<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION

                            Washington, D.C.  20549

                                   FORM 10-Q

(Mark One)

(X) QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED June 30, 1998

                                      OR

( ) TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____________

Commission file number    0-22622

                       INTERACTIVE ENTERTAINMENT LIMITED
            (Exact name of registrant as specified in its charter)

            BERMUDA                                             98-0170199
(State or other Jurisdiction of                              (I.R.S. Employer
Incorporation or Organization)                            Identification Number)

                        845 CROSSOVER LANE, SUITE D-215
                               MEMPHIS, TN 38117
                   (Address of principal executive offices)

                                (901) 537-3800
             (Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes __X___ No _____

The registrant had 20,824,587 shares of common stock outstanding as of July 31,
1998.

Exhibit index is located on page 20.
<PAGE>
 
                       INTERACTIVE ENTERTAINMENT LIMITED

                                     INDEX

<TABLE>
<CAPTION>
                                                                                      PAGE
<S>                                                                                   <C>
PART I.  FINANCIAL INFORMATION        

Item 1.  Consolidated Financial Statements
 
         Consolidated Balance Sheets - June 30, 1998 and December 31, 1997              3
 
         Consolidated Statements of Operations - Three Months ended June 30, 1998
         and June 30, 1997                                                              4
 
         Consolidated Statements of Operations - Six Months ended June 30, 1998
         and Four Months ended June 30, 1997                                            4
 
         Consolidated Statements of Cash Flows - Six Months ended June 30, 1998
         and Four Months ended June 30, 1997                                            5
 
         Notes to Consolidated Financial Statements                                     6
 
Item 2.  Management's Discussion and Analysis of Financial Condition and              
         Results of Operations                                                         13
 
PART II. OTHER INFORMATION
 
Item 2.(c) Changes in Securities                                                       18
 
Item 4.    Submission of Matters to a Vote of Security Holders                         19
 
Item 6.(a) Exhibits                                                                    20
 
Item 6.(b) Reports on Form 8-K                                                         22
 
</TABLE>

                                       2
<PAGE>
 
                        PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

              INTERACTIVE ENTERTAINMENT LIMITED AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
                                  (UNAUDITED)
<TABLE>
<CAPTION>
                                                                            June 30,             December 31,
                                                                              1998                   1997
                                                                          ------------           ------------
<S>                                                                       <C>                    <C>
                               ASSETS
Current Assets
  Cash and cash equivalents                                               $    766,742           $  1,239,864
  Accounts and notes receivable, less allowance
    for doubtful accounts of $46,828                                           102,274                  3,859
  Prepaid expenses                                                             185,890                 97,205
                                                                          ------------           ------------
        Total current assets                                                 1,054,906              1,340,928
                                                                          ------------           ------------
Furniture, fixtures and equipment, at cost                                     982,240                974,568
   Less: accumulated depreciation                                            (270,845)              (154,610)
                                                                          ------------           ------------
      Furniture fixtures and equipment, net                                    711,395                819,958

Software development costs, net                                              2,409,227              2,376,782

Singapore Airlines agreement                                                 1,855,800              1,855,800

Other assets                                                                         -                165,599

Goodwill                                                                    18,000,246             20,952,284
                                                                          ------------           ------------
        Total assets                                                      $ 24,031,574           $ 27,511,351
                                                                          ============           ============
               LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities
  Accounts payable and accrued expenses                                   $  1,019,457           $    644,051
                                                                          ------------           ------------
        Total current liabilities                                            1,019,457                644,051

Convertible debentures                                                               -                530,000

Shareholders' equity
  Class A preferred shares, $0.01 par value, authorized - 3,000
    shares, outstanding - 2,637 shares and 2,737 shares                             26                     27                    
  Class B preferred shares, $0.01 par value, authorized - 5,000,000
    shares, outstanding - 1,300 shares and 1,000 shares                             13                     10                    
  Common shares, $0.01 par value, authorized - 50,000,000
    shares, outstanding - 20,753,442 and 19,428,334 shares                     207,534                194,283
  Additional paid-in-capital                                                64,517,533             60,951,919
  Accumulated deficit                                                      (41,712,989)           (34,808,939)
                                                                          ------------           ------------
                                                                            23,012,117             26,337,300
                                                                          ------------           ------------
        Total liabilities and shareholders' equity                        $ 24,031,574           $ 27,511,351
                                                                          ============           ============
</TABLE>

                                       3
<PAGE>
 
                       INTERACTIVE ENTERTAINMENT LIMITED
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (UNAUDITED)
<TABLE>
<CAPTION>



                                                         Three Months Ended June 30,      Six Months         Four Months
                                                         ---------------------------         Ended              Ended
                                                            1998            1997         June 30, 1998      June 30, 1997
                                                         -----------     -----------    ---------------    ---------------
<S>  <C>                                                 <C>             <C>             <C>                <C>
Revenue                                                  $    57,505     $         -      $   111,605       $         -

Operating Expenses
     General and administrative                              799,800       1,020,025        1,552,570         1,094,864
     Consulting and contract labor                            99,486       2,694,740          173,230         2,754,168
     Marketing                                                26,004          88,585          115,811           104,992
     Management fees                                               -          55,667                -            73,167
     Legal                                                    74,816         299,722          152,079           345,118
     Depreciation and amortization                         2,381,271         329,099        4,676,386           336,614
                                                         -----------     -----------      -----------       -----------
                                                           3,381,377       4,487,838        6,670,076         4,708,923

Other (Income) and Expense
     Interest expense                                         34,725       3,688,904          188,249         3,689,015
     Interest income                                          (7,365)         (5,820)         (15,242)           (7,868)
                                                         -----------     -----------      -----------       -----------
                                                              27,360       3,683,084          173,007         3,681,147

Loss Before Minority Interest
     and Extraordinary Item                                3,351,232       8,170,922        6,731,478         8,390,070
     Minority interest                                             -        (163,842)               -          (163,842)
                                                         -----------     -----------      -----------       -----------

Loss Before Extraordinary Item                             3,351,232       8,007,080        6,731,478         8,226,228
     Early extinguishment of debt                                  -       1,824,222                -         1,824,222
                                                         -----------     -----------      -----------       -----------
Net Loss                                                 $ 3,351,232     $ 9,831,302      $ 6,731,478       $10,050,450
                                                         ===========     ===========      ===========       ===========

Basic and Diluted Loss Per Share
Numerator for basic and diluted loss per share:
     Net loss                                            $ 3,351,232     $ 9,831,302      $ 6,731,478       $10,050,450
     Preferred stock dividends                                87,352          82,122          172,573            82,122
                                                         -----------     -----------      -----------       -----------
     Loss to common shareholders                         $ 3,438,584     $ 9,913,424      $ 6,904,051       $10,132,572
                                                         ===========     ===========      ===========       ===========

Denominator for basic and diluted loss per share
     Weighted average shares outstanding                  20,486,394      11,061,656       20,237,230        10,743,497
                                                         ===========     ===========      ===========       ===========

Loss Per Share
     Before extraordinary item                           $      0.17     $      0.73      $      0.34         $    0.77
     Extraordinary item                                            -            0.16                -              0.17
                                                         -----------     -----------      -----------       -----------
Net Loss Per Share                                       $      0.17     $      0.89      $      0.34         $    0.94
                                                         ===========     ===========      ===========       ===========
</TABLE>

                                       4
<PAGE>
 
                       INTERACTIVE ENTERTAINMENT LIMITED
                           STATEMENTS OF CASH FLOWS
                                  (UNAUDITED)
<TABLE>
<CAPTION>

                                                                                 Six Months        Four Months
                                                                                   Ended              Ended
                                                                               June 30, 1998      June 30, 1997
                                                                              ---------------    ---------------
<S>                                                                           <C>                <C>
OPERATING ACTIVITIES
Net Loss                                                                        $(6,731,478)      $(10,050,450)
Reconciliation of net loss to net cash used in operating activities
    Depreciation and amortization                                                 4,676,386            336,614
    Issuance of shares for financing fee                                                  -            650,000
    Issuance of shares for consulting agreement                                           -          2,417,568
    Extraordinary loss on debt conversion                                                 -          1,824,222
    Non-cash interest expense                                                         5,493          3,603,000
    Other                                                                            12,821             60,189
    Changes in assets/liabilities (excluding effect of acquisition)
        Accounts receivable                                                         (45,889)            44,597
        Prepaid expenses                                                            (88,686)          (139,215)
        Other assets                                                                165,599           (217,853)
        Accounts payable and accrued expenses                                       333,281            (48,822)
                                                                                -----------       ------------
           Net cash used in operating activities                                 (1,672,473)        (1,520,150)
                                                                                -----------       ------------

INVESTING ACTIVITIES
    Purchases of furniture and fixtures and equipment                                (7,672)           (30,835)
    Software development                                                           (101,280)          (446,672)
                                                                                -----------       ------------
           Net cash used in investing activities                                   (108,952)          (477,507)
                                                                                -----------       ------------

FINANCING ACTIVITIES
    Advances from affiliated companies                                                    -          1,007,875
    Issuance of preferred stock                                                     270,313                  -
    Issuance of common stock                                                      1,310,563                  -
    Issuance of convertible debentures                                                    -            763,250
    Redemption of preferred stock                                                  (100,000)                 -
    Payment of preferred stock dividends                                           (172,573)           (82,122)
                                                                                -----------       ------------
           Net cash provided by financing activities                              1,308,303          1,689,003
                                                                                -----------       ------------

    Net decrease in cash                                                           (473,122)          (308,654)
    Cash, beginning of period                                                     1,239,864            626,074
                                                                                -----------       ------------
    Cash, end of period                                                         $   766,742       $    317,420
                                                                                ===========       ============
</TABLE>

                                       5
<PAGE>
 
              INTERACTIVE ENTERTAINMENT LIMITED AND SUBSIDIARIES

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 1 - NATURE OF OPERATIONS

The consolidated financial statements of Interactive Entertainment Limited and
Subsidiaries ("IEL" or the "Company") included herein have been prepared
pursuant to the rules and regulations of the Securities and Exchange Commission
("SEC"). In management's opinion, these financial statements include all
adjustments, consisting only of normal recurring adjustments, necessary for a
fair presentation of the results of operations for the interim periods
presented. Pursuant to SEC rules and regulations, certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted from these statements unless significant changes have taken place since
the end of the most recent fiscal year. For this reason, the consolidated
financial statements and notes thereto should be read in conjunction with the
financial statements and notes included in the Company's Annual Report on Form
10-K/A No. 2 for the year ended December 31, 1997.

The Company is a Bermuda exempted company which, in June 1997, changed its name
from Sky Games International, Ltd. ("SGI") to Interactive Entertainment Limited.
The Company's activities are focused on providing inflight gaming software and
services by developing, implementing and operating a computer-based interactive
video entertainment system of gaming and other entertainment activities on, but
not limited to, the aircraft of international commercial air carriers.

The Company has entered into a contract to provide its gaming software to one
international airline, Singapore Airlines ("SIA"). SIA has selected the
Matsushita Avionics Systems Corporation ("MASC") hardware platform and operating
system for its interactive entertainment system. The Company has completed the
process of integrating its software with the MASC network and operating system,
and other third party provided software with which the Company's software is
also required to be integrated pursuant to its agreements with SIA. Following a
series of laboratory tests and aircraft trials, SIA launched the first flight
with gaming on June 1, 1998. Based on conversations with SIA, the Company
expects that the first aircraft equipped with the Sky Games(TM) software will be
flown for up to two months from the launch date to evaluate: (i) acceptance of
the system by passengers; and (ii) the effectiveness of the already completed
crew training and to identify and, if necessary, correct any technical issues
that may be discovered during operations. Upon an evaluation satisfactory to
SIA, it is expected that the system would then be rolled out to the remaining
SIA fleet of wide-body aircraft over a period of up to 24 months. The roll-out
is to be made ultimately to all classes of service on SIA's fleet of 58 wide-
body aircraft. The pace of the roll-out depends on various factors such as
acceptance of the system, time for crew training and the necessity of addressing
technical issues. As a result, there is no timetable for the roll-out and one
cannot be predicted. It is in SIA's discretion to determine whether the
performance of the Company's software is sufficient and when the roll-out is to
begin. Management continues to believe the success of its software on SIA will
be critical to its ability to secure additional airline contracts. The Company
has yet to receive any significant revenues under its agreement with SIA and may
never receive any such anticipated revenues.

On January 13, 1998, the Company completed the acquisition of all the
outstanding capital stock of Inflight Interactive Limited ("IIL") in exchange
for 500,000 shares of the Company's $.01 par value common stock (the "Common
Stock"). IIL is a United Kingdom developer and provider of amusement games to
the airline industry. The games are marketed under the name Sky Play and are
currently operating on a number of airlines, including American Airlines, Cathay
Pacific, Egypt Air, Lauda Air, Malaysia Airlines, Saudi Arabian Airlines, and
Virgin Atlantic. Sky Play games are in development for Air China. The purchase
agreement provides for the Company to issue up to


                                       6
<PAGE>
 
250,000 additional shares of Common Stock to the previous owners of IIL upon
achievement of certain milestones regarding implementation of the Company's Sky
Games gaming software with an international airline to be designated by the
parties. The acquisition was accounted for using the purchase method.

Until the Company receives sufficient cash flow from operations, additional
funding will be required to allow the Company to continue operations. Based on
discussions with potential investors, management believes the Company will be
successful in obtaining sufficient financing to enable the Company to continue
its operations for the foreseeable future; however, such funding may not be on
terms that are as favorable as those available to established companies and is
likely to be dilutive to current stockholders.

On April 23, 1997, the Board of Directors of the Company approved and adopted a
resolution changing the fiscal year end of the Company to December 31 of each
year from the last day of February of each year. Therefore, the Consolidated
Financial Statements include the six month period ending June 30, 1998 and the
four month period ending June 30, 1997.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Cash and Cash Equivalents

The Company considers cash on hand, deposits in banks and short-term investments
with maturities of three months or less as cash and cash equivalents.

Software Development

All software production costs (i.e., external and internal programmers, graphic
design and testing) were capitalized until the software was available for
general release to customers in accordance with the provisions of Statement of
Financial Accounting Standards ("SFAS") No. 86, "Accounting for the Costs of
Computer Software to be Sold, Leased, or Otherwise Marketed." The software costs
are being amortized using the straight-line method over the remaining estimated
economic life of the product, currently estimated at three years. The amount of
amortization expense recorded from the date of release (June 1, 1998) to June
30, 1998 was approximately $69,000.

Furniture, Fixtures and Equipment

The Company's furniture, fixtures and equipment is recorded at cost and
depreciated over its estimated economic life which is generally three to five
years. Additions and improvements that materially extend the useful lives are
capitalized, while repairs and maintenance costs are expensed as incurred.

Goodwill

The excess of purchase price over net assets acquired, which arose from the
acquisition of the minority interest of Old IEL (as defined and discussed in
Note 3) is being amortized on a straight-line basis over three years. The amount
of amortization expense recorded for the six months ended June 30, 1998 was
approximately $4,252,000.

The excess of purchase price over net assets acquired, which arose from the
acquisition of IIL, is also being amortized on a straight-line basis over three
years. The amount of amortization expense recorded from the purchase date
(January 13, 1998) through June 30, 1998 was approximately $239,000.

Management regularly evaluates whether or not the future undiscounted cash flows
of the Company are sufficient to recover the carrying amount of assets.
Additionally, management continually monitors such factors as the status of new
or proposed legislation, the competitive environment and advances in the
computer software and hardware industries. If the estimated future undiscounted
cash flows are not sufficient to recover the carrying amount of the assets and,


                                       7
<PAGE>
 
accordingly, an impairment has occurred, management intends to write down the
carrying amount to its estimated fair value based on discounted cash flows.

Singapore Airlines Agreement

In conjunction with the acquisition of the minority interest of Old IEL, the
Company allocated approximately $1,856,000 of the purchase price to the value of
the agreement with Singapore Airlines. This amount will be amortized on a
straight-line basis over the term of the agreement. The agreement is for an
initial three year term which begins upon the earlier of (a) nine months from
the date of the first successful commercial installation of the software or (b)
upon installation of the software in eight aircraft. Therefore, the financial
statements do not include an expense for amortization of the amount allocated to
the value of the agreement.

Impairment of Long-Lived Assets

In accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed of," management continually
evaluates whether events or changes in circumstances indicate that the carrying
amount of long-lived assets may not be recoverable. Based on management's
evaluations, no significant impairments of long-lived assets occurred during the
six months and four months ended June 30, 1998 and 1997, respectively.

Stock-Based Compensation

The Company accounts for employee stock-based compensation using the intrinsic
value method prescribed in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," ("APB No. 25") and related
interpretations.

Loss Per Share

In 1997, the Financial Accounting Standards Board issued Statement No. 128,
"Earnings Per Share," ("SFAS No. 128"). SFAS No. 128 replaced the calculation of
primary and fully diluted earnings per share with basic and diluted earnings per
share. Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is very similar to the previously reported fully diluted
earnings per share. For the six months and four months ended June 30, 1998 and
1997, respectively, there is no difference between basic and diluted loss per
share as all stock options, warrants, convertible debentures and convertible
preferred stock are antidilutive for the periods presented. The Performance
Shares have no rights and, therefore are excluded from per share calculations.
See Note 8.

Use of Estimates

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries: Sky Games International Corp. (a Nevada
corporation), Creator Island Equities Inc., (a British Columbia corporation),
IEL (Singapore) Pte. Ltd. (a Singapore corporation) and, (since January 13,
1998), Inflight Interactive Limited (a U.K. corporation). For periods prior to
the acquisition of the minority interest in Old IEL discussed in Note 3, the
consolidated financial statements also include the accounts of SGI Holding
Corporation Ltd. and the Company's 80% ownership of Old IEL. All material
intercompany transactions have been eliminated in consolidation.


                                       8
<PAGE>
 
Comprehensive Income

During 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income," ("SFAS
No. 130"). The Company adopted this statement as of the beginning of 1998. SFAS
No 130 established new rules for the reporting and display of comprehensive
income and its components. There is no difference between the net loss and the
total comprehensive net loss for the six months ended June 30, 1998 and the four
months ended June 30, 1997.

NOTE 3 - ACQUISITION OF MINORITY INTEREST

Prior to June 17, 1997, the Company operated its principal business activities
under the name Sky Games International, Ltd. through its indirectly 80%-owned
subsidiary then known as Interactive Entertainment Limited ("Old IEL"). The
remaining 20% of Old IEL was held by an affiliate of Harrah's Entertainment,
Inc. (which, together with its affiliates, is referred to herein as "Harrah's").
Harrah's also managed the operations of Old IEL pursuant to a management
agreement effective December 30, 1994, (the "Management Agreement").

Effective June 17, 1997, pursuant to a Plan and Agreement of Merger and
Amalgamation dated May 13, 1997, Old IEL was merged into the Company (the
"Amalgamations"). As part of the Amalgamations, the Management Agreement with
Harrah's was terminated. Harrah's received a total of 5,879,040 shares of Common
Stock in exchange for its 20% ownership interest in Old IEL and as consideration
for the termination of the Management Agreement. The Amalgamation has been
accounted for under the purchase method. The shares issued to Harrah's were
valued at $26,255,793 based on the average quoted market price of the Company's
Common Stock when the Amalgamations were announced, or $4.466 per share.

NOTE 4 - CONVERTIBLE DEBENTURES

During the ten months ended December 31, 1997, the Company issued $2,163,250 of
8% convertible debentures due in 1999. The outstanding balance of convertible
debentures as of December 31, 1997 totaled $530,000.

The debentures contained a feature that provided for conversion into Common
Stock at a price below the current market at the time of issue. The value of
this beneficial conversion feature, totaling approximately $628,000 was
capitalized in other assets with a corresponding increase to additional paid-in
capital. Placement fees of $149,000 incurred upon sale of the debentures were
also capitalized. The value of the conversion feature and the placement fees
were amortized to interest expense over the original life of the debenture. Any
unamortized amount was expensed upon conversion of the debenture.

All of the debentures outstanding, including accrued interest, as of December
31, 1997 were converted into 252,862 shares of Common Stock during the first
quarter of 1998, and all remaining deferred interest charges and placement fees
totaling $148,000 were expensed during the period and are included as interest
expense during the six month period ended June 30, 1998.

NOTE 5 - SHAREHOLDERS' EQUITY

In December 1994, the Company discontinued an engineering and marketing
arrangement with B/E Aerospace, Inc. ("BEA"). As part of the termination, the
Company issued to BEA a promissory note in the original principal amount of $2.5
million at 12% per annum. On February 28, 1997, an agreement was reached with
BEA to exchange the note, including accrued and unpaid interest, for Class A
Preference Shares at $1,000 per share. The exchange for 2,737 Class A Preference
Shares was completed in June, 1997, at which time the Company recorded an
extraordinary expense of approximately $1,824,000 for early retirement of the
debt.


                                       9
<PAGE>
 
The Company has an agreement with BEA pursuant to which BEA and the Company have
agreed that the Company will redeem the Class A Preference Shares held by BEA at
their redemption price of $1,000 per share plus accrued and unpaid dividends in
installments equal to $100,000 on June 30, 1998, $200,000 on each of July 31,
August 31 and September 30, 1998, and $100,000 on the last business day of each
month thereafter beginning October 31, 1998 through May 31, 2000. If the Company
is in compliance with its redemption obligations, BEA has agreed not to convert
any of its Class A Preference Shares. Subject to the terms of such agreement,
the Class A Preference Shares are otherwise convertible by their terms at any
time into a number of shares of Common Stock, determined by dividing $1,000 per
share of Class A Preference Shares, plus any accrued and unpaid dividends
thereon by: (i) prior to February 28, 1999, a conversion price equal to 70% of
the average mean of the closing bid and ask prices of the Common Stock for the
20 trading days prior to the conversion (the "Market Price"); (ii) after
February 28, 1999 and prior to August 31, 1999, a conversion price equal to 65%
of the Market Price; and (iii) after August 31, 1999, a conversion price equal
to 60% of the Market Price. Dividends on the Class A Preference Shares are
cumulative and payable quarterly at an annual dividend rate of 9%. The Company,
at its option, may redeem the Class A Preference Shares, in whole or in part, at
any time and from time to time, at a redemption price of $1,000 per share plus
any accrued and unpaid dividends thereon. The Company is not required to redeem
the Class A Preference Shares under their terms. Upon liquidation, holders of
the Class A Preference Shares will be entitled to repayment of an amount equal
to $1,000 per share plus accrued and unpaid dividends, prior to any
distributions to holders of Common Stock. The Class A Preference Shares do not
have any voting rights. During the six month period ended June 30, 1998, 100
shares of the Class A Preference Shares were redeemed by the Company. An
additional 200 shares were redeemed as scheduled in July 1998.

In October 1997, the Company completed an agreement with an investor for the
private placement of 925,747 shares of Common Stock for an aggregate purchase
price of $3.0 million. $1.5 million (approximately $1,352,000 net of offering
expenses), ("Tranche A"), was received upon closing while the remaining $1.5
million ("Tranche B") was to be funded upon and was contingent upon completion
of the first flight with the Company's software available in all seats of a
Singapore Airlines aircraft prior to April 22, 1998. For each five shares of
Common Stock purchased and held for a minimum of six months, the investor was to
have received one warrant for the purchase of additional shares. Warrants were
to be exercisable at a price of $3.8125 per share for 18 months from their
issue. As of April 2, 1998 the Company and the investor agreed to amended terms
under which 50% of the remaining portion ($750,000) was funded immediately while
the other 50% was to be funded under the terms of the original agreement. The
subscription price for the Common Stock purchased in Tranche B was revised to
$2.62125. Warrants issuable under Tranche A will not be issued. However, for
each of the 286,123 Common Share purchased in Tranche B, 0.85 of a warrant to
purchase Common Stock will be issued after a six month holding period for the
Common Stock purchased in Tranche B. The warrants, if issued, will have an
exercise price of $2.62125 and a term of 18 months. The first $750,000 was
funded under the amended terms; however, the flight required for funding of the
second $750,000 did not take place prior to April 22, 1998. Subsequently, IEL
and the investor agreed to a $750,000 purchase on the same terms. This
additional investment was consummated on June 5, 1998.

On December 17, 1997, the Company issued 1,000 shares of Series A Convertible
Preference Shares of the Company's Class B Preferred Stock to two investors for
a total consideration of $1,000,000. The Series A Class B Preference Shares are
convertible after three months into a number of shares of Common Stock,
determined by dividing the stated value of $1,000 per share by the lesser of:
$3.2038 (the "Fixed Conversion Price") and a price (the "Floating Conversion
Price") calculated by (i) determining the average of the three lowest closing
bid prices for the Common Stock during the thirty trading days occurring
immediately prior to, but not including, the


                                      10
<PAGE>
 
conversion date, and (ii) multiplying such average by a defined conversion
percentage (the "Conversion Percentage"). The Conversion Percentage decreases
from 100% to 85% as the holding period increases. Dividends are cumulative and
may be paid, at the option of the Company and with prior notice, in additional
shares of Common Stock at an annual dividend rate of 8%. Warrants for the
purchase of 61,718 shares of Common Stock were issued in connection with the
issuance of the Series A Class B Convertible Preference Shares. The warrants,
which have an exercise price of $3.2038, are exercisable beginning June 17, 1998
and expire on December 17, 1999. Under the agreement, the Company had the option
of selling a second tranche with 123,434 warrants for an aggregate purchase
price of $2,000,000 following the installation of the Company's gaming software
on an SIA aircraft and the availability of the software to paying passengers in
the entire cabin. The Company's option with respect to the second tranche, was
set to expire on June 17, 1998. Upon agreement of the parties, funding of the
second tranche was deferred until a registration statement for resale of Common
Stock issued upon conversion of the Series A Class B Preference Shares had been
declared effective by the SEC. The registration statement was declared effective
on July 15, and the additional funding of $2,000,000 was completed on July 24,
1998.

As of February 20, 1998, the Company sold 300 shares of Series B Class B
Convertible Preferred Stock at $1,000 per share.  The Series B Class B
Convertible Preferred Stock has the same dividend and conversion features as the
Series A Class B Convertible Preferred Stock.  The investor also received a
warrant to purchase 18,515 shares of Common Stock at a price of $3.2038 for 18
months.

NOTE 6 - INCOME TAXES

As a Bermuda exempted company, IEL is not currently subject to income tax filing
requirements in Bermuda.  The Company operates in the U.S. as a branch of a
foreign corporation.  As a foreign corporation with a U.S. trade or business,
the Company will be subject to tax in the U.S. on the income earned that is
effectively connected with that trade or business.  Tax carryforwards in taxable
jurisdictions have not been determined.  Deferred tax assets, if any, would be
fully reserved.  Other than the tax associated with the U.S. earned interest
income, there are no income tax provisions, benefits, liabilities or assets
reflected in the accompanying financial statements.

NOTE 7 - RELATED PARTY TRANSACTIONS

Pursuant to the Management Agreement, Harrah's managed Old IEL.  The Management
Agreement provided for Harrah's to receive a management fee equal to the greater
of $10,000 per whole month or a percentage of gross revenues, as defined.  The
Management Agreement was terminated June 17, 1997 in conjunction with the
Amalgamations.  Management fees totaled $36,000 for the four month period ending
June 30, 1997.

Under the terms of the Management Agreement, the Company transferred cash to
Harrah's for payments made on the Company's behalf to support its operations,
including accounts payable, payroll and capital expenditures.  The net transfers
for the four month period ending June 30, 1997 totaled approximately $143,000.

The Company was charged a fee by Harrah's for administrative services (including
legal, accounting, information technology and office occupancy).  The Company
was charged approximately $150,000 for the four month period ending June 30,
1997.  This arrangement ended with termination of the Management Agreement, and
there were no similar charges during the six month period ended June 30, 1998.

                                       11
<PAGE>
 
On June 17, 1997, the Company entered into a Continuing Services Agreement with
Harrah's under which Harrah's provides certain telecommunications, computer
systems support and consulting services to the Company.  The Company incurred a
cost of approximately $69,300 and $11,000 during the six month period ended June
30, 1998 and the four month period ending June 30, 1997, respectively, under
this agreement.

During 1996, the Company entered into a sublicense agreement with Harrah's,
which provided the Company with rights to use an immediate authorization
credit/debit system that Harrah's is developing.  IEL elected not to renew the
sublicense upon its expiration in September 1997.  The Company reimbursed
Harrah's for a portion of the development costs which totaled $40,000 for the
four month period ending June 30, 1997.

On June 17, 1997, in conjunction with the Amalgamations, the Company entered
into a Software License Agreement with Harrah's (the "License Agreement").  The
License Agreement is a non-exclusive, fully-paid, perpetual, world-wide license
to Harrah's and its affiliates to use the Company's gaming technology in non-
competitive uses in traditional casino venues owned, operated or managed by
Harrah's affiliates.  The License Agreement includes source codes for all
software, but neither party to the License Agreement has any obligations to
share or provide any improvements or modifications with the other party.  There
was no additional consideration paid by Harrah's for the License Agreement.

The Company paid approximately $115,000 during the four month period ending June
30, 1997 to directors and companies with common directors for management and
consulting services and for reimbursement of expenses.

On April 30, 1997, the Company entered into a Consulting Agreement with James P.
Grymyr, then a director of the Company, whereby Mr. Grymyr would provide
consulting services to the Company as requested by the Company from time to
time.  Under the terms of the Consulting Agreement, the Company issued to Mr.
Grymyr 586,077 shares of Common Stock as consideration for all such consulting
services both past and future.  The value of the stock, approximately $2.4
million, is reflected in the Statements of Operations for the four month period
ended June 30, 1997 as consulting and contract labor expense.

Geller & Co., of which Laurence Geller is Chairman and CEO, performed consulting
services for the Company pursuant to a retainer agreement that commenced in
February, 1996 and terminated August 14, 1997.  Geller & Co. was paid a monthly
retainer of $5,000.  Pursuant to Geller & Co.'s retainer, a grant of options for
200,000 shares of Common Stock with an exercise price of $3.00 and a term of ten
years was also made to Geller & Co.  In addition, Geller & Co. received 200,000
shares of Common Stock that would vest upon the closing of a major financing.
The Board determined that the Amalgamations which occurred June 17, 1997
constituted a major financing, and, consequently, the 200,000 shares vested
during 1997.  Upon vesting of the 200,000 shares of Common Stock, the Company
incurred an expense of $650,000 which is included in general and administrative
expense for the four months ending June 30, 1997.  Mr. Geller has been Chairman
of the Board of Directors of the Company since September 30, 1996.  The annual
compensation of the Chairman of the Board is $100,000 from September, 1997 and
is accruing and remains unpaid until the Company generates sufficient cash flows
from operations.

NOTE 8 - AGREEMENT REGARDING REDEMPTION OF PERFORMANCE SHARES

When the Company acquired the rights to the inflight gaming software from Sky
Games International, Inc. ("SGII") on November 7, 1991, a portion of the
consideration was 3,000,000 shares of Common Stock which, according to then
applicable requirements, were placed in escrow, to be released on the basis of
one share for each U.S. $1.78 of net cash flow generated from the assets over a
ten-year period (the "Performance Shares").  2,000,000 of the 

                                       12
<PAGE>
 
Performance Shares were issued to SGII (87% of the outstanding stock of which
was owned by James P. Grymyr, formerly a director of the Company, and his wife)
and 1,000,000 shares were issued to Anthony Clements, a director of the Company.
An additional 525,000 shares, which were issued to Dr. Rex E. Fortescue,
formerly a director of the Company, are held in the escrow on the same terms and
are also included as Performance Shares. Each of Messrs. Clements and Fortescue,
as of April 30, 1997, agreed to allow the Company to redeem and cancel the
Performance Shares when and if they are released from escrow for any reason
whatsoever (the "Redemption Agreement"). As consideration for such agreement to
tender the Performance Shares for cancellation by the Company in the event they
are ever released from the escrow, the Company has issued to Messrs. Clements
and Fortescue, 333,333 and 175,000 shares of Common Stock, respectively. SGII,
as of April 30, 1997, also agreed that it will tender the 2,000,000 Performance
Shares which it holds for cancellation by the Company when and if such
Performance Shares are released from escrow for any reason whatsoever (the
"Redemption and Cancellation Agreement"). As consideration of such agreement, in
February 1997, the Company expensed the outstanding balance of a note made by
SGII to the Company in the approximate amount of $550,000 and issued to SGII
80,590 shares of Common Stock. In the event the Performance Shares are not
released prior to six months after the end of the Company's financial year
ending in the year 2002, the Performance Shares will automatically be canceled
in accordance with the terms of the escrow agreement.

Each of Messrs. Clements and Fortescue have the right to include the 508,333
shares of Common Stock issued in connection with the Redemption Agreement in
certain registered offerings conducted by the Company prior to February 25,
1999.  As part of the agreements to allow the redemption and cancellation of the
Performance Shares, the holders of the Performance Shares have issued an
irrevocable proxy to a bank which has agreed not to vote the Performance Shares
at any General Meeting of Shareholders or otherwise.  The irrevocable proxy and
the agreement not to vote the Performance Shares will terminate upon the
cancellation of the Performance Shares.  The escrow agent is prohibited from
canceling the Performance Shares under the escrow agreement.

The Performance Shares have no rights and, therefore are excluded from per share
calculations for all periods presented.  Effective April 30, 1997, the
Performance Shares were no longer considered outstanding for financial statement
purposes.

Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS

Overview

Interactive Entertainment Limited ("IEL" or the "Company"), formerly known as
Sky Games International Ltd. ("SGI"), is a Bermuda exempted company which was
incorporated on January 28, 1981.  The Company's activities are focused on
providing inflight gaming software and services by developing, implementing and
operating a computer-based interactive video entertainment system of gaming and
other entertainment activities on, but not limited to, the aircraft of
international commercial air carriers.

On December 30, 1994, the Company entered into a Shareholders Agreement with SGI
Holding Corporation Limited ("SGIH"), a wholly-owned subsidiary of SGI, and an
affiliate of Harrah's Entertainment, Inc. ("Harrah's"), to form a company then
known as Interactive Entertainment Limited ("Old IEL"), the result of which was
that Old IEL became owned 80% by SGIH and 20% by an affiliate of Harrah's.
Pursuant to the Management Agreement (the "Management Agreement"), Old IEL was
managed by an affiliate of Harrah's.

                                       13
<PAGE>
 
At a Special General Meeting of shareholders held on June 16, 1997, pursuant to
a Plan and Agreement of Merger and Amalgamation dated May 13, 1997, (the
"Amalgamation Agreement"), Old IEL was merged into SGIH and then into SGI (the
"Amalgamations"). Prior to the Amalgamations, Harrah's owned 20% of the capital
stock of Old IEL and did not own any capital stock or other securities of SGI
and had no representatives on the Board of Directors. As a result of the
Amalgamations and the termination of the Management Agreement, the outstanding
shares of Old IEL common stock held by Harrah's were converted into 5,879,040
shares of $.01 par value common stock of the Company (the "Common Stock").
Harrah's also received 1,007,875 shares of Common Stock upon conversion of a
loan, (the "Harrah's Loan"), made to Old IEL. Harrah's therefore became the
largest shareholder of the Company holding approximately 38.6% of the
outstanding shares at the time of the Amalgamations.

Pursuant to the Amalgamation Agreement, Harrah's was provided with the right to
appoint persons to the Board and to specified committees in a number generally
proportionate to their share holdings calculated on a "fully diluted" basis as
defined in the Company's bye-laws.  Additionally, Harrah's was provided with the
right to approve specified significant corporate actions by the Company for as
long as the ownership of Common Stock by Harrah's is in excess of 20% (10% in
some cases) of the outstanding voting shares computed on a fully diluted basis.

Upon consummation of the Amalgamations, SGI changed its name to Interactive
Entertainment Limited and consolidated operations formerly performed at its
Vancouver, British Columbia office into its Memphis, Tennessee headquarters.

The Company has yet to generate any significant operating revenues and has no
assurance of future revenues.  Its principal activities through June 30, 1998,
consisted of developing, testing and marketing the inflight gaming software.  As
of June 30, 1998, IEL had a contract to provide its gaming software to Singapore
Airlines ("SIA"), which has various termination provisions.  The contract
provides for a six-month minimum trial period for the parties to assess the
operation of the inflight gaming system and public acceptance of the inflight
gaming business. The trial period began June 1, 1998 with the launch of gaming
on one aircraft  During this trial period, the airline has no affirmative
obligation to install the system on any or all of its aircraft; although, if 12
aircraft are not installed with the system within 18 months from the date
inflight gaming begins, IEL may terminate the contract.  The contract with
Singapore Airlines is the Company's only contract to provide its gaming software
to an airline.

The Company's software was installed on one SIA B747-400 on June 1, 1998.  The
aircraft flew 42 flight segments during the month.  Gaming was not activated on
14 of the flight segments due to technical problems with the hardware which
caused system components to drop from the aircraft's local area network thus
disabling gaming.  IEL is working with SIA and MASC to improve availability of
the hardware system by changes in the hardware configuration, changes to make
IEL's software more fault tolerant or by a combination of both.

Passenger penetration was below expectations.  SIA is restricted by the
Singapore government from advertisement of the gaming features.  At the current
time, passengers are made aware of the availability of gaming only through a
cabin announcement on the aircraft's public address system shortly after takeoff
and by a brochure in the seat pocket.  SIA has agreed to enhance the cabin
announcement, redesign the brochure, and add information about the availability
of gaming to the airlines video.  In addition, SIA is in the process of
rebranding the gaming function from KrisGames II to KrisWorld Gaming to better
define its purpose.  Management believes these efforts will increase
participation.  Other than flights on the Singapore-Hong Kong route, all flights
included at least one segment with an overnight flight during which passengers
have a greater tendency to sleep rather than to seek entertainment options.

                                       14
<PAGE>
 
The average length of play was also below expectations.  Management believes
that this is due to the fact that approximately half of the gaming flights were
on the Singapore-Hong Kong routes.  This is a flight of approximately 3.5 hours
with limited leisure time available to passengers after delivery of cabin
services.  The average length of play is expected to increase as the games are
added to more aircraft flying longer routes.

Technical issues and participation notwithstanding, there were two areas in
which results exceeded expectations.  The average bet by participants was
significantly higher than initial expectations.  Management had been concerned
that limitations imposed by the aircraft's local area network might lead to
fewer bets per hour than projected. These concerns proved to be unfounded, and
the rate of play comfortably exceeded expectations.

The Company is pursuing additional contracts.  However, gaming is prohibited on
the aircraft of U.S. commercial air carriers and on all flights to and from the
United States.  Other countries may introduce similar prohibitions, which could
limit the prospects for additional contracts and result in termination of the
contract with Singapore Airlines or any future contracts with other airlines.
The Company is currently in discussions with several additional airlines and is
negotiating terms of an agreement with one of these airlines.

On April 4, 1998, the Company initiated a trial of its interactive gaming
application in 85 cabins of the cruise ship Sun Princess, operated by Princess
Cruises.  In addition to providing the gaming application, the Company designed,
developed and installed an order management system that functions between the
set-top box in each of the trial cabins and the ship's guest billing system.
This system allows passengers to order certain merchandise and services,
including gaming, from the television sets in their cabins, provides order
tracking and manages in-cabin movies, while providing an interface to the ship's
guest billing system to allow charges to be posted directly to their folios.
This trial was performed in conjunction with Transdigital Communications
Corporation.  Based on initial results of the trial, Princess concluded that,
although the system was well received by passengers and functioned as designed,
utilization by passengers to purchase merchandise, shore excursions and movies
and to use the gaming features was insufficient to justify the estimated current
level of capital expenditures required to retrofit each cabin and stateroom.

On January 13, 1998, the Company completed the acquisition of all the
outstanding stock of Inflight Interactive Limited ("IIL") in exchange for
500,000 shares of the Company's Common Stock.  IIL is a U. K. developer and
provider of amusement games to the airline industry marketed under the name Sky
Play.  IIL's games are currently operating on approximately 60 aircraft of seven
airlines, including American Airlines, Cathay Pacific, Egypt Air, Lauda Air,
Malaysia Airlines, Saudi Arabian Airlines and Virgin Atlantic.  Development
efforts are underway with Air China.

The Company does not believe that it has exposure to the "Year 2000 Problem."
Software developed by the Company is compliant with dates in the year 2000.  The
Company uses commercial software produced by a variety of vendors and believes
that all of its major systems are compliant.


Results of Operations

During 1997, the Board of Directors changed the Company's fiscal year from the
last day of February to the last day of December.  As a result of the change,
the comparable year-to-date period in 1997 consists of the four months ended
June 30.  Therefore the following discussion relating to year-to-date operations
compares a four month period in 1997 with a six month period in 1998.  Amounts
are rounded to the nearest $1,000.
 
                                       15
<PAGE>
 
Three Months Ended June 30, 1998 and 1997

Revenue from operations for the three months ended June 30, 1998 was $58,000
compared to zero during the three months ended June 30, 1997.  Revenue consisted
primarily of fees generated from the Sky Play amusement games acquired with the
purchase of IIL.  Since the IIL acquisition was completed in January 1998, there
was no comparable revenue in the 1997 period.  Revenue from the Company's gaming
operations which were launched on June 1, 1998 were minimal.

General and administrative expense decreased by $220,000.  This includes a
decrease in payroll and related costs of $368,000.  Payroll and related costs
for the three months ended June 30, 1997 included $650,000 for the expense of
shares issued to Geller & Co. upon completion of the Amalgamations. This
reduction was offset by increased staffing in 1998 compared to 1997 as the
Company built a permanent staff. Travel costs increased by $57,000 due to
increased travel associated with testing and implementation of the Company's
software product.

Expenses for consulting and contract labor decreased by $2,595,000.  The 1997
period included an expense of $2.4 million for the Grymyr Consulting Agreement.

Legal expenses decreased by $225,000.  The 1997 period included legal costs in
conjunction with the Amalgamations.

Depreciation and amortization expenses increased by $2,052,000.  $1,819,000 of
the increase was attributable to amortization of goodwill associated with the
Amalgamations which occurred in June 1997.  $128,000 was due to amortization of
goodwill associated with the purchase of ILL in January 1998.  $69,000 was due
to amortization of development costs on the Company's primary software products
which began in June 1998.  Depreciation expense increased by $36,000 due to
increases in furniture, fixtures and equipment that occurred in late 1997.

Interest expense decreased by $3,654,000.  The 1997 period included an expense
of $3,466,000 for the beneficial conversion feature of the Harrah's Loan and
additional amounts for interest and amortization of deferred finance charges on
the convertible debentures.  There were no convertible debentures outstanding
during the three months ended June 30, 1998.

During the three months ended June 30, 1997, the Company recorded an
extraordinary expense in the amount of $1,824,000 related to the exchange of the
Class A Preference Shares for debt.  There was no comparable expense in 1998.

Six Months Ended June 30, 1998 and Four Months Ended June 30, 1997

Revenue from operations for the six months ended June 30, 1998 was $112,000
compared to zero in the four months ended June 30, 1997.  Revenue consisted
primarily of fees generated from the Sky Play amusement games acquired with the
purchase of IIL.  Since the IIL acquisition was completed in January 1998, there
was no comparable revenue during the four months ended June 30, 1997.

General and administrative expense increased by $458,000.  An increase in
payroll and related costs of $620,000 in the six months ended June 30, 1998 was
offset by a reduction of $650,000 in executive compensation attributable to the
expense of the shares issued to Geller & Co. upon completion of the
Amalgamations in the four months ended June 30, 1997.  The Company's development
of a permanent staff and reduction in dependence on contractors accounted for
the 1998 increase.  Travel costs increased by $171,000 due to increased travel
associated with testing and implementation of the Company's software product and
a six month period compared to a four month period.  Business insurance costs
increased by $68,000; the Company had no 
 
                                       16
<PAGE>
 
business insurance until June 1997. Tax expense increased by $56,000 due to
consolidation of the Company's headquarters in Memphis, Tennessee in mid-1997
and the Company becoming subject to state and local taxes. Other expense
increases for 1998 are generally attributable to the six month vs. four month
comparison.

Expenses for consulting and contract labor decreased by $2,581,000.  The expense
for the four months ended June 30, 1997 included an expense of $2.4 million for
the Grymyr Consulting Agreement.  The Company began building a permanent staff
in mid-1997 to reduce dependence upon contract labor.

Legal expenses decreased by $193,000.  The four months ended June 30, 1997
included legal costs in conjunction with the Amalgamations.

Depreciation and amortization expenses increased by $4,340,000.  $3,945,000 of
the increase was attributable to amortization of goodwill associated with the
Amalgamations which occurred in June 1997.  $239,000 was due to amortization of
goodwill associated with the purchase of ILL in January 1998.  $69,000 was due
to amortization of development costs on the Company's primary software product
which began in June 1998.  Depreciation expense increased by $87,000 due to
increases in furniture, fixtures and equipment that occurred in late 1997.

Interest expense decreased by $3,501,000.  The four months ended June 30, 1997
included an expense of $3,466,000 for the beneficial conversion feature of the
Harrah's Loan.

During the four months ended June 30, 1997, the Company recorded an
extraordinary expense in the amount of $1,824,000 related to the exchange of the
Class A Preference Shares for debt.  There was no comparable expense during the
six months ended June 30, 1998.


Liquidity and Capital Resources

At June 30, 1998 the Company had working capital of $35,000.  The Company's
primary source of funding has been through sales of its equity and securities
convertible into equity.

Effective February 20, 1998, the Company sold 300 shares of Series B Class B
Convertible Preferred Stock at $1,000 per share.  The Series B Class B
Convertible Preferred Stock has the same dividend and conversion features as the
Series A Class B Convertible Preferred Stock issued in December 1997.  The
investor also received a warrant to purchase 18,515 shares of Common Stock at a
price of $3.2038 for 18 months.  (See Part II, Item 2, Changes in Securities.)

As of April 2, 1998, the Company sold 286,123 shares of Common Stock in a
private placement for $750,000.  For each share of Common Stock purchased and
held for a minimum of six months, the investor will receive 0.85 of a warrant
for the purchase of additional shares.  The warrants, if issued, will be
exercisable at a price of $2.62125 per share for 18 months from their issue.
(See Part II, Item 2, Changes in Securities.)

On June 5, 1998, the Company sold an additional 286,123 shares of Common Stock
to the same investor in a private placement for $750,000.  For each share of
Common Stock purchased and held for a minimum of six months, the investor will
receive 0.85 of a warrant for the purchase of additional shares.  The warrants,
if issued, will be exercisable at a price of $2.62125 per share for 18 months
from their issue.  (See Part II, Item 2, Changes in Securities.)

On July 23 and July 24 the Company issued a total of 2,000 shares of Series A
Convertible Preference Shares of the Company's Class B Preferred Stock for a
total consideration of $2,000.000.  Warrants for the purchase of 123,434 shares
of Common Stock were issued in 

                                       17
<PAGE>
 
connection with the issuance of the Series A Class B Convertible Preference
Shares. The warrants, which have an exercise price of $3.2038, are exercisable
immediately and expire on December 17, 1999. (See Part II, Item 2, Changes in
Securities.)

During the second quarter of 1997, the Company established a target of raising a
total of $8.0 million in equity to provide funding for the Company's operating
needs. Through July 1998 a total of $6.5 million had been raised by the Company.
The Company is currently negotiating commitments for additional capital to
complete its equity target and believes that these efforts will be successful.
Any such additional funding is likely to be dilutive to current stockholders.

The Company has not yet generated any significant operating revenue under its
agreements with Singapore Airlines. Until the Company receives sufficient cash
flow from operations, additional funding will be required to allow the Company
to continue operations. Absent sufficient cash flow from operations, the short-
term viability of the Company and the Company's ability to continue its
operations is directly dependent upon the completion of significant additional
financing.

Forward-Looking Information

This Form 10-Q contains forward-looking statements that include among others,
statements concerning the Company's plans to implement its software products,
commence generating revenue from certain of its products, expectations as to
funding its capital requirements, the impact of competition, future plans and
strategies, statements which include the words "believe," "expect," and
"anticipate" and other statements of expectations, beliefs, anticipated
developments and other matters that are not historical facts. These statements
reflect the Company's views with respect to such matters. Management cautions
the reader that these forward-looking statements are subject to risks and
uncertainties that could cause actual events or results to materially differ
from those expressed or implied by the statements.

                          PART II. OTHER INFORMATION

Item 2 - Changes in Securities

In October 1997, the Company completed an agreement with Henderson International
Investments Ltd. ("HIIL") for the private placement of 925,747 shares of Common
Stock for an aggregate purchase price of $3.0 million. $1.5 million
(approximately $1,352,000 net of offering expenses), ("Tranche A"), was received
upon closing while the remaining $1.5 million ("Tranche B") was to be funded
upon and was contingent upon completion of the first flight with the Company's
software available in all seats of a Singapore Airlines aircraft prior to April
22, 1998. For each five shares of Common Stock purchased and held for a minimum
of six months, HIIL was to have received one warrant for the purchase of
additional shares. Warrants were to be exercisable at a price of $3.8125 per
share for 18 months from their issue. As of April 2, 1998 the Company and HIIL
agreed to amended terms under which 50% of the remaining portion ($750,000) was
funded immediately while the other 50% was to be funded under the terms of the
original agreement. The subscription price for the Common Stock purchased in
Tranche B was revised to $2.62125. Warrants issuable under Tranche A will not be
issued. However, for each of the 286,123 shares of Common Stock purchased in
Tranche B, 0.85 of a warrant to purchase Common Stock will be issued after a six
month holding period for the Common Stock purchased in Tranche B. The warrants,
if issued, will have an exercise price of $2.62125 and a term of 18 months. The
first $750,000 was funded under the amended terms; however, the flight required
for funding of the second $750,000 did not take place prior to April 22, 1998.
Subsequently, IEL and HIIL agreed to a $750,000 purchase on the same terms. This
additional investment was consummated on June 5, 1998. A fee of $90,000 is due
to European Venture Finance for the 1998 placements. The Common Stock was placed
in reliance on the exemption from registration under the Securities Act provided
by Regulation D promulgated under the Securities Act.

                                      18
<PAGE>

On December 17, 1997, the Company issued 1,000 shares of Series A Convertible
Preference Shares of the Company's Class B Preferred Stock for a total
consideration of $1,000,000 to Marshall Capital Management, Inc. (formerly
Proprietary Convertible Investment Group, Inc.) and CC Investments LDC. The
Series A Class B Preference Shares are convertible after three months into a
number of shares of Common Stock, determined by dividing the stated value of
$1,000 per share by the lesser of: $3.2038 (the "Fixed Conversion Price") and a
price (the "Floating Conversion Price") calculated by (i) determining the
average of the three lowest closing bid prices for the Common Stock during the
thirty trading days occurring immediately prior to, but not including, the
conversion date, and (ii) multiplying such average by a defined conversion
percentage (the "Conversion Percentage"). The Conversion Percentage decreases
from 100% to 85% as the holding period increases. Dividends are cumulative and
may be paid, at the option of the Company and with prior notice, in additional
shares of Common Stock at an annual dividend rate of 8%. Warrants for the
purchase of 61,718 shares of Common Stock were issued in connection with the
issuance of the Series A Class B Convertible Preference Shares. The warrants,
which have an exercise price of $3.2038, are exercisable beginning June 17, 1998
and expire on December 17, 1999. Under the agreement, the Company had the option
of selling a second tranche with 123,434 warrants for an aggregate purchase
price of $2,000,000 following the installation of the Company's gaming software
on an SIA aircraft and the availability of the software to paying passengers in
the entire cabin. The Company's option with respect to the second tranche, was
set to expire on June 17, 1998. Upon agreement of the parties, funding of the
second tranche was deferred until a registration statement for resale of Common
Stock issued upon conversion of the Series A Class B Preference Shares had been
declared effective by the SEC. The registration statement was declared effective
on July 15, and the additional funding of $2,000,000 was completed on July 24,
1998. A fee of $140,000 is due to European Venture Finance for the 1998
placements. The Common Stock and warrants were placed in reliance on the
exemption from registration under the Securities Act provided by Regulation D
promulgated under the Securities Act. The Series A Class B Preference Shares do
not have any voting rights.

Item 4.  Submission of Matters to a Vote of Security Holders

The Company's held its Annual General Meeting for the fiscal period ended
December 31, 1997 on May 14, 1998. The following matters were voted upon at the
meeting:

     1.   Election of seven persons to the Board of Directors;

     2.   Ratification of the appointment of Ernst & Young LLP as the Company's
independent public accountants.

There were 15,403,611 shares of Common Stock voted at the Annual General Meeting
as follows:

     1.   Election of Directors:
 
<TABLE>
<CAPTION>
                                     Votes For            Votes Withheld             Abstain               Not Voted
                                     ---------            --------------             -------               ---------
      Nominee                    Number        %          Number       %         Number       %         Number        %
      -------                    ------       ----        -------     ---        -------     ---        -------      ---
<S>                            <C>            <C>         <C>         <C>        <C>         <C>        <C>          <C>
Anthony P. Clements            14,247,463     92.5        464,579     3.0        172,819     1.1        518,750      3.4
Brian Deeson                   14,152,513     91.9        559,529     3.6        172,819     1.1        518,750      3.4
Quinten Dreesmann*             14,226,663     92.4        485,379     3.1        172,819     1.1        518,750      3.4
Laurence Geller                13,989,813     90.8        722,229     4.7        172,819     1.1        518,750      3.4
Phillip Gordon                 13,989,213     90.8        722,829     4.7        172,819     1.1        518,750      3.4
Amnon Shiboleth                13,989,213     90.8        722,829     4.7        172,819     1.1        518,750      3.4
Gordon Stevenson               14,319,813     93.0        392,229     2.5        172,819     1.1        518,750      3.4
</TABLE>

                                      19
<PAGE>
 
*Mr. Malcolm Burke, an incumbent director, withdrew his name from nomination for
re-election.  Ballots cast in the name of Mr. Burke were voted to Mr. Dreesmann.

     2. Approval of Ernst & Young LLP

<TABLE>
<CAPTION>
                 Number          %
             ---------------  --------
<S>          <C>              <C>
For               14,394,797     93.4
Against               55,285      0.4
Withheld             374,629      2.4
Abstain               60,150      0.4
Not Voted            518,750      3.4
</TABLE>

Item 6.  Exhibits and Reports on Form 8-K

(a)  Exhibits

EXHIBIT     DESCRIPTION
----------  ------------------------------------------------------------------
2.          Plan and Agreement of Merger and Amalgamation, dated as of May 13,
            1997, among the Company, SGI Holding Corporation Limited, IEL and
            Harrah's Interactive Investment Company. (Incorporated by reference
            to the same numbered exhibit to the Registrant's Form 8-K as filed
            with the SEC on June 27, 1997.)

3.i(a)      Articles of Incorporation (Yukon Territory). (Incorporated by
            reference to Exhibit 1.1 to the Registrant's Annual Report on Form
            20-F (File No. 0-22622) as filed with the SEC on October 12, 1993.)

3.i(b)      Certificate of Continuance (Bermuda). (Incorporated by reference to
            Exhibit 1.2 to the Registrant's Annual Report on Form 20-F (File No.
            0-22622) as filed with the SEC on September 16, 1996.)

3.ii        Bye-Laws as amended. (Incorporated by reference to the same numbered
            exhibit to the Registrant's Annual Report on Form 10-K/A No. 2 as
            filed with the SEC on July 8, 1998.)

4.1         Escrow Agreement dated May 27, 1992, as amended, among Montreal
            Trust Company of Canada, the Company and certain shareholders.
            (Incorporated by reference to Exhibit 3.2 to the Registrant's Annual
            Report on Form 20-F (File No. 0-22622) as filed with the SEC on
            October 12, 1993.)

4.2         Redemption Agreement, dated as of February 25, 1997, between the
            Company and Anthony Clements and Rex Fortescue. (Incorporated by
            reference to Exhibit 3.12 to the Registrant's Annual Report on Form
            20-F (File No. 0-22622) as filed with the SEC on September 12,
            1997.)

4.3         Redemption and Cancellation Agreement, dated as of April 30, 1997,
            between the Company and Sky Games International, Inc. (Incorporated
            by reference to Exhibit 3.13 to the Registrant's Annual Report on
            Form 20-F (File No. 0-22622) as filed with the SEC on September 12,
            1997.)

4.4         Shareholder Rights Agreement, dated June 17, 1997, between the
            Company and Harrah's Interactive Investment Company. (Incorporated
            by reference to Exhibit 3.15 to the Registrant's Annual Report on
            Form 20-F (File No. 0-22622) as filed with the SEC on September 12,
            1997.)

4.5         Registration and Preemptive Rights Agreement, dated June 17, 1997,
            between the Company and Harrah's Interactive Investment Company.
            (Incorporated by reference to Exhibit 4(a) to the Registrant's
            Form 8-K as filed with the SEC on June 27, 1997.)

4.6         Registration Rights Agreement, dated June 17, 1997, between the
            Company and B/E Aerospace, Inc. (Incorporated by reference to 
            Exhibit 4(b) to the Registrant's Form 8-K as filed with the SEC on
            June 27, 1997.)

4.7         Subscription Agreement, dated as of October 22, 1997, between the
            Company and

                                       20
<PAGE>
 
            Henderson International Investments Limited. (Incorporated by
            reference to Exhibit 3.22 to the Registrant's Quarterly Report on
            Form 10-Q/A No. 1 as filed with the SEC on July 8, 1998.)

4.8         Subscription Agreement, dated as of October 22, 1997, between the
            Company and Michael A. Irwin. (Incorporated by reference to Exhibit
            3.23 to the Registrant's Quarterly Report on Form 10-Q/A No. 1 as
            filed with the SEC on July 8, 1998.)

4.9         First Amendment to Registration and Preemptive Rights Agreement
            dated March 18, 1998 between the Company and Harrah's Interactive
            Investment Company. (Incorporated by reference to Exhibit 99.22 to
            the Registrant's Amended Registration Statement on Form S-3 as filed
            with the SEC on July 15, 1998.)

4.10        First Amendment to Subscription Agreement between the Company and
            Henderson International Investments Limited dated as of April 2,
            1998. (Incorporated by reference to Exhibit 99.23 to the
            Registrant's Amended Registration Statement on Form S-3 as filed
            with the SEC on July 15, 1998.)

4.11        Securities Purchase Agreement between the Company and each of
            Marshall Capital Management, Inc. (formerly Proprietary Convertible
            Investment Group, Inc.) and CC Investments, LDC dated as of December
            17, 1997. (Incorporated by reference to Exhibit 99 to the
            Registrant's Form 8-K as filed with the SEC on December 24, 1997.)

4.12        Registration Rights Agreement between the Company and each of
            Marshall Capital Management, Inc. (formerly Proprietary Convertible
            Investment Group, Inc.) and CC Investments, LDC dated as of December
            17, 1997. (Incorporated by reference to Exhibit 4(c) to the
            Registrant's Form 8-K as filed with the SEC on December 24, 1997.)

4.13        Securities Purchase Agreement between the Company and Palisades
            Holding, Inc. dated February 20, 1998. (Incorporated by reference to
            Exhibit 99.6 to the Registrant's Amended Registration Statement on
            Form S-3 as filed with the SEC on July 15, 1998.)

4.14        Registration Rights Agreement between the Company and Palisades
            Holding, Inc. dated February 20, 1998. (Incorporated by reference to
            Exhibit 99.5 to the Registrant's Amended Registration Statement on
            Form S-3 as filed with the SEC on July 15, 1998.)

4.15        Securities Agreement between the Company and B/E Aerospace, Inc.
            dated June 25, 1998. (Incorporated by reference to Exhibit 99.1 to
            the Registrant's Form 8-K filed with the SEC July 2, 1998.)

10.5*       Services Agreement, dated as of November 7, 1995, between IEL and
            Singapore Airlines Limited. (Incorporated by reference to Exhibit
            3.9 to the Registrant's Annual Report on Form 20-F (File No. 0-
            22622) as filed with the SEC on September 16, 1996.)

10.6*       Software License and Software Services Agreement, dated as of
            November 7, 1995, between IEL and Singapore Airlines Limited.
            (Incorporated by reference to Exhibit 3.10 to the Registrant's
            Annual Report on Form 20-F (File No. 0-22622) as filed with the SEC
            on September 16, 1996.)

10.7        Sublease Agreement dated as of June 5, 1997, between IEL and
            Harrah's Operating Company, Inc. (Incorporated by reference to
            Exhibit 3.11 to the Registrant's Annual Report on Form 20-F (File
            No. 0-22622) as filed with the SEC on September 12, 1997.)

10.8        Consulting Agreement, dated as of April 30, 1997, between the
            Company and James P. Grymyr. (Incorporated by reference to Exhibit
            3.14 to the Registrant's Annual Report on Form 20-F (File No. 0-
            22622) as filed with the SEC on September 12, 1997.)

10.9*       Software License Agreement, dated June 17, 1997, between the Company
            and Harrah's Interactive Investment Company. (Incorporated by
            reference to Exhibit 3.16 to the Registrant's Annual Report on Form
            20-F (File No. 0-22622) as filed with the SEC on September 12,
            1997.)

10.10       Continuing Services Agreement, dated June 17, 1997, between the
            Company

                                       21
<PAGE>
 
            and Harrah's Interactive Entertainment Company. (Incorporated by
            reference to Exhibit 3.17 to the Registrant's Annual Report on Form
            20-F (File No. 0-22622) as filed with the SEC on September 12,
            1997.)

10.11       Termination Agreement and Release, dated as of June 17, 1997, among
            the Company, SGI Holding Corporation Limited, IEL, Harrah's
            Interactive Investment Company, and Harrah's Interactive
            Entertainment Company. (Incorporated by reference to Exhibit 3.21 to
            the Registrant's Annual Report on Form 20-F (File No. 0-22622) as
            filed with the SEC on September 12, 1997.)

27**        Financial Data Schedule
*Confidential treatment has been granted.
**Submitted herewith.

(b)  REPORTS FILED ON FORM 8-K

     8-K filed July 2, 1998 for Securities Agreement dated June 25, 1998.

                                       22
<PAGE>
 
                                   Signature

Pursuant to the requirements of the Securities and Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.


                       INTERACTIVE ENTERTAINMENT LIMITED


August 10, 1998                        BY: /s/ David B. Lamm
                                           --------------------------
                                           Chief Financial Officer


August 10, 1998                        BY: /s/ Michael A. Irwin
                                           --------------------------
                                           Controller
                                           (Chief Accounting Officer)
        
                                       23