<PAGE>
 
               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 10549

                                  FORM 10-KSB

(Mark one)
 [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934 (FEE REQUIRED)
                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
                                       OR
 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
     For the transition period from  _______________ to ______________

Commission File No. 0-17927

                           JANEX INTERNATIONAL, INC.
                 (Name of small business issuer in its charter)

          COLORADO                                84-1034251
(State or other jurisdiction of              (I.R.S. Employer
incorporation or organization)                Identification No.)
 
   615 HOPE ROAD, BUILDING ONE
       EATONTOWN,  NEW JERSEY                       07724
(Address of principal executive offices)         (Zip Code)

         Issuer's telephone number, including area code: (732) 462-5201

       Securities registered pursuant to Section 12(b) of the Act:  NONE

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

                           COMMON STOCK, NO PAR VALUE
                           --------------------------
                                (TITLE OF CLASS)

Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act 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
    ---     ---

Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B 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.
                              ---

The issuer's net revenue for its most recent fiscal year was $5,596,979.

The aggregate market value of the voting stock held by non-affiliates of the
issuer as of March 31, 1998 was $2,490,526

Number of registrant's shares of Common Stock outstanding as of April 1, 1998
was 9,962,105.

Documents incorporated by reference:  None                          Page 1 of 63
Exhibit Index Page: 60
<PAGE>
 
                                     PART I


ITEM 1.   DESCRIPTION OF BUSINESS.

BUSINESS DEVELOPMENT
--------------------

     Janex International, Inc., formerly known as With Design in Mind
International, Inc., was incorporated in Colorado on July 28, 1986, and is the
parent corporation of With Design in Mind, a California corporation ("WDIM"), a
wholly owned subsidiary that it acquired on August 19, 1988, Janex Corporation,
a New Jersey corporation ("Janex"), a wholly owned subsidiary acquired on
October 6, 1993, and Malibu Fun Stuffed, Inc., a California corporation
("Malibu"), a wholly owned subsidiary acquired on August 4, 1995. Janex
International, Inc. is also the parent corporation of Pro Gains Company Limited,
a Hong Kong corporation ("Pro Gains"), owned 50% by Janex International, Inc.,
and 50% by Janex, and the parent corporation of Malibu Fun Stuffed International
Limited, a Hong Kong corporation ("MFSI"), owned 99% by Malibu and 1% by Janex
International, Inc. As used in herein, the term "the Company" refers to Janex
International, Inc. and its wholly owned subsidiaries, unless the context
indicates otherwise. From October 6, 1993, to August 4, 1995, the Company's
business was conducted primarily through its subsidiaries Janex and Pro Gains.
Prior to October 6, 1993, business was conducted primarily through WDIM.
Subsequent to August 4, 1995, business has been conducted primarily through
Janex, Pro Gains, Malibu and MFSI. The Company's principal place of business is
located at 615 Hope Road, Building One, Eatontown, New Jersey 07724. The
Company's telephone number is (732) 935-0707.

     In September 1993, the Company entered into an agreement to purchase all of
the outstanding stock of MJL Marketing Inc. ("MJL"), a New Jersey corporation.
The acquisition was completed on October 6, 1993. In November 1993 the Company
changed the name of MJL to Janex Corporation so that the corporate name would
match the brand name under which most of the Janex products are marketed. Under
the agreement to purchase MJL, the shareholders of MJL received 1,200,000 shares
of the Company's Common Stock (restricted), with certain registration rights,
and $600,000 at the closing. An additional $150,000 was to be paid in January
1994 and $1,000,000 was payable on an installment basis over a period of three
years. Subsequently the $150,000 note was paid in three equal payments of
$50,000 on April 30, June 30 and September 30, 1994. Further, through several
extensions, the holders of the $1,000,000 (at December 31, 1997 the amount
payable was $500,000) of notes have agreed to extend payments of the notes to
February 1, 1999, subject to certain interest payments and the granting of
certain warrants. See "Certain Relationships and Related Transactions" and
Description of Securities--Friedland Warrants and --Lesnick Warrants."

     The business of Janex has historically focused on the manufacturing and
marketing of children's toys, coin and gumball banks, flashlights and battery
operated toothbrushes marketed under the brand name Janex. Janex incorporates
licensed characters into most of its products, and sells its products to United
States mass merchant retailers, toy specialty stores and department stores.
Sales and manufacturing were historically facilitated through Janex's sister
company in Hong Kong, Pro Gains. Effective with the acquisition, Pro Gains
became a subsidiary of the Company, 50% of the stock of which is owned by Janex,
and the other 50% by Janex 

                                       2
<PAGE>
 
International, Inc.

     In July 1995, the Company entered into an agreement to acquire all of the
outstanding stock of Malibu and its affiliate MFSI ("Malibu Agreement"). The
acquisition was completed on August 4, 1995. Under the Malibu Agreement, the
shareholders of Malibu and MFSI received 125,000 shares of the Company's Common
Stock (restricted) and $50,000 at the closing. In addition, the former
shareholders of Malibu were entitled to an earn-out based on the future
performance of Malibu and MFSI. However, the former shareholders of Malibu and
the Company entered into an agreement, dated June 28, 1996, eliminating the
earn-out provisions in return for the issuance of 150,000 shares of Janex
International Common Stock (restricted).

     Malibu and MFSI (collectively referred to as the "Malibu Division") operate
in tandem similar to Janex and Pro Gains (collectively referred to as the "Janex
Division"). Together they develop, manufacture and market toys and novelty gift
items, selling to mass merchant retailers, chains stores, and specialty stores
primarily in the United States. Effective with the acquisition MFSI became a
subsidiary of the Company, 99% of the stock of which is owned by Malibu, and 1%
of which is owned by Janex International, Inc.

     The product line of the Malibu Division differs from that of the Janex
Division in that most of the Malibu Division products ("Malibu Products") do not
incorporate licensed characters. Further the Company considers the Janex
Division products ("Janex Products") to be of a functional nature and not
necessarily toys, while the Malibu Products fall more clearly into the toy
category. Therefore, the Company operates Malibu and MFSI, and Janex and Pro
Gains, as two distinct divisions. Nevertheless, their methods of operation and
procedures are almost identical, and therefore will not be separately discussed
herein, unless there are significant differences.

     The Company merged the operations of Janex and Malibu, and the operations
of Pro Gains and MFSI, during 1996. Subsequent to effecting those mergers, the
Company will continue to maintain the Janex Product line and the Malibu Product
line as two separate product lines.

     On August 4, 1997, Mr. Sheldon Morick, then the Chief Executive Officer,
President and Director of the Company, resigned his positions with the Company.
Mr. Leslie Friedland, the former co-owner of Janex Corporation agreed to serve
as Chief Executive Officer, President and Director of the Company. Mr. Dan
Lesnick, also a former co-owner of Janex Corporation, agreed to serve as
Executive Vice-President and Chief Operating Officer and was appointed as a
Director of the Company.


BUSINESS OF ISSUER
------------------

PRODUCTS

     The Company's products are either created by the Company or licensed from
independent inventors. The Company is constantly seeking new ideas from many
sources and is frequently approached by inventors who propose that the Company
manufacture and market a product based on their designs or concepts. If a design
or concept is licensed by the Company, the Company will, in some cases, make
significant modifications for the purpose of enhancing the product's 

                                       3
<PAGE>
 
features or eliminating unnecessary or costly aspects. Royalties are payable by
the Company with respect to products manufactured from designs or technologies
licensed by the Company from inventors or other third parties.

     Most of the Janex Products incorporate licensed fantasy characters. Once
the decision has been made to include a specific product in the line, the Janex
Division will endeavor to obtain licenses to incorporate fantasy characters into
the product. Presently, the Janex Division has licenses to utilize one or more
trademarks and/or copyrights owned or controlled by The Walt Disney Company,
Caterpillar, Inc., New Line Cinema, MCA/Universal Merchandising, Inc., Children
Television Workshop, Australian Broadcasting Corporation, The Lyons Group,
Lionel, LLC, Warner Bros. Corporation and Turner Home Entertainment, Inc.
Although the basic underlying product may stay the same, generally the product
goes through a stage of customization to tailor that product design to the
license which is to be incorporated into it.

     The Janex Products are targeted for sale by mass merchant retailers for
prices ranging from $3 to $30. Generally, the commercial life expectancy of any
given Janex Product is virtually unlimited in its generic state (i.e., without a
licensed character). For example, the predecessors of Janex marketed battery
operated toothbrushes for over twenty years. However, the commercial life span
of any particular version of one of the Janex Products is directly tied into the
length of the license agreement for the fantasy character incorporated into that
product, and the popularity of that fantasy character with consumers. Since most
of the Janex Division license agreements are written for a term of two years,
and given that the popularity of most fantasy characters is short lived, the
Company estimates that the useful life of any given version of the Janex
Products will be no more than two years. Although the Company intends to
continue to market some version of every one of the Janex Products it now sells
for at least the next three years, the Company nevertheless is actively
developing new products which could incorporate fantasy characters.

     The Janex Product line currently includes the following: battery operated
Power Toothbrush and Stand, battery operated Power Toothbrush (without stand),
battery operated Power Flashlight, Action/Talking Alarm Clock, Role Play Gear,
Foam and Vinyl Coin Bank, Deluxe Doll Carrier, Deluxe Doll Diaper Bag, Budget
Doll Bedding Assortment, Doll Comforter and Pillow Set and Lil' Miss Executive
Play Set.

     The Malibu Products do not normally incorporate licensed fantasy
characters. As a result, this division is not limited by licensor approval of
the products it develops and sells. Therefore, the product line reflects a more
opportunistic and diverse approach than the Janex Product line. The Malibu
Products are targeted for sale by mass merchant retailers, specialty retailers
and gift stores at prices ranging from $3 to $40. The commercial life span of
the Malibu Products could be long-lived, as is the case with many toys that are
not tied into a fashion or fad, but the Company expects the life span of any of
the Malibu Product to be no more than five years. Consequently, the Company is
constantly seeking new product concepts for the Malibu Product line, and
further, is continually redesigning and repacking existing products to improve
consumer appeal.

     The Malibu Products include the following: Wee Wet Pets, Wet Pet Babies,
Water Wings, Water Rings, Train Adventure Video Set and Mr. Baby Proofer.

                                       4
<PAGE>
 
     The Company intends to add several new products in 1998, subject to the
availability of working capital. See "Management's Discussion and Analysis or
Plan of Operations--Liquidity and Capital Resources." The concentration of new
product introductions will be on products of similar characteristics to those
already in the Company's product lines, i.e., similar retail price levels, the
capability of incorporating a fanciful licensed character (for Janex Products),
similar target age groups, functional or toys, suitable for manufacture through
existing or similar factories, and suitable for distribution through existing
distribution channels. The Company intends to continue to include in its
strategy for product line growth the possibility of acquiring other companies,
particularly where potential acquisition candidates offer product line,
manufacturing or marketing synergies.

     The Company's products carry a 90-day limited warranty.


GOVERNMENT REGULATIONS

     The Company is subject to the provision of, among other laws, the Federal
Hazardous Substances Act and the Federal Consumer Products Safety Act. Those
laws empower the Consumer Products Safety Commission (the "CPSC") to protect
children from hazardous products. The CPSC has the authority to exclude from the
market articles which are found to be hazardous and can require a manufacturer
to repurchase such products under certain circumstances. Any such determination
by the CPSC is subject to court review. Similar laws exist in some states and
cities in the United States and in many jurisdictions throughout the world. The
Company endeavors to comply with all applicable regulations through a program of
quality inspections and product testing. The Company maintains product liability
insurance in the amount of $2,000,000.


MARKETING, DISTRIBUTION AND CUSTOMERS
 
     The Company sells its products nationwide to retailers primarily through a
network of independent sales representative firms. One of those independent
sales representative firms is owned by the Company's President. That firm
represents the Company's products to three of its largest customers. See
"Certain Relationships and Related Transactions." The Company's products are
displayed at two major consumer product shows in January and February of each
year, and at a number of smaller specialty market shows throughout the year.
Marketing activities for the Company's product lines primarily target mass
merchant retailers in the United States and Canada, such as Kmart, Wal-Mart,
Target, and Toys R Us, as well as smaller regional merchants, drug chains,
department stores and gift stores. In 1997, Target and Toys R Us represented 14%
and 39% of the Company's revenues, respectively.

     The product marketing strategy for the Janex Product line is to market the
line as a selection of products for children that are primarily functional in
nature, may in certain circumstances be used as toys, incorporate licensed
characters where possible, are marketed under one brand name, Janex, and that
retail for prices between $3 and $30. The brand name provides an umbrella for
all products which helps both the sell-in of the product line to retailers, and
the sell-through to customers.

                                       5
<PAGE>
 
     The product marketing strategy for the Malibu Product line is to market a
line of reasonably priced toys and novelty gift items that are different from
other products on the market, either through unique product design or innovative
packaging. The marketing strategy is opportunistic, meaning that the Malibu
Division will include in its product line almost any product for reasons of
advantageous entry costs and/or significant consumer demand, if the Company
believes the product can make a material contribution to corporate
profitability. Further, if profitable, the Malibu Products will be customized,
either in design or in packaging, to meet the needs of specific customers.

     The Company currently offers to customers two primary methods of purchasing
product: on customary industry credit terms, FOB the Company's primary warehouse
facility in Baltimore, Maryland; or on a letter of credit basis, through the
Hong Kong subsidiaries Pro Gains and MFSI, FOB Hong Kong. Under these terms,
title to the goods passes to the buyer at the point of origin, and in most cases
the buyer is responsible for the costs of transportation.

     Domestic inventories are kept in a third party contract warehouse facility
located in Baltimore, Maryland. See "Certain Relationships and Related
Transactions." Orders from domestic customers are processed at the Company's
offices in New Jersey. Shipping documents are forwarded to the Baltimore
warehouse, which fills the orders and ensures shipment of product to customers
in accordance with customer specified shipping instructions. The warehouse
confirms shipment to the customer, and the Company then invoices the customer
from New Jersey.

     Letter of credit orders are processed through the Company's Hong Kong
subsidiaries, Pro Gains and MFSI. The Company has no employees in Hong Kong, but
instead has entered into a service agreement with Li & Fung (Trading) Limited
("Li & Fung"), a Hong Kong based services company (also referred to in the
industry as an agent), that provides the personnel and facilities to accomplish
accepting orders primarily from United States and Canadian based retailers,
arranging for the manufacture of products to fill those orders, delivering the
products to the customer or the customer's representative in Hong Kong, and then
processing the necessary documentation to negotiate payment for the goods by way
of letters of credit or, in some instances, by direct wire transfer from the
customer.

     Historically, Janex sold to customers primarily on a letter of credit
basis, FOB Hong Kong. Although Janex maintained a domestic warehouse in
Baltimore, Maryland, and did ship to customers FOB Baltimore, this type of
business was not emphasized, because to do so required continued investment in
inventory and accounts receivable. Management believes that shipping to
customers on normal credit terms from domestic inventories may provide access to
a base of potential new customers that do not purchase on a letter of credit
basis. This group of customers would include smaller retailers that do not
purchase enough to make letter of credit purchasing advantageous, and certain
larger multi-location retailers that rely on their suppliers to provide
inventory and logistics services along with product. In order to facilitate
shipping to smaller retailers, the Company has entered into an agreement with
Advantage Merchandise, a warehouse in San Diego, California. Advantage
Merchandise purchase directly from the Company, on a letter of credit basis,
enough inventory to fulfill orders sold by the Company, through its network of
sales representative firms. Advantage Merchandise then processes these orders,
delivering the product to the customer and then processing the collection of the
accounts receivable.

                                       6
<PAGE>
 
MANUFACTURING
 
     Most of the Company's products are manufactured to the Company's
specifications by manufacturers based in Macau and China. The Company does have
one product manufactured in the United States, and further has products
assembled in the United States from components acquired from companies located
in the United States, China and Brazil. The Company believes that teaming
contract manufacturers with Company employees yields cost savings, maximizes the
design resources of the Company and shortens the new product introduction cycle.
During the design stage, Company employees work closely with employees of the
manufacturers, and also travel to the manufacturers' facilities, in order to
accomplish the Company's design goals. Company employees also travel to the
manufacturing facilities for the purpose of inspecting the manufacturing process
and verifying the effectiveness of quality control and assurance programs.
Manufactured products may be shipped to the Company's warehouse in Baltimore,
Maryland, for inspection and distribution. Alternatively, products may be
shipped directly from the manufacturer to the customer.

     Molds and tooling for those products manufactured in the Orient are
procured and owned by Pro Gains or MFSI. Regardless of whether the goods are
destined for delivery to the Company's warehouse facility in Baltimore, or
destined for delivery direct to a customer, Pro Gains or MFSI, through Li &
Fung, initiates all orders for product with the manufacturer, and pays the
manufacturer, through Li & Fung, subsequent to the delivery of the product in
accordance with payment terms agreed to between the Company and the
manufacturer. All products manufactured in the Orient are manufactured
specifically for a customer order, or specifically for shipment to the Baltimore
warehouse. From time to time, the Company may have on hand a supply of specific
components for incorporation into finished products, if those components are
difficult to procure, have long lead times on delivery, or have minimum order
quantities associated therewith.


PRODUCT DESIGN AND SELECTION

     For the Janex Product line, the Company seeks to identify functional
products for children that will provide a benefit for both the parent and the
child, which are suited to the incorporation of a licensed fantasy character,
and which are not already being manufactured and marketed effectively by other
companies.

     Traditionally, mothers purchase the majority of all children's products.
Therefore, the primary target audience for the product line is mothers of boys
and girls between the ages of three and ten. The Company believes that one of
the greatest needs of any parent is help in "managing" their children. This
would include such activities as help in keeping dolls and other playthings
organized, brushing teeth, teaching children about money, and getting children
to do their chores. The Janex Products are designed to be functional fun
products which would help a parent "manage" their children and at the same time
make routine activities and chores fun and/or easier for the child to perform.

     For the Malibu Product line, the Company seeks to identify toys for which a
demand exists, and that can be made more attractive or fun by incorporating a
unique design or by 

                                       7
<PAGE>
 
packaging the product in a manner that is different from other similar products
on the market. Since the Company does not have the financial strength to support
the Malibu Products with television advertising, the product design and unique
packaging are designed to capture the attention of consumers at the shelf level.

     New products are initially selected based upon what management believes, in
its experience, will be successful. However, in order to seek to reduce the
expense of producing a product that may not sell, the Company may utilize the
services of professional market research companies to perform product testings
and to determine product viability. In the product selection and design process
input is also solicited from buyers at certain retailers, and from sales
representatives. Feedback from these market research techniques is also used in
the development of product packaging and in the establishment of product price
levels. In addition, for the Janex Products, since most incorporate licensed
characters, the licensor's input into product and packaging design is always
solicited, and in some cases may even be required by the terms and conditions of
the license agreement.

     While the Company has been the sole originator of several of its products,
it actively seeks innovative and unusual product concepts from third parties.
Management attempts to be open and accessible to inventors who may have new
product ideas. The Company receives many unsolicited proposals from inventors
seeking to interest the Company in licensing their product. Company management
frequently meets with inventors to review the various proposed products. If and
when the Company determines that it is willing to license a product, it seeks to
obtain the exclusive marketing and manufacturing rights for the duration of the
patent, if the product is patentable, or other suitably lengthy period if not
patentable.

     Historically, the Company has not incurred any significant costs in
connection with research and development and does not expect to do so in the
foreseeable future. The Company keeps the direct investment in research and
development on new products to a minimum by entering into agreements with
product researchers/inventors providing for ongoing royalty participation should
a given product be brought to market. Once the decision has been made to include
a product in one of the Company's product lines, the Company typically incurs
start-up costs in the range of $5,000 to $20,000 for each version of that
product introduced. Such costs include producing one or more prototypes of a
product, obtaining licensor approval (if it is licensed) on concept, artwork and
sculpting, and acquiring any required molds and tooling for production. Subject
to the availability of funds, the Company expects to spend approximately
$350,000 in 1998 for start-up costs pertaining to new products.

     For the Janex Product line, the Company continually searches for new
characters to license. A new fantasy character can be used on new products as
well as extend the life of an existing product. The Company attends trade shows,
subscribes to industry publications, and utilizes the services of licensing
consultants to ensure that, when new licenses become available, the Company
receives due consideration from the licensor as a potential licensing candidate.
When new licenses are acquired, the licensors generally specify exactly what
products the licensed characters can be incorporated into, the territory in
which products incorporating those licenses can be sold, the royalty rate
payable on sales of products, the royalty advance (if any), and the royalty
guarantee (if any). The amount of the royalty rate, advance and guarantee
required under any given license agreement is generally a function of the
credibility of the owner of the licensed 

                                       8
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property, and the popularity of the licensed character with the target market.

     For the Janex Products, the Company seeks licenses which may open up
additional target market groups. As an example, the Little Mermaid character on
a battery operated toothbrush is a suitable product for a four year old girl.
That same battery operated toothbrush with a Batman character on it would be a
suitable product for a seven year old boy. As a result, the Company endeavors as
part of its product development program to ensure that it has spread its
available license acquisition funds across a range of licenses, rather than
investing heavily in only one or two licenses. Subject to the availability of
funds, the Company expects to spend approximately $200,000 in 1998 on the
acquisition of new licenses, exclusive of ongoing royalties.

 
COMPETITION

     The market for both toys and functional children's products is served by
many manufacturers, both foreign and domestic. Many products are available over
a broad price range, and the market is competitive, includes numerous small
manufacturers, and is dominated by three industry giants. The Company classifies
the competition for its product lines three categories, as follows: (1) toy and
novelty gift manufacturers, (2) functional product manufacturers, and (3) direct
functional children's product competitors.

     Toy and novelty gift manufacturers are companies which are primarily in the
business of manufacturing and marketing toys. Functional product manufacturers
are companies which are primarily in the business of manufacturing and marketing
a specific type, or group, of functional products, such as furniture, lighting,
or clocks, but which may include in their product line certain functional
children's products. Direct functional children's product competitors are
companies which manufacture and market functional children's products as their
company's primary business. All companies that fall into these three categories
compete with the Company's product lines.

     There is considerable competition for the consumer's dollar in the
Company's target markets. However, the Janex Products are differentiated from
those of the competition by relying heavily on the use of licensed characters.
The Malibu Products are differentiated from those of the competition by relying
on unique product designs and unique packaging. Although the Company attempts to
protect its products with patents and/or trademarks when available, successful
products in any product classification are always susceptible to imitation or
"knock-off." The Company seeks to maintain a competitive advantage by continuing
the introduction of new products and/or product enhancements over time, by
producing high quality products, and by pursuing licenses for a broad range of
children's characters.

     For the Janex Products, given the reliance on licensed characters to
differentiate products and to drive sales, competition must also be viewed from
the perspective of the competition between companies for licenses. Most license
agreements are non-exclusive, and limited in duration. Within the industry, two
years is the standard term for most license agreements. When licenses become
available, or when they are up for renewal, the licensor may give the license to
the company which is willing to offer the highest royalty rate, advance royalty
amount, or royalty guarantee. The Company ranks as a very small player in the
industry, and is extremely vulnerable in the competition for licenses, should
financial strength become a primary decision making 

                                       9
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criterion of the licensor.

     /1/Licensors do not normally license multiple manufacturers for the same
product in the same territory, although technically under the terms of many
license agreements they could. This option is generally reserved by the licensor
as a method of dealing with licensees that do not perform. In addition,
licensors tend not to auction licenses, where the license would go to the
highest bidder. Instead most licensors, particularly those concerned with the
longevity of their characters, base the license granting decision more on the
ability of the manufacturer to make the products, to sell the products, to
manufacture quality products that enhance the value of the license and the
licensor's reputation, to account accurately for the sales of products, and to
pay royalties due on a timely basis. Also, most reputable licensors recognize
the value of the relationship between the licensee and their customers, and
realize the potential disruption that could occur by precipitously replacing
licensees.

     The Company believes its relationship with its major licensors to be
excellent, and believes that it will continue to be able to obtain from its
existing licensors, and new licensors, the necessary licenses to maintain a
competitive advantage in the marketplace. However, there is no guarantee that
the Company will be able to obtain the licenses necessary to maintain a
competitive advantage, and failure to obtain those licenses would adversely
effect the sales of Janex Products.

     Since the Janex Division relies upon licensed characters as the primary
method of differentiating its products from those of other companies, revenues
tend to be a function of the general popularity of the characters licensed by
the Company vis-a-vis those characters licensed to competing companies. Further,
the Janex Products account for the majority of the sales of the Company. (See "-
-Management's Discussion and Analysis or Plan of Operations"). As a result, more
traditional indicators of revenue stability such as the state of the economy,
market share, financial strength and/or weakness of the company and historical
growth rate offer limited insight as tools to predict future performance. Thus,
the strength, or weakness, of the licenses held by the Company can be expected
to a have a major influence on revenues and profitability, and over time it
would not be unexpected for the Company to experience both significant upward
and downward fluctuations in sales. These upward and downward swings in revenue
associated with "fad" or "hit" licenses that generate tremendous sales volumes
for short periods make the business of selling products that incorporate
licensed fantasy characters extremely volatile, in comparison to businesses that
do not sell products that incorporate licensed fantasy characters, and that do
not sell products that are considered fads.

     The volatility of revenues and profits created as a result of the
significant reliance on licensed characters by Janex Products is expected over
time to reduce as Malibu Products increasingly contribute to the operations of
the Company.

-----------
    /1/The respective licensors in each instance have registered, own and/or
control the trademark, registered trademarks and/or copyright rights to the
characters licensed and the characters, likenesses thereof, names, pictures,
drawings and any other associations with those characters are used by the
Company strictly under license from the respective licensor.

                                       10
<PAGE>
 
PATENTS, TRADEMARKS AND LICENSES

     For those products that can be patented, the Company normally takes the
steps necessary to do so. However, the Company recognizes that patents are not
totally effective in prohibiting competitors from producing similar products
that could compete with those of the Company. Therefore, the Company does not
rely heavily upon patent protection to maintain its competitive position. The
Company believes that its growth, competitive position and success are dependent
upon its right to use specific licensed characters and trademarks, its ability
to develop and design unique products and packaging, its relationships with
customers, and its relationship with contract manufacturers.

     The Company has entered into a number of license agreements for the use of
licensed fantasy characters on its products. These license agreements typically
run for two years, require a payment of royalties on sales of up to 16%, require
royalty advances of up to $50,000, and in some instances have guaranteed
royalties of up to $200,000. The following is a list of the current licensors to
the Company and the characters licensed:
 
     -   The Walt Disney Company for Mickey's Stuff for Kids, Little Mermaid, 
         Hercules and 101 Dalmatians/1/

     -   Warner Bros. Corporation for Batman, Superman and Looney Tunes/1/

     -   Children Television Workshop for Sesame Street/1/

     -   Lionel LLC for Lionel Trains/1/

     -   New Line Cinema Corporation for Lost in Space/1/

     -   Turner Home Entertainment, Inc. for Johnny Quest/1/

     -   MCA/Universal Merchandising for Lost World/1/

     -   UPA Productions of America for Godzilla/1/

     -   Australian Broadcasting Corporation for Bananas in Pajamas./1/

     In addition, the Company has entered into a number of license agreements
for the use of product designs and for the rights to use certain trademarks.
These license agreements typically run two to five years, require payment of
royalties on sales of up to 6%, and require royalty advances of up to $15,000.
See "Certain Relationships and Related Transactions."

BACKLOG

     Shipment of the Company's products is anticipated to peak during the summer
months period and, consequently it is expected that the Company's backlog will
be at a maximum during June, July and August. If items are not in stock,
delivery typically takes between one and three months. When items are in stock,
items are normally shipped on the date upon which the customer 

------------
     /1/The respective licensors in each instance have registered, own and/or
control the trademark, registered trademarks and/or copyright rights to the
characters licensed and the characters, likenesses thereof, names, pictures,
drawings and any other associations with those characters are used by the
Company strictly under license from the respective licensor.

                                       11
<PAGE>
 
has requested shipment.

     At December 31, 1996, the backlog of orders was approximately $1.25 million
and at December 31, 1997, the backlog of orders was approximately $1.0 million.


EMPLOYEES

     As of April 1, 1998, the Company had four full-time employees. The full-
time employees were engaged as follows: one in accounting, two in marketing and
product development and one in general and sales management. The Company has
never experienced a work stoppage and the Company believes that relations with
its employees are good. None of the Company's employees are covered by
collective bargaining agreements.


ITEM 2.   DESCRIPTION OF PROPERTY.

     As of October 1, 1997, the Company moved its headquarters to Eatontown, NJ,
and are presently sub-leasing offices from Les Friedland & Associates for a
nominal fee.

     The Company had entered into a lease, effective April 1, 1994, for 2,202
square feet of office space in a multi-tenant high rise building located at
21700 Oxnard Street, Woodland Hills, California (the "Office"). The Company and
the Landlord amended the lease, effective January 1, 1996, providing the Company
with an additional 2,460 square feet of space adjacent to its current offices,
and extended the expiration date of the lease to December 31, 2000. The lease
allows for its early termination anytime after March 1997, provided that the
Company enters into another lease with the landlord in the same complex.
Effective April 1, 1997, the Company entered into an agreement to sublease a
portion of the facility to a third party for the balance of the lease. The
Company is presently concluding negotiations to sub-lease the remaining portion
of the facility for the balance of the lease.

     With the acquisition of Malibu, the Company acquired the lease on 4,432
square feet of industrial warehouse space in a multi-tenant industrial complex
located at 5312 Derry Avenue, Suites Q & R, Agoura Hills, California (the
"Warehouse"). The lease expired on March 31, 1998. In December, 1995, the
Company had sublet the Warehouse for the remaining term of the lease. The rental
income under the sublease was approximately equal to the rent the Company was
obligated to pay.

                                       12
<PAGE>
 
ITEM 3.   LEGAL PROCEEDINGS.

SHAREHOLDER LITIGATION

     On July 15, 1997, Actional Limited ("Actional"), a company that previously
manufactured products for the Company, filed a Complaint against Janex
Corporation, OSP Publishing ("OSP") and O.S.P. Acquisition Corporation ("OSP
Acquisition"), in the Superior Court for the State of California, County of Los
Angeles, Case No. BC 174599. The Complaint sets forth a cause of action against
Janex Corporation for breach of contract, seeking damages in the sum of
$112,500. The Company filed an answer to the Complaint, denying all allegations
and claims. The Company filed a Cross-Complaint against Actional, OSP and OSP
Acquisition, for breach of contract (against Actional), rescission (against OSP
and OSP Acquisition) and declaratory relief against all defendants. The
Company's breach of contract claim against Actional alleges that Actional
manufactured defective merchandise causing damage to the Company in the sum of
$241,129.85, plus other damages to be proved at trial.

     On July 15, 1997, Actional filed an additional Complaint against the
Company in the Superior Court for the State of California, County of Los
Angeles, Case No. BD 174598. The Complaint sets forth causes of action against
Janex Corporation for open book account and for account stated and seeks to
recover $113,895.17. The Company filed an answer to the Complaint, denying all
allegations and claims. The Company filed a Cross-Complaint against Actional,
OSP and OSP Acquisition, for breach of contract (against Actional), rescission
(against OSP and OSP Acquisition) and declaratory relief against all defendants.
The Company's breach of contract claim against Actional alleges that Actional
manufactured defective merchandise causing damage to the Company in the sum of
$241,120.85, plus other damages to be proved at trial. The Company requested
that both of Actional's cases be consolidated and the Court entered an order to
that effect.

     Both of these cases have been settled for a total payment of $50,000. In
connection with the settlement, the $50,000 has been deposited into an
attorneys' trust account to be paid subject to inspection an acceptance of
certain tools and molds delivered to the Company by Actional. made.


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

     There were no matters submitted to a vote of the Company's security holders
during the fourth quarter of the fiscal year ended December 31, 1997.

                                       13
<PAGE>
 
                                    PART II

ITEM 5.   MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

PRICE RANGE OF OUTSTANDING COMMON STOCK

     On October 16, 1989, the Common Stock began trading on the National
Association of Securities Dealers Automated Quotation System ("NASDAQ") and has
been quoted on NASDAQ since that date except for the period from June 7, 1990,
to June 18, 1990. The Company's stock were deleted from the NASDAQ Stock Market
effective July 17, 1997, as a consequence of the Company's failure to meet the
minimum capital and surplus requirements for continued listing. The Company's
now traded on the OTC Bulletin Board. The following table sets forth the high
and low bid prices for each fiscal quarter from January 1, 1996, through
December 31, 1997, as reported by the National Association of Securities
Dealers. Such quotations reflect inter-dealer prices, without retail mark-up,
mark-down or commission and do not necessarily represent actual transactions.

        Year Ended December 31, 1997    High (1)  Low (1)
 
        First Quarter                     $1.44    $ .56
        Second Quarter                    $ .72    $ .31
        Third Quarter                     $ .63    $ .06
        Fourth Quarter                    $ .75    $ .18
 
        Year Ended December 31, 1996     High      Low
 
        First Quarter                     $2.25    $1.00
        Second Quarter                    $2.06    $1.25
        Third Quarter                     $2.13    $1.00
        Fourth Quarter                    $2.13    $1.06

(1) The closing price on the OTC Bulletin Board on March 31, 1998 was $0.25 per
share of Common Stock. As of March 31, 1998, the Company had approximately 840
shareholders of record.

DIVIDEND POLICY

     The Company has not paid dividends on its Common Stock and does not
anticipate paying dividends in the foreseeable future. The Company anticipates
that all earnings, if any, in the foreseeable future, will be retained for
development of the Company's business.

                                       14
<PAGE>
 
ITEM 6.   MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.

     The following discussion should be read in conjunction with the Company's
audited consolidated financial statements and notes thereto appearing elsewhere
in this Form 10-KSB.

OVERVIEW

     From inception (July 1986) to June 1992, the Company developed and marketed
a variety of consumer products that were sold by retailers of gift, novelty and
educational items throughout the United States ("Gift Products"). In 1990, the
Company expanded its product line with the introduction of the MicroTheatre
Display Unit, which was intended for commercial markets. During 1991 and 1992,
the Company had revenues from MicroTheatre related products of $3,580,000,
primarily as a result of a contract with Sega Enterprises Ltd., which produced
revenues of $3,000,000 from the licensing of a video game (the "Game") and the
sale of certain optical system kits ("Kits"). However, the Game was not a
commercial success, Sega did not purchase any Kits after the initial order, and
advised the Company in December 1992, that it did not intend to purchase any
additional Kits. At or about the same time, management had serious concerns
regarding the market for the Company's products, since revenues from the Gift
Products went from a high of $8,204,697 for the year ended September 30, 1989,
to $2,636,411 for the year ended September 30, 1992, due to what management
believed was the continuation of a downward trend in the demand for high-end
novelty gift items. Accordingly, management changed the Company's product
philosophy and focus, to that of producing functional children's products.

     In early 1993, the Company introduced a new line of functional children's
products, under the brand name "Great Stuff." But, by June 1993, management
realized that the Great Stuff product line was not gaining acceptance, and the
Company began looking for other sources of revenue. In June 1993, the Company
sought to obtain sales revenue by entering into a license and distribution
agreement with Deco Disc Industries, Inc. ("Deco Disc"), which gave the Company
the right to distribute to the Gift and Specialty retail markets a line of
patented greeting cards and ornaments with "pop out" compact discs. However,
when orders for the Deco Disc products did not materialize as expected, with
total Deco Disc product orders totaling only about $190,000, management began
searching for an acquisition and in October 1993, MJL Marketing, Inc. (now known
as Janex Corporation) and its affiliate Pro Gains, a successful manufacturer and
distributor of children's products which utilized fanciful licensed characters
on their products, was acquired.

                                       15
<PAGE>
 
     The operating results of Pro Gains and Janex for the fiscal years 1992 and
1993 (prior to their acquisition by the Company) indicate that independently Pro
Gains was profitable while Janex incurred losses. However, the two companies
operated in tandem, with considerable interdependencies and combined they
generated a profit. While subsequent to the acquisition, the Company's
operations were restructured, Pro Gains and Janex continue to operate in tandem
to achieve consolidated objectives, and by design, significant interdependencies
continue to exist. Management measures their performance on a combined rather
than an individual basis. Both companies sell their products primarily to
customers in the United States. However, Pro Gains sells free on board (FOB)
Hong Kong, on a letter of credit basis, while Janex sells FOB the Company's
warehouse, in Baltimore, Maryland, on customary industry credit terms. It is
normally the customer that determines the form of the transaction. Accordingly,
consideration and comparison of those measurable standards of performance such
as sales, operating profits and identifiable assets for these entities as if
they were operating independently may not be meaningful.

     With the acquisition of Janex in October 1993, the Company ceased marketing
the Great Stuff, Deco Disc and MicroTheatre product lines and focused entirely
on marketing the Janex products. See "Business of Issuer--Products."

     By May of 1995 it became apparent that the order flow for 1995 was
significantly behind that of 1994, and management became increasingly concerned
about the Company's reliance on licensed product, given the volatility of the
licensing business and the cost of acquiring licenses. See "Business of Issuer -
Competition". Therefore the decision was made to investigate the possibility of
adding other product lines, and to evaluate various acquisition opportunities
that were presented to the Company for its consideration. As a result, on August
4, 1995, the Company acquired Malibu and its Hong Kong affiliate MFSI. See
"Liquidity and Capital Resources". The two acquired companies operate in tandem
similar to Janex and Pro Gains. Together they develop, manufacture (through
subcontractors) and market toys and novelty gift items, selling primarily in the
United States to mass merchant retailers, chain stores, and specialty stores,
both FOB the Company's warehouse in Baltimore, Maryland, and FOB Hong Kong.

                                       16
<PAGE>
 
RESULTS OF OPERATIONS OF THE COMPANY

The following table sets forth, for the periods indicated, the relative
percentage that certain income and expense items bear to net sales.

                                                    Year Ended      Year Ended
                                                  December 31,    December 31,
                                                      1997            1996

        Net sales                                   100.0%          100.0%

        Cost of sales                                59.9            61.1

                                                     40.1            38.9

        Royalties                                    11.6            14.0

        Selling, general and                         
         administrative expenses                     39.5            49.5 
                                   
        Depreciation and Amortization                 9.9            11.0

        Write-off of goodwill and 
         intangible assets                           29.3              --

        Operating loss                              (50.2)          (35.6)

        Other expense                                (6.4)           (4.5)
                                   
        Loss before taxes                           (56.6)          (40.1)

        Income tax expense                            (.1)           (0.2)

        Net loss                                    (56.7)%         (40.3)%


MATERIAL CHANGES IN RESULTS OF OPERATIONS
FISCAL YEARS ENDED DECEMBER 31, 1997 AND DECEMBER 31, 1996

     Sales for the year ended December 31, 1997 were $5,596,979, as compared to
$7,112,921 for the year ended December 31, 1996, a decrease of $1,515,942 or
21%. The net loss for the year ended December 31, 1997 was $3,174,851 or $0.55
per share, compared to a net loss of $2,865,439 or $0.56 per share for the year
ended December 31, 1996.

     Sales during the year ended December 31, 1997, were primarily from shipment
of products from the Malibu product lines. This line of Wet Pets generated sales
of $2,817,410 or 50% of total sales. Shipment of products incorporating
characters licensed from The Walt Disney Company, generated sales of $628,184 or
11% of total sales, and the shipment of products incorporating characters
licensed from Warner Bros., generated sales of $1,361,780 or 24% of total sales.
This compares to sales during the year ended December 31, 1996, when licenses
from The Walt Disney Company generated sales of $2,735,273 or 38% of total
sales, and licenses from Warner Bros. generated $2,467,849 or 35% of total
sales.

     Sales for Janex and Malibu ("Domestic Sales") for the year ended December
31, 1997, were $856,975 or 15% of sales, and sales for Pro Gains and MFSI ("FOB
Hong Kong") for the year ended December 31, 1997, were $4,740,004 or 85% of
sales. This compares to Domestic Sales for the year ended December 31, 1996 of
$1,789,985 or 25% of total sales, and FOB Hong Kong sales for the year of
$5,322,936 or 75% of total sales. Since Janex and Pro Gains, and Malibu and
MFSI, operate in tandem as two profit centers, the net profit of each entity
viewed alone would not be meaningful. In general, products sold by Janex and
Malibu generate a slightly 

                                       17
<PAGE>
 
greater gross profit than those sold by Pro Gains and MFSI to compensate for the
higher costs of servicing domestic business, including the costs of carrying
inventory, and the costs of carrying trade receivables. While management does
anticipate a major change in the shift of a higher percentage of total sales
generated from FOB Hong Kong shipments, it is the customer that ultimately
decides whether the goods are shipped FOB a United States warehouse, or FOB Hong
Kong.

     Gross profit was 40.1% for the year ended December 31, 1997, as compared to
38.9% for the year ended December 31, 1996. Management sets prices on most
products to achieve a gross profit of between 40% and 45%. The gross profit was 
negatively affected by the write down of inventories of approximately $50,000 
and $100,000 for the years ended December 31, 1997 and 1996, respectively, and 
by the sales of product of approximately $78,000 and $92,000, at or below cost, 
for the years ended December 31, 1997 and 1996, respectively. In addition, gross
profit generated on sales of Malibu Products for the year ended December 31,
1997, was 42% and for December 31, 1996 was 35%, well below the target rate set
for the Company overall.

     Royalty expense was $651,422 for the year ended December 31, 1997 or 11.6%
of sales, as compared to royalties of $1,002,429 for the year ended December 31,
1996, which was 14.0% of sales. The decrease in royalties as a percentage of
sales is a result of two factors. A significant shift in the sales mix to a
higher proportion of non-royalty sales, which include the Wet Pet Line, resulted
in a reduction of royalty expense. This reduction partially was offset by a
provision for loss of $292,500 that was charged to operations to meet royalty
guarantees made on contracts under which insufficient product sales were
generated to meet the minimum guarantees due through December 31, 1997.

     Selling, general and administrative ("SG&A") expenses were $2,208,106 or
39.5% of sales for the year ended December 31, 1997, as compared to $3,509,706
or 49.5% of sales for the year ended December 31, 1996. SG&A expenses are
comprised of fixed overhead costs and variable selling expenses. The fixed
overhead portion of SG&A for the year ended December 31, 1997 was $1,733,101,
$764,109 or 31%, less than in 1996. SG&A decreased during 1997 primarily as a
result of decreases in payroll costs of 36.2% or $503,647, decreases in travel
and accommodation costs of 25.1% or $47,870, decreases in sales and marketing
costs of 30.5% or $78,019, decreases in product development costs of 93.5% or
$23,875, decreases in communication costs of 43.9% or $76,034, decreases in
professional fees and investor relations of 6.0% or $9,265 and decreases in
financial costs of 32.2% or $51,841. These decreases were offset by increases in
occupancy costs of 2.8% or $2,287, increases in office expenses of 17.4% or
$5,856 and increases in insurance costs of 54.7% or $18,297.

     The variable selling cost component of SG&A was $475,003 for the year ended
December 31, 1997 or 8.5% of sales, compared to $1,012,496 for the year ended
December 31, 1996, which was 14.2% of sales. Variable selling costs include
sales representative's commission, agent's commission, freight, product
liability insurance, testing fees and other charges that vary directly with
sales volume. Management expects variable selling costs to be between 10% and
12% of sales. Variable selling costs were slightly lower in 1997 as compared to
1996 as a result of a decrease in the cost of local transportation charges in
Hong Kong for moving customer orders from the factory to the delivery point and
as a result of a decrease in testing fees.

     In conjunction with the change in management during August 1997, new
management conducted a review of the Company's operations, financial condition
and business prospects. As 

                                       18
<PAGE>
 
a result, new management decided to decrease the Company's dependence on
licensed products and to develop and market new product lines. In light of the
historical operating losses from the Company's existing product lines, limited
working capital, and the change in the Company's business focus, the Company
determined to write-off certain intangible assets aggregating $1,643,386. This
write-off consisted of trademarks, licensing relationships and goodwill.

     For the year ended December 31, 1997, interest expense increased by $35,885
to $389,401 or 7.0% of net sales, as compared to $35,516 or 4.9% of net sales
for the year ended December 31, 1996.

     During 1997, the Company recorded income tax expense of $3,548, compared to
income tax expense in 1996 of $12,485. The Company does not expect there to be
any federal income tax liability for 1997, as the Company suffered a net loss.
The income tax expense relates to income tax paid primarily on state tax
returns.

SEASONALITY AND QUARTERLY FLUCTUATIONS

     The Company's business follows closely that of other companies with
children oriented product lines, which tend to generate the greater part of both
sales and profits during the Christmas selling season. The Company expects that
sales will be higher in the third and fourth quarters of the year, as compared
to the first and second quarters of the year, with over 50% of shipping expected
to take place between April and September.


LIQUIDITY AND CAPITAL RESOURCES
 
     The Company had positive cash flow from operating activities of $323,180
for the year ended December 31, 1997, compared to a negative cash flow in 1996
of $712,787. The difference between the 1997 cash flow and the 1996 cash flow
from operating activities resulted primarily from accounts receivable
decreases of $196,848 and accounts payable and accrued expenses increases of
$401,957, reduced by an increase in net loss of $309,412 as a consequence of the
drop in revenues between 1996 and 1997. Inventories decreased by $396,530.
Prepaid and other assets decreased by $289,160 and amortization and depreciation
increased by $1,444,099 primarily due to the write-off of goodwill and other
intangible assets.

     The Company generated $103,018 in investing activities for the year ended
December 31, 1997, compared to using $734,420 in 1996. The decrease in cash used
in investing activities relates primarily to a slight decrease in expenditures
to build tools and molds and to develop new products. During the year ended
December 31, 1997, the Company invested $190,898 in additions to property, plant
and equipment, of which approximately $174,499 was for tooling for new products,
and the Company invested $106,084 in product development costs. Additionally,
the Company redeemed $400,000 of its certificate of deposit. During 1996, the
Company made comparable investments of $430,007 in property, plant and
equipment, of which approximately $333,000 was for tooling for new products, and
the Company invested $304,413 in product development costs.

     The Company used $448,142 from financing activities during the year ended
December 31, 

                                       19
<PAGE>
 
1997, compared to generating $850,259 during 1996. The cash used in financing
activities came primarily from an decrease in bank debt of $400,000, a decrease
in note payable of $312,167, a decrease in loan payable - agent of $200,975 and
offset by proceeds of stockholder notes payable of $115,000 and proceeds of
issuance of common stock of $350,000.

     The Company believes that its existing cash balance together with its
existing lines of credit and projected cash flow from operations will not be
sufficient to fund projected order flow, overhead and debt repayment for the
fiscal year ending December 31, 1998. Accordingly, the Company must obtain
additional financing in order to maintain its current level of operations. If
financing is not obtained in the immediate future, then the company will have to
reduce operations to a level consistent with available working capital. The
Company is actively seeking additional sources of financing, including but not
limited to a merger with or acquisition by another company. There can be no
assurances that any such additional financing will be available on a timely
basis and/or under acceptable terms. The Company has experienced recurring
losses from operations, negative cash flows and decreases in working capital.
The Company's independent certified public accountants have included an
explanatory paragraph in their report indicating there is substantial doubt with
respect to the Company's ability to continue as a going concern.

     The Company had a $1,000,000 line of credit with a bank with interest at
9.5%, pursuant to a loan agreement which expired on May 3, 1996. The line of
credit was secured by a $500,000 certificate of deposit purchased from the bank
and a first priority security interest in all of the assets of the Company. On
March 20, 1996, the Company and the bank agreed to reduce the amount available
under the line of credit to $500,000 (including the ability of the Company to
utilize the line of credit to issue up to $100,000 of stand-by letters of
credit), and the bank waived certain covenant violations under the original loan
agreement. On May 27, 1997, the Company and the bank further agreed to reduce
the line of credit to $100,000 (including the ability of the Company to utilize
the line of credit to issue $100,000 of stand-by letters of credit), and in
conjunction therewith, the $400,000 outstanding balance of the line of credit
was repaid in full by reducing the balance of the certificate of deposit. The
line of credit is secured by the remaining $100,000 balance of the certificate
of deposit at December 31, 1997.

     The Company, through a Hong Kong bank, has a line of credit for the
Company's subsidiary, Pro Gains, which allowed Pro Gains to discount with the
bank letters of credit issued to Pro Gains by its customers. The credit line was
tailored to match the Company's selling season. From May to November the credit
line was HK$7,000,000 (US$900,000) and from December to April the line was
HK$1,500,000 (US$200,000). Janex International, Inc. had issued a guarantee to
the Hong Kong bank in the full amount of the credit line. At September 30, 1997,
the bank decided not to renew the credit facility.

     Effective as of April 19, 1996, pursuant to a Revolving Credit Agreement
(the "Agreement") with an individual lender (who is also a significant
shareholder of the Company) (the "Lender") that expires on October 19, 1999,
Janex Corporation arranged to borrow up to $900,000, with interest at 9.5%
payable quarterly. See "Certain Relationships and Related Party Transactions."
The Agreement is secured by all of the assets of Janex Corporation, and the
guarantee of Janex International, Inc. As additional consideration, the Company
granted the Lender warrants to purchase up to 900,000 shares of the Company's
common stock (restricted), with certain "piggy-back" registration rights,
exercisable at a price of $1.45 per share through 

                                       20
<PAGE>
 
April 19, 2000. The warrants vest in equal increments of 180,000 on the first
day of consecutive six-month periods commencing April 19, 1996. However, to the
extent that amounts borrowed under the Agreement are paid off and the Agreement
is canceled during its term, any unvested warrants shall be void. As of December
31, 1997 and 1996, the Company had borrowed $615,000 and $500,000, respectively,
pursuant to this Agreement. In addition, the Company has used an additional
$150,000 as security to issue stand-by letters of credit in connection with the
loan payable to the Company's Hong Kong agent.

     Under the terms of the stock purchase agreement for the acquisition of
Janex, the Company issued two promissory notes to two stockholders totalling
$1,000,000, payable in semi-annual installments over a three-year period (at
December 31, 1995, the amount payable was $458,760, representing the present
value of the future payments under the obligation discount at 9%, not including
imputed interest accrued but not paid). The first three payments of $166,667
each under the $1,000,000 note were made on June 30, 1994, December 31, 1994,
and June 30, 1995. On December 29, 1995, the holders of the $1,000,000 of notes
agreed to a deferral of the payment due on December 31, 1995, to June 30, 1996.
As a condition of the deferral, the Company agreed to pay the note holders
interest on the deferred payments at the rate of 9% per annum from December 31,
1995 to the date of payment. On June 28, 1996, the note holders agreed to
further extend the payment date for all remaining payments to February 1, 1998,
subject to payment of interest at the rate of 9.5% per annum, retroactive to
January 1, 1996.  Quarterly interest payments commenced on September 1, 1996.
Further, in connection with the extension of the notes, the Company entered into
a warrant agreement with each of the note holders, providing for the issuance of
up to 282,994 warrants to one of them and up to 167,994 warrants to the other,
to acquire a total of 450,998 shares of the Company's Common Stock (restricted),
exercisable at a price of $1.45 per share through June 28, 2000, with certain
"piggy-back" registration rights. The warrants vest in a six-month increments
over the term of the loan, and if the loan is paid off early, certain of the
warrants will be void. On August 4, 1997, the note holders agreed to further
extend the payment date to February 1, 1999. The outstanding loan balance as of
December 31, 1997 and 1996, was $500,000. See "Certain Relationships and Related
Party Transactions."

     The Company charged to operations $214,292 and $180,477 of imputed interest
expense from the issuance of stock purchase warrants noted in the above two
paragraphs in the years ended December 31, 1997 and 1996, respectively.

     In addition, as part of the June 28, 1996 Agreement with the stockholders,
the payment of commissions owing one of the stockholders was extended to
February 1, 1998. Furthermore, the unpaid commission balance bears interest at
9.5% per annum beginning January 1, 1996, until paid with interest paid
quarterly beginning September 1, 1996. The outstanding commission loan balance
as of December 31, 1997 was $115,000.

     On December 22, 1995, the Company borrowed $500,000 in a private unsecured
loan transaction. Under the terms of the loan agreement, payments are to be made
on a periodic basis based upon the level of certain sales. The loan accrues
interest monthly on the unpaid portion at the rate of two percent (2%) above the
prime rate.

     In addition, an agreement was reached whereby an additional $340,000 was
added to the outstanding balance as of December 31, 1996. The balance of this
note payable at December 31, 

                                       21
<PAGE>
 
1997 is $219,189.

     Pursuant to an agency agreement dated October 23, 1995, the Company,
through its Hong Kong subsidiaries, Pro Gains and MFSI, may borrow up to
$450,000 from its Hong Kong agent for the payment of product development and
tooling costs, provided that the Company issues to the agent an irrevocable
stand-by letter of credit for $150,000. The loan is to be repaid from
collections of certain customer invoices at the rate of 5% of the invoice
amount, with interest at 2% above the Hong Kong prime rate, and any balance
remaining unpaid at December 31, 1997 will be due and payable on December 15,
1998. The Agent will retain ownership of all tooling paid for with the credit
facility until the credit facility is repaid. The credit facility is available
in each year that the agency agreement is in effect, which was for an initial
term of two years. In March 1996, the Company opened the stand-by letter of
credit to the Agent. As of December 31, 1997, the Company had borrowed $249,113
under this credit facility.

     Pursuant to a supplementary agency agreement dated September 24, 1996, the
Company may borrow up to another $200,000 from its Agent provided that the
Company issues to the Agent an irrevocable stand-by letter of credit for
$100,000. Any advance under this facility is to be repaid within 60 days from
the date of advance with interest at 2% above the Hong Kong prime rate, and any
balance remaining unpaid at December 31, 1997, will be due and payable on
January 15, 1998.

     In November 1996, the Company opened the stand-by letter of credit to the
Agent. As of December 31, 1997, the Company had no borrowing under this credit
facility.

     On August 4, 1995, the Company acquired all of the outstanding stock of
Malibu, a California corporation, and its then affiliated Hong Kong company,
MFSI. Under the terms of the purchase agreement, the Company issued 125,000
shares of the Company's restricted common stock to the former stockholder of the
acquired companies, and paid $50,000 cash. The Company recorded the acquisition
using the purchase method of accounting. Under this method, the allocation of
the purchase price to Malibu's and MFSI's assets and liabilities is required to
reflect fair value. The Company allocated the excess of purchase price over net
assets acquired to goodwill. In addition, the former stockholders of Malibu and
MFSI were entitled to an earn-out based on future performance of Malibu and
MFSI. In October 1996, the parties revised this agreement and the former owners
of Malibu were issued 150,000 shares of restricted common stock of the Company
in exchange for cancellation of the earn-out provisions of the agreement. The
common stock was valued at $1.00 per share, which was management's estimate of
the fair value at the time. Accordingly, $150,000 was recorded as compensation
expense.

     Under the terms of the warrant agreement granting Deco Disc warrants to
purchase 500,000 shares of the Company's common stock (the "Warrant Agreement"),
the Company was obligated to register the stock underlying the warrants, and to
use its best efforts to maintain the registration statement effective during the
period the warrants are exercisable. Deco Disc threatened to sue the Company,
claiming that the Company did not file the registration statement on a timely
basis, and that the registration statement was not kept effective by the
Company, resulting in Deco Disc being damaged. In order to avoid any potential
litigation, on March 26, 1996, the Company and Deco Disc entered into a
Settlement Agreement and Specific Release under which the Company issued to Deco
Disc additional warrants to purchase 100,000 shares of 

                                       22
<PAGE>
 
the Company's common stock (restricted), with certain "piggy-back" registration
rights, at a price of $0.64 per share in exchange for Deco Disc releasing the
Company from any and all prior claims relating to violations of the Warrant
Agreement, and failure to update the registration statement. As a result of the
foregoing transaction, during the year ended December 31, 1996, the Company
recorded a charge to operations of $84,125 as management's estimate of the fair
value of the 100,000 common stock purchase warrants.

     During the year ended December 31, 1995, the Company received $147,200 from
a warrant holder pursuant to the warrant holder exercising warrants to purchase
230,000 shares of the Company's Common Stock.

     During the year ended December 31, 1996, the Company received $64,000 from
a warrant holder pursuant to the warrant holder exercising warrants to purchase
100,000 shares of the Company's common stock.

     During the year ended December 31, 1997, the Company received $350,000 from
the issuance of 2,692,307 shares of common stock in a private placement.

     As of December 31, 1997, the Company had cash and certificates of deposit
of $264,672, working capital deficit of $(1,782,770) and a current ratio of .29-
to-1. This compares to cash of $686,616, working deficit of $(1,192,746) and a
current ratio of .61-to-1 as of December 31, 1996. The Company had, at December
31, 1997, consolidated stockholders' deficit of $(2,049,126), as compared to
consolidated stockholders' equity at December 31, 1996 of $775,725.

     As of December 31, 1997, the Company has a deferred tax asset of $3,187,587
resulting from net operating loss carry forwards and other temporary
differences. It is not possible at this time to determine that the realization
of the deferred tax assets is more likely than not; accordingly, a valuation
reserve has been established for the full amount.


NEW ACCOUNTING POLICIES

     In June 1997, the Financial Accounting Standards Board issued two new
disclosure standards.

     SFAS No. 130, "Reporting Comprehensive Income," establishes standards for
reporting and display of comprehensive income, its components and accumulated
balances. Comprehensive income is defined to include all changes in equity
except those resulting from investments by owners and distributions to owners.
Among other disclosures, SFAS No. 130 requires that all items that are required
to be recognized under current accounting standards as components of
comprehensive income be reported in a financial statement that is displayed with
the same prominence as other financial statements.

     SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information," which supersedes SFAS No. 14, "Financial Reporting for Segments of
a Business Enterprise," establishes standards for the way that public companies
report information about operating segments in interim financial statements and
requires reporting of selected information about operating segments in interim
financial statements issued to the public. It also establishes standards for
disclosures regarding products and services, geographic areas and major
customers. SFAS No. 131, defines operating segments as components of a company
about which separate financial information is available that is evaluated
regularly by management in deciding how to allocate resources and in assessing
performance.

     SFAS No's 130 and 131 are effective for financial statements for periods
beginning after December 15, 1997 and requires comparative information for
earlier years to be restated. Because of the relatively recent issuance of these
standards, management has been unable to fully evaluate the impact, if any, it
may have on future financial statement disclosures. Results of operations and
financial position, however, will be unaffected by implementation of these
standards.


INFLATION

     Management believes that inflation has not had a significant impact on the
Company's costs and profits during the past two years.

                                       23
<PAGE>
 
ITEM 7. FINANCIAL STATEMENTS.

                                                                       Page
                                                                      Number
                                                                      ------
 
 
   REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS'                  25
                                                                     
   CONSOLIDATED FINANCIAL STATEMENTS:                                
                                                                     
            Balance Sheet as of December 31, 1997                       26
                                                                     
            Statements of Operations for the years ended             
             December 31, 1997 and December 31, 1996                    27
                                                                     
            Statement of Changes in Stockholders' Equity             
             (Deficiency) for the years ended December 31, 1997      
             and December 31, 1996                                      28
                                                                     
            Statements of Cash Flows for the years ended             
             December 31, 1997 and December 31, 1996                 29-30
                                                                     
   NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS                    31-51
 
                                       24
<PAGE>
 
              REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

Board of Directors and Stockholders
Janex International, Inc.
Eatontown, New Jersey

We have audited the accompanying consolidated balance sheet of Janex
International, Inc. as of December 31, 1997, and the related consolidated
statements of operations, changes in stockholders' equity, and cash flows for
each of the two years in the period ended December 31, 1997. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Janex
International, Inc. as of December 31, 1997, and the consolidated results of
their operations and their cash flows for the each of the two years in the 
period ended December 31, 1997, in conformity with generally accepted accounting
principles.

The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 3 to the
consolidated financial statements, the Company has suffered recurring losses
from operations, including a net loss of $3,174,851 for the year ended December
31, 1997, and has negative working capital of $1,782,770 and a net stockholders'
deficit of $2,049,126 at December 31, 1997. The Company has also been slow and
delinquent in paying its accounts payables and other obligations. These factors
raise substantial doubt about the Company's ability to continue as a going
concern. There is no assurance that the Company will be able to realize its
recorded assets and liquidate its liabilities in the normal course of business.
Management's plans in regard to these matters are also described in Note 3. The
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.


BDO Seidman, LLP

March 30, 1998

                                       25
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                           CONSOLIDATED BALANCE SHEET

                                                           December 31, 1997
                                                        
ASSETS (Notes 8 and 9)                                  
CURRENT ASSETS                                          
 Cash and cash equivalents                                  $    164,672
 Certificate of deposit (Note 8)                                 100,000
 Accounts receivable, net of allowance of $10,439                225,826
 Inventories (Note 2 and 4)                                      173,107
 Prepaid royalties                                                61,626
 Other current assets                                             19,925
                                                        
                                                        
Total current assets                                             745,156
PROPERTY AND EQUIPMENT, net (Note 5)                             395,165
INTANGIBLE ASSETS, net (Note 7)                                  325,988
PRODUCT DEVELOPMENT COSTS, net (Note 6)                          122,827
DEFERRED LOAN CHARGES (Note 9)                                   116,863
OTHER ASSETS                                                       2,801
                                                        
                                                            $  1,708,800
LIABILITIES AND STOCKHOLDERS' EQUITY                    
CURRENT LIABILITIES                                     
 Loans payable - agent (Note 12)                            $    249,113
 Note payable (Note 11)                                          219,189
 Accounts payable                                                685,725
 Accrued expenses (Note 10)                                    1,373,899
                                                        
                                                        
Total current liabilities                                      2,527,926
Notes payable - stockholders (Note 9)                          1,230,000
                                                        
                                                        
Total liabilities                                              3,757,926
Commitments and contingencies (Note 15)                 
STOCKHOLDERS' (DEFICIT) (Note 14):                      
 Class A convertible preferred stock, no par value,     
  5,000,000 shares authorized; none issued and outstanding
 Common stock, no par value; 20,000,000 shares authorized;
  7,989,028 shares issued and outstanding                     11,618,816
                                                        
 Additional paid-in capital                                      554,517
 Accumulated deficit                                         (14,222,459)
                                                        
                                                        
Total stockholders' equity (deficit)                          (2,049,126)
                                                        
                                                        
                                                            $  1,708,800

          See accompanying notes to consolidated financial statements.

                                       26
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS

                                                   Years ended December 31,
 
                                                      1997          1996
 
NET SALES                                         $ 5,596,979   $ 7,112,921
 
COSTS AND EXPENSES
 Cost of sales                                      3,354,114     4,348,280
 Selling, general and administrative (Note 16)      2,208,106     3,509,706
 Royalty expense (Note 15)                            651,422     1,002,429
 Depreciation and amortization                        551,951       783,095
 Write-off of goodwill and intangible assets        1,643,386             -
 
Total cost and expenses                             8,408,979     9,643,510
 
OPERATING LOSS                                     (2,812,000)   (2,530,589)
OTHER INCOME (EXPENSE)
 Interest income                                       21,461        38,995
 Interest expense                                    (389,401)     (353,516)
 Foreign exchange loss (Note 2)                         4,887        (7,844)
 Gain on disposal of fixed assets                       3,750             -
 
Total other income (expense)                         (359,303)     (322,365)
 
LOSS BEFORE INCOME TAXES                           (3,171,303)   (2,852,954)
 
INCOME TAX PROVISION (Note 13)                          3,548        12,485
 
NET LOSS                                          $(3,174,851)  $(2,865,439)
 
LOSS PER COMMON SHARE                                  $(0.55)       $(0.56)
 
Weighted average number of shares outstanding       5,745,439     5,161,242


          See accompanying notes to consolidated financial statements.

                                       27
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

      CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)
                     YEARS ENDED DECEMBER 31, 1997 AND 1996



<TABLE>
<CAPTION>
                                                              
                                                             Common Stock           Additional                         Total   
                                                                                     Paid-In         Accumulated    Stockholders'
                                                          Shares      Amount         Capital          Deficit     (Deficit)/Equity
<S>                                                      <C>          <C>           <C>            <C>              <C>
BALANCE, DECEMBER 31, 1995                               5,046,721    $11,054,816   $        -     $ (8,182,169)     $ 2,872,647
                                                                                                 
Issuance of common stock warrants due to                         -              -       84,125                -           84,125
 settlement agreement (Note 14)                                                                  
                                                                                                 
Issuance of common stock due to exercise of                100,000         64,000            -                -           64,000
 warrants (Note 14)                                                                                           
                                                                                                              
Issuance of common stock in lieu of Malibu                 150,000        150,000            -                -          150,000
 Fun Stuffed earn-out (Note 14)                                                                  
                                                                                                 
Issuance of common stock warrants (Note 9)                       -              -      470,392                -          470,392
                                                                                                 
Net loss                                                         -              -            -       (2,865,439)      (2,865,439)
                                                                                                 
                                                                                                 
BALANCE, DECEMBER 31, 1996                               5,296,721     11,268,816      554,517      (11,047,608)         775,725
                                                                                                 
Issuance of common stock                                 2,692,307        350,000            -                -          350,000
                                                                                                 
Net loss                                                         -              -            -       (3,174,851)      (3,174,851)
                                                                                                 
                                                                                                 
BALANCE, DECEMBER 31, 1997                               7,989,028    $11,618,816     $554,517     $(14,222,459)     $(2,049,126)
</TABLE>

          See accompanying notes to consolidated financial statements.

                                       28
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS



<TABLE>
<CAPTION>
                                                               Years ended December 31,
 
                                                                  1997          1996
<S>                                                           <C>           <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
 Net loss                                                     $(3,174,851)  $(2,865,439)
 Adjustments to reconcile net loss to net cash provided by
   (used in) operating activities:
    Provision for losses on accounts receivable                  (192,195)       76,787
    Amortization of licensing relationships,                    1,695,563       223,885
      trademarks and goodwill (Note 7)
    Amortization of product development costs                     225,728       245,884
    Amortization of loan charges (Note 9)                         214,292       180,477
    Depreciation                                                  272,088       313,326
    Unrealized foreign exchange losses                                  -         7,844
    Issuance of common stock in lieu of earn-out (Note 14)              -       150,000
    Issuance of stock warrants (Note 14)                                -        84,125
    Increase (decrease) from changes in:
      Accounts receivable                                         196,848       187,721
      Inventories                                                 396,530        35,986
      Prepaid royalty                                             120,839       (62,470)
      Prepaids and other assets                                   168,321       (76,541)
      Accounts payable                                           (123,583)      445,630
      Accrued expenses                                            525,540       344,644
      Income tax payable                                           (1,940)       (4,646)
 
Net cash provided by (used in) operating activities               323,180      (712,787)
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 Additions to property and equipment                             (190,898)     (430,007)
 Additions to product development costs                          (106,084)     (304,413)
 Decrease in certificate of deposit                               400,000             -
Net cash provided by (used in) investing activities           $   103,018   $  (734,420)
</TABLE>

          See accompanying notes to consolidated financial statements.

                                       29
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
                                                       Years ended December 31,
                                                          1997         1996
<S>                                                    <C>          <C>
 
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
CASH FLOWS FROM FINANCING ACTIVITIES:
 Payments on bank loan                                  $(400,000)   $(351,425)
 Proceeds (payments) from note payable                   (312,167)      31,356
 Proceeds (payments) from loans payable - agent          (200,975)     450,088
 Issuance of stockholder notes payable                    115,000      656,240
 Proceeds from issuance of common stock                   350,000            -
 Proceeds from exercise of warrants and                         -       64,000
   common stock options
 
Net cash provided by (used in) financing activities      (448,142)     850,259
 
NET DECREASE IN CASH AND CASH EQUIVALENTS                 (21,944)    (596,948)
CASH AND CASH EQUIVALENTS, AT BEGINNING OF YEAR           186,616      783,564
 
CASH AND CASH EQUIVALENTS, AT END OF YEAR               $ 164,672    $ 186,616
 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 Cash paid during the year for:
   Interest                                             $  38,456    $ 128,515
   Income taxes                                         $   3,548    $  17,131
</TABLE>

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES

In 1996, the Company issued warrants of $470,392 pertaining to a loan extension
and opening of line of credit. Deferred loan charges pertaining to the loan
extension and line of credit were $180,477 at December 31, 1996; $214,292 was
amortized during the year ended December 31, 1997 (see Note 9).

          See accompanying notes to consolidated financial statements.

                                       30
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 1 - GENERAL

Janex International, Inc. (the "Company") was incorporated in Colorado on July
28, 1986 and is the parent corporation of With Design in Mind ("WDIM"), a
California corporation, Janex Corporation ("Janex"), a New Jersey corporation,
and Malibu Fun Stuffed ("Malibu"), a California corporation, all wholly-owned
subsidiaries. Janex International, Inc. is also the parent corporation of Pro
Gains Company Limited ("Pro Gains"), a Hong Kong corporation, owned 50% by Janex
International, Inc., and 50% by Janex. Malibu Fun Stuffed International Limited
("MFSI"), a Hong Kong corporation, is owned 99% by Malibu and 1% by Janex
International, Inc. As used in the report, the term "the Company" refers to
Janex International, Inc. and its subsidiaries, unless the context indicates
otherwise.

The Company's business is conducted primarily through its subsidiaries, Janex,
Pro Gains, Malibu and MFSI. The Company's business consists mainly of
developing, manufacturing (through subcontractors), marketing and selling toys
and functional children's products ("Children's Products"). These products
include 1) coin banks, flashlights and battery operated toothbrushes marketed
under the brand name "Janex" and 2) plush, and video sets marketed under the
brand name "Malibu Fun Stuffed!", all of which retail for prices between $3 and
$40. The Children's Products are manufactured to the Company's specifications,
which are approved by the Licensors, by manufacturers based in Macau, China and
the United States and are sold nationwide to mass merchant retailers, toy
specialty stores, department stores and gift shops, through a network of
independent sales representative firms.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION

The accompanying consolidated financial statements include the operations of the
Company, its wholly owned subsidiaries, WDIM, Janex, Malibu, Pro Gains and MFSI.
All intercompany balances have been eliminated.

                                       31
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

CASH EQUIVALENTS

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

REVENUE RECOGNITION

Revenue is recognized upon shipment of the product, with appropriate allowances
made for estimated returns and uncollectible accounts.

INVENTORIES

Inventories, which consist principally of finished goods, are stated at the
lower of cost or market. Cost is determined on various methods which approximate
the first-in, first-out method.

PROPERTY AND EQUIPMENT

Property and equipment are stated at cost. Depreciation and amortization are
computed on the straight-line basis over the estimated useful lives of the
related assets, principally 2 to 5 years for molds, machinery and equipment and
furniture and fixtures. Leasehold improvements are amortized over the shorter of
their estimated useful lives or the lease term.

INTANGIBLE ASSETS

Intangible assets resulting from business acquisitions, consist of cost in
excess of net assets of subsidiaries acquired (goodwill), licensing
relationships and trademarks. Goodwill is being amortized on a straight-line
basis over the period of expected benefit of 10 to 20 years. Licensing
relationships and trademarks are being amortized over 9 to 15 years using the
straight-line method. Management has a policy to review goodwill and other
productive assets at each quarterly balance sheet date for possible impairment.
This policy includes recognizing write-downs if it is probable that measurable
undiscounted future cash flows and/or the aggregate net cash flows of an asset,
as measured by current revenues and costs (exclusive of depreciation) over the
asset's remaining depreciable life, are not sufficient to recover the net book
value of an asset.

                                       32
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

PRODUCT DEVELOPMENT COSTS

Product development costs consist of product design and development (through
subcontractors) for the various toys and children's products the Company sells.
The designs are stated at the lower of cost or net realizable value and
amortized on a straight-line basis over a 1 to 2 year period. Such costs are
periodically reviewed each year based on management's estimates of sales of
related products. Product development costs are written off when management
believes they provide no future benefit.

DEFERRED LOAN CHARGES

Deferred loan charges are amortized over the expected terms of the related loans
or notes payable.

CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

Financial instruments that potentially subject the Company to concentrations of
credit risk consist principally of cash investments and unsecured trade
receivables.

The Company maintains cash and cash equivalents in short-term investments with
various financial institutions. These financial institutions are located in the
United States and Hong Kong. The Company performs periodic evaluations of the
financial situation of these institutions, as part of the Company's investment
strategy.

The Company's two largest customers totaled approximately 53% and 22% of net
sales in 1997 and 1996 (see Note 16). The loss of either of these major
customers could have a material adverse effect on the results of the Company's
operations. The Company routinely assesses the financial strength of its
customers and, as a consequence, believes that its trade accounts receivable
credit risk exposure is limited. The Company does not require collateral to
support customer receivables. The Company maintains allowances for potential
credit losses and such losses have been within management's expectations.

ROYALTIES

Royalties due to licensors are generally provided for based upon a negotiated
percentage of underlying net sales and are frequently subject to a minimum
guaranteed royalty obligation. Prepaid royalties are recouped against royalties
accrued on the sale of licensed products.

PRODUCT WARRANTY

Estimated warranty costs are provided for at the time of sale of the warranted
products.

                                       33
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

PRINCIPLES OF TRANSLATION

All balance sheet accounts of the Company's foreign subsidiaries are translated
at the current exchange rate at balance sheet date, while income statement items
are translated at the average currency exchange rates for each period presented.
The resulting translation adjustments, if significant (in December 31, 1997 and
1996, the adjustment was not significant), are recorded as a separate component
of stockholders' equity.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The carrying amounts of financial instruments including cash and cash
equivalents, accounts receivable, loans payable, notes payable, accounts payable
and accrued expenses approximate fair value because of their short maturity.

It is not practicable to estimate the fair value of the notes payable -
stockholders due to their related party nature.

INCOME TAXES

Income taxes are accounted for in accordance with Statement of Financial
Accounting Standards (SFAS) 109 "Accounting for Income Taxes." The statement
employs an asset and liability approach for financial accounting and reporting
of deferred income taxes. Generally, SFAS 109 allows for recognition of deferred
tax assets in the current period for the future benefit of net operating loss
carryforward and items for which expenses have been recognized for financial
statement purposes but will be deductible in future periods. A valuation
allowance is recognized, if on the weight of available evidence it is more
likely than not that some portion or all of the deferred tax assets will not be
realized.

LOSS PER COMMON SHARE

In 1997, the Financial Accounting Standards Board issued SFAS No. 128, "Earnings
per Share." SFAS 128 replaced the calculation of primary and fully diluted
earnings per share. Unlike primary earnings per share, basic earnings per share
excludes the dilutive effects of options. Basic earnings per share has been
computed using the weighted average number of shares of common stock outstanding
for the period. Diluted earnings (loss) per share includes the effect, if any,
of unissued shares underlying warrants, computed using the treasury stock
method.

                                       34
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

ACCOUNTING ESTIMATES

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from these estimates. Many of the Company's
estimates and assumptions used in the financial statements relate to the
Company's products, which are subject to market changes. It is reasonably
possible that changes may occur in the near term that would affect management's
estimates with respect to accounts receivable, inventories, equipment and values
of intangibles.

RECLASSIFICATIONS

Certain items previously reported in specific financial statements captions have
been reclassified to conform with the 1997 presentation.

LONG-LIVED ASSETS

Statement of Financial Accounting Standards No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of"
(SFAS No. 121) establishes guidelines regarding when impairment losses on long-
lived assets, which include plant and equipment, and certain identifiable
intangible assets, should be recognized and how impairment losses should be
measured.

STOCK COMPENSATION PLANS

Statements of Financial Accounting Standards No. 123, "Accounting for Stock-
Based Compensation" (SFAS No. 123) establishes a fair value method accounting
for stock-based compensation plans and for transactions in which an entity
acquires goods or services from non-employees in exchange for equity
instruments. The Company adopted this accounting standard on January 1, 1996. In
accordance with SFAS No. 123, the Company has chosen to continue to account for
stock-based compensation utilizing the intrinsic value method prescribed in
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees." Accordingly, compensation cost for stock options and warrants is
measured as the excess, if any, of the fair market price of the Company's stock
at the date of the grant over the amount an employee must pay to acquire the
stock.

Also, in accordance with SFAS 123, the Company has provided footnote disclosure
with respect to stock-based employee compensation. The cost of stock-based
employee compensation is measured at the grant date based on the value of the
award and recognizes this cost over the service period. The value of the stock
based award is determined using a pricing model whereby compensation cost is the
excess of the fair value of the stock as determined by the model at grant date
or other measurement date over the amount an employee must pay to acquire the
stock.

                                       35
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

NEW ACCOUNTING POLICIES

 In June 1997, the Financial Accounting Standards Board issued two new
disclosure standards.

  SFAS No. 130, "Reporting Comprehensive Income," establishes standards for
reporting and display of comprehensive income, its components and accumulated
balances. Comprehensive income is defined to include all changes in equity
except those resulting from investments by owners and distributions to owners.
Among other disclosures, SFAS No. 130 requires that all items that are required
to be recognized under current accounting standards as components of
comprehensive income be reported in a financial statement that is displayed with
the same prominence as other financial statements.

  SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information," which supersedes SFAS No. 14, "Financial Reporting for Segments of
a Business Enterprise," establishes standards for the way that public companies
report information about operating segments in interim financial statements and
requires reporting of selected information about operating segments in interim
financial statements issued to the public. It also establishes standards for
disclosures regarding products and services, geographic areas and major
customers. SFAS No. 131, defines operating segments as components of a company
about which separate financial information is available that is evaluated
regularly by management in deciding how to allocate resources and in assessing
performance.

  SFAS No's 130 and 131 are effective for financial statements for periods
beginning after December 15, 1997 and requires comparative information for
earlier years to be restated. Because of the relatively recent issuance of these
standards, management has been unable to fully evaluate the impact, if any, it
may have on future financial statement disclosures. Results of operations and
financial position, however, will be unaffected by implementation of these
standards.

NOTE 3 - GOING CONCERN

The Company has suffered recurring losses from operations, has a net loss of
$3,174,851 and has negative working capital of $1,782,770 and a net stockholders
deficit of $2,049,126 for the year ended December 31, 1997. The Company's. These
conditions raise substantial doubt about the Company's ability to continue as a
going concern. There is no assurance that the Company will be able to realize
its recorded assets and liquidate its liabilities in the normal course of
business. The accompanying financial statements do not include any adjustments
that might result from the outcome of this uncertainty.

                                       36
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 3 - GOING CONCERN

The Company has been able to continue in operation through the financial support
provided by a combination of both debt and equity financing. Continued
operations depend upon the Company continuing to obtain financing for its
activities. Management's plan for the Company includes raising additional
working capital through debt and/or equity financing until profitable operations
and positive cash flow are achieved and maintained. However, no assurances can
be given that the Company will be successful in raising additional capital.
Further, should the Company be successful in raising additional capital, there
is no assurance that the Company will achieve profitability or positive cash
flow. If the Company is unable to obtain adequate additional financing,
management will be required to curtail the operations of the Company.

NOTE 4 - INVENTORIES

At December 31, 1997 and 1996, the Company had raw materials and work in
progress of $135,364 and $8,883, respectively and finished goods of $37,743 and
$560,754, respectively.

NOTE 5 - PROPERTY AND EQUIPMENT

Property and equipment consisted of the following:
                                      December 31,
                                   1997          1996
                               ------------  ------------
 
   Leasehold improvements      $     3,866   $     2,506
   Equipment and furniture         146,593       139,419
   Molds                         1,756,229     1,573,865
                               -----------   -----------
                                 1,906,688     1,715,790
   Accumulated depreciation     (1,511,523)   (1,239,435)
                               -----------   -----------
                               $   395,165   $   476,355
                               ===========   ===========

Depreciation expense for the years ended December 31, 1997 and 1996 amounted to
$274,045 and $313,326, respectively.

                                       37
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 6 - PRODUCT DEVELOPMENT COSTS

Product development costs consisted of the following:

                                     December 31,
                                   1997         1996
                                -----------  ----------
 
   Product development costs    $1,009,165   $ 903,081
   Accumulated amortization       (886,338)   (660,610)
                                ----------   ---------
                                $  122,827   $ 242,471
                                ==========   =========
 
Amortization expense for the years ended December 31, 1997 and 1996 amounted to
$225,728 and $245,884, respectively.

 
NOTE 7 - INTANGIBLE ASSETS
 
Intangible assets consisted of the following:
                                                      December 31,
                                                      1997         1996
                                                 ---------   ----------
 
   Goodwill                                      $ 422,220   $1,459,724
   Licensing relationships                               -      795,014
   Trademarks                                        5,808      385,129
                                                 ---------   ----------
                                                   428,028    2,639,867
   Accumulated amortization                       (102,040)    (618,316)
                                                 ---------   ----------
                                                 $ 325,988   $2,021,551
                                                 =========   ==========

Amortization expense for the years ended December 31, 1997 and 1996 amounted to
$52,178 and $223,885, respectively.

In addition, during 1997, the Company, in accordance with SFAS No. 121 (Note 2),
wrote off goodwill, licensing relationships and trademarks of $1,643,386,
because they were considered to have no value. The goodwill from the acquisition
from Malibu continues to be amortized over a ten year period.


NOTE 8 - LOAN PAYABLE - BANK

The Company had a $1,000,000 line of credit with a bank with interest at 9.5%,
pursuant to a loan agreement which expired on May 3, 1996. The line of credit
was secured by a $500,000 certificate of deposit purchased from the bank and a
first priority security interest in all of the assets of the Company. On March
20, 1996, the Company and the bank agreed to reduce the amount available under
the line of credit to $500,000 (including the ability of the Company to utilize
the line of credit to issue up to $100,000 

                                       38
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


of stand-by letters of credit), and the bank waived certain covenant
violations under the original loan agreement. On May 27, 1997, the Company and
the bank further agreed to reduce the line of credit to $100,000 (including the
ability of the Company to utilize the line of credit to issue $100,000 of stand-
by letters of credit), and in conjunction therewith, the $400,000 outstanding
balance of the line of credit was repaid in full by reducing the balance of the
certificate of deposit. The line of credit is secured by the remaining $100,000
balance of the certificate of deposit at December 31, 1997.

The Company, through a Hong Kong bank, has a line of credit for the Company's
subsidiary, Pro Gains, which allows Pro Gains to discount with the bank letters
of credit issued to Pro Gains by its customers. The credit line was tailored to
match the Company's selling season. From May to November the credit line was
HK$7,000,000 (approximately US$900,000) and from December to April the line was
HK$1,500,000 (approximately US$200,000). Janex International, Inc. had issued a
guarantee to the Hong Kong bank in the full amount of the credit line. At
September 30, 1997, the bank decided not to renew the credit facility.


NOTE 9 - NOTES PAYABLE - STOCKHOLDERS

Effective as of April 19, 1996, pursuant to a Revolving Credit Agreement (the
"Agreement") with an individual lender (who is also a significant shareholder of
the Company) (the "Lender") that expires on October 19, 1999, Janex Corporation
arranged to borrow up to $900,000, with interest at 9.5% payable quarterly. The
Agreement is secured by all of the assets of Janex Corporation, and the
guarantee of Janex International, Inc. As additional consideration, the Company
granted the Lender warrants to purchase up to 900,000 shares of the Company's
common stock (restricted), with certain "piggy-back" registration rights,
exercisable at a price of $1.45 per share through April 19, 2000. The warrants
vest in equal increments of 180,000 on the first day of consecutive six-month
periods commencing April 19, 1996. However, to the extent that amounts borrowed
under the Agreement are paid off and the Agreement is canceled during its term,
any unvested warrants shall be void. As of December 31, 1997 and 1996, the
Company had borrowed $615,000 and $500,000, respectively, pursuant to this
Agreement. In addition, the Company has used an additional $150,000 as security
to issue a stand-by letters of credit in connection with the loan payable to the
Company's Hong Kong agent (see Note 12).

Under the terms of the stock purchase agreement for the acquisition of Janex,
the Company issued two promissory notes to two stockholders totalling
$1,000,000, payable in semi-annual installments over a three-year period (at
December 31, 1995, the amount payable was $458,760, representing the present
value of the future payments under the obligation discount at 9%, not including
imputed interest accrued but not paid). The first three payments of $166,667
each under the $1,000,000 note were made on June 30, 1994, December 31, 1994,
and June 30, 1995. On December 29, 1995, the holders of the $1,000,000 of notes
agreed to a deferral of the payment due on December 31, 1995, to June 30, 1996.
As a condition of the deferral, the Company agreed to pay the note holders
interest on the deferred payments at the rate of 9% per annum from December 31,
1995 to the date of payment. On June 28, 1996, the note holders agreed to
further extend the payment date for all remaining payments to February 1, 1998,
subject to payment of interest at the rate of 9.5% per annum, retroactive to
January 1, 1996. On August 4, 1997, the note holders agreed to further extend 
the payment date to February 1, 1999. Quarterly interest

                                       39
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

payments commenced on September 1, 1996. Further, in connection with the
extension of the notes, the Company entered into a warrant agreement with each
of the note holders, providing for the issuance of up to 282,994 warrants to one
of them and up to 167,994 warrants to the other, to acquire a total of 450,998
shares of the Company's Common Stock (restricted), exercisable at a price of
$1.45 per share through June 28, 2000, with certain "piggy-back" registration
rights. The warrants vest in a six-month increments over the term of the loan,
and if the loan is paid off early, certain of the warrants will be void. The
outstanding loan balance as of December 31, 1997 and 1996, was $500,000.

The Company charged to operations $214,292 and $180,477 of imputed interest
expense from the issuance of stock purchase warrants noted in the above two
paragraphs in the years ended December 31, 1997 and 1996, respectively.

                                       40
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 9 - NOTES PAYABLE - STOCKHOLDERS (Continued)

In addition, as part of the June 28, 1996 Agreement with the stockholders, the
payment of commissions owing one of the stockholders was extended to February 1,
1998. Furthermore, the unpaid commission balance bears interest at 9.5% per
annum beginning January 1, 1996, until paid with interest paid quarterly
beginning September 1, 1996. The outstanding commission loan balance as of
December 31, 1997 was $115,000.

NOTE 10 - ACCRUED EXPENSES

Accrued expenses consisted of the following at December 31, 1997:
 
                                             Amount
                                           ----------
 
   Allowance for returns and allowances    $  334,763
   Accrued royalties                          588,608
   Accrued commissions                         80,721
   Accrued interest                           137,341
   Other accrued expenses                     232,466
                                           ----------
                                           $1,373,899
                                           ==========

NOTE 11 - NOTE PAYABLE

On December 22, 1995, the Company borrowed $500,000 in a private unsecured loan
transaction. Under the terms of the loan agreement, payments are to be made on a
periodic basis based upon the level of certain sales. The loan accrues interest
monthly on the unpaid portion at the rate of two percent (2%) above the prime
rate.

In addition, an agreement was reached whereby an additional $340,000 was added
to the outstanding balance as of December 31, 1996. The balance of this note
payable at December 31, 1997 is $219,189.

                                       41
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 12 - LOAN PAYABLE - AGENT

Pursuant to an agency agreement dated October 23, 1995, the Company, through its
Hong Kong subsidiaries, Pro Gains and MFSI, may borrow up to $450,000 from its
Hong Kong agent for the payment of product development and tooling costs,
provided that the Company issues to the agent an irrevocable stand-by letter of
credit for $150,000. The loan is to be repaid from collections of certain
customer invoices at the rate of 5% of the invoice amount, with interest at 2%
above the Hong Kong prime rate, and any balance remaining unpaid at December 31,
1997 will be due and payable on December 15, 1998. The Agent will retain
ownership of all tooling paid for with the credit facility until the credit
facility is repaid. The credit facility is available in each year that the
agency agreement is in effect, which was for an initial term of two years. In
March 1996, the Company opened the stand-by letter of credit to the Agent. As of
December 31, 1997, the Company had borrowed $249,113 under this credit facility.

Pursuant to a supplementary agency agreement dated September 24, 1996, the
Company may borrow an additional $200,000 from its Agent provided that the
Company issues to the Agent an irrevocable stand-by letter of credit for
$100,000. Any advance under this facility is to be repaid within 60 days from
the date of advance with interest at 2% above the Hong Kong prime rate, and any
balance remaining unpaid at December 31, 1997, will be due and payable on
January 15, 1998.

In November 1996, the Company opened the stand-by letter of credit to the Agent.
As of December 31, 1997, the Company had no borrowing under this credit
facility.

NOTE 13 - INCOME TAXES

The income tax provision, all of which is current, consists of the following for
the years ended December 31, 1997 and 1996:

                                  Years ended December 31,
                                      1997        1996
 Current:                   
   Federal                          $    -     $     -
   State                             3,548       5,167
   Foreign                               -       7,318
                                    $3,548     $12,485

                                       42
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

   
   
   NOTE 13 - INCOME TAXES (Continued)
   
The Company's total deferred tax assets and liabilities and deferred tax asset
valuation allowance are comprised of the following temporary differences and
carryforwards:
 
                                                          December 31,
                                                       1997         1996
                                                    -----------  -----------
 
   Deferred tax assets:
     Provision for losses on accounts receivable    $    4,520   $   67,363
     Inventory reserve                                  34,939       19,485
     Product development costs                               -        8,660
     Inventory capitalization                            2,724       38,848
     State income taxes                                  1,223          669
     Net operating loss carryforward                 3,405,971    3,714,775
                                                    ----------   ----------
 
   Total deferred tax assets                         3,449,377    3,849,800
 
   Deferred tax liability:
 
     Accumulated depreciation and amortization        (261,790)      (6,532)
                                                    ----------   ----------
 
   Net deferred tax assets                           3,187,587    3,843,268
 
   Less: Valuation allowance                         3,187,587    3,843,268
                                                    ----------   ----------
                                                    $        -   $        -
                                                    ==========   ==========


The net deferred tax assets have a 100% valuation allowance as the Company
cannot determine if it is more likely than not that the deferred tax assets will
be realized.

                                       43
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 13 - INCOME TAXES (Continued)

The income tax provision and the applicable income taxes from the extraordinary
item differs from the amount computed by applying the U.S. Federal income tax
rate (34%) because of the effect of the following items:
<TABLE>
<CAPTION>
                                                                      December 31,
                                                                    1997        1996
                                                                 ----------  ----------
<S>                                                              <C>         <C>
   U.S. Federal statutory rate applied to pretax income          $(192,444)  $(970,004)
   Permanent differences                                             2,756       2,861
   State income taxes, net of Federal benefit                        3,548       5,167
   Tax effect of unrecognized net operating loss carryforward      189,688     967,143
   Income tax for foreign subsidiaries                                   -       7,318
                                                                 ---------   ---------
   Income tax provision                                          $   3,548   $  12,485
                                                                 =========   =========
</TABLE>

At December 31, 1997, the Company had federal and state net operating loss (NOL)
carryforwards of approximately $9,273,000 and $2,721,000, respectively. NOL
carry forwards can be used to offset future taxable income. If not used, the
federal and State NOL carryforwards will expire through 2012 and 2002,
respectively. Federal tax rules impose limitations on the use of NOL
carryforwards from a change in ownership. The loss before taxes related to the
foreign subsidiaries for the years ended December 31, 1997 and 1996 were
$883,494 and $1,098,974, respectively.

NOTE 14 - STOCKHOLDERS' EQUITY

COMMON STOCK

On August 4, 1995, the Company acquired all of the outstanding stock of Malibu
and its affiliated Hong Kong company, MFSI. Under the terms of the purchase
agreement, the Company issued 125,000 shares of restricted common stock to the
former owners of the acquired companies, and paid $50,000 at the closing. In
addition, the former shareholders of Malibu were entitled to an earn-out based
on the future performance of Malibu and MFSI. In October 1996, the Company
revised this agreement and issued the former owners of Malibu 150,000 shares of
restricted common stock in exchange for cancellation of the earn-out provisions
of the agreement. The common stock was valued at $1.00 per share, which was
management's estimate of the fair value at the time. Accordingly, $150,000 was
recorded as compensation expense.

During 1996 the Company received $64,000 from the warrant holders pursuant to
their exercising 100,000 warrants to purchase 100,000 shares of the Company's
stock.

                                       44
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 14 - STOCKHOLDERS' EQUITY (Continued)

COMMON STOCK (Continued)

During the year ended December 31, 1996, under the terms of a warrant agreement
granting Deco Disc warrants to purchase 500,000 shares of the Company's common
stock, the Company was obligated to register the stock underlying the warrants,
and to use its best efforts to maintain the registration statement effective
during the period the warrants are exercisable. Deco Disc threatened to sue the
Company, claiming that the Company did not file the registration statement on a
timely basis, and that the registration statement was not kept effective by the
Company, resulting in Deco Disc being damaged. In order to avoid any potential
litigation, on March 26, 1996, the Company and Deco Disc entered into a
Settlement Agreement and Specific Release under which the Company issued to Deco
Disc additional warrants to purchase 100,000 shares of the Company's common
stock (restricted), with certain "piggy-back" registration rights, at a price of
$.64 per share, in exchange for Deco Disc releasing the Company from any and all
prior claims relating to violations of the Warrant Agreement and failure to
update the registration statement. As a result of the foregoing transaction,
during the year ended December 31, 1996, the Company recorded a charge to
operations of $84,125 as management's estimate of the fair value of the 100,000
common stock purchase warrants.

On August 27, 1997, the Company issued 2,307,692 shares of restricted common
stock at fair market value for a total purchase price of $300,000 in a private
placement with two present and significant shareholders and creditor of the
Company.

On October 4, 1997, the Company issued 384,615 shares of restricted common stock
at fair market value for a total purchase price of $50,000 in a private
placement.

STOCK OPTIONS AND WARRANTS

The Company has used stock options and warrants in connection with compensation
to employees, certain other agreements, and private placements. Options and
warrants granted, exercised and forfeited were as follows:

                                             Weighted Average
                                  Option     Exercise Price
 
Balance at December 31, 1996    2,345,236               1.47
Granted                                 -                  -
Exercised                               -                  -
Forfeited                        (499,000)             (1.54)
Balance at December 31, 1997    1,846,236              $1.45

                                       45
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)



NOTE 14 - STOCKHOLDERS' EQUITY (Continued)

STOCK OPTIONS AND WARRANTS (Continued)

The weighted average exercise price at the date of grant for options and
warrants granted during the years ended December 31, 1997 and 1996 was $0 and
$0.41, respectively.

Options and warrants as of December 31, 1997 are as follows:

<TABLE>
<CAPTION>
                           Outstanding                                              Exercisable
                                         Weighted Average                                Weighted Average
 Price Per Share     Warrants                     Exercise Life      Warrants                     Exercise Life
                       and                              in             and                              in
                     Options     Exercise Price       Years          Options     Exercise Price       Years
<S>                <C>           <C>             <C>               <C>           <C>             <C>
 
     $0.840          270,000          $0.640            4.0          270,000          $0.640           4.0
      0.850           56,250           0.850            4.0           56,250           0.850           4.0
      1.250           25,000           1.250            3.0           12,500           0.000           0.0
      1.450        1,314,986           1.450            2.9        1,134,986           1.450           2.8
      1.500           25,000           1.500            4.0           25,000           1.500           4.0
      2.125           20,000           2.125            4.0           20,000           2.125           4.0
      3.250          135,000           3.250            5.0          135,000           3.250           5.0
Total              1,846,236          $1.450            3.4        1,653,736          $1.450           3.6
</TABLE>
 
All stock options issued to employees have an exercise price not less than the
fair market value of the Company's common stock on the date of grant, and in
accordance with accounting for such options utilizing the intrinsic value method
there is no related compensation expense recorded in the Company's financial
statements. Had compensation cost for stock-based compensation been determined
based on the fair value at the grant dates consistent with the method of SFAS
123, the Company's net loss and loss per share for the years ended December 31,
1997 and 1996 would have been reduced to the pro forma amounts presented below:
 
                             1997          1996
                         ------------  ------------
   Net loss
     As reported         $(3,174,851)  $(2,865,439)
     Pro forma           $(3,189,919)  $(2,932,579)
 
   Net loss per share
     As reported         $      (.55)  $      (.56)
     Pro forma           $      (.55)  $      (.57)

                                       46
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 14 - STOCKHOLDERS' EQUITY (Continued)

STOCK OPTIONS AND WARRANTS (CONTINUED)

The fair value of options and warrants is estimated on the date of grants
utilizing the Black-Scholes option pricing with the following weighted average
assumptions for years ended December 31, 1997 and 1996: expected life of 4.4 and
5.1 years, expected volatility of 22.5%, risk-free interest rate of 6%, and a 0%
dividend yield.

Due to the fact that the Company's options and warrants vest over several years
and additional awards are made each year, the above proforma numbers are not
indicative of the financial impact had the disclosure provisions of FASB 123
been applicable to all years of previous options and warrant grants.


NOTE 15 - COMMITMENTS AND  CONTINGENCIES

OPERATING LEASES

The Company leases its current facility under a cancelable operating lease and
maintains a noncancelable operating lease on its former facility.  The Company
and the landlord amended the lease, effective January 1, 1996, providing the
Company with additional space, and extended the expiration of the lease to
December 31, 2000.  The lease allows for its early termination anytime after
March 1997, provided that the Company enters into another lease with the
landlord in the same complex.  Effective April 1, 1997, the Company entered into
an agreement to sublease a portion of the facility to a third party for the
balance of the lease.  The Company also leases the facilities previously
occupied by Malibu under a noncancelable operating lease which expired March 31,
1998.  The Company is currently subleasing these facilities to a third party.
The monthly rental income derived from the sublease is approximately the same as
the rent expense.  At December 31, 1997, the total minimum lease rental payments
are as follows:
 
December 31,     Amount
--------------  --------
 
     1998       $108,800
     1999        101,800
     2000        101,800
                --------

                $312,400
                ========

                                       47
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 15 - COMMITMENTS AND CONTINGENCIES

OPERATING LEASES (Continued)

Net rental expense was $68,276 and $77,313 for the years ended December 31, 1997
and 1996, respectively.

ROYALTIES

At December 31, 1997, the Company has commitments for minimum guaranteed
royalties under licensing agreements as follows:

   December 31,       Amount
   ------------     ----------
                   
   1999              $393,880
   2000               144,000
                     --------
 
                     $537,880
                     ========

Total royalty expense was $651,422 and $1,002,429 for the years ended December
31, 1997 and 1996, respectively.

NOTE 16 - SEGMENT INFORMATION

The Company had sales to certain customers comprising 10% or more of total
sales.  The following table sets forth the percentage of sales of these
customers to total domestic sales and total foreign sales.
 
                     1997                 1996
                              
                United   Hong        United   Hong
                States   Kong        States   Kong
                              
Customer A        10%    45%           16%    21%
Customer B        14     14             6      1
                              
                  24%    59%           22%    22%

In 1997, customer A and customer B represented 39% and 14% of the Company's
sales. In 1996, customer A and customer B represented 21% and 22% of the
Company's sales.

                                       48
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)

 
NOTE 16 - SEGMENT INFORMATION (Continued)
 
 A summary of the Company's operations by geographical area for the years ended
December 31, 1997 and 1996 were as follows:
<TABLE> 
<CAPTION> 
                                                                  Adjustments   
                                                                       and
                                    United States    Hong Kong   Eliminations   Consolidated
<S>                                 <C>            <C>          <C>            <C>
1997:
Net sales:
 Customers                            $   856,975  $ 4,740,004   $          -    $ 5,596,979
 Intercompany                           1,844,086       22,621     (1,866,707)             -

Total revenue                         $ 2,701,061  $ 4,762,625    $(1,866,707)   $ 5,596,979

Operating loss                        $(3,767,147) $   955,147   $          -    $(2,812,000)
Interest income                                                                       21,461
Interest expense                                                                    (389,401)
Foreign exchange loss                                                                  4,887
Gain on disposal of fixed assets                                                       3,750
 
Loss before income taxes                                                          (3,171,303)
Income tax provision                                                                   3,548
 
Net loss                                                                         $(3,174,851)
 
Identified assets                     $ 7,682,811  $   676,523    $(6,815,811)   $ 1,543,523
Corporate assets                                                                     165,277
 
Total assets                                                                     $ 1,708,800
 
Total liabilities                                                                $ 3,757,926
 
1996:
Net sales:
 Customers                            $ 1,789,985  $ 5,322,936   $          -    $ 7,112,921
 Intercompany                           2,068,200      707,945     (2,776,145)             -
 
Total revenue                         $ 3,858,185  $ 6,030,881    $(2,776,145)   $ 7,112,921
 
Operating loss                        $(1,450,015) $(1,080,574)  $          -    $(2,530,589)
Interest income                                                                       38,995
Interest expense                                                                    (353,516)
Foreign exchange loss                                                                 (7,844)
 
Loss before income taxes                                                          (2,852,954)
Income tax provision                                                                  12,485
 
Net loss                                                                         $(2,865,439)
 
Identified assets                     $ 7,448,172   $1,543,550    $(4,602,980)   $ 4,388,742
Corporate assets                                                                     543,034
 
Total assets                                                                     $ 4,931,776
Total liabilities                                                                $ 4,156,051
</TABLE>

                                       49
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)


NOTE 16 - SEGMENT INFORMATION (Continued)

The Company's operations are structured to achieve consolidated objectives. As a
result, significant interdependencies and overlaps exist among the Company's
operating units. Accordingly, the net sales, operating loss and identifiable
assets shown for each geographic area may not be indicative of the amounts which
would have been reported if the operating units were independent of one another.
Intercompany sales are at cost. Operating income or loss is net sales less
related costs and operating expenses, excluding interest. Corporate assets are
those assets maintained for general purposes, principally cash, short-term
investments and administration facilities.

NOTE 17 - RELATED PARTY TRANSACTIONS

The Company pays commissions at the rate of 4% of net sales generated by a
company owned by a major stockholder, relating to customers located in New York,
New Jersey, Connecticut and Pennsylvania. Commissions on such sales of
approximately $2,450,000 and $3,025,000 amounted to $98,166 and $113,675 for the
years ended December 31, 1997 and 1996, respectively, which are included in
selling, general and administrative expenses. Accrued commissions included in
accrued expenses and accounts payable, on such sales amounted to $68,262 as of
December 31, 1997. In addition, $17,993 is included in accounts payable for
general and administrative expenses. The Company also rented showroom space from
this major stockholder for which the Company paid $26,000 during 1997. In
addition, the Company utilizes the services of a public warehouse facility in
Baltimore, Maryland that is owned by the father of the major stockholder for a
fee based on the amount of goods received and shipped. Fees amounted to $20,911
and $62,852 for the years ended December 31, 1997 and 1996.

The former father-in-law of the major stockholder has an informal oral
arrangement with the Company whereby he guarantees a $255,000 letter of credit
from the Company to one of its licensors. The letter of credit expires on
November 30, 1998. Howard Moore Associates, Inc. ("HMA"), of which the former
father-in-law of the major stockholder is the sole shareholder and President,
has a Royalty Agreement with the Company whereby HMA receives a commission of 1%
of the net revenue received by the Company from sales of products using a
certain company's trademark and certain licensed characters. Under the Royalty
Agreement, HMA was paid, or will be paid, $8,038 for the year ended December 31,
1997 and was paid $19,499 for the year ended December 31, 1996.

NOTE 18 - DISCLOSURE OF CERTAIN RISKS AND UNCERTAINTIES

COMPETITION; DEPENDENCE ON LICENSES

The Company competes with numerous other companies, most of which have
substantially greater financial and other resources than those of the Company.
The Company's success depends upon the Company's ability to continue licensing
fantasy characters for use with the Company's products. Most licensing
agreements are non-exclusive and limited in duration, with two years being
typical. Competition for licenses is intense, thus there can be no assurance
that the Company will be successful in renewing its present licenses or in
obtaining new licenses.

                                       50
<PAGE>
 
                           JANEX INTERNATIONAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                  (Continued)



NOTE 18 - DISCLOSURE OF CERTAIN RISKS AND UNCERTAINTIES (Continued)

PRODUCT OBSOLESCENCE

Because consumer preferences can change rapidly, the Company's success will
ultimately depend on its ability to successfully introduce new products. The
success of new products depends on a variety of factors including product
selection, timely and efficient completion of product design, timely and
efficient implementation of manufacturing and assembly processes and effective
sales and marketing. Because new product commitments must be made well in
advance of sales, new product decisions must anticipate future market demand.
There is no assurance that the Company will be successful in introducing new
products. The Company has and is continuing to review and conduct investigations
into new products to evaluate them for commercial viability.

SEASONALITY

The Company expects its highest level of net sales and income before taxes
during the quarter ending September 30, due to the Holiday season. If, for any
reason, the Company's sales were to be substantially below those normally
expected during such quarter, the Company's annual results would be adversely
affected.

DEPENDENCE ON FOREIGN MANUFACTURING

The Company does not have manufacturing facilities. Most of the Company's
products are manufactured by contract manufacturers in the Far East. The
Company's operations are subject to the customary risks of doing business
abroad, including insufficient Company supervision of quality control,
fluctuations in the value of currencies, tariffs, export duties, quotas,
restrictions on the transfer of funds, work stoppages and, in certain parts of
the world, political instability. To date, these factors have not had a material
adverse impact on the Company's operations, but there is no assurance that one
or more of these factors will not adversely affect the Company in the future.

DEPENDENCE ON SIGNIFICANT CUSTOMERS

The Company historically has had a concentration of significant customers.
Although the Company considers its commercial relationships with its significant
customers to be good, a loss of these customers, or a significant decrease in
purchases by these customers, could have an adverse effect on the Company's
operations. The Company does not have any long-term contracts with any of its
customers and none are expected to be signed. Long-term contracts are not
customary in the retail industry.

                                       51
<PAGE>
 
ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
      AND FINANCIAL DISCLOSURE.

                                     None

                                   PART III

ITEM 9.  DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
      COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.

The following table sets forth information regarding the Company's executive
officers and directors as of December 31, 1997:

Name                    Age                        Position
 
Leslie Friedland         44  Chairman of the Board, President, Chief Executive
                               Officer, and Director
Daniel Lesnick           45  Janex Corporation, Executive Vice President and
                               Chief Operating Officer
Lance James              50  Janex Corporation, Vice President of Sales
Michael D. Handelman     37  Janex Corporation, Vice President and Chief
                               Financial Officer
Alex Hughes, Jr.         72  Director

     LESLIE FRIEDLAND, has been President, Chief Executive Officer and a
Director of the Company since August 4, 1997. Mr. Friedland is the owner of LFA
Associates, a manufacture representative firm, which represents 18 different
lines in the mid-Atlantic region.

     DANIEL LESNICK, has been Executive Vice President and Chief Operating
Officer, since August 4, 1997. Mr. Lesnick has been a Director of the Company
since August 29, 1997.  Prior to that time, Mr. Lesnick had been Executive Vice
President of Janex Corporation, a wholly owned subsidiary of Janex
International, Inc., from October 6, 1993 to January 31, 1997, at which time he
left the Company. From August 1988 to October 5, 1993, Mr. Lesnick was Vice
President and co-owner of MJL Marketing Inc. (now Janex). He was Director of
Sales and Marketing for Sunk Yong Company, a Korean corporation operating in a
number of different industries, from February 1986 to July 1988. Previously Mr.
Lesnick held positions as Merchandising Manager with Spencer Gifts and as a
Senior Buyer with Lionel Leisure, both specialty retailers. Mr. Lesnick holds an
associate degree in marketing.

     LANCE JAMES, has been Vice President of Sales of Janex since September 22,
1997.  From August 1995 to September 1997, Mr. James was National Sales Manager
of SRM Company, which is a New Jersey toy manufacturer. From July 1997 to August
1995, he was Vice Present of Sales of Kids of America.

     MICHAEL D. HANDELMAN, has been Vice President, Chief Financial Officer of
Janex since August 1996. From October 1993 to December 1995, Mr. Handelman was
Vice President, Chief Financial Officer of LAK Acquisition Corp which owned the
Los Angeles Kings hockey franchise. From April 1988 to October 1993 he was a
senior manager for the public accounting firm of Amsterdam & Dressler, CPA's.
Prior to that, Mr. Handelman spent 9 years with various public accounting firms.

                                       52
<PAGE>
 
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT

     Section 16(a) of the Securities Exchange Act of 1934 requires the Company's
executive officers, directors and persons who beneficially own more than 10% of
the Company's Common Stock to file initial reports of ownership and reports of
changes in ownership with the Securities and Exchange Commission ("SEC"). Such
persons are required by SEC regulations to furnish the Company with copies of
all Section 16(a) forms filed by such persons.

     Based solely on the Company's review of forms furnished to the Company, the
Company believes that all filing requirements applicable to the Company's
executive officers, directors, and more than 10% shareholders were complied
with, except that an Initial Statement of Beneficial Ownership of Securities for
Howard W. Moore, a more than 10% shareholder, was not timely filed when Mr.
Moore's beneficial ownership exceed 10% in May 1996. The filing was made on
January 27, 1997. Mr. Moore advised the Company that the failure to timely file
was inadvertent.


ITEM 10.  EXECUTIVE COMPENSATION.

COMPENSATION OF DIRECTORS

     Directors who are not employees of the Company receive $500 for each
directors meeting attended, and may be granted options to purchase stock in the
Company at the discretion of the Board. No fees for serving as directors of the
Company are payable to employees of the Company. Directors are reimbursed for
reasonable out-of-pocket expenses incurred in performing their functions as
directors of the Company.

                                       53
<PAGE>
 
COMPENSATION OF OFFICERS AND KEY EMPLOYEES

     The following table sets forth the compensation paid or to be paid by the
Company with respect to the fiscal year ended December 31, 1997, to the
executive officers whose total annual salary and bonus exceeded $100,000 /(1)/:

<TABLE>
<CAPTION>
 
                                     ANNUAL COMPENSATION/(1)/        LONG TERM
                                                                   COMPENSATION
 
NAME & PRINCIPAL            YEAR   SALARY   BONUS      OTHER          AWARDS
 POSITION                                           ANNUAL COM-      OPTIONS
                                                   PENSATION/(2)/    (SHARES)
<S>                         <C>   <C>       <C>    <C>             <C>
 
Sheldon F. Morick           1997  $131,575  $  -      $ 7,709        $      -
Chairman of the Board,      1996   228,250     -        7,709               -
Chief Executive Officer,    1995   241,250     -       13,017         100,000/(3)/
 President and Director
Michael D. Handelman        1997  $112,199  $  -      $ 7,149        $      -
Chief Financial Officer     1996    57,500     -        3,025          25,000
 and Vice President
</TABLE>


/(1)/ Compensation under Company employee benefit plans, to which all employees
      of the Company are eligible, is not included in the table.
/(2)/ Includes car allowances, Company paid vehicles and Company paid
      health/life/disability insurance.
/(3)/ These options were not issued under the Company's 1991 Non-Statutory Stock
      Option Plan ("Plan") as that Plan was terminated on June 8, 1994.  These
      options have expired.
/(4)/ Resigned as Officer and Director on August 4, 1997.


The following table provides certain information concerning grants of options to
purchase the Company's Common Stock made during the fiscal year ended December
31, 1997, to persons named in the Summary Compensation Table:


<TABLE>
<CAPTION>
 
                                 Option Grants in Last Fiscal Year
                                 Individual Grants in Fiscal 1997
 
        Name               Number of         % of Total Options     Exercise or     Expiration Date
                           Securities           Granted to              Base
                      Underlying Options       Employees in Fiscal Price ($/sh)
                          Granted (1)              Year
<S>                   <C>                   <C>                   <C>               <C>
 
Sheldon Morick CEO           -0-                   -0-                    -
Michael Handelman            -0-                   -0-                    -
</TABLE>

The following table provides certain information concerning each exercise of
stock options during the fiscal year ended December 31, 1997, and the value of
unexercised options at December 31, 1997, to persons named in the Summary
Compensation Table:

                                       54
<PAGE>
 
<TABLE>
<CAPTION>
 
                             Aggregated Option Exercises in Last Fiscal Year
                                    and Fiscal Year End Option Values
 
Name                       Shares       Value Realized   Number of Securities     Value of Unexercisable
                          Acquired                       Underlying Unexercised   In-the-Money Options at
                        on Exercise                       Options at FY-End              FY-End

                                                                                       Exercisable/
                                                           Exercisable/Total          Unexercisable
<S>                    <C>              <C>             <C>                      <C>
Sheldon Morick, CEO           -               -                      0/0                        $-/-
Michael Handelman             -               -            12,500/25,000                        $-/-
</TABLE>

EMPLOYMENT ARRANGEMENTS
 
   The Board of Directors and Leslie Friedland have agreed that Mr. Friedland
will not be compensated for his services for the period August 4, 1997 to
December 31, 1998.

   The Board of Directors has provided for compensation for Daniel Lesnick,
Executive Vice President of Janex, commencing January 1, 1998, at a salary of
$8,667 per month plus $552 per month of taxable benefits (a total of $110,624 on
an annualized basis), beginning January 1, 1998. For the period from August 4,
1997 through December 31, 1997, the Board of Directors and Mr. Lesnick agreed
that Mr. Lesnick would not be compensated for his services.

   The Board of Directors has provided for compensation for Lance James, Vice
President of Sales of Janex, at a salary of $6,250 per month plus $952 per month
of taxable benefits (a total of $86,424 on an annualized basis). Mr. James'
employment commenced on September 22, 1997.

   The Board of Directors has provided for compensation for Michael D.
Handelman, Chief Financial Officer, at a salary of $8,625 per month.

   In August 1995, the Company established a 401K Profit Sharing Plan ("401K")
for the benefit of the employees of the Company. Under the provisions of the
401K, employees may make contributions on a tax deferred basis to their 401K
account, up to the legal limits provided for by United States income tax
regulations. The Company, at its discretion, may contribute a portion of the
Company's profits to the 401K. Such contributions are allocated between members
of the 401K based on a pre-stated formula. Employer contributions vest with 401K
participants at the rate of 20% per year, beginning in year two and ending in
year six of employment. For the year ended December 31, 1997, the Company did
not make a contribution to the 401K.

   The Company has a health insurance plan, which covers all employees in a non-
discriminatory manner. With the exception of the health insurance plan and the
401K, the Company has no insurance or medical reimbursement plans covering its
officers or directors, nor do they contemplate implementing any such plans at
this time.

                                       55
<PAGE>
 
ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

   The following table sets forth information, as of March 31, 1998, with
respect to the beneficial ownership of the Company's Common Stock by each person
known by the Company to be the beneficial owner of more than five percent of the
outstanding Common Stock, by each of the Company's directors, and by the
officers and directors of the Company as a group:
<TABLE>
<CAPTION>
 
                                                     Shares Owned       Percent
Beneficial Owners(1)                                 Beneficially    of Class (11)
--------------------                                ---------------  -------------
<S>                                                 <C>              <C>
 
Security ownership of certain beneficial owners:
 
Howard W. Moore                                       4,919,046 (4)          42.3%
2056 Bobtail Circle
Henderson, NV 89012
 
Security ownership of management:
 
Leslie Friedland                                        909,994 (2)           7.8%
615 Hope Road
Bldg 1, First Floor
Eatontown, NJ  07724
 
Daniel Lesnick                                          659,994 (5)           5.9%
615 Hope Road
Bldg 1, First Floor
Eatontown, N.J. 07724
 
All officers and directors
 as a group (two persons)                             1,569,988 (6)          13.7
</TABLE>

(1) Unless otherwise indicated in the footnotes, and subject to community
    property laws where applicable, each of the security holders has sole voting
    and investment power with respect to the shares beneficially owned.
(2) Includes 282,994 shares issuable upon exercise of warrants granted to Mr.
    Friedland under the Friedland Warrant Agreement, which warrants are 
    presently exercisable. See "Certain Relationships and Related Transactions."
(3) Includes 270,000 shares issuable upon exercise of warrants, all of which are
    presently exercisable.
(4) Includes shares owned by H&M Moore Investment Group, Inc., Howard Moore
    Associates, Inc., and Howard Moore as Trustee of the Howard Moore
    Associates, Inc. Retirement Trust.Includes 135,000 warrants currently
    exercisable at $3.25 per share. Includes 720,000 shares issuable upon
    exercise of warrants granted to the Moore Trust in connection with the Moore
    Revolving Loan, which are presently exercisable. See "Certain Relationships
    and Related Transactions."
(5) Executive Vice President - Janex. Former owner of Janex, stock issued in
    partial payment of Janex purchase price. Includes 131,994 shares issuable
    upon exercise of warrants granted to Mr. Lesnick under the Lesnick Warrant
    Agreement,which warrants are presently exercisable.See "Certain
    Relationships and Related Transactions."
(6) Includes 414,988 shares issuable pursuant to warrants which are presently
    exercisable.
(7) Based upon 9,962,105 shares of Common Stock issued and outstanding on March
    31, 1998.

     The Company is not aware of any contract or other arrangement, including a
pledge of the Company's securities, that could result in a change in the control
of the Company.The Company is not aware of any voting trusts.

                                       56
<PAGE>
 
ITEM 12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

     The Company has engaged the services of a manufacturers representative
firm, Les Friedland Associates ("LFA"), to represent the Company to customers
located in the states of New York, New Jersey, Connecticut and Pennsylvania. LFA
represents the Company to three of its largest customers, Toys R Us, Wal-Mart
and Kmart. The principal owner and operator of LFA, Mr. Leslie Friedland, is one
of the former owners of Janex, and currently owns 627,000 shares of the
Company's stock. See "Security Ownership of Certain Beneficial Owners and
Management." Under the terms of the representative agreement ("LFA Agreement"),
LFA was to be paid a commission of 4.25% on all sales that it generates within
its territory. Effective April 1, 1995, LFA and the Company agreed to reduce the
commission rate under the LFA Agreement to 4%. The terms and conditions of the
representative agreement are standard in the industry, and the agreement is
cancelable at any time with 30 days notice. Pursuant to the LFA Agreement, LFA
was paid, or will be paid, $98,166 for the year ended December 31, 1997 and was
paid, or will be paid, $113,675 for the year ended December 31, 1996. Further,
the Company rented showroom space from LFA during a major industry trade shows
in 1997, for which the Company paid $26,000. The rate charged by LFA for the
showroom rental is competitive with other showroom space rental rates during the
show period.

     On June 28, 1996, the Company and Leslie Friedland entered into an
agreement whereby the due date on the Company's note held by Mr. Friedland was
extended to February 1, 1998. Additionally the Company owed Mr. Friedland
$115,000 for commissions as of December 31, 1995, which Mr. Friedland also
extended to December 31, 1997.See "Certain Relationships and Related
Transactions."In connection with such extension agreement, the Company granted
warrants to Mr. Friedland to acquire up to 282,994 shares of the Company's
Common Stock (restricted), with certain "piggy-back" registration rights.These
warrants have an exercise price of $1.45 and expire on June 28, 2000.The
warrants vest in six-month increments over the term of the loan, commencing on
June 28, 1996. All of the warrants are now vested and exercisable.

     On June 28, 1996, the Company and Daniel Lesnick, Executive Vice President
of Janex, entered into an agreement whereby the due date on Company's note held
by Mr. Lesnick was extended to February 1, 1998.See "Certain Relationships and
Related Transactions."In connection with such extension agreement, the Company
granted warrants to Mr. Lesnick to acquire up to 131,994 shares of the Company's
Common Stock (restricted), with certain "piggy-back" registration rights.These
warrants have an exercise price of $1.45 and expire on June 28, 2000.The
warrants vest in 6-month increments over the term of the loan, commencing on
June 28, 1996. All of the warrants are now vested and exercisable.

     The Company utilizes the services of a public warehouse facility, Hollins
Distributors, in Baltimore, Maryland. The warehouse facility charges the Company
a fee based on the amount of goods received, and the amount of goods shipped.
The rates charged by Hollins Distributors are competitive with those of other
public warehouses, and the relationship can be terminated annually upon 60 days
written notification. Hollins Distributors is owned by Mr. Howard Friedland, the
father of Mr. Leslie Friedland. Hollins Distributors was paid, or will be paid,
$20,911 for the year ended December 31, 1997 and was paid $62,652 for the year
ended December 31, 1996.

                                       57
<PAGE>
 
     Howard W. Moore, was formerly the father-in-law of Mr. Leslie Friedland.
Mr. Moore has an informal oral arrangement with Janex whereby Mr. Moore
guarantees a $255,000 letter of credit from Janex to one of its licensors. The
letter of credit expires on November 30, 1998. There is no provision requiring
Mr. Moore to continue his guarantee beyond the expiration date.Howard Moore
Associates, Inc. ("HMA"), of which Mr. Moore is the sole shareholder and
President, has a Royalty Agreement with Janex whereby HMA receives a commission
of 1% of the net revenue received by Janex from sales of products using a
certain company's trademark and certain licensed characters. Under the Royalty
Agreement, HMA was paid, or will be paid, $8,038 for the year ended December 31,
1997 and was paid, or will be paid, $19,499 for the year ended December 31,
1996.

     Mr. Moore is also the Trustee of the Howard Moore Associates, Inc.
Retirement Trust ("Trust") and is the President and sole shareholder of H&M
Moore Investment Group, Inc. ("H&M"). Mr. Moore may be deemed to be the
beneficial owner of all the shares of Common Stock and warrants, owned by HMA,
the Trust and H&M. On or about May 17, 1994, the Company raised $494,100 in a
private placement. In connection with the private placement, the Company offered
units ("Units") consisting of one share of Common Stock and a warrant to acquire
one share of Common Stock for every two Units purchased. Consequently, the
following shares of Common Stock and warrants were issued:
 
Purchaser                                             Common Stock  Warrants
---------                                             ------------  --------
 
H&M Moore Investment Group, Inc.                           206,600   103,300
Howard Moore, as Trustee of the Howard
  Moore Associates, Inc. Retirement Trust                   63,400    31,700

     The Units were sold at a purchase price of $1.83 each, which was the
average of the closing bid and ask prices for the shares of Common Stock as
quoted on NASDAQ for the ten trading days prior to the date of the sale. The
warrants have an exercise price of $3.25 per share and expire on May 17, 2000.

     HMA, in connection with consulting services previously rendered to the
Company, was previously granted options to acquire 115,000 shares of the
Company's Common Stock. 75,000 options were granted at an exercise price of
$1.00, and 40,000 options were granted at an exercise price of $1.50. On or
about May 17, 1994, HMA exercised the options and acquired 115,000 shares of
Common Stock, for gross proceeds to the Company of $135,000.

     On April 19, 1996, the Company entered into a Revolving Loan Agreement
("Revolving Loan Agreement") with the Moore Trust.See "Certain Relationships and
Related Transactions."Under the terms of the Revolving Loan Agreement, the Moore
Trust agreed to loan to the Company, on a revolving basis, up to $900,000, at 9-
1/2% per annum on the outstanding balance, during the period April 19, 1996
through September 19, 1998.The loan is secured by all of the assets of Janex
(subject to the prior lien of the Company's bank lender) and is guaranteed by
Janex International.In connection with the loan, the Company entered into a
Warrant Agreement with the Lender, providing for the issuance of up to 900,000
warrants to acquire 900,000 shares of the Janex International Common Stock
(restricted), with certain "piggy-back" registration rights.These warrants have
an exercise price of $1.45 and expire on April 19, 2000. The warrants vest in 6-
month increments over the term of the loan, commencing on April 19, 1996. All of
the warrants are now vested and exercisable.

                                       58
<PAGE>
 
     Michael Moore is the son of Howard Moore. On March 29, 1995, the Company
entered into a license agreement with Michael Moore under which the Company
licensed two product concepts which have since been incorporated into the
Company's product line. The Company is obligated under the agreement to pay a
royalty of 3% of the gross sales of products incorporating these concepts. The
Company can terminate the agreement at any time with 60 days notice, otherwise
the agreement will terminate at such time as the Company ceases to sell and
market products incorporating the concepts for a period of twelve months. Under
the agreement, Michael Moore was paid royalties of $445 for the year ended
December 31, 1996, and was paid, or will be paid, royalties of $0 for the year
ended December 31, 1997.

                                       59
<PAGE>
 
                                    PART IV


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

   (a) Exhibits. The following exhibits have been or are being filed herewith,
       --------                                                               
and are numbered in accordance with Item 601 of Regulation S-B:

<TABLE> 
<CAPTION>
Exhibit  
Number   Description
-------  -----------
         
<C>      <S>
    2.1  Agreement of Purchase and Sale of Stock by and among With Design in Mind
         International, Inc., Leslie Friedland, and Daniel Lesnick, dated October 6,
         1993, relating to the acquisition of MJL Marketing Inc., a New Jersey
         corporation. (11)
    2.2  Agreement of Purchase and Sale of Stock by and among Janex International,
         Inc., Malibu Fun Stuffed, Malibu Fun Stuffed International Limited, Terence
         Davis and Marie Boule (18)
    3.1  Articles of Incorporation. (1)
    3.2  Amendment No. 1 to Articles of Incorporation. (3)
    3.3  Statement of Resolution Establishing Series for Shares. (3)
    3.4  Amendment No. 2 to Articles of Incorporation. (3)
    3.5  Bylaws of the Company. (2)
    3.6  Articles of Amendment to Articles of Incorporation, dated August 11, 1994
         and filed on August 16, 1994. (15)
    4.1  Specimen Common Stock Certificate. (3)
    4.2  Specimen Warrant Certificate. (6)
    4.3  Form of Warrant Agreement. (6)
    4.4  1991 Non-Statutory Stock Option Plan. (5)
    4.5  Amendment No. 1 dated January 15, 1993, to 1991 Non-Statutory Stock
         Option Plan. (10)
    4.6  Amendment No. 2 dated September 13, 1993, to 1991 Non-Statutory Stock
         Option Plan. (10)
    4.7  Warrant Agreement dated May 17, 1994, by and between the Company and
         Howard Moore, Trustee of the Howard Moore Associates, Inc. Retirement
         Trust, dated December 30, 1990. (13)
    4.8  Warrant Agreement dated May 17, 1994, by and between the Company and
         H&M Moore Investment Group, Inc. (13)
    4.9  Settlement Warrant Agreement dated March 26, 1996, by and between the
         Company and Deco Disc Industries, Inc. (19)
   4.10  Warrant Agreement dated April 19, 1996, by and between the Company and
         the Moore Trust. (21)
   4.11  Warrant Agreement dated June 29, 1996, by and between the Company and
         Leslie Friedland. (21)
</TABLE> 

                                       60
<PAGE>
 
<TABLE> 
<S>      <C>
   4.12  Warrant Agreement dated June 28, 1996, by and between the Company and
         Daniel Lesnick. (21)
    5    Opinion of Tilles, Webb, Kulla & Grant, a Law Corporation, as to the
         legality of the securities being registered. (16)
   10.1  Lease Agreement between With Design in Mind International, Inc., a
         Colorado corporation and Warner Center Business Park Properties III, L.P.
         for premises located at 21700 Oxnard Street, Suite 1610, Woodland Hills, CA
         91367 dated January 6, 1994. (10)
   10.2  Employment Contract with Sheldon F. Morick, dated February 26, 1993. (10)
   10.3  Employment Contract with Daniel Lesnick, dated October 6, 1993. (10)
   10.4  Stock Option Agreement with Sheldon F. Morick, dated June 30, 1002.  (10)
   10.5  Stock Option Agreement with Sheldon F. Morick. dated February 26, 1993.
         (10)
   10.6  Stock Option Agreement with Sheldon F. Morick, dated November 17, 1993.
         (10)
   10.7  Stock Option Agreement with Michael S. Manahan, dated June 30, 1992. (10)
   10.8  Stock Option Agreement with Michael S. Manahan, dated November 17,
         1993. (10)
   10.9  Stock Option Agreement with Renee White Fraser, dated June 25, 1993. (10)
  10.10  Stock Option Agreement with Renee White Fraser, dated November 17, 1993.
         (10)
  10.11  Stock Purchase Agreement dated May 17, 1994, by and between the Company
         and Howard Moore, Trustee of the Howard Moore Association, Inc.
         Retirement Trust, dated December 30, 1990 (13)
  10.12  Stock Purchase Agreement dated May 17, 1994, by and between the Company
         and H&M Moore Investment Group, Inc. (13)
  10.13  Settlement Agreement dated October 17, 1994, by and between the Company
         and Dentsu Prox Inc. (14)
  10.14  Stock Option Agreement with Sheldon F. Morick dated April 3, 1995. (17)
  10.15  Stock Option Agreement with Daniel Lesnick dated April 3, 1995. (17)
  10.16  Stock Option Agreement with Michael S. Manahan dated April 3, 1995. (17)
  10.17  Stock Option Agreement with Renee W. Fraser dated April 3, 1995. (17)
  10.18  Employment Contract with Terence Davis, dated August 4, 1995. (19)
  10.19  Settlement Agreement and Specific Release by and between the Company,
         Deco Disc Industries, Inc., and its shareholders, Donald Spector, Michael
         Deutch, Barbara Carver and James McGraw dated March 26, 1996. (19)
  10.20  Employment Agreement, dated April 15, 1996, by and between the Company
         and Lawrence Bernstein. (21)
  10.21  Stock Option Agreement with Lawrence Bernstein, April 15, 1996. (21)
  10.22  Extension Agreement, dated June 28, 1996, by and between the Company and
         Leslie Friedland. (21)
  10.23  Extension Agreement, dated June 28, 1996, by and between the Company and
         Daniel Lesnick. (21)
</TABLE> 

                                       61
<PAGE>
 
<TABLE> 
<S>      <C>
  10.24  Inter-Creditor Agreement, dated June 28, 1996, by and between the
         Company, Leslie Friedland, Daniel Lesnick and the Moore Trust. (21)
  10.25  Modification Agreement, dated June 29, 1996, by and between the Company,
         Terence F. Davis and Marie Boule. (21)
   16    Letter to Securities and Exchange Commission from Kellogg & Andelson,
         dated October 31, 1995. (8)
   21    Subsidiaries of the registrant:
         1)  With Design in Mind, a California corporation, a wholly-owned
         subsidiary
         2)  Janex Corporation, a New Jersey corporation, a wholly-owned subsidiary
         3)  Pro Gain Company Limited, a Hong Kong corporation, a wholly-owned
         subsidiary
         4)  Malibu Fun Stuffed, Inc., a California corporation, a wholly-owned
         subsidiary
         5)  Malibu Fun Stuffed International Limited, a Hong Kong corporation, a
         wholly-owned subsidiary
</TABLE>
______________________________
(1)  Incorporated by reference to Exhibit 3(a) to the Company's Registration
     Statement on Form 8-A, filed with the Commission on August 15, 1989 and
     declared effective on September 1, 1989.
(2)  Incorporated by reference to Exhibit 3(b) to the Company's Registration
     Statement on Form 8-A, filed with the Commission on August 15, 1989 and
     declared effective on September 1, 1989.
(3)  Filed on August 8, 1990 as an exhibit to the Company's Registration
     Statement on Form S-1.
(4)  Filed as exhibit to the Company's Form 10-Q for the quarter ended December
     31, 1990.
(5)  Filed on March 20, 1991 as an exhibit to Amendment No. 1 to the Company's
     Registration Statement on Form S-1.
(6)  Filed on May 7, 1991 as an exhibit to Amendment No. 2 to the Company's
     Registration Statement on Form S-1.
(7)  Filed as an exhibit to the Company's Form 10-K for the fiscal year ended
     September 30, 1991.
(8)  Filed as an exhibit to the Company's Form 10-KSB for the fiscal year ended
     September 30, 1992.
(9)  Filed as an exhibit to the Company's Form 8-K dated September 3, 1992.
(10) Filed as an exhibit to the Company's Form 10-KSB for the fiscal year ended
     December 31, 1993.
(11) Filed as an exhibit to the Company's Form 8-K dated October 6, 1993.
(12) Filed as an exhibit to the Company's Form 8-K dated January 4, 1994.
(13) Filed as an exhibit to the Company's Form 8-K dated May 17, 1994.
(14) Filed as an exhibit to the Company's Form 8-K dated October 14, 1994.
(15) Filed on December 20, 1994 as an exhibit to the Company's Registration
     Statement.
(16) Filed on February 9, 1995 as an exhibit to Pre-Effective Amendment No. 1 to
     the Company's Registration Statement.
(17) Filed as an exhibit to the Company's Form 8-K dated April 3, 1995.
(18) Filed as an exhibit to the Company's Form 8-K dated August 4, 1995.
(19) Filed as an exhibit to the Company's Form 10-KSB, for the fiscal year ended
     December 31, 1995.
(20) Filed as an exhibit to the Company's Form 8-K/A dated October 5, 1995.
(21) Filed as an exhibit to Post-Effective Amendment No. 1 to the Company's
     Registration Statement dated August 9, 1996.

     b)  Reports on form 8-K. There were no reports filed on form 8-K during the
         --------------------                                                   
         last quarter of the fiscal year.

                                       62
<PAGE>
 
                                   SIGNATURES

     In accordance with Section 13 or 15(d) of the Securities Act of 1934, the
registrant has caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

Dated: April 15, 1998
                              JANEX INTERNATIONAL, INC.


                                  By:  /s/ Leslie Friedland
                                       ----------------------------------------
                                       Leslie Friedland, Chairman of the Board,
                                       President and Chief Executive Officer

     In accordance with the Securities Exchange Act of 1934, this report has
been signed by the following persons on behalf of the registrant in the
capacities and on the dates indicated.



Signatures                      Title                                   Date
----------                      -----                                   ----

/s/ Leslie Friedland            Chairman of the Board, President  April 15, 1998
----------------------          Chief Executive Officer and             
Leslie Friedland                Director                    
                                                             



/s/ Michael Handelman           Vice President,                   April 15, 1998
-----------------------         Chief Financial Officer 
Michael Handelman                                       



/s/ Daniel Lesnick              Executive Vice President          April 15, 1998
------------------              Chief Operating Officer
Daniel Lesnick                  and Director           
                                           

                                       63