rights, preferences,
privileges and restrictions, including voting rights, of those shares without
any further vote or action by the stockholders. The Preferred Stock could be
issued with voting, liquidation, dividend and other rights superior to those of
the Common Stock. In March 1998, the Company adopted a stockholder's rights plan
(the "Rights Agreement") and, in connection therewith, will distribute one
preferred share purchase right for each outstanding share of the Company's
Common Stock outstanding on April 2, 1998. Pursuant to the Rights Agreement,
upon the occurrence of certain triggering events related to an unsolicited
takeover attempt of the Company, each purchase right not owned by certain
hostile acquirors will entitle its holder to purchase shares of the Company's
Series A Preferred Stock, which is convertible into Common Stock, at a value
below the then current market value of the preferred stock. The rights of the
holders of Common Stock will be subject to, and may be adversely affected by,
the rights of the holders of the share purchase rights and of any Preferred
Stock that may be issued in the future. The issuance of Preferred Stock, while
providing desirable flexibility in connection with possible acquisitions and
other corporate purposes, could have the effect of making it more difficult for
a third party to acquire a majority of the outstanding voting stock of the
Company. Further, certain provisions of the Company's Certificate of
Incorporation and Bylaws and of Delaware law could delay or make more difficult
a merger, tender offer or proxy contest involving the Company.


                                       31

<PAGE>   32

ITEM 7.  FINANCIAL STATEMENTS.


                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                                               PAGE
                                                                                                               ----
<S>                                                                                                            <C>
CONSOLIDATED FINANCIAL STATEMENTS OF BRILLIANT DIGITAL ENTERTAINMENT, INC.

Report of Independent Accountants ..........................................................................    33

Consolidated Balance Sheet as of December 31, 1997 .........................................................    34

Consolidated Statements of Operations for the year ended June 30, 1996, for the six months ended
   December 31, 1995 (unaudited) and December 31, 1996, and for the years ended December 31,
   1996 (unaudited) and December 31, 1997 ..................................................................    35

Consolidated Statements of Stockholders' Equity (Deficiency) for the year ended June 30, 1996,
   the six months ended December 31, 1996, and the year ended December 31 ,1997 ............................    36

Consolidated Statements of Cash Flows for the year ended June 30, 1996, for the
   six months ended December 31, 1995 (unaudited) and December 31, 1996, and for
   the years ended December 31, 1996 (unaudited) and December 31,
   1997 ....................................................................................................    37

Notes to Consolidated Financial Statements .................................................................    39
</TABLE>


                                       32

<PAGE>   33

                        REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Shareholders
of Brilliant Digital Entertainment, Inc.

         In our opinion, the accompanying consolidated balance sheet and the
related consolidated statements of operations and stockholders' equity
(deficiency) and of cash flows present fairly, in all material respects, the
financial position of Brilliant Digital Entertainment, Inc. (the "Company") and
its subsidiary at December 31, 1997, and the results of their operations and
their cash flows for the year in conformity with generally accepted accounting
principles. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audit. We conducted our audit of these statements in
accordance with generally accepted auditing standards which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for the opinion expressed
above. The financial statements of Brilliant Digital Entertainment, Inc. for the
six months ended December 31, 1996 and the year ended June 30, 1996 were audited
by other independent accountants whose report dated March 24, 1997 expressed an
unqualified opinion on those statements.


Price Waterhouse LLP

March 18, 1998
Los Angeles, California


                                       33

<PAGE>   34

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                           CONSOLIDATED BALANCE SHEET
                      (In thousands, except per share data)

<TABLE>
<CAPTION>
                                                                                   DECEMBER 31,
                                                                                       1997
                                                                                   -----------
<S>                                                                                <C>
ASSETS
Current assets:
     Cash and cash equivalents............................................         $   12,338
     Accounts receivable..................................................              2,088
     Other assets.........................................................                296
                                                                                   -----------
Total current assets......................................................             14,722
Property, plant and equipment, net........................................                633
Movie software costs......................................................              1,136
Other assets, net.........................................................                352
                                                                                   -----------
Total assets..............................................................         $   16,843
                                                                                   ===========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
     Accounts payable.....................................................         $      179
     Accrued expenses.....................................................              1,842
                                                                                   -----------
Total current liabilities.................................................              2,021
Commitments and contingencies
Stockholders equity:
     Preferred Stock ($0.001 par value; 1,000,000 shares
        authorized; no shares issued or outstanding)......................               --

     Common Stock ($0.001 par value; 30,000,000 shares
        authorized;  9,403,001 shares issued and outstanding..............                  9

     Additional paid-in capital...........................................             21,268
     Accumulated deficit..................................................             (6,260)
     Cumulative translation adjustment....................................               (195)
                                                                                   -----------
Total stockholders' equity................................................             14,822
                                                                                   -----------
Total liabilities and stockholders' equity................................         $   16,843
                                                                                   ===========
</TABLE>

                 See Notes to Consolidated Financial Statements.


                                       34

<PAGE>   35


                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                      (In thousands, except per share data)

<TABLE>
<CAPTION>
                                             YEAR ENDED         SIX MONTHS ENDED               YEAR ENDED
                                              JUNE 30,            DECEMBER 31,                 DECEMBER 31,
                                                            ------------------------       -------------------
                                                1996          1995           1996           1996         1997
                                             ----------      -------        -------        -------     -------
                                                             (UNAUDITED)                   (UNAUDITED)
Revenues:
<S>                                           <C>            <C>            <C>            <C>         <C>
   Software sales .....................       $ 1,468        $   877        $    96        $   682     $ 2,246

   Development fees ...................           586            307            254            531         235
                                              -------        -------        -------        -------     -------
        Total revenues ................         2,054          1,184            350          1,213       2,481
Cost of revenues:
   Software sales .....................           284            195             21             77          44
   Development fees ...................           455            239            165            381        --
                                              -------        -------        -------        -------     -------
        Total cost of revenues ........           739            434            186            458          44
                                              -------        -------        -------        -------     -------
Gross profit ..........................         1,315            750            164            755       2,437
Operating expenses:
   Sales and marketing ................           163             35            970          1,101       1,090
   General and administrative .........           366            129          1,065          1,268       2,217
   Research and development ...........           174            103          1,877          1,996       1,709
   Depreciation .......................           102             46             74            130         214
                                              -------        -------        -------        -------     -------
        Total operating expenses ......           805            313          3,986          4,495       5,230
                                              -------        -------        -------        -------     -------
Income (loss) from operations .........           510            437         (3,822)        (3,740)     (2,793)
Other income (expense):
   Export market development grant ....           122           --             --              126         148
   Gain (loss) on foreign exchange
       transactions ...................            14             17           --               (5)         27
   Interest income ....................             2           --               41             43         313
   Interest expense ...................           (95)           (64)           (54)           (84)       --
                                              -------        -------        -------        -------     -------
        Total other income (expense) ..            43            (47)           (13)            80         488
                                              -------        -------        -------        -------     -------
Income (loss) before income taxes .....           553            390         (3,835)        (3,660)     (2,305)
Provision for income taxes ............          --             --             --             --          --
                                              -------        -------        -------        -------     -------
Net income (loss) .....................       $   553        $   390        $(3,835)       $(3,660)    $(2,305)
                                              =======        =======        =======        =======     =======


Basic and diluted net income (loss) per
     share ............................       $  0.12        $  0.09        $ (0.79)       $ (0.78)    $ (0.31)
                                              =======        =======        =======        =======     =======
Weighted average number of shares
   used in computing basic and diluted
   net income (loss) per share ........         4,473          4,473          4,883          4,678       7,384
                                              =======        =======        =======        =======     =======
</TABLE>

                 See Notes to Consolidated Financial Statements.


                                       35

<PAGE>   36

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
          CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
                        (IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
                                                COMMON STOCK                    RETAINED
                                             ------------------   ADDITIONAL    EARNINGS      CUMULATIVE
                                               NO. OF              PAID-IN    (ACCUMULATED   TRANSLATION
                                               SHARES    AMOUNT    CAPITAL      DEFICIT)      ADJUSTMENT    TOTAL
                                             ----------  ------   ----------  ------------   ------------  -------
<S>                                          <C>         <C>      <C>         <C>            <C>           <C>
Balance at June 30, 1995 ...........         4,473,040       4          10         (673)           12         (647)
    Repurchase of shares ...........           (44,200)   --          --           --            --           --
    Cancellation of shares .........            (8,840)   --          --           --            --           --
    Foreign exchange translation ...              --      --          --           --             (36)         (36)
    Net income .....................              --      --          --            553          --            553
                                            ----------   -----      ------       ------          ----      -------
Balance at June 30, 1996 ...........         4,420,000       4          10         (120)          (24)        (130)
    Grant of warrants ..............              --      --         1,096         --            --          1,096
    Initial public offering, net of
        expenses of $1,468 .........         2,000,000       2       8,530         --            --          8,532
    Conversion of SAND note ........           780,001       1       1,499         --            --          1,500
    Grant of stock options .........              --      --           185         --            --            185
    Foreign exchange translation ...              --      --          --           --              (3)          (3)
    Net loss .......................              --      --          --         (3,835)         --         (3,835)
                                            ----------   -----      ------       ------          ----      -------
Balance at December 31, 1996 .......         7,200,001       7      11,320       (3,955)          (27)       7,345
    Grant of warrants ..............              --      --           140         --            --            140
    Grant of stock options .........              --      --            12         --            --             12
    Exercise of stock options ......             3,000    --          --           --            --           --
    Public offering, net of expenses
        of $1,202 ..................         2,200,000       2       9,796         --            --          9,798
    Foreign exchange translation ...              --      --          --           --            (168)        (168)
    Net loss .......................              --      --          --         (2,305)         --         (2,305)
                                            ----------   -----      ------       ------          ----      -------
Balance at December 31, 1997 .......         9,403,001       9      21,268       (6,260)         (195)      14,822
                                            ==========   =====      ======       ======          ====      =======
</TABLE>

                 See Notes to Consolidated Financial Statements.

                                       36

<PAGE>   37

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                               YEAR ENDED     SIX MONTHS ENDED
                                                JUNE 30,        DECEMBER 31,       YEAR ENDED DECEMBER 31,
                                                            --------------------   -----------------------
                                                  1996         1995       1996        1996         1997
                                               ----------   ----------   -------   ----------    ---------
<S>                                            <C>          <C>          <C>       <C>           <C>
                                                            (UNAUDITED)            (UNAUDITED)
OPERATING ACTIVITIES
Net income (loss) ........................        $ 553       $ 390      $(3,835)    $(3,660)    $ (2,305)
Adjustments to reconcile net income (loss)
   to the net cash provided by (used in)
   operating activities:
     Depreciation and amortization .......          102          46           74         150          473
     Effect of warrants granted ..........         --          --          1,096       1,096          140
     Effect of stock options granted .....         --          --            125         123           12
     Effect of SAND Note .................         --          --          1,350       1,350         --
     Changes in operating assets and
     liabilities:
       Accounts receivable ...............         (633)       (869)         551         807       (1,986)
       Movie software costs ..............         --          --           --          --         (1,284)
       Other assets ......................         --          --           (371)       (391)        (478)
       Accounts payable and accruals .....           40           7          791         823        1,225
       Deferred revenue ..................         --          --            (50)        (49)        (154)
                                                  -----       -----      -------     -------     --------
Net cash provided by (used in) operating
   activities ............................           62        (426)        (269)        249       (4,357)

INVESTING ACTIVITIES
Purchases of equipment ...................         (110)        (72)         (69)       (104)        (599)
                                                  -----       -----      -------     -------     --------
Net cash used in investing activities ....         (110)        (72)         (69)       (104)        (599)

FINANCING ACTIVITIES
Proceeds from issuance of shares .........         --          --          8,532       8,532        9,798
Increase in amounts payable to related
   parties ...............................          711         702          491         780         --
Repayments of amounts payable to related
   parties ...............................         (672)       (169)      (1,145)     (1,943)         (78)
                                                  -----       -----      -------     -------     --------
Net cash provided by financing activities            39         533        7,878       7,369        9,720
                                                  -----       -----      -------     -------     --------
NET INCREASE (DECREASE) IN CASH AND
   CASH EQUIVALENTS ......................           (9)         35        7,540       7,514        4,764

Translation adjustments ..................           13           2           (2)         (9)         (17)
Cash and cash equivalents at beginning
   of period .............................           49          49           53          86        7,591
                                                  -----       -----      -------     -------     --------
Cash and cash equivalents at end  of
   period ................................        $  53       $  86      $ 7,591     $ 7,591     $ 12,338
                                                  =====       =====      =======     =======     ========

Supplemental disclosure of cash flow
  information:
  Cash paid during the period for:
     Interest ............................        $--         $--        $   204     $   204     $   --
</TABLE>


                 See Notes to Consolidated Financial Statements.

                                       37

<PAGE>   38

SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITY:

         In September 1996, the Company acquired SAND and in consideration
therefore issued a one-year $1,500,000 convertible promissory note. (See Note 3
of the Notes to Consolidated Financial Statements.) The purchase price was
allocated to in-process research and development ($1,350,000), which amount was
included in operating expenses for the six months ended December 31, 1996, and
to certain assets ($150,000), which amount was included in other assets at
December 31, 1996.

         During the six months ended December 31, 1996, the Company recorded
$60,000 of stock option deferred compensation, which was included in other
assets at December 31, 1996 (see Note 5 of the Notes to Consolidated Financial
Statements).


                                       38

<PAGE>   39
                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997


1.       DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

         Brilliant Digital Entertainment, Inc. ("Brilliant" or the "Company") is
a production and development studio producing digital entertainment for
distribution over the Internet and on CD-ROM. In July 1996, the Company
incorporated in the State of Delaware and, in August 1996, issued an aggregate
of 1,000,000 shares of its Common Stock in exchange for all of the capital stock
of Brilliant Interactive Ideas, Pty. Ltd., a company incorporated in the State
of New South Wales, Australia ("BII Australia") (the "Exchange"). Historically,
BII Australia developed, produced and marketed interactive multimedia titles for
the education and entertainment markets. The Company operates, and BII Australia
operated, principally in the computer software industry. BII Australia operated
predominantly in Australia with significant exports to the United States.

         On September 13, 1996, the Company effected a 4.42 for 1 stock split
(the "Stock Split") resulting in a 3,420,000 increase in the number of shares of
Common Stock outstanding.

         These financial statements have been restated to give retroactive
effect to the Exchange, the subsequent consolidation of the Company and BII
Australia, and the Stock Split.

         In September 1996 the Company completed its acquisition of Sega
Australia New Development ("SAND") (see Note 3), which owns the rights to
proprietary software tools which are designed to allow the Company to both
develop a new genre of digital entertainment products, and to produce ancillary
products cost effectively. The results of operations of SAND are included in the
Company's consolidated financial statements from the date of acquisition.

2.       SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

         The consolidated financial statements of the Company include the
accounts of Brilliant and its wholly owned subsidiary. All significant
inter-company balances and transactions have been eliminated.

Fiscal Year

         The Company changed its fiscal year-end from June 30 to December 31,
effective December 31, 1996.

Revenue Recognition

                  The Company recognizes software revenue in accordance with
AICPA Statement of Position ("SOP") 91-1, "Software Revenue Recognition". The
Accounting Standards Executive Committee issued SOP 97-2, "Software Revenue
Recognition" in October 1997 effective for transactions entered into in fiscal
periods beginning after December 15, 1997. SOP 97-2 supersedes SOP 91-1 and
provides revised and expanded guidance on when revenue should be recognized and
in what amounts for licensing, selling, leasing, or otherwise marketing computer
software. The Company adopted SOP 97-2 in the first quarter of 1998. The
adoption of SOP 97-2 may materially affect the period in which revenues from
distribution contracts are recognized in the future, however, the potential
future impact cannot currently be determined .

         Software Sales: The Company grants distribution rights to its CD-ROM
products to distributors in exchange for a non-refundable minimum fixed fee and
a percentage of sales of the products. Revenue related to the non-refundable
minimum fixed fee is recognized when the CD-ROM master is delivered to the
customer. Revenue related to a percentage of sales is recognized upon
notification by the distributor that a royalty has been earned by the Company.


                                       39

<PAGE>   40
                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997

         Software sales resulting from the Company selling completed software
products are recognized upon shipment of product.

         It is the Company's policy to provide for estimated returns at the time
software sales revenue is recognized. For the year ended June 30, 1996, the six
months ended December 31, 1996, and the year ended December 31, 1997, the
Company had experienced no returns on software sales.

         Development Fees: In exchange for the development of CD-ROM products
pursuant to an agreement with a software customer, the Company receives
development fees. The software development agreements generally specify certain
"milestones" which must be achieved throughout the development process. As these
milestones are achieved, the Company recognizes the portion of the development
fee allocated to each milestone.

Cost of Revenues

         Cost of revenues related to software sales consists primarily of
royalties to third parties and the direct costs and production overhead required
to reproduce and package software products. Cost of revenues related to
development fees consists primarily of salaries, benefits and overhead
associated with the development of specific software products to customer
specifications, as well as costs of outside contractors engaged from time to
time in creating aspects of software products such as animation, voice recording
and music.

Research and Development Costs

         The Company incurs research and development costs relating to the
development of traditional CD-ROM software tools which provide the technical
infrastructure for production of CD-ROM titles produced by the Company. The
Company incurred research and development costs of $174,000, $1,877,000, and
$1,709,000 for the fiscal year ended June 30, 1996, the six months ended
December 31, 1996, and the year ended December 31, 1997, respectively. The
amount for the six months ended December 31, 1996 includes $1,350,000 of
in-process research and development, which was expensed in accounting for the
SAND acquisition (see Note 3).

Movie Software Costs

         Movie software costs include costs of development and production
including labor, material and production overhead.

         The Company's current accounting policy follows Statement of Financial
Accounting Standards No. 86 ("SFAS No. 86"), which provides for the
capitalization of software development costs once technological feasibility is
established. The capitalized costs are then amortized beginning on the date the
product is made available for sale either on a straight-line basis over the
estimated product life or on a ratio of current revenues to total projected
product revenues, whichever results in the greater amortization amount. Prior to
the establishment of technological feasibility, these costs are expensed as
incurred. It is reasonably possible that the estimates of anticipated future
gross revenues, the remaining estimated economic life of the product, or both
will be reduced significantly in the near term due to the failure of the
Company's new product to achieve commercial success. As a result, the carrying
amount of the capitalized movie software costs and licensing advances included
in other assets may be materially reduced in the short term.

         Prior to reaching technological feasibility, the Company expensed all
costs related to the development of both its software tools and Multipath Movie
titles. During the third quarter of 1997, the Company began capitalizing certain
development costs related to the production of Multipath Movies in accordance
with SFAS No. 86. As of December 31, 1997 no amounts of these capitalized
development costs had been amortized.

Cash Equivalents

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


                                       40

<PAGE>   41
                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997

Property, Plant and Equipment

         Property, plant and equipment are stated at cost. Depreciation and
amortization are provided using the straight-line method over estimated useful
lives ranging up to four years.

Income Taxes

         The Company uses the asset and liability method to account for income
taxes as required by Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes" ("SFAS No. 109"). Under this method, deferred tax
assets and liabilities are determined based on differences between financial
reporting and tax bases of assets and liabilities and are measured using enacted
tax rules and laws that will be in effect when the differences are expected to
reverse.

Foreign Currency Translation

         The functional currency of BII Australia is its local currency,
Australian dollars. Assets and liabilities of BII Australia are translated into
U.S. dollars (the reporting currency) using current exchange rates ($0.652 at
December 31, 1997), and revenues and expenses are translated into U.S. dollars
using average exchange rates ($0.760 for the year ended June 30, 1996, $0.792
for the six months ended December 31, 1996, $0.742 for the year ended December
31, 1997). The effects of foreign currency translation adjustments are deferred
and included as a component of stockholders' equity.

         Foreign currency transaction gains and losses are a result of the
effect of exchange rate changes on transactions denominated in currencies other
than the functional currency. Foreign currency transaction gains (losses) are
included in the statements of operations.

Net Income (Loss) Per Share

         Net income (loss) per share is computed using the weighted average
number of shares of common stock outstanding. Common equivalent shares from
stock options and warrants (using the treasury stock method) have been included
in the computation when dilutive.

         In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS
No. 128"). SFAS No. 128, effective for periods ending after December 15, 1997,
revises the computation, presentation, and disclosure requirements of earnings
per share. Principal among computation revisions is the replacement of primary
earnings per share with basic earnings per share, which does not consider common
stock equivalents. In addition, SFAS No. 128 modifies certain dilutive
computations and replaces fully diluted earnings per share with diluted earnings
per share. Options and warrants representing common shares of 910,000 and
1,223,000 were excluded from the average number of common and common equivalent
shares outstanding in the diluted EPS calculation for the six months ended
December 31, 1996 and the year ended December 31, 1997, respectively, because
they were anti-dilutive. The Company has adopted SFAS No. 128 for the year ended
December 31, 1997 and has restated prior periods presented to conform to SFAS No
128.

Stock Options

         In October 1995, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for
Stock-Based Compensation" ("SFAS No. 123") which defines a fair-value-based
method of accounting for employee stock options or similar equity instruments.
This statement gives entities a choice to recognize related compensation expense
by adopting the new fair-value method or to measure compensation using the
intrinsic value method under Accounting Principles Board (APB) Opinion No. 25,
the former standard. If the former standard for measurement is elected, SFAS No.
123 requires supplemental disclosure to show the effect of using the new
measurement criteria. The Company has used the intrinsic value method prescribed
by APB Opinion No. 25. See Note 5 for supplemental disclosure.


                                       41

<PAGE>   42
                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997

Concentration of Credit Risk

         Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of cash, short-term investments
and accounts receivable. The Company has investment policies that limit
investments to short-term investment grade securities. Accounts receivable are
principally from distributors and retailers of the Company's products. The
Company performs credit evaluations and generally does not require collateral.
At December 31, 1997, 95% of the Company's accounts receivable arose from a
non-exclusive CD-ROM distribution agreement with one customer, Packard Bell NEC.

         The Company analyzes customer receivables to determine the necessity of
an allowance for doubtful accounts. For the year ended December 31, 1997, no
such allowance was considered necessary.

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 amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.


3.       ACQUISITION OF SAND

         In September 1996, the Company and Sega Ozisoft entered into an Asset
Purchase Agreement (the "SAND Acquisition Agreement") to acquire SAND, a
division of Sega Ozisoft. Pursuant to the SAND Acquisition Agreement, the
Company acquired SAND and in consideration therefor issued a $1,500,000
convertible promissory note which, upon the completion of the Company's initial
public offering of Common Stock was automatically converted into 780,001 shares
of Common Stock of the Company. The acquisition was accounted for using the
purchase method.

         SAND was created to develop state-of-the-art technology for
interactive, digital, Multipath Movies. SAND was in the development stage,
devoting substantially all of its efforts to research and development. During
its development stage, SAND incurred significant costs to develop proprietary
software tools to be used in the creation and development of a new genre of
interactive digital entertainment called "Multipath Movies." (Through the date
of the SAND Acquisition, SAND had incurred research and development expenses of
approximately $1,563,000.)

         The SAND Acquisition Agreement also provides that the Company shall pay
to Sega Ozisoft a royalty of 12.5% of "Adjusted Gross Receipts" on the
Cyberswine Multipath Movie. Adjusted Gross Receipts is gross receipts received
by the Company on the Cyberswine Multipath Movie after deducting any royalties
and fees payable to Cyberswine licensors. Pursuant to an agreement between Sega
Ozisoft and the licensor of the characters and content of Cyberswine, the
Company will be required to pay to the Cyberswine licensor a royalty of 2% of
gross revenues less cost of goods on all sales of Cyberswine products.

         Pursuant to the SAND Acquisition Agreement, Sega Ozisoft agreed to fund
certain development expenses of the Company prior to the closing of the
Offering; and the Company agreed to reimburse Sega Ozisoft from the proceeds of
the Offering for all expenses advanced by Sega Ozisoft for any period after
October 31, 1996, and all expenses in excess of $59,000 per month advanced by
Sega Ozisoft for August, September and October 1996. As of December 31, 1996,
the Company had incurred a total obligation of $84,000 pursuant to this
agreement which amount is included in amounts payable to related parties at
December 31, 1996. During the year ended December 31, 1997 the Company repaid
all amounts due to Sega Ozisoft.


                                       42

<PAGE>   43
                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997

         The following summarized, unaudited pro forma results of operations for
the year ended June 30, 1996 assume the SAND acquisition occurred as of the
beginning of the period, after giving effect to the conversion of the SAND Note
into 780,001 shares of common stock. Because SAND assets were charged to expense
on the date of acquisition, there is no material pro forma effect for the six
months ended December 31, 1996.

<TABLE>
<CAPTION>
                                                       YEAR ENDED
                                                      JUNE 30, 1996
                                                      -------------
                                                       (unaudited)
<S>                                                   <C>
Revenues.........................................       $1,881,000
Net loss.........................................       $(797,000)
Net loss per share...............................       $   (0.15)
</TABLE>

4.       RELATED PARTY TRANSACTIONS

         Pacific Interactive Education Pty. Ltd. ("PIE") entered into an oral
agreement with BII Australia whereby Mark Miller, a shareholder and director of
PIE and a director of BII Australia, provides consulting services to BII
Australia. Pursuant to the oral agreement, PIE was paid $69,000, $18,000 and $0
for the fiscal year ended June 30, 1996, the six months ended December 31, 1996,
and the year ended December 31, 1997, respectively, for such services.

         Since March 1994, PIE has made periodic cash advances to BII Australia
for working capital purposes. On October 24, 1994, PIE and BII Australia entered
into a formal loan agreement to reflect the parties' lending relationship. The
maximum amount BII Australia could borrow from PIE pursuant to the loan
agreement was $631,000. The interest rate of the note was 12.5% and the note
plus accrued interest was due and payable on December 31, 1994. By written
agreement (the "Note Extension") dated September 13, 1996, the maturity of the
note was extended until the earlier to occur of the Company's initial public
offering of Common Stock or December 31, 1996. Pursuant to the Note Extension,
PIE and BII Australia increased the maximum amount BII Australia could borrow
under the loan agreement to $710,000. In December 1996, BII Australia repaid PIE
in full for the balance outstanding ($733,000, including accrued interest of
$199,000).

         BII Australia periodically purchases certain computer equipment from
PIE. For the fiscal year ended June 30, 1996, the six months ended December 31,
1996, and the year ended December 31, 1997, BII Australia's purchases totaled
$16,000, $8,000 and $0, respectively.

         Mark Miller is a shareholder of Multimedia Connexion Pty. Ltd. BII
Australia periodically purchases hardware and software from Multimedia Connexion
Pty. Ltd. For the fiscal year ended June 30, 1996, and the year ended December
31, 1997, BII Australia purchased computer equipment totaling $16,000, and
$121,000, respectively. No purchases were made during the six months ended
December 31, 1996.

         Peter Dodds was a shareholder of BII Australia from inception to May
10, 1996. Mr. Dodds is also a shareholder of Andwhen Pty. Limited ("Andwhen").
Mr. Dodds provided consulting services to BII Australia in 1996. In exchange for
such services, fees of $51,000 were paid to Andwhen for the fiscal year ended
June 30, 1996. No consulting fees were paid during the six months ended December
31, 1996 or the year ended December 31, 1997.

         Certain equipment owned by Andwhen was leased to BII Australia pursuant
to an agreement dated March 1, 1994. On May 10, 1996, the agreement was
terminated. As a result, the equipment was transferred to BII Australia and BII
Australia agreed to pay to Andwhen a total amount of approximately $87,000 for
the purchase of such equipment. Of this amount, $20,000 was paid upon
termination of the agreement. The balance was due in equal monthly installments
of approximately $4,500 each. The balance was paid in full in December 1996.

         In December 1994, BII Australia entered into a Software License
Agreement (the "Sega Agreement") with Sega Ozisoft Pty. Ltd. ("Sega Ozisoft").
Mark Dyne and Kevin Bermeister are directors and shareholders of Sega Ozisoft
and directors and stockholders of the Company. Pursuant to the terms of


                                       43

<PAGE>   44
                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997

the Sega Agreement, Sega Ozisoft became the exclusive distributor in Australia
and New Zealand of certain CD-ROM products developed by BII Australia. Pursuant
to the terms of the Sega Agreement, BII Australia received non-refundable
advances totaling $71,000 from Sega Ozisoft in the fiscal year ended June 30,
1995. In addition, BII Australia was entitled to receive royalty payments of
$6.31 per net unit sold. Such royalty was reducible to $4.73 per net unit sold
after 2,000 units had been sold of each title. The non-refundable advances were
recoupable from the royalties earned by BII Australia under the Sega Agreement.
As of December 31, 1996, BII Australia had received no royalty payments relating
to the Sega Agreement. The Sega Agreement expired on December 15, 1996.

         In November 1995, BII Australia entered into a Distribution Agreement
(the "Consumer Electronics Agreement") with Consumer Electronics Pty. Ltd.
("Consumer Electronics"). Mark Dyne and Kevin Bermeister are both directors and
shareholders of Consumer Electronics. BII Australia developed, pursuant to the
Consumer Electronics Agreement, several CD-ROM products to be distributed by
Consumer Electronics in South Africa and neighboring territories. In addition,
BII Australia granted to Consumer Electronics certain bundling rights to the
CD-ROM products in the same territories. Pursuant to the Consumer Electronics
Agreement, BII Australia was entitled to receive a non-refundable advance of
$85,000, of which $21,000 was paid in the fiscal year ended June 30, 1996. In
September 1996, the Company agreed to reduce the remaining advance by 25% in
exchange for an immediate payment of the balance due. On October 15, 1996, the
Company received $48,000 representing the full amount due pursuant to the
re-negotiated terms. The Company anticipates no further receipts pursuant to the
Consumer Electronics Agreement, which expired on December 6, 1996.

         Kevin Bermeister and Mark Dyne are both directors and shareholders of
Packard Bell Pty. Ltd. Between February 1994 and June 30, 1996, BII Australia
purchased an aggregate of approximately $38,000 in goods from Packard Bell Pty.
Ltd. During the six months ended December 31, 1996, and the year ended December
31, 1997, BII Australia purchased an additional $9,000 and $7,000, respectively,
in goods from Packard Bell Pty. Ltd.

         In January 1996, BII Australia entered into a Multimedia Software
Development and Production agreement (the "Development Agreement") with Sega
Ozisoft for Cyberswine. Pursuant to the terms of the Development Agreement, BII
Australia was entitled to receive payment for certain assistant production
services. Amounts were payable by Sega Ozisoft upon attainment of mutually
determined milestones. In September 1996, the Company entered into the SAND
Acquisition Agreement (see Note 3) which provided for additional payments for
production services, and which superseded the Development Agreement. As of June
30, 1996, the Company had received $120,000 and had recorded a receivable of
$52,000, which was received in July and August 1996. For the six months ended
December 31, 1996 the Company billed an additional $92,000, of which $29,000 was
receivable at December 31, 1996, and was collected during the year ended
December 31, 1997.

         Mark Dyne is a director of Monto Holdings Pty. Ltd. ("Monto"). Monto
entered into a multimedia production agreement with BII Australia dated March
14, 1995 whereby Monto paid BII Australia $180,000 to be used to develop a
series of two CD-ROM interactive magazine programs based on a television series.
BII Australia has arranged for publication and distribution of the completed
software packages and is obligated to pay to Monto 50% of the net receipts from
the sale of the software packages. As of June 30, 1996, net receipts under the
agreement totaled approximately $25,000 and payments to Monto totaled $12,000.
In addition, a liability to Monto for $7,000 was recorded at June 30, 1996. In
the six months ended December 31, 1996, no additional receipts or payments were
made pursuant to this agreement. During the year ended December 31, 1997, the
liability to Monto was reduced to $4,000.

         Diana Maranon is a director of the Company. Averil Associates, Inc.
("Averil Associates"), a financial advisory firm founded and controlled by Ms.
Maranon, has, since November 1995, performed services for the Company including
investigation of strategic alternatives and assistance with the Company's common
stock offerings. As consideration for such services, the Company paid to Averil
Associates $25,000 as of June 30, 1996, $200,000 during the six months ended
December 31, 1996, and $22,000 for the year ended December 31, 1997, plus out of
pocket expenses, and granted to Chloe Holding, Inc. ("Chloe"), an affiliate of
Averil Associates, currently exercisable warrants to purchase 40,222 shares of
Common Stock with an exercise price of $0.0326 per share. In connection with the
Company's December 1997 offering of Common Stock, the Company made a cash
payment to Averil Associates of $180,000 and granted to Chloe warrants to
purchase 15,040 shares of Common Stock at an exercise price of 110% of the
offering price.

         Between September and November 1996, the Company executed three
promissory notes in favor of Reefknot, a


                                       44

<PAGE>   45
                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997

shareholder of the Company, in the principal amounts of $150,000, $50,000 and
$145,000. The notes bore interest at the rate of 10% per annum. In December
1996, the Company repaid Reefknot in full the balance outstanding of $350,000
including accrued interest of $5,000.

         Gary Barber is a director of the Company and a shareholder of Morgan
Creek Productions, Inc. From May 1989 until July 1997, Mr. Barber was employed
by Morgan Creek Productions, Inc. From January 1995 until July 1997, he was Vice
Chairman and Chief Operating Officer of Morgan Creek Productions, Inc. In
September 1996, the Company entered into a strategic relationship with Morgan
Creek Interactive, Inc. ("Morgan Creek"), an affiliate of Morgan Creek
Productions, Inc., to provide creative product for the Company's Multipath
Movies. Pursuant to the agreement between the Company and Morgan Creek, the
Company is obligated to fund entirely the development of two Multipath Movies.
The first project commenced under this agreement is a thirteen episode comedy
adventure series featuring the Ace Ventura character.

5.       STOCKHOLDERS' EQUITY

Common Stock

         The holders of Common Stock are entitled to one vote for each share
held of record on all matters on which the holders of Common Stock are entitled
to vote. The holders of Common Stock are entitled to receive dividends when, as
and if declared by the Board of Directors out of funds legally available
therefor. In the event of liquidation, dissolution or winding up of the Company,
the holders of Common Stock are entitled subject to the rights of holders of
Preferred Stock issued by the Company, if any, to share ratably in all assets
remaining available for distribution to them after payment of liabilities and
after provision is made for each class of stock, if any, having preference over
the Common Stock.

         The holders of Common Stock have no preemptive or conversion rights and
they are not subject to further calls or assessments by the Company. There are
no redemption or sinking fund provisions applicable to the Common Stock. The
outstanding shares of Common Stock are fully paid and nonassessable.

Preferred Stock

         The Company is authorized to issue 1,000,000 shares of Preferred Stock,
par value $0.001 per share. As of December 31, 1997 no shares were issued or
outstanding. The Board of Directors has the authority to issue the authorized
and unissued Preferred Stock in one or more series with such designations,
rights and preferences as may be determined from time to time by the Board of
Directors. Accordingly, the Board of Directors is empowered, without stockholder
approval, to issue Preferred Stock with dividend, liquidation, conversion,
voting or other rights which adversely affect the voting power or other rights
of the holders of the Company's Common Stock.

Warrants

         During September 1996 the Company entered into two strategic agreements
with terms that provided for the issuance of warrants to purchase a total of
685,000 shares of the Company's Common Stock. Warrants to purchase 600,000
shares of Common Stock are exercisable at $5.00, the initial public offering
price of the Company's Common Stock. Additionally, 35,000 and 50,000 of the
warrants are exercisable at $4.00 and $5.20, respectively. The warrants expire
in September 1999. The value of the warrants is calculated to be $1,096,000
which has been recorded as an expense charge to operations with a corresponding
credit to stockholders' equity in the six months ended December 31, 1996.

         In September 1997, the Company issued warrants to purchase 200,000
shares of the Company's Common Stock, exercisable at $10.00, in connection with
a distribution agreement. The warrants expire in February 1999. The value of the
warrants is calculated to be $140,000 which has been recorded as an expense
charge to operations with a corresponding credit to stockholders' equity.

1996 Stock Option Plan


                                       45

<PAGE>   46

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997


         The Company adopted a Stock Option Plan (the "1996 Plan") which became
effective on September 13, 1996. Each director, officer, employee or consultant
of the Company or any of its subsidiaries is eligible to be considered for the
grant of awards under the 1996 Plan. The maximum number of shares of Common
Stock that may be issued pursuant to awards granted under the 1996 Plan is
1,080,000, subject to certain adjustments to prevent dilution. Any shares of
Common Stock subject to an award which for any reason expires or terminates
unexercised are again available for issuance under the 1996 Plan. The maximum
number of shares of Common Stock with respect to which options or rights may be
granted under the 1996 Plan to any executive or other employee during any fiscal
year is 100,000, subject to certain adjustments to prevent dilution.

         As of October 23, 1996, the Board had granted options covering an
aggregate of 185,000 shares of Common Stock to certain directors (125,000
shares) and employees (60,000 shares) of the Company, with an exercise price of
$10 per share. In November 1996, the exercise price of the options was repriced
to $4.00 per share. The directors options were granted effective as each
director joined the Board of Directors and were immediately fully vested. In
accordance with APB No. 25, the Company recognized compensation expense of
$125,000 in 1996 in connection with the granting of the directors' stock
options. The options granted to employees vest over a four year period. In
connection with these employee stock options, $0 and $15,000 was recognized as
compensation expense in the six months ended December 31, 1996 and the year
ended December 31,1997, respectively, and deferred compensation of $46,000 is
included in other assets at December 31, 1997. Although any award that was duly
granted may thereafter be exercised or settled in accordance with its terms, no
shares of Common Stock may be issued pursuant to any award made after September
13, 2006.

         During 1997, the Company granted additional options covering 101,000
shares of Common Stock to certain employees of the Company with a weighted
average exercise price of $5.19 per share, and vesting over a 4 year period. In
connection with these employee stock options, compensation expense of $12,000
was recognized in 1997.

         The following table summarizes stock option activity:

<TABLE>
<CAPTION>
                                                          Number
                                                         of Shares       Option Price
                                                         ---------       ------------
<S>                                                      <C>             <C>
Outstanding at June 30, 1996 ....................            --
Granted .........................................         185,000         $4.00
Exercised .......................................            --
-------------------------------------------------        --------         -----------
Outstanding at December 31, 1996 ................         185,000         $4.00
Granted .........................................         101,000         $0.01-$6.38
Exercised .......................................          (3,000)        $0.01
-------------------------------------------------        --------         -----------
Outstanding at December 31, 1997 ................         283,000         $4.00-$6.38

Exercisable  at December 31, 1997 ...............         163,326         $4.00-$5.00
</TABLE>


         As discussed in Note 2, the Company has adopted the disclosure-only
provisions of Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation." SFAS No. 123 requires the use of option valuation
models to provide supplemental information regarding options granted after 1994.
Pro forma information regarding net income and earnings per share shown below
was determined as if the Company had accounted for its employee stock options
under the fair value method of SFAS No. 123.

         The fair value of the options as examined at the date of grant is based
on a Black-Scholes option pricing model with the following weighted-average
assumptions for 1996 and 1997, respectively: interest rates of 6.6% and 6.0%;
dividend yields of 0% for both years; volatility factors of the expected market
price of the Company's common stock of 38.8% and 45.0%; and expected life of the
options of 3 years for both years. These assumptions resulted in a weighted
average fair value of $2.80 and $2.03 per share for stock options granted in
1996 and 1997, respectively.


                                       46

<PAGE>   47

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997

         The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options. The Company's employee stock
options have not been traded. In addition, the assumptions used in option
valuation models are highly subjective, particularly the expected stock price
volatility of the underlying stock. Because changes in these subjective input
assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not provide a reliable single measure of the
fair value of its employee stock options.

         For purposes of pro forma disclosures, the estimated fair value of the
options is amortized over the options' vesting periods. The pro forma effect on
net income for 1996 and 1997 is not representative of the pro forma effect on
net income in future years because it reflects expense for only one year's
vesting. Pro forma information in future years will reflect the amortization of
a larger number of stock options granted in succeeding years. The Company's pro
forma information is as follows:

<TABLE>
<CAPTION>
                                                           SIX MONTHS ENDED         YEAR ENDED
                                                          DECEMBER 31, 1996      DECEMBER 31, 1997
                                                          -----------------      -----------------
<S>                                                       <C>                    <C>
Net loss, as reported...................................     $(3,835,000)          $(2,305,000)
Net loss, pro forma.....................................     $(3,992,000)          $(2,409,000)
Basic and diluted loss per share, as reported...........     $     (0.79)          $     (0.31)
Basic and diluted loss per share, pro forma.............     $     (0.82)          $     (0.33)
</TABLE>


6.       COMMITMENTS AND CONTINGENCIES

         In 1995, Pick Two Limited ("Pick Two"), made a $193,000 non-refundable
advance to BII Australia to develop certain software. In 1996, Pick Two made an
additional $19,000 non-refundable advance to BII Australia. These advances were
non-interest bearing, and were to be repaid from proceeds from the sales of the
completed software. During the six months ended December 31, 1996, approximately
$48,000 of the advances were repaid out of proceeds received from the sale of
certain research materials. During the year ended December 31, 1997 the balance
of the advances were recognized as revenue.

         In September 1996, the Company entered into a strategic relationship
with Crawford Productions Pty., Ltd. ("Crawford") to provide creative product
for the Company's Multipath Movies. Pursuant to the agreement between the
Company and Crawford, the Company is obligated to contribute up to one half of
the costs incurred to develop and produce each project selected by the parties,
if any, for development into Multipath Movie titles, which cost per film is
anticipated to be approximately $790,000. To date, no projects have been
identified for development by the parties.

         At December 31, 1997, the Company was obligated under certain licensing
agreements to make minimum payments totalling $198,000 for use of certain
properties and characters in development of its products.

         The Company leases its facilities under operating lease agreements
expiring through 2003. Future minimum payments as of December 31, 1997 under
these leases are as follows:

<TABLE>
<S>                                     <C>
       1998                              $   290,000
       1999                                  310,000
       2000                                  268,000
       2001                                  122,000
       2002                                   71,000
       2003                                    6,000
                                        =============
                                         $ 1,067,000
                                        =============
</TABLE>

Rent expense was $24,000, $18,000 and $166,000 for the year ended June 30, 1996,
the six months ended December 31, 1996 and the year ended December 31, 1997,
respectively.


                                       47

<PAGE>   48

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997


7.       INCOME TAXES

         The Company has adopted the asset and liability method of accounting
for income taxes. Income tax expense shown in the statements of operations is
calculated on the operating profit before tax, adjusted for items which, due to
treatment under income tax legislation, create permanent differences between
accounting profit and taxable income. Deferred income taxes under FAS No. 109
reflect the net tax effects of temporary differences between the carrying
amounts of assets and liabilities for financial reporting purposes and the
amounts used for income tax purposes.

         The Company's net income for fiscal year ended June 30, 1996 is related
to the Australian operations of BII Australia. As a result, no provision was
made for United States federal income taxes. Due to BII Australia's net losses
for 1994 and 1995, net operating loss carry forwards ("NOL's") were generated
for Australian tax purposes. A portion of these Australian NOL's were offset
against BII Australia's taxable income for fiscal year ended June 30, 1996. At
June 30, 1996 BII Australia had NOL's remaining of approximately $160,000, which
increased to approximately $743,000 at December 31, 1996 and decreased to
approximately $186,000 at December 31, 1997, and which are available for offset
against Australian taxable income in the future. These NOL's may be carried
forward indefinitely. During the six months ended December 31, 1996 and the year
ended December 31, 1997, the U.S. parent incurred tax losses resulting in an NOL
carry forwards of approximately $477,000 and $3,949,000, respectively. The
losses will begin to expire in the year 2011.
No tax benefit has been recorded for these NOL's.

         The significant components of the net deferred tax assets and
liabilities recorded in the accompanying consolidated balance sheet as of
December 31, 1997 are as follows:

<TABLE>
<CAPTION>
                                                                             DECEMBER 31,
                                                                                 1997
                                                                            -------------
<S>                                                                         <C>
Deferred tax assets:
   Acquired in-process research and development..........................   $    450,000
   Stock options.........................................................         56,000
   Warrants issued.......................................................        494,000
   Provisions............................................................        143,000
   Net operating loss carry forward......................................      1,623,000
   Other deferred tax assets.............................................          4,000
                                                                            -------------
   Total deferred tax assets.............................................      2,770,000
   Valuation allowance...................................................      2,348,000
                                                                            -------------
Net deferred tax assets..................................................        422,000
Deferred tax liabilities:
   Deferred movie software costs.........................................        422,000
                                                                            =============
Net deferred tax assets (liabilities) ...................................           --
                                                                            =============
</TABLE>


                                       48

<PAGE>   49

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997


                  The reconciliation of the effective income tax rate to the
Federal statutory rate is as follows:


<TABLE>
<CAPTION>
                                                       YEAR ENDED JUNE      SIX MONTHS ENDED        YEAR ENDED
                                                              30,              DECEMBER 31,        DECEMBER 31,
                                                             1996                 1996                 1997
                                                       ---------------      ----------------       ------------
<S>                                                    <C>                  <C>                    <C>
Federal income tax rate ...........................           34.0%                34.0%                34.0%
Foreign and U. S. tax effect attributable to
   foreign operations .............................            2.0                 --                   --
Effect of net operating loss and net operating loss
   carry forward ..................................          (36.0)               (34.0)               (34.0)
                                                           -------              -------              -------

Effective income tax rate .........................            0.0%                 0.0%                 0.0%
                                                           =======              =======              =======
</TABLE>


8.       PROPERTY, PLANT AND EQUIPMENT

         Property, plant and equipment consists of the following:

<TABLE>
<CAPTION>
                                  DECEMBER 31, 1997
                                 -------------------
<S>                              <C>
Computers and Equipment .....        $   838,000
Leasehold Improvements ......            152,000
Furniture and Fixtures ......             90,000
                                     -----------
                                       1,080,000
Less accumulated depreciation           (447,000)
                                     -----------
                                     $   633,000
                                     ===========
</TABLE>



9.       ACCRUED EXPENSES

         Accrued expenses consist of the following:


<TABLE>
<CAPTION>
                              DECEMBER 31,
                                  1997
                              ------------
<S>                           <C>
Employee compensation         $  670,000
Advertising ..........           445,000
Offering costs payable           321,000
Insurance ............           153,000
Other ................           253,000
                              ----------
                              $1,842,000
                              ==========
</TABLE>


                                       49

<PAGE>   50

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997


10.      OTHER INCOME AND EXPENSE

         Other income for the fiscal year ended June 30, 1996, and the year
ended December 31, 1997 include an export market development grant of $122,000,
and $148,000, respectively, from the Australian Trade Commission for
participating in certain export activities. Interest expense for the year ended
June 30, 1996 related to the note payable to PIE (see Note 4). Interest expense
for the six months ended December 31, 1996 included $49,000 related to PIE and
$5,000 related to Reefknot (see Note 4).


11.      GEOGRAPHICAL INFORMATION AND MAJOR CUSTOMERS

         The Company's operations for the year ended June 30, 1996 consisted
solely of the operations of BII Australia. The operations of BII Australia are
in Australia, with significant exports to the United States. In September 1997,
the Company recognized revenue under a distribution agreement with a significant
U.S. customer. The following schedule sets forth the revenues and accounts
receivable of the Company by geographic area:

<TABLE>
<CAPTION>
                                                 UNITED
                                                 STATES          AUSTRALIA         OTHER
                                               ----------        ---------       --------
<S>                                            <C>               <C>             <C>
Year ended June 30, 1996:
   Revenues from unaffiliated customers        $  932,000        $258,000        $235,000
   Revenues from affiliated customers .           316,000         264,000          49,000
                                               ----------        --------        --------

   Total revenues .....................        $1,248,000        $522,000        $284,000
                                               ==========        ========        ========

Six Months ended December 31, 1996:
   Revenues from unaffiliated customers        $   68,000        $184,000        $  8,000
   Revenues from affiliated customers .              --            63,000          27,000
                                               ----------        --------        --------

   Total revenues .....................        $   68,000        $247,000        $ 35,000
                                               ==========        ========        ========

Year ended December 31, 1997:
   Revenues from unaffiliated customers        $2,229,000        $196,000        $ 56,000
   Revenues from affiliated customers .              --              --              --
                                               ----------        --------        --------

   Total revenues .....................        $2,229,000        $196,000        $ 56,000
                                               ==========        ========        ========

Accounts Receivable as of:
    December 31, 1997 .................        $2,088,000            --              --
                                               ==========        ========        ========
</TABLE>

         For each of the periods shown above, all of the operating expenses of
the Company were incurred and paid in Australia, with the exception of royalties
due to third parties incurred in 1997, and certain corporate expenses since
September 1996. The identifiable assets of the Company, other than accounts
receivable and corporate assets, are predominantly related to the operations in
Australia.

         In the fiscal year ended June 30, 1996, three customers accounted for
more than 10% of total revenues (Packard Bell Electronics, Inc., 15% or
$316,000; Shortland Publications, 11% or $226,000; and Ocean of America, Inc.,
40% or $813,000). In the six months ended December 31, 1996, four customers
accounted for more than 10% of total revenues (Frontline Agency, 17% or $60,000;
Interplay Productions, Inc., 17% or $60,000; Sega Ozisoft, 18% or $62,000; and
Golden Dolphin Productions Pty. Ltd., 35% or $122,000). For the year ended
December 31, 1997, one customer accounted for more than 10% of total revenues
(Packard Bell NEC, 80% or $1,973,000).


                                       50

<PAGE>   51

                      BRILLIANT DIGITAL ENTERTAINMENT, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                DECEMBER 31, 1997


12.      SUBSEQUENT EVENT

         On March 20, 1998 the Company authorized the issuance of 513,500
options to employees pursuant to the 1996 Plan.

         In March 1998, the Company adopted a stockholder's rights plan and, in
connection therewith, will distribute one preferred share purchase right for
each outstanding share of the Company's Common Stock outstanding on April 2,
1998. Upon the occurrence of certain events, each purchase right not owned by
certain hostile acquirors will entitle its holder to purchase shares of the
Company's Series A Preferred Stock, which is convertible into Common Stock, at a
value below the then current market value of the preferred stock. The rights of
the holders of Common Stock will be subject to, and may be adversely affected
by, the rights of the holders of the share purchase rights and of any Preferred
Stock that may be issued in the future.


                                       51

<PAGE>   52
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE.

           None.

                                    PART III


ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT.

         Information regarding Directors and Executive Officers of Registrant
will appear in the proxy statement for the 1998 Annual Meeting of Stockholders,
and is incorporated herein by reference.


ITEM 10. EXECUTIVE COMPENSATION.

         Information regarding executive compensation will appear in the proxy
statement for the 1998 Annual Meeting of Stockholders, and is incorporated
herein by reference.


ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

         Information regarding security ownership of certain beneficial owners
and management will appear in the proxy statement for the 1998 Annual Meeting of
Stockholders, and is incorporated herein by reference.


ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

         Information regarding certain relationships and related transactions
will appear in the proxy statement for the 1998 Annual Meeting of Stockholders,
and is incorporated by this reference.


ITEM 13. EXHIBITS, LIST AND REPORTS ON FORM 8-K.

         (a)      Exhibits:

                  See attached Exhibit List.

         (b)      Reports on Form 8-K.

                  Report on Form 8-K dated November 4, 1997 reporting under Item
                  5 thereof Registrant's press release dated October 24, 1997,
                  disclosing the Registrant's distribution agreement with
                  Packard Bell NEC.


                                       52

<PAGE>   53

                                   SIGNATURES

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

                           BRILLIANT DIGITAL ENTERTAINMENT, INC.

                                    /s/ Michael Ozen
                                    --------------------------------------------
                           By:      Michael Ozen
                           Its:     Chief Financial Officer (Principal Financial
                                    and Accounting Officer) and Secretary

                                POWER OF ATTORNEY

         Each person whose signature appears below constitutes and appoints Mark
Dyne and Michael Ozen, and each of them, as his true and lawful
attorneys-in-fact and agents with full power of substitution and resubstitution,
for him and his name, place and stead, in any and all capacities, to sign any or
all amendments to this Annual Report on Form 10-KSB and to file the same, with
all exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and
agents, and each of them, full power and authority to do and perform each and
every act and thing requisite and necessary to be done in and about the
foregoing, as fully to all intents and purposes as he might or could do in
person, hereby ratifying and confirming all that said attorneys-in-fact and
agents, or either of them, or their substitutes, may lawfully do or cause to be
done by virtue hereof.

                                   SIGNATURES
         In accordance with the Exchange Act, this report has been signed below
by the following persons on behalf of the Registrant and in the capacities and
on the dates indicated.

<TABLE>
<CAPTION>
           Signature                       Title                                            Date
           ---------                       -----                                            ----
<S>                                 <C>                                                 <C>
        /s/ Mark Dyne               Chief Executive Officer and Chairman                March 27, 1998
--------------------------------    of the Board of Directors
        Mark Dyne

        /s/ Kevin Bermeister        President and Director                              March 27, 1998
--------------------------------
        Kevin Bermeister

        /s/ Michael Ozen            Chief Financial Officer (Principal Financial        March 27, 1998
--------------------------------    and Accounting Officer) and Secretary
        Michael Ozen

        /s/ Mark Miller             Vice President, Operations and Production           March 27, 1998
--------------------------------    and Director
        Mark Miller

        /s/ Gary Barber             Director                                            March 27, 1998
--------------------------------
        Gary Barber

        /s/ Diana Maranon           Director                                            March 27, 1998
--------------------------------
        Diana Maranon

        /s/ Ray Musci               Director                                            March 27, 1998
--------------------------------
        Ray Musci

        /s/ Garth Saloner           Director                                            March 27, 1998
--------------------------------
        Garth Saloner

        /s/ Jeff Scheinrock         Director                                            March 27, 1998
--------------------------------
        Jeff Scheinrock
</TABLE>


                                       53

<PAGE>   54
                                  EXHIBIT INDEX

        EXHIBIT
        NUMBER
                               EXHIBIT DESCRIPTION

         2.1      Exchange Agreement, dated August 20, 1996, by and among the
                  Registrant, Brilliant Interactive Ideas Pty. Ltd. ("BII
                  Australia"), Reefknot Limited and Pacific Interactive
                  Education Pty. Limited. Incorporated by reference to Exhibit
                  2.1 to Form S-1 filed on September 17, 1996, and the
                  amendments thereto.

         2.2      Asset Purchase Agreement, dated September 12, 1996, by and
                  between the Registrant and Sega Ozisoft Pty. Ltd. Incorporated
                  by reference to Exhibit 2.2 to Form S-1 filed on September 17,
                  1996, and the amendments thereto.

         3.1      Amended and Restated Certificate of Incorporation of
                  Registrant. Incorporated by reference to Exhibit 3.1 to Form
                  S-1 filed on September 17, 1996, and the amendments thereto.

         3.2      Amended and Restated Bylaws of Registrant. Incorporated by
                  reference to Exhibit 3.2 to Form S-1 filed on September 17,
                  1996, and the amendments thereto.

         4.1      Specimen Stock Certificate of Common Stock of Registrant.
                  Incorporated by reference to Exhibit 4.1 to Form S-1 filed on
                  September 17, 1996, and the amendments thereto.

         10.1     Registrant's 1996 Stock Option Plan. Incorporated by reference
                  to Exhibit 10.1 to Form S-1 filed on September 17, 1996, and
                  the amendments thereto.

         10.2     Form of Registrant's Stock Option Agreement (Non-Statutory
                  Stock Option). Incorporated by reference to Exhibit 10.2 to
                  Form S-1 filed on September 17, 1996, and the amendments
                  thereto.

         10.3     Form of Registrants's Stock Option Agreement (Incentive Stock
                  Option). Incorporated by reference to Exhibit 10.3 to Form S-1
                  filed on September 17, 1996, and the amendments thereto.

         10.4     Distribution Agreement, dated November 22, 1995, by and
                  between BII Australia and Consumer Electronics Pty. Ltd.
                  Incorporated by reference to Exhibit 10.4 to Form S-1 filed on
                  September 17, 1996, and the amendments thereto. [Portions of
                  this Exhibit have been deleted and filed separately with the
                  Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.5     CD-ROM Distribution Agreement, dated September 14, 1996 by and
                  between the Registrant and Packard Bell NEC. Incorporated by
                  reference to Exhibit 10.5 to Form S-1 filed on September 17,
                  1996, and the amendments thereto. [Portions of this Exhibit
                  have been deleted and filed separately with the Securities and
                  Exchange Commission pursuant to a grant of Confidential
                  Treatment.]

         10.6     Distribution Agreement, dated August 22, 1995, by and between
                  BII Australia and Packard Bell Electronics Inc. Incorporated
                  by reference to Exhibit 10.6 to Form S-1 filed on September
                  17, 1996, and the amendments thereto. [Portions of this
                  Exhibit have been deleted and filed separately with the
                  Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.7     Software License Agreement, dated May 2, 1995, by and between
                  BII Australia and Packard Bell Electronics Inc. Incorporated
                  by reference to Exhibit 10.7 to Form S-1 filed on September
                  17, 1996, and the amendments thereto. [Portions of this
                  Exhibit have been deleted and filed separately with the
                  Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.8     Agreement, dated February 18, 1996, by and between Golden
                  Dolphin Productions Pty. Ltd.


                                       54

<PAGE>   55

        EXHIBIT
        NUMBER
                               EXHIBIT DESCRIPTION

                  and BII Australia. Incorporated by reference to Exhibit 10.8
                  to Form S-1 filed on September 17, 1996, and the amendments
                  thereto. [Portions of this Exhibit have been deleted and filed
                  separately with the Securities and Exchange Commission
                  pursuant to a grant of Confidential Treatment.]

         10.9     Memorandum of Agreement, dated September 5, 1996, by and
                  between the Registrant and Bantam Doubleday Dell Books For
                  Young Readers. Incorporated by reference to Exhibit 10.9 to
                  Form S-1 filed on September 17, 1996, and the amendments
                  thereto. [Portions of this Exhibit have been deleted and filed
                  separately with the Securities and Exchange Commission
                  pursuant to a grant of Confidential Treatment.]

         10.10    Production Agreement, dated March 18, 1994, by and between
                  Pick Two Ltd. and BII Australia. Incorporated by reference to
                  Exhibit 10.10 to Form S-1 filed on September 17, 1996, and the
                  amendments thereto. [Portions of this Exhibit have been
                  deleted and filed separately with the Securities and Exchange
                  Commission pursuant to a grant of Confidential Treatment.]

         10.11    Assistant Multimedia Software Development & Production
                  Agreement, dated January 17, 1996, by and between Sega Ozisoft
                  Pty. Limited and BII Australia. Incorporated by reference to
                  Exhibit 10.11 to Form S-1 filed on September 17, 1996, and the
                  amendments thereto. [Portions of this Exhibit have been
                  deleted and filed separately with the Securities and Exchange
                  Commission pursuant to a grant of Confidential Treatment.]

         10.12    Licensing Agreement for "Cyberswine" Story Concept &
                  Characters, dated July 19, 1995, by and between Eat Cyberfist
                  Pty. Limited and Sega Ozisoft Pty Limited. Incorporated by
                  reference to Exhibit 10.12 to Form S-1 filed on September 17,
                  1996, and the amendments thereto. [Portions of this Exhibit
                  have been deleted and filed separately with the Securities and
                  Exchange Commission pursuant to a grant of Confidential
                  Treatment.]

         10.13    Distribution Agreement, dated November 2, 1995, by and between
                  BII Australia and Roadshow Entertainment Pty. Ltd.
                  Incorporated by reference to Exhibit 10.13 to Form S-1 filed
                  on September 17, 1996, and the amendments thereto. [Portions
                  of this Exhibit have been deleted and filed separately with
                  the Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.14    Publishing Agreement, dated March 9, 1994, by and between
                  Shortland Publications Limited and BII Australia. Incorporated
                  by reference to Exhibit 10.14 to Form S-1 filed on September
                  17, 1996, and the amendments thereto. [Portions of this
                  Exhibit have been deleted and filed separately with the
                  Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.15    Settlement Agreements and Mutual General Releases, by and
                  among BII Australia, Ray Musci, Ocean of America, Inc., and
                  Ocean Software, Ltd. and Ocean International, Ltd.
                  Incorporated by reference to Exhibit 10.15 to Form S-1 filed
                  on September 17, 1996, and the amendments thereto. [Portions
                  of this Exhibit have been deleted and filed separately with
                  the Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.16    Publishing Agreement, dated December 1, 1994, by and between
                  Shortland Publications Limited and BII Australia. Incorporated
                  by reference to Exhibit 10.16 to Form S-1 filed on September
                  17, 1996, and the amendments thereto. [Portions of this
                  Exhibit have been deleted and filed separately with the
                  Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.17    Distribution Agreement, dated July 1, 1996, by and between BII
                  Australia and Fujitsu Basic Software Corporation. Incorporated
                  by reference to Exhibit 10.7 to Form S-1 filed on


                                       55

<PAGE>   56

        EXHIBIT
        NUMBER
                               EXHIBIT DESCRIPTION

                  September 17, 1996, and the amendments thereto. [Portions of
                  this Exhibit have been deleted and filed separately with the
                  Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.18    License Agreement -- Domestic, dated July 31, 1996, between
                  the Hearst Corporation, King Features Syndicate Division and
                  the Registrant. Incorporated by reference to Exhibit 10.18 to
                  Form S-1 filed on September 17, 1996, and the amendments
                  thereto. [Portions of this Exhibit have been deleted and filed
                  separately with the Securities and Exchange Commission
                  pursuant to a grant of Confidential Treatment.]

         10.19    Distribution Agreement, dated September 29, 1995, by and
                  between BII Australia and Ocean of America, Inc. Incorporated
                  by reference to Exhibit 10.19 to Form S-1 filed on September
                  17, 1996, and the amendments thereto. [Portions of this
                  Exhibit have been deleted and filed separately with the
                  Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.20    Distribution Agreement, dated February 22, 1996, by and
                  between BII Australia and Shortland Publications Limited.
                  Incorporated by reference to Exhibit 10.20 to Form S-1 filed
                  on September 17, 1996, and the amendments thereto. [Portions
                  of this Exhibit have been deleted and filed separately with
                  the Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.21    Heads of Agreement, dated November 25, 1994, by and between
                  SAND and Eat Cyberfist Pty. Limited. Incorporated by reference
                  to Exhibit 10.21 to Form S-1 filed on September 17, 1996, and
                  the amendments thereto. [Portions of this Exhibit have been
                  deleted and filed separately with the Securities and Exchange
                  Commission pursuant to a grant of Confidential Treatment.]

         10.22    Software License Agreement, dated December 15, 1994, by and
                  between BII Australia and Sega Ozisoft. Incorporated by
                  reference to Exhibit 10.22 to Form S-1 filed on September 17,
                  1996, and the amendments thereto. [Portions of this Exhibit
                  have been deleted and filed separately with the Securities and
                  Exchange Commission pursuant to a grant of Confidential
                  Treatment.]

         10.23    Memorandum of Understanding, dated September 14, 1996, by and
                  between the Registrant and Morgan Creek Interactive, Inc.
                  Incorporated by reference to Exhibit 10.23 to Form S-1 filed
                  on September 17, 1996, and the amendments thereto. [Portions
                  of this Exhibit have been deleted and filed separately with
                  the Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.24    Multimedia Production Agreement, dated March 14, 1995, by and
                  between BII Australia and Monto Holdings Pty. Ltd.
                  Incorporated by reference to Exhibit 10.24 to Form S-1 filed
                  on September 17, 1996, and the amendments thereto. [Portions
                  of this Exhibit have been deleted and filed separately with
                  the Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.25    Nontransferable Redeemable Warrant Agreement, dated September
                  14, 1996, by and between the Registrant and Packard Bell NEC.
                  Incorporated by reference to Exhibit 10.25 to Form S-1 filed
                  on September 17, 1996, and the amendments thereto.

         10.26    License Agreement by and between Beyond Properties Pty. Ltd.
                  and BII Australia. Incorporated by reference to Exhibit 10.26
                  to Form S-1 filed on September 17, 1996, and the amendments
                  thereto. [Portions of this Exhibit have been deleted and filed
                  separately with the Securities and Exchange Commission
                  pursuant to a grant of Confidential Treatment.]


                                       56

<PAGE>   57

        EXHIBIT
        NUMBER
                               EXHIBIT DESCRIPTION

         10.27    Registrant's Promissory Note, dated September 10, 1996.
                  Incorporated by reference to Exhibit 10.27 to Form S-1 filed
                  on September 17, 1996, and the amendments thereto.

         10.28    Form of Registrant's Indemnification Agreement. Incorporated
                  by reference to Exhibit 10.28 to Form S-1 filed on September
                  17, 1996, and the amendments thereto.

         10.29    Form of Registrant's Employee Confidential Information and
                  Non-Solicitation Agreement. Incorporated by reference to
                  Exhibit 10.29 to Form S-1 filed on September 17, 1996, and the
                  amendments thereto.

         10.30    Commercial Lease by and among Hilrok Properties Pty. Limited,
                  Peter Dodds and Simon Van Wyk. Incorporated by reference to
                  Exhibit 10.30 to Form S-1 filed on September 17, 1996, and the
                  amendments thereto.

         10.31    Loan Agreement, dated October 10, 1994, by and between BII
                  Australia and PIE. Incorporated by reference to Exhibit 10.31
                  to Form S-1 filed on September 17, 1996, and the amendments
                  thereto.

         10.32    Commercial Lease, dated August 8, 1994, by and between PW
                  Securities Pty. Ltd. and Sega Ozisoft. Incorporated by
                  reference to Exhibit 10.32 to Form S-1 filed on September 17,
                  1996, and the amendments thereto.

         10.33    PIE Loan Extension, dated September 13, 1996, by and among
                  PIE, BII Australia and the Registrant. Incorporated by
                  reference to Exhibit 10.33 to Form S-1 filed on September 17,
                  1996, and the amendments thereto.

         10.34    Agreement, dated September 12, 1996, by and between the
                  Registrant and Crawford Productions Pty. Limited. Incorporated
                  by reference to Exhibit 10.34 to Form S-1 filed on September
                  17, 1996, and the amendments thereto.

         10.35    Engagement Letter, dated May 1, 1996, by and between Averil
                  Associates, Inc. and the Registrant. Incorporated by reference
                  to Exhibit 10.35 to Form S-1 filed on September 17, 1996, and
                  the amendments thereto.

         10.36    Warrant Agreement by and between Chloe Holdings, Inc. and the
                  Registrant. Incorporated by reference to Exhibit 10.36 to Form
                  S-1 filed on September 17, 1996, and the amendments thereto.

         10.37    Product Agreement, dated January 12, 1996, by and between
                  Interplay Productions and BII Australia. Incorporated by
                  reference to Exhibit 10.37 to Form S-1 filed on September 17,
                  1996, and the amendments thereto. [Portions of this Exhibit
                  have been deleted and filed separately with the Securities and
                  Exchange Commission pursuant to a grant of Confidential
                  Treatment.]

         10.38    Standard Form Lease Agreement, dated May 16, 1997, between
                  Topanga & Victory Partners L.P. and the Registrant.
                  Incorporated by reference to Exhibit 10.1 to Quarterly Report
                  on Form 10-QSB for the quarter ended June 30, 1997. [Portions
                  of this Exhibit have been deleted and filed separately with
                  the Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.39    Site Management Agreement, dated August 1, 1997, between
                  CompuServe Incorporated and the Registrant. Incorporated by
                  reference to Exhibit 10.1 to Quarterly Report on Form 10-QSB
                  for the quarter ended September 30, 1997. [Portions of this
                  Exhibit have been deleted and filed separately with the
                  Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]


                                       57

<PAGE>   58

        EXHIBIT
        NUMBER
                               EXHIBIT DESCRIPTION

         10.40    Redeemable Warrant Agreement, dated September 1, 1997, between
                  Packard Bell NEC and the Registrant. Incorporated by reference
                  to Exhibit 10.40 to Form SB-2 filed on November 5, 1997, and
                  the amendments thereto.

         10.41    Engagement Letter, dated August 1, 1997, between Averil
                  Associates, Inc. and the Registrant. Incorporated by reference
                  to Exhibit 10.41 to Form SB-2 filed on November 5, 1997, and
                  the amendments thereto.

         10.42    CD-ROM Distribution Agreement, dated September 22, 1997,
                  between Packard Bell NEC and the Registrant. Incorporated by
                  reference to Exhibit 10.2 to Quarterly Report on Form 10-QSB
                  for the quarter ended September 30, 1997. [Portions of this
                  Exhibit have been deleted and filed separately with the
                  Securities and Exchange Commission pursuant to a grant of
                  Confidential Treatment.]

         10.43    Warrant Agreement, dated November 4, 1997, between Chloe
                  Holdings, Inc. and the Registrant. Incorporated by reference
                  to Exhibit 10.43 to Form SB-2 filed on November 5, 1997, and
                  the amendments thereto.

         10.44    Lease Agreement, dated January 12, 1998, between Capital
                  Credit Company Pty. Limited and Winmor Pty. Limited and BII
                  Australia.

         10.45    Lease Agreement between Daiwa Real Estate Co. Ltd. and BII
                  Australia.

         21.1     List of Subsidiaries. Incorporated by reference to Exhibit
                  21.1 to Form S-1 filed on September 17, 1996, and the
                  amendments thereto.

         23.1     Consent of Ernst & Young LLP.

         23.2     Consent of Price Waterhouse LLP.

         24.1     Power of Attorney (included on signature page).

         27.1     Financial Data Schedule.


                                       58