<PAGE>

                        LAZARE KAPLAN INTERNATIONAL INC.

                                      2005
                                  ANNUAL REPORT


                                        1




<PAGE>

               Lazare Kaplan International Inc. 2005 Annual Report

Lazare Kaplan International Inc. is engaged in the cutting and polishing of
ideal cut diamonds, which it laser inscribes and distributes to quality retail
jewelers internationally under the brand name "Lazare Diamonds'r'" Diamonds,
whatever their size, which are cut and polished by Lazare Kaplan craftsmen, are
finished to precise proportions, bringing out all of the diamond's natural
brilliance, sparkle and fire. In addition, Lazare Kaplan also cuts and polishes
fine make (non-ideal) commercial diamonds and high pressure, high temperature
(HPHT) processed diamonds sold under the Bellataire'r' diamonds brand name.
These stones are sold through wholesalers and distributors and, to a growing
extent, through retail jewelers. Lazare Kaplan is also engaged in the buying and
selling of uncut rough diamonds.

                             American Stock Exchange
       The Company's common stock is traded on the American Stock Exchange
                          under the ticker symbol LKI.

                                    Form 10-K

Upon written request, a copy of the Company's Form 10-K Annual Report without
exhibits for the year ended May 31, 2005 as filed with the Securities and
Exchange Commission, will be made available to stockholders without charge.
Requests should be directed to the Controller, Mr. Ned Cochrane, Lazare Kaplan
International Inc., 19 West 44th Street, New York, New York 10036.

                                 Annual Meeting
                                November 10, 2005
                                     10 A.M.
                                  Sofitel Hotel
                               45 West 44th Street
                          Second floor, Trocadero Room
                            New York, New York 10036

                 Market Prices of Common Stock by Fiscal Quarter

<TABLE>
<CAPTION>
              Fiscal 2005
            --------------
             High     Low
            ------   -----
<S>         <C>      <C>
First ...   $ 8.89   $7.25
Second ..    10.40    6.95
Third ...    10.98    8.85
Fourth ..    12.55    7.51
</TABLE>

<TABLE>
<CAPTION>
              Fiscal 2004
            -------------
            High     Low
            -----   -----
<S>         <C>     <C>
First ...   $7.05   $5.60
Second ..    7.35    6.34
Third ...    7.50    6.55
Fourth ..    9.19    7.00
</TABLE>

As of July 31, 2005 there were 1,730 stockholders of record of the 8,395,306
issued and outstanding shares of the common stock of the Company, including CEDE
& Co. and other institutional holders who held an aggregate of 3,360,836 shares
of common stock as nominees for an undisclosed number of beneficial holders.


                                        2




<PAGE>


To Our Shareholders:

         Continued expansion of the U.S. economy in general, and the willingness
of the American consumer to spend discretionary resources on luxury items in
particular, resulted in another good year for the diamond and jewelry industry.
Demand for diamonds was also driven by growing markets in China, India and other
countries in the Far East. The fiscal year ended May 31, 2005 also saw strong
demand for rough diamonds with noticeable shortages and ensuing price pressures
in many categories and sizes. Although rough prices ran ahead of polished prices
for a great part of the year, polished prices gradually rose in the face of
steady demand and increased rough costs. As the raw material cost is an
important and oftentimes the major component of polished diamond prices, the
industry and the Company, had to be particularly vigilant defending
manufacturing margins. The Company successfully overcame the challenge of
ongoing margin pressure.

         Total Company revenue in fiscal 2005 was $421.4 million, compared to
$235.8 million in 2004. Net profit was $5.2 million, compared to $2.4 million in
2004.

         The transformation of the diamond industry continued to fare well in
the past year in light of the demand generated by a sustained global GDP growth.
However, it is important to note that the new dispensation that increasingly
depends on how the unpredictable, yet unavoidable, cyclical swings in supply and
demand impact diamond pricing has so far remained untested. That test will take
place sometime in the future and at a time that cannot be foreseen. The high and
increasing level of bank and trade financing of both the polished and rough
pipelines is, and will remain, an area for concern. For those of us who believe
that price volatility is part of economic life in free markets, excessive and
sometimes imprudent leveraging and resulting liquidity events accentuate the
magnitude of corrective swings. This concern is particularly applicable to
diamond pricing, as it does not lend itself to risk attenuation through the use
of financial instruments. Anyone who holds diamond inventory has a long
position. In order to manage this industry-related risk, the Company is always
attentive to its balance sheet, the amount and terms of its borrowings, its
ability to respond quickly to changing conditions, and its business decisions by
an ongoing risk/reward review. As part of this strategy, the Company seeks
market and sourcing diversification, it tries to align its long-term interests
with those of its customers and suppliers and, whenever possible, it seeks to
establish strategic relationships that can adjust to the increasing degree of
price volatility that is now part of the diamond industry.

         In June 2005, the Company was advised by the Diamond Trading Company
(DTC), an important rough diamond supplier to the Company, that its status as a
sightholder under the DTC Supplier of Choice (SOC) program has been renewed for
the next two and a half years. The Company's longstanding commitments to
effective global downstream marketing, branding, quality service, a strong
balance sheet, best practices and transparency, once again assured it a high
ranking under SOC criteria.

         The Company's operations in Angola are making good progress. Under the
2004 multi-year Technical Assistance Contract with SODIAM, the Angolan
Government parastatal legally responsible for marketing rough diamonds produced
in Angola, nine rough diamond purchasing stations have been opened and staffed.
With the infrastructure now in place and operational and with the effective
cooperation of SODIAM, the level of purchases has been ramping up. The diamonds
are sold in Antwerp, Belgium, in a joint SODIAM-LKI marketing office, where
SODIAM employees and trainees work side by side with LKI technicians and experts
to optimize the economic performance of the operation. As the Angolan Government
has now rightly focused attention on steps to improve the social and economic
well being of its citizens, the Company has signed a three-year agreement with
USAID to provide human and material resources jointly to implement social
responsibility projects in the diamond producing area of Lunda Norte. Additional
donors have indicated an interest in participating, as have the Angolan national
and provincial authorities. Projects under the agreement will be designed in
consultation with the local population to address its needs and priorities, and
will be implemented in an effective, hands-on fashion, to assure that the local
population derives the maximum benefits from this exemplary public/private
development

                                       3




<PAGE>


project. The Company is proud to have provided the leadership for this
humanitarian, as well as enlightened self-interest initiative.

         Russia, the world's second largest diamond producer, is approaching
another political cycle, and events in that country should increasingly be
viewed through this lens as well as the usual economic risk/reward criteria that
business must exercise. The Company remains confident that the historic and
unique transformation of that great nation will continue apace to ensure the
well-being of the Russian people, as well as Russia's position as an important
and reliable participant in our increasingly interdependent world. The Company's
contractually anchored Cooperation Agreements with AK Alrosa, Russia's
world-class diamond mining company, are now in their ninth year of profitable
operations, having weathered several up and down cycles in the diamond business,
provided a global platform for marketing downstream Russian diamonds produced
and polished in Russia, and the underlying deal structure for the first non-oil
financing under the General Project Incentive Agreement (PIA) between the U.S.
Government and the Ministry of Finance and the Central Bank of the Russian
Federation.

         The Company has strengthened and expanded its rough trading and
marketing capabilities, as reflected in the higher rough diamond component of
its total revenues. Rough diamond sourcing and trading will continue to be a
growing profit center for the Company, as well as a regulating mechanism for
flexibility in its decision on what diamonds to cut and polish. This is an
important tool to meet economic thresholds at a time when polished diamonds are
under margin pressure due to market effervescence in rough diamond pricing.
Rough diamond trading is a high velocity, lower margin segment, and the Company
has focused on securing the sourcing, assembling the technical skills, and
obtaining the financing liquidity to remain an increasingly important
participant.

     The Company is growing its market share for polished diamonds - its core
business - by pursuing a vigorous, multi-pronged approach:

o        Careful attention to the needs and cultivation of our traditional
         customer base -- the well-established fine jewelers with quality
         orientation and a leadership position in the community -- remains the
         Company's first priority. To address this, the Company has strengthened
         its in-house and road sales and marketing force by promotion, addition
         and result-oriented motivation. It will continue to vigorously pursue
         the implementation of increased market share goals.

o        The Company's product offering has been broadened by the addition of
         generic ideal cut, squares, cushions and finely cut commercial stones,
         as well as large stones, to its flagship product - The Lazare Diamond,
         The World's Most Beautiful Diamond'r'.

o        Our enhanced ability to meet our customers' broader band of diamond
         needs, the refocusing of our sales approach to work with our loyal
         customers to enhance their competitive position and profitability, is
         transforming our relationship with important customers from that of a
         vendor to a deeper, more interdependent one based on "reciprocity."
         This strengthens the degree of mutual reliance and permits forward
         looking planning to benefit both sides.

o        The Company has a global scope and will continue to expand its position
         in markets outside of the U.S. Several steps have been taken to
         strengthen market position in China, the Far East, Europe and Latin
         America -- all areas where the Company is achieving considerable sales
         growth. The Company remains alert to new opportunities in established
         markets as well as new markets for diamonds as they develop and grow.

o        The Company continues to deploy resources -- both human and material --
         in national and local advertising and marketing initiatives, public
         relations events, in-house and customer staff training, and cooperative
         marketing and advertising programs with our customers. The Company has
         successfully increased its participation in several U.S. and
         International trade

                                     4




<PAGE>


         fairs and continues to take steps to raise its trade and consumer
         visibility.

o        The important, long-stagnant Japanese diamond market is rebounding -- a
         market in which the Company holds a recognized position established
         over many years. Using this as a platform, and in cooperation with
         experienced and qualified risk-sharing partners, the Company continues
         to roll out its self-standing LKI stores as well as the
         store-within-store program. The Company is successfully pursuing this
         program in other Far East markets and is presently reviewing the
         experience gained and lessons learned, to determine the desirability
         and feasibility of accelerating similar programs in new markets
         including the U.S.

o        The Company's jewelry department, having completed a successful year
         under imaginative and talented new leadership, is focused on offering
         an attractive saleable jewelry collection designed for specific market
         tastes. The jewelry department is also designing important jewelry
         pieces, selecting and assembling the diamonds from the Company's
         extensive inventory and presenting them to customers for inspection
         prior to setting the diamonds in platinum or gold. This affords the
         customers a participation in the final design and, at the same time, is
         a cost effective way of keeping jewelry inventory to a minimum.


         Good progress has been made by the Company in implementing its
     Cooperation Agreement with NamGem - Namibia's flagship cutting and
     polishing plant. The Government of Namibia continues to provide its good
     offices to ensure the proper and adequate supply of rough diamonds. The
     economics and technical proficiency of the trained work force justify
     moving into the manufacture of larger sizes, and, in cooperation with the
     Namibian Government, the Company expects to address this issue in the
     coming year.

         In South Africa, the agreement signed with Nozala Investments (Pty.)
     Ltd., a broadly based women's empowerment investment group, is being
     implemented. The Diamond Cutting License and approvals have been received
     from the government authorities, a cutting and polishing facility staffed
     by skilled, trained craftsmen qualified to cut larger stones is
     operational, and the DTC has approved Nozala Diamonds (Pty.) Ltd. (the
     company jointly owned by Nozala Investments and LKI) as a South African
     sightholder. To encourage local beneficiation and greater economic and
     employment participation by previously disenfranchised citizens, the
     government of South Africa has introduced legislation in the Parliament
     that will mandate the local manufacture of sizes and qualities of rough
     diamonds mined in South Africa that can effectively compete with other
     lower-cost manufacturing centers. The Company has had extensive experience
     in successfully transferring technical and executive skills, and in close
     alignment with the objectives and direction of South Africa's pending
     legislation, it will expand the Nozala Diamonds cutting operation and
     employment as an increasing supply of rough diamonds is made available.

         The Company is examining projects to assess economic viability and
     eligibility under the previously announced financing agreement with the
     U.S. Overseas Private Investment Corporation (OPIC) applicable to diamond
     beneficiation and mining projects in Angola, Botswana, Namibia, Russia and
     South Africa.

         The Company is discussing with LJ Superabrasives Holding Inc. (who in
     2004 acquired an interest in the Bellataire'r' operations from the General
     Electric Company) to determine and agree on the steps necessary to
     reinvigorate the Bellataire'r' project and expand the business
     opportunities that this technology presents. There is a specific,
     economically viable market niche for natural diamonds that have undergone
     this new high pressure, high temperature process to irreversibly improve
     the color of certain select natural diamonds. The Company and Littlejohn
     will continue the practice originally adopted by the Company and General
     Electric to clearly identify Bellataire'r' diamonds, laser inscribe the
     stones with a distinctive marking and

                                     5





<PAGE>

     accompany each sale with a gem laboratory grading report. The Company is
     co-inventor and co-owner of certain applicable patents that have been
     issued.

         The Company's long established manufacturing facility in Puerto Rico
     has undergone a complete refurbishing in line with the Company's dedication
     to stay in the forefront of technical innovations and new systems. The
     Company has been, and will remain, a leader in adopting and adapting
     state-of-the-art technology and methods to ensure economic proficiency and
     quality control. Our skilled technicians in Puerto Rico have also provided
     the technical managers for the cutting facilities in other parts of the
     world and remain an effective hands-on training center for new talent.

         In recent years, the diamond industry -- conservative by tradition and
     not prone to rapid change -- has had to adjust to a new and more intrusive
     business and regulatory environment. In general, at times more slowly than
     events warranted, the industry has faced up to the new realities that stem
     from the times we live in. Although less than perfect, as most human
     endeavors are, the Kimberley Process Certification Scheme and the World
     Diamond Council's System of Warranties were good initiatives initiated by a
     closer industry, Non-Governmental Organization (NGO) and multi-government
     cooperation. Though the conflicts in diamond producing areas that prompted
     the Kimberley Process are now mostly history, other challenges of great
     importance and gravity lie ahead for us and for the industry and must be
     addressed. Diamonds are by their very nature a valuable, easily
     transportable, fungible product and, thus, the many responsible businessmen
     and women engaged in this business and who are good citizens of the world,
     must help carry the burden to protect the industry from the few who will
     abuse commerce in diamonds for their own evil purposes. The USA PATRIOT Act
     and similar legislation in other diamond centers will increasingly govern
     transactions in the responsible diamond trade. The Company welcomes these
     developments that reflect the need to address the perils of our times.
     Strong and clear industry and governmental leadership will be required to
     help establish and implement appropriate and effective measures so that the
     great majority in the industry can continue to play a constructive business
     role and at the same time contribute to development, employment and
     celebration of life's joyful and celebratory milestones - as diamonds
     always have.

         Our appreciation and thanks go to the Company's staff all over the
     world. We take pride and great satisfaction in what you do and how you do
     it, and we will jointly continue to do our best to create an environment
     where individual initiative is recognized, valued and rewarded.

Maurice Tempelsman
Chairman of the Board

Leon Tempelsman
Vice Chairman of the Board






                                       6





<PAGE>

                             Selected Financial Data

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------
(In thousands, except share and per share data)           2005       2004       2003         2002          2001
-----------------------------------------------------------------------------------------------------------------
<S>                                                     <C>        <C>        <C>          <C>           <C>
Net sales                                               $421,411   $235,775   $203,159     $189,548      $270,786
-----------------------------------------------------------------------------------------------------------------

Income/(loss) before income tax provision/(benefit)
   and cumulative effect of change in accounting
   principle                                            $  7,870   $  3,273   $  3,256     $ (1,842)     $  2,401
-----------------------------------------------------------------------------------------------------------------

Income/(loss) before cumulative effect of change
   in accounting principle                              $  7,870   $  2,399   $  2,066     $ (1,226)     $  1,543
-----------------------------------------------------------------------------------------------------------------

Net income/(loss)                                       $  5,230   $  2,399   $  1,094(1)  $ (1,226)(3)  $  1,543
-----------------------------------------------------------------------------------------------------------------

Basic earnings/(loss) per share before cumulative
   effect of change in accounting principle (based on
   the weighted average number of shares)               $   0.62   $   0.28   $   0.24     $  (0.16)     $   0.20
-----------------------------------------------------------------------------------------------------------------

Basic earnings/(loss) per share (based on
   weighted average number of shares)                   $   0.62   $   0.28   $   0.13     $  (0.16)     $   0.20
-----------------------------------------------------------------------------------------------------------------

Diluted earnings/(loss) per share before cumulative
   effect of change in accounting principle (based on
   the weighted average number of shares)               $   0.60   $   0.28   $   0.24     $  (0.16)     $   0.20
-----------------------------------------------------------------------------------------------------------------

Diluted earnings/(loss) per share (based on
   the weighted average number of shares)               $   0.60   $   0.28   $   0.13     $  (0.16)     $   0.20
-----------------------------------------------------------------------------------------------------------------
At May 31:
Total assets                                            $250,284   $180,712   $160,411     $147,987      $175,918
-----------------------------------------------------------------------------------------------------------------
Long-term debt                                          $ 60,000   $ 34,726   $ 16,756     $ 12,089      $ 39,626
-----------------------------------------------------------------------------------------------------------------
Working capital                                         $141,556   $110,599   $ 90,175     $ 83,457      $101,378
-----------------------------------------------------------------------------------------------------------------
Stockholders' equity                                    $ 96,305   $ 92,416   $ 90,207     $ 90,106(2)   $ 79,934
-----------------------------------------------------------------------------------------------------------------
</TABLE>

Note: No cash dividends were declared or paid by the Company during the past
five fiscal years.

(1)  Includes $1.0 million (net of tax) charge for the cumulative effect of a
     change in accounting principle.

(2)  Reflects the effect of the private sale of 1,305,000 shares of common
     stock, consisting of 1,180,000 of previously repurchased treasury shares
     and 125,000 authorized but unissued shares. Proceeds from the sale were
     approximately $11.5 million (net of costs).

(3)  Includes $0.3 million (net of tax) of benefit associated with a partial
     recovery of inventory.

                                       7




<PAGE>

                      Management's Discussion and Analysis

     This Annual Report contains, in addition to historical information, certain
forward-looking statements that involve significant risks and uncertainties.
Such forward-looking statements are based on management's belief as well as
assumptions made by, and information currently available to, management pursuant
to the "safe harbor" provisions of the Private Securities Litigation Reform Act
of 1995. The Company's actual results could differ materially from those
expressed in or implied by the forward-looking statements contained herein.
Factors that could cause or contribute to such differences include, but are not
limited to, those discussed herein and in Item 1--"Description of Business", and
elsewhere in the Company's Annual Report on Form 10-K for the fiscal year ended
May 31, 2005. The Company undertakes no obligation to release publicly the
result of any revisions to these forward-looking statements that may be made to
reflect events or circumstances after the date of this Annual Report or to
reflect the occurrence of other unanticipated events.

     This discussion and analysis should be read in conjunction with the
Selected Financial Data and the audited consolidated financial statements and
related notes of the Company contained elsewhere in this report. In this
discussion, the years "2005", "2004" and "2003" refer to the fiscal years ended
May 31, 2005, 2004 and 2003, respectively.

Overview

     The Company is engaged in the cutting, polishing and selling of ideally
proportioned diamonds which it markets internationally under the brand name
"Lazare Diamonds'r'". Ideally proportioned diamonds are distinguished from
non-ideal cut ("commercial") diamonds by the symmetrical relationship of their
facets, which optimize the balance of brilliance, sparkle and fire in a polished
diamond. The Company's domestic manufacturing facility, located in Puerto Rico,
is believed by the Company to be the largest diamond cutting facility in the
United States. In addition, through various cooperative agreements, the Company
cuts and polishes commercial diamonds which it markets to wholesalers,
distributors and retail jewelers. Rough stones purchased by the Company are
either selected for manufacturing or resold as rough diamonds in the
marketplace.

     The Company's overall revenues are, in part, dependent upon the
availability of rough diamonds, the world's known sources of which are highly
concentrated. The Diamond Trading Company ("DTC") is the world's largest rough
diamond selling organization. The Company has been a client of the DTC for
approximately 60 years. The Company supplements its rough diamond needs by
secondary market purchases and has entered into relationships with other primary
source suppliers.

     The Company has a technical assistance and cooperation agreement regarding
the purchasing and marketing of rough diamonds with Sociedade de Comercializacao
de Diamantes de Angola SARL ("SODIAM"), the government entity responsible for
development and marketing of diamonds produced in Angola. Rough diamond buying
from this operation commenced during the first fiscal quarter of 2005.

     The Company has agreements with AK ALROSA of Russia, which is the largest
producer of rough diamonds in Russia. Under the terms of these agreements, the
Company sells polished diamonds that are cut in facilities jointly managed and
supervised by the Company and ALROSA personnel. The proceeds from the sale of
these polished diamonds, after deduction of rough diamond cost, generally are
shared equally with ALROSA.

     The Company has signed a strategic cooperation agreement with NamGem
Diamond Manufacturing Company (PTY) Ltd. ("NamGem") for the cutting and
polishing of diamonds in Namibia. NamGem is Namibia's flagship venture in the
international diamond polishing industry. Under the terms of the agreement, the
Company provides technical manufacturing assistance and supervises the
manufacture of the Company's rough diamonds deemed suitable to cut and polish.
Production under this agreement commenced during the third quarter of 2004. The
Company continues its efforts to develop additional sources of rough diamonds,
including potential opportunities in Africa.

     In November of 2004 the Company signed an agreement with Nozala Investments
(Pty) Ltd., a broadly based women's empowerment investment group, for
cooperation in South Africa's diamond sector. The agreement contemplates diamond
mining, cutting, polishing, and distribution. The joint venture is in line with
the South African Government's recently announced program to promote new
entrants and investment in the domestic diamond sector, increasing the sector's
contribution to economic development. Initial cutting and


                                       8




<PAGE>

polishing activities will concentrate on local sources of rough diamond supply.

     Through February 2009, the Company's wholly-owned subsidiary, Pegasus
Overseas Ltd. ("POL") has an exclusive agreement with a formerly wholly-owned
subsidiary of General Electric Company ("GE") under which POL will market
natural diamonds that have undergone a new high pressure, high temperature
(HPHT) process to improve the color of certain gem diamonds without reducing
their all-natural content. POL sells only diamonds that have undergone the HPHT
process under the Bellataire'r' brand name.

     While the Company believes that its success in maintaining quantities and
qualities of polished inventory that best meet its customers' needs is achieved
through its ability to fully integrate its diverse rough and polished diamond
sources, any significant disruption of the Company's access to its primary
source suppliers could have a material adverse effect on the Company.

Results of Operations

2005 Compared to 2004

Net Sales

     Net sales in 2005 of $421.4 million were $185.6 million or 79% higher than
net sales in 2004.

     Polished diamond revenues in 2005 were $156.9 million, as compared to
$142.7 million in 2004. The increase in polished sales primarily reflects
increased sales of branded diamonds and jewelry. The increase in branded sales
largely reflects growth of jewelry and loose Lazare Diamonds to both new and
existing Southeast Asia based customers. Factors leading to this increase
include greater brand awareness resulting from increased advertising and an
overall strengthening of regional economies.

     Commencing in the third quarter of fiscal 2004, the Company's sourcing
included material relating to its cooperation agreement with NamGem for the
cutting and polishing of diamonds in Namibia.

     Rough diamond sales in 2005 were $264.5 million, an increase of $171.4
million over 2004. The increase in rough diamond sales is primarily related to
the commencement of Angolan rough buying and trading operations during the first
fiscal quarter of 2005. The 2005 increase also reflects an increase in the
supply of rough diamonds made available to the Company by other rough diamond
producers. The increase in supply from producers reflects, among other things,
the Company's competitive strength and its quality reputation in the industry.
The Company's supply of rough diamonds also increased during 2005 as a result of
an increase in its allocation of stones associated with the Company's
cooperation agreement with NamGem.

Gross Profit

     During 2005 gross margin on net polished sales was 16.2% compared to 15.3%
in 2004. The increase in polished gross margin reflects increased sales of
higher margin branded diamonds and jewelry partially offset by a decrease in
margins earned on increased sales of fine commercial make diamonds (which
typically carry a lower gross margin than branded diamonds). The decline in
gross margin on fine commercial make diamonds reflects increased rough diamond
prices which the Company was unable to fully pass through to customers during
the year.

     Rough gross margin during 2005 was 3.5% compared to 4.6% in the prior year.
The decrease in rough gross margin percentage primarily reflects the
commencement of Angolan rough buying operations which are not expected to
contribute to the Company's rough gross margin during its first year of
operations. Offsetting the dilutive margin impact of Angolan rough sales, the
Company's aggregate rough gross margin from all other sources increased during
2005 reflecting an improvement in the overall market conditions for the
categories of stones the Company trades.

     As a result of the foregoing, overall gross margin percentage during 2005
was 8.2% compared to 11.1% in 2004.

Selling, General and Administrative Expenses

     Selling, general and administrative expenses for 2005 were $24.5 million,
as compared to $22.0 million for 2004. The increase for 2005 reflects increased
advertising, personnel and related costs directed toward expanding sourcing and
supporting the distribution of branded diamonds, jewelry and fine commercial
make polished diamonds.

Interest Expense


                                       9




<PAGE>

     Interest expense for 2005 was $2.4 million, as compared to $0.9 million
for 2004. This increase primarily reflects increased levels of borrowing and
higher interest rates during 2005. Increased borrowings during 2005 primarily
related to the expansion of rough sourcing and cutting and polishing operations.

Income Tax

     The Company's effective tax rate for 2005 was 33.5% as compared to 26.7%
for the prior year. This increase is primarily attributable to an increase in
the percentage of income earned in higher tax rate jurisdictions.

Earnings Per Share

     Basic and fully diluted earnings per share for 2005 were $0.62 and $0.60,
respectively, During 2004 basic and fully diluted earnings per share were each
$0.28. Basic earnings per share is computed based upon the weighted average
number of common shares outstanding. Diluted earnings per share include the
impact of dilutive stock options.

2004 Compared to 2003

Net Sales

     Net sales in 2004 of $235.8 million were 16% higher than net sales of
$203.2 million in 2003.

     The Company's net revenue from the sale of polished diamonds of $142.7
million in 2004 was 6% higher than 2003 sales of $135.0 million. The increase in
polished sales reflects increased sales of branded diamonds partially offset by
lower sales of commercial stones.

     Rough diamond sales were $93.1 million in 2004, an increase of $25.0
million, or 37% compared to $68.1 million in 2003. The increase from the prior
year is attributable to an increase in rough diamond sourcing by the Company and
an increase in overall rough diamond prices. During 2004, the Company's sourcing
included material relating to its cooperation agreement with NamGem Diamond
Manufacturing Company (PTY) Ltd. ("NamGem") for the cutting and polishing of
diamonds in Namibia, which began during the third quarter of 2004.

Gross Profit

     The Company's gross margin on net sales of polished diamonds includes all
overhead costs associated with the purchase, sale and manufacture of rough
stones (the "Polished Diamond Gross Margin"). Polished Diamond Gross Margin for
2004 was 15.3% compared to 15.2% for 2003.This increase reflects improved
margins on branded products offset by lower margins on fine make commercial
stones.

     The Company's gross margin on sales of rough stones not selected for
manufacturing, and sales of stones from the rough trading operation, includes an
allocation of overhead costs estimated to be associated with the purchase and
sale of rough stones. In 2004, the rough diamond margin was 4.6%, compared to
3.9% in 2003. The improvement in rough diamond gross margin reflects a
strengthening of market demand for categories of stones that the Company
normally sells in rough form.

     During 2004, the overall gross margin on net sales of both polished
diamonds and rough diamonds was 11.1% as compared to 11.4% in 2003. This
decrease in overall gross margin primarily reflects a shift in sales mix toward
lower margin rough sales.

Selling, General and Administrative Expenses

     Selling, general and administrative expenses in 2004 were $22.0 million as
compared to $19.4 million in 2003. This increase reflects increased advertising,
personnel and consulting costs directed toward expanding distribution and
sourcing. Consistent therewith, in April 2004 the Company announced that it
entered into a technical cooperation agreement with Sociedade de Comercializacao
de Diamantes de Angola, SARL ("SODIAM"), the governmental entity responsible for
the development and marketing of diamonds produced in Angola. Angolan rough
diamond buying operations pursuant to this agreement began during the first
quarter of fiscal 2005.

Interest Expense

     Interest expense in 2004 was $0.9 million as compared to $0.5 million
in 2003. This increase primarily reflects increased levels of borrowing.

Income Taxes

     The Company's effective tax rate during 2004 was 26.7% as compared to 36.5%
in 2003. The decrease is primarily attributable to an increase in the


                                      10




<PAGE>

percentage of income earned in lower tax rate jurisdictions.

Earnings Per Share

     Basic and fully diluted earnings per share for 2004 were each $0.28. During
2003, basic and fully diluted earnings per share were each $0.13, while basic
and diluted earnings per share before the cumulative effect of change in
accounting principle were each $0.24 per share. Basic earnings per share is
computed based upon the weighted average number of common shares outstanding.
Diluted earnings per share include the impact of dilutive stock options.

New Accounting Pronouncements

     In December 2004, the Financial Accounting Standards Board (FASB) revised
Statement of Financial Accounting Standards (SFAS) No. 123 "Share-Based
Payment". SFAS No. 123(R) will require the Company to expense stock options.
Adoption is required for the annual reporting periods beginning after June 15,
2005.

Foreign Operations

     International business represents a major portion of the Company's revenues
and profits. All purchases of rough diamonds worldwide are denominated in U.S.
dollars. All of the Company's foreign sales are denominated in U.S. dollars,
with the exception of those sales made by the Company's subsidiary, Lazare
Kaplan Japan Inc., which are denominated in Japanese yen. The functional
currency for Lazare Kaplan Japan is the Japanese yen and, as of May 31, 2005 and
2004, the Company recognized cumulative foreign currency translation adjustments
with regard to the activities of Lazare Kaplan Japan in the amount of $(241,000)
and $(286,000) respectively, which are shown as a component of stockholders'
equity in the accompanying balance sheets.

Liquidity--Capital Resources

     The Company used $22.5 million and $21.8 million of cash flow for
operations in 2005 and 2004, respectively. The Company's usage of cash flow from
operations, funded by an increase in borrowings, was primarily used to expand
inventory sourcing and support increased sales volume.

     The Company's working capital at May 31, 2005, 2004 and 2003 was $141.6
million, $110.6 million and $90.2 million, respectively. The increase in working
capital primarily reflects funding of increased current assets with the proceeds
of debt classified as long-term.

     Fixed asset additions of $1.8 million in 2005 primarily reflects the
expansion and upgrading of manufacturing facilities. Fixed asset additions of
$2.2 million in 2004 reflects the impact of relocating office headquarters of
approximately $1.2 million and the addition of machinery and equipment required
for manufacturing. The Company is obligated for $0.6 million of costs
associated with certain construction in progress it expects to complete
during the year ended May 31, 2006. Total capital expenditures for fiscal
2006 are not expected to exceed $2.0 million.

     The Company has a long-term unsecured revolving loan agreement. The
agreement provides that the Company may borrow up to $35.0 million (including up
to $1.0 million under letters of credit, $0.7 million issued at May 31, 2005) in
the aggregate through December 1, 2006. The loan term may be extended in
one-year increments commencing November 30, 2005, subject to the consent of the
lending banks. Borrowings under this agreement bear interest at (a) the higher
of the banks base rate or one half of one percent above the Federal Funds
Effective Rate, or (b) 160 basis points above LIBOR. The applicable interest
rate is contingent upon the method of borrowing selected by the Company. The
proceeds of this facility are available for the Company's working capital needs.
The revolving loan agreement contains certain provisions that require, among
other things, (a) maintenance of defined levels of working capital, net worth
and profitability, and (b) limitation on other borrowing levels, investments,
capital expenditures, dividends and the repurchase of treasury shares. As of May
31, 2005 and 2004, the balance outstanding under this facility was $33.0 million
and $20.0 million, respectively. In July 2005 the maximum amount available under
this agreement was increased to $45.0 million.

     During 2004, the Company entered into an additional long-term unsecured,
revolving loan agreement with a bank under which it may borrow up to $30.0
million in the aggregate through December 1, 2006. The loan term may be extended
in one year increments commencing November 30, 2005, subject to the consent of
the bank. Borrowings under this agreement bear interest at (a) the higher of the
banks base rate or one half of one percent above the Federal Funds Effective
Rate, or (b) 160 basis points above LIBOR. The applicable interest rate is
contingent upon the method of borrowing selected by the Company. The proceeds of
this facility are available for working capital purposes. The loan agreement


                                      11




<PAGE>

contains certain provisions that require, among other things, (a) maintenance of
defined levels of working capital, net worth and profitability, (b) limitations
on borrowing levels, investments and capital expenditures and (c) limitations on
dividends and the repurchase of treasury shares. Borrowings under this loan
agreement amounted to $29.2 million at May 31, 2005.

     The Company has a $40.0 million unsecured, uncommitted line of credit with
a bank. As of May 31, 2005 and 2004, the balance outstanding under this line of
credit was $14.5 million and $16.9 million, respectively. This line of credit is
available for the Company's working capital requirements. Amounts borrowed under
this line are payable on demand. In July 2005 the amount available under this
line was increased to $45.0 million.

     A subsidiary of the Company maintains a loan facility which enables it to
borrow up to 550 million Japanese yen (approximately $5.0 million U.S. dollars)
at an interest rate 1% above the Japanese yen LIBOR through November 2006.
Borrowings under the facility are available for working capital purposes. The
Company guarantees repayment of amounts borrowed. Borrowings under the loan are
used in support of its operations in Japan. As of May 31, 2004, the balance
outstanding under this facility was $4.7 million U.S. dollars. There were no
borrowings under this facility at May 31, 2005.

     The Company's long-term facilities do not contain subjective acceleration
clauses or require the Company to utilize a lockbox whereby remittances from the
Company's customers reduce the debt outstanding.

     Long-term debt of $60.0 million outstanding at May 31, 2005 is scheduled to
be repaid in the fiscal year ended May 31, 2007. The Company was in compliance
with its debt covenants at May 31, 2005.

     The following table includes aggregate information about the Company's
contractual obligations as of May 31, 2005 and the periods in which payments are
due. Certain of these amounts are not required to be included in the Company's
consolidated balance sheet (in millions):

<TABLE>
<CAPTION>
----------------------------------------------------------------
  Payments Due by             Less than   1 - 3   4 - 5   Over 5
       Period         Total     1 year    years   years    years
----------------------------------------------------------------
<S>                   <C>       <C>       <C>      <C>     <C>
Debt                  $80.5     $20.5     $60.0    $ --    $ --
Operating Leases        9.7       0.9       1.4     1.2     6.2
----------------------------------------------------------------
Total Contractual
   Cash Obligations   $90.2     $21.4     $61.4    $1.2    $6.2
================================================================
</TABLE>

     In addition to amounts reflected in the above table, the Company is
obligated for $0.6 million of costs associated with certain construction in
progress.

     Management believes the Company has the ability to meet its current and
anticipated financing needs for the next twelve months with the facilities in
place and funds from operations.

     Stockholders' equity was $96.3 million at May 31, 2005 as compared to $92.4
million at May 31, 2004. This increase primarily reflects current year earnings
offset by $2.0 million of treasury stock purchases. No dividends were paid to
stockholders during the year ended May 31, 2005.

Critical Accounting Policies

     Use of Accounting Estimates-The preparation of financial statements in
conformity with accounting principles generally accepted in the United States
requires management to make certain estimates and assumptions that could affect
the amounts reported in the financial statements and accompanying notes. Actual
results could differ from these estimates.

     Revenue Recognition--The Company recognizes revenue when title and risk of
ownership have passed to the buyer, the earnings process is complete and the
sale price is fixed or determinable. In addition, in certain instances, the
Company may be entitled to receive incremental profits from its customers on the
sale of certain stones. Such profits are recognized as revenue when realized.
Conversely, in certain instances, the Company is obligated to share profits it
realizes on the sale of stones. This additional cost is included in cost of
sales when the related revenue is recognized. When necessary, the Company
provides for estimated returns (where a right to return exists) in the same
period the revenue is recorded. These estimates are based upon historical
analysis, customer agreements and/or currently known factors that arise in the
normal course of business. No reserve for returns was deemed necessary at
May 31, 2005 and 2004.


                                      12




<PAGE>

     Inventories--Inventories, including amounts on consignment with customers,
are stated at the lower of cost or market, using either the first-in, first-out
method, or average cost method. The Company provides an inventory reserve equal
to the difference between the cost of the inventory and the estimated market
value, to ensure inventories are stated at the lower of cost or market. The
determination of market value is highly subjective as it is based on the
relative significance assigned to various attributes of a diamond, including
carat weight, color, clarity and quality of cut. If actual market conditions are
less favorable than those projected by management, inventory write-downs may be
required.

     Allowance for Doubtful Accounts--Accounts receivable are reduced by an
allowance for amounts that may be uncollectible in the future. Estimates are
used in determining the allowance for doubtful accounts and are based on the
Company's ongoing credit evaluations of customers, customer payment history and
account aging.

     Deferred Tax Assets--Deferred income taxes reflect the net tax effects of
(a) temporary differences between the carrying amounts of assets and liabilities
for financial reporting purposes and the amounts used for income tax purposes,
and (b) net operating loss carryforwards. The Company provides a valuation
allowance for the estimated unrecoverable portion of the deferred tax assets.
Factors that the Company considers in assessing the likelihood of future
realization include the forecast of future taxable income and available tax
planning strategies. Realization of the net deferred tax assets is dependent on
generating sufficient taxable income prior to the expiration of net operating
loss carryforwards. Although realization is not assured, management believes it
is more likely than not that the net deferred tax asset will be realized. The
Company will continue to monitor and assess the recoverability of its deferred
tax assets in the future for changes to the tax code, change in statutory tax
rates and the projected level of taxable income.

     Asset Impairment--The Company records impairment losses on long-lived
assets used in operations when events and circumstances indicate that the assets
might be impaired and the undiscounted cash flows estimated to be generated by
the related assets are less than the carrying amounts of those assets. In
assessing the recoverability of the Company's long-lived assets, the Company
makes assumptions in determining estimated future sales, profit margin and
expenses to arrive at estimated future cash flows. If the Company determines,
based upon such measures, that the carrying amount is impaired, the long-lived
asset will be written down to its recoverable value based upon either the
discounted future cash flows or appraised fair value. The fair value of assets
could be different using different estimates and assumptions in these valuation
techniques.

Business Developments

     Under the terms of its agreement with AK ALROSA of Russia, ALROSA has
agreed to supply a minimum of $45 million per year of large rough gem diamonds
believed by the Company to be suitable for processing. Since May 1997, pursuant
to this agreement the Company has received regular shipments of polished stones.
The Company is selling the resulting polished gemstones through its worldwide
distribution network. The proceeds from the sale of these polished diamonds,
after deduction of rough diamond cost, generally are shared equally with ALROSA.
This agreement serves as a long-term off-take arrangement to secure the
repayment of financing which has been received by ALROSA from a United States
commercial bank and is guaranteed by the Export-Import Bank of the United States
(Eximbank) for the purchase by ALROSA of U.S. manufactured mining equipment.
This equipment is being used by ALROSA to increase production in its diamond
mines.

     In March 1999, (in furtherance of a Memorandum of Understanding signed by
Eximbank, ALROSA and the Company) the Company and ALROSA entered into a
Cooperation Agreement to expand their relationship in the cutting, polishing and
marketing of gem diamonds for up to $100 million a year. Under the terms of this
agreement, the Company and ALROSA agreed to refurbish additional diamond cutting
facilities. At present, the Company's operations in Russia are consolidated in
two facilities, both of which are fully operational.

     During the fourth quarter of 2004 the Company signed a four year technical
assistance and cooperation agreement regarding the purchasing and marketing of
rough diamonds with SODIAM, the government entity responsible for the
development and marketing of diamonds produced in Angola. The Company began
active Angolan buying operations during the first quarter of fiscal 2005.

     During the third quarter 2004 the Company signed a cooperation agreement
with NamGem for the cutting and polishing of diamonds in Namibia. NamGem is
Namibia's flagship venture in the international diamond polishing industry.
Under the


                                      13




<PAGE>

terms of the agreement the Company provides marketing and technical
manufacturing assistance to NamGem. The Company purchases rough diamonds and
supervise's the manufacturing of those deemed suitable to cut and polish. The
Company pays NamGem for manufacturing on a fee for services basis. All rough and
polished diamonds are bought and sold by the Company for its account.

     In November of 2004 the Company signed an agreement with Nozala Investments
(Pty) Ltd., a broadly based women's empowerment investment group, for
cooperation in South Africa's diamond sector. The agreement contemplates diamond
mining, cutting, polishing, and distribution. The joint venture is in line with
the South African Government's recently announced program to promote new
entrants and investment in the domestic diamond sector, increasing the sector's
contribution to economic development. Initial cutting and polishing activities
will concentrate on local sources of rough diamond supply.

     Through February 2009, the Company's wholly-owned subsidiary, Pegasus
Overseas Ltd. ("POL") has an exclusive agreement with a formerly wholly-owned
subsidiary of General Electric Company ("GE") under which POL will market
natural diamonds that have undergone a new high pressure, high temperature
(HPHT) process to improve the color of certain gem diamonds without reducing
their all-natural content. The process is permanent and irreversible and it does
not involve treatments such as irradiation, laser drilling, surface coating or
fracture filling and is conducted before the final cutting and polishing by the
Company. The process will be used only on a select, limited range of natural
diamonds with qualifying colors, sizes and clarities for both round and fancy
shapes. The estimated number of gemstones with characteristics suitable for this
process is a small fraction of the overall diamond market. POL sells only
diamonds that have undergone the HPHT process under the Bellataire'r' brand
name. In connection with this agreement, the Company granted a security interest
in POL's diamond inventory amounting to $13.5 million at May 31, 2005.

     During 2004 GE advised the Company that it had sold its subsidiary
(subsequently renamed Diamond Innovations Inc. "DI") engaged in the Bellataire
operations to LJ Superabrasives Holding Inc. ("LJ").

     As a concerned member of the international diamond industry and global
community at large, the Company fully supports and complies with policies which
prohibit the trade in conflict diamonds, prevent money laundering and combat the
financing of terrorism, a position which reflects the Company's leadership in
the industry. The Company fully complies with clean diamond trading and
anti-money laundering legislation adopted by the United States Government such
as the USA Patriot Act and the Clean Diamond Trade Act, and supports relevant
resolutions of concerned regional governments and international organizations
including the OECD and the United Nations. The Company is a founding member of
the United Nations Global Compact which was launched in 2000 to "initiate a
global compact of shared values and principles which will give a human face to
the global market". The Company will continue to join various industry and trade
associations in condemning and combating the trade in illicit diamonds and to
comply fully with World Diamond Congress resolutions for industry
self-regulation in respect of the Kimberley Process Certification Scheme,
including implementation of the prescribed System of Warranties and Code of
Conduct. Furthermore, the Company long ago adopted the highest professional and
ethical standards in every aspect of our business and is fully compliant with
the DTC's recently developed Diamond Best Practices Principles.

Risks and Uncertainties

     The world's sources of rough diamonds are highly concentrated in a limited
number of countries. Varying degrees of political and economic risk exist in
many of these countries. As a consequence, the diamond business is subject to
various sovereign risks beyond the Company's control, such as changes in laws
and policies affecting foreign trade and investment. In addition, the Company is
subject to various political and economic risks, including the instability of
foreign economies and governments, labor disputes, war and civil disturbances
and other risks that could cause production difficulties or stoppages, restrict
the movement of inventory or result in the deprivation or loss of contract
rights or the taking of property by nationalization or expropriation without
fair compensation.

     The Company's business is dependent upon the availability of rough
diamonds. Based upon published reports, the Company believes that more than half
of the world's current diamond output is sold by the Diamond Trading Company
("DTC"), the rough diamond sales arm of the De Beers Group.


                                      14




<PAGE>

Although the DTC has historically been one of the Company's major suppliers of
rough diamonds, the Company has diversified its sources of supply by entering
into arrangements with other primary source suppliers and has been able to
supplement its rough diamond needs by purchasing supplies in the secondary
market. While the Company believes that it has good relationships with its
suppliers and that its sources of supply are sufficient to meet its present and
foreseeable needs, the Company's rough diamond supplies, and therefore, its
manufacturing capacity, could be adversely affected by political and economic
developments in producing countries over which it has no control. While the
Company believes that alternative sources of supply may be available, any
significant disruption of the Company's access to its primary source suppliers
could have a material adverse effect on its ability to purchase rough diamonds.

     In July 2000, the DTC announced significant changes in its approach to
rough diamond marketing. In brief, the DTC stated that it will stop open market
purchases and alter its market control and pricing policies. Henceforth, the DTC
has said it will focus on selling its own mining productions through its
"supplier of choice" marketing programs. These policy changes are intended to
drive consumer demand for diamond jewelry by fostering the development of
efficient distribution networks that stimulate demand, support the emergence of
internationally recognized brands to meet consumer needs, supply clients with a
consistent supply of rough diamonds and encourage and support additional
investment in marketing and advertising programs with the goal of developing an
industry led by advertising and marketing support.

     Further, through its control of the world's diamond output, the DTC could
exert significant control over the pricing of rough and polished diamonds. A
large rapid increase in rough diamond prices could materially adversely affect
the Company's revenue and operating margins if the increased cost of the rough
diamonds could not be passed along to its customers in a timely manner.
Alternatively, any rapid decrease in the price of polished diamonds could have a
material adverse affect on the Company in terms of inventory losses and lower
margins.

     The Company is currently a DTC Sightholder under the Supplier of Choice
Program. The Company believes it is well positioned to benefit from these
changes in the DTC's approach to diamond marketing. However, there can be no
assurance that this policy change will not have a material adverse effect on the
Company's operations.

     In addition, the Company's manufacturing operations abroad are subject to
various political and economic risks, including the instability of foreign
economies and governments, labor disputes, war and civil disturbances and other
risks that could cause production difficulties or stoppages, restrict the
movement of inventory or result in the deprivation or loss of contract rights or
the taking of property by nationalization or expropriation without fair
compensation.

     The Company's cooperation arrangement with ALROSA is a significant part of
its operations. The Company believes it is well positioned to benefit from the
reorganization of the diamond industry in Russia. However there can be no
assurance that the resulting change will not have a material adverse effect on
the Company's operations.

     As described above, POL has an exclusive agreement expiring in 2009 with DI
under which POL markets natural diamonds that have undergone a new color
enhancement process. The high pressure, high temperature (HPHT) process is
designed to improve the color of qualifying diamonds without reducing their
all-natural content. POL relies upon GE and DI for certain financial, processing
and technology support in connection with the preparation and sale of
Bellataire'r' HPHT diamonds.


                                      15




<PAGE>

                         Consolidated Income Statements

<TABLE>
<CAPTION>
                                                                    Year ended May 31,
-----------------------------------------------------------------------------------------------
(In thousands, except share and per share data)               2005         2004         2003
-----------------------------------------------------------------------------------------------
<S>                                                        <C>          <C>          <C>
Net sales                                                  $  421,411   $  235,775   $  203,159
Cost of sales                                                 386,677      209,631      180,001
-----------------------------------------------------------------------------------------------
                                                               34,734       26,144       23,158
-----------------------------------------------------------------------------------------------

Selling, general and administrative expenses                   24,475       21,971       19,428
Interest expense                                                2,389          900          474
-----------------------------------------------------------------------------------------------
                                                               26,864       22,871       19,902
-----------------------------------------------------------------------------------------------

Income before income tax provision                              7,870        3,273        3,256
Income tax provison                                             2,640          874        1,190
-----------------------------------------------------------------------------------------------

Income before cumulative effect of change in
   accounting principle                                         5,230        2,399        2,066
Cumulative effect of change in accounting principle, net
   of tax                                                          --           --         (972)
-----------------------------------------------------------------------------------------------
NET INCOME                                                 $    5,230   $    2,399   $    1,094
===============================================================================================
EARNINGS PER SHARE

Basic earnings per share before cumulative effect
   of change in accounting principle                       $     0.62   $     0.28   $     0.24
===============================================================================================

Basic earnings per share                                   $     0.62   $     0.28   $     0.13
===============================================================================================

Average number of shares outstanding
   during the period                                        8,448,704    8,513,687    8,637,397
===============================================================================================

Diluted earnings per share before cumulative
   effect of change in accounting principle                $     0.60   $     0.28   $     0.24
===============================================================================================

Diluted earnings per share                                 $     0.60   $     0.28   $     0.13
===============================================================================================

Average number of shares outstanding during the period,
   assuming dilution                                        8,653,222    8,599,954    8,658,396
===============================================================================================
</TABLE>

See notes to consolidated financial statements.


                                      16




<PAGE>

                           Consolidated Balance Sheets

<TABLE>
<CAPTION>
                                                             May 31,
--------------------------------------------------------------------------
(In thousands, except share data)                        2005       2004
--------------------------------------------------------------------------
<S>                                                    <C>        <C>
Assets
CURRENT ASSETS:
Cash and cash equivalents                              $ 10,320   $  1,209
Accounts receivables, less allowance for doubtful
   accounts ($360 and $365 in 2005 and 2004,
   respectively)                                         86,990     61,812
Inventories, net:
      Rough stones                                       22,779     11,944
      Polished stones                                   101,805     81,433
                                                       -------------------
         Total inventories                              124,584     93,377
                                                       -------------------
Prepaid expenses and other current assets                11,697      5,918
Deferred tax assets-current                               1,944      1,853
--------------------------------------------------------------------------
            TOTAL CURRENT ASSETS                        235,535    164,169

Property, plant and equipment, net                        7,892      7,246
Other assets                                                855        915
Deferred tax assets, net                                  6,002      8,382
--------------------------------------------------------------------------
                                                       $250,284   $180,712
==========================================================================
Liabilities and Stockholders' Equity
CURRENT LIABILITIES:
Accounts payable and other current liabilities         $ 77,241   $ 46,677
Current portion of long- term debt and lines of credit   16,738      6,893
--------------------------------------------------------------------------
            TOTAL CURRENT LIABILITIES                    93,979     53,570

Long-term debt                                           60,000     34,726
--------------------------------------------------------------------------
            TOTAL LIABILITIES                           153,979     88,296
--------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES
--------------------------------------------------------------------------
STOCKHOLDERS' EQUITY
   Preferred stock, par value $.01 per share:
      Authorized 1,500,000; no shares outstanding            --         --
   Common stock, par value $1 per share:
      Authorized 12,000,000 shares; issued 8,802,679
      and 8,710,619 in 2005 and 2004, respectively        8,803      8,711
   Additional paid-in capital                            62,090     61,595
   Cumulative translation adjustment                       (241)      (286)
   Retained earnings                                     28,772     23,542
--------------------------------------------------------------------------
                                                         99,424     93,562
Less treasury stock, 407,373 and 210,100 shares
   at cost in 2005 and 2004, respectively                (3,119)    (1,146)
--------------------------------------------------------------------------
            TOTAL STOCKHOLDERS' EQUITY                   96,305     92,416
--------------------------------------------------------------------------
                                                       $250,284   $180,712
==========================================================================
</TABLE>

See notes to consolidated financial statements.


                                      17




<PAGE>
                      Consolidated Statements of Cash Flows

<TABLE>
<CAPTION>
                                                                  Year ended May 31,
------------------------------------------------------------------------------------------
(In thousands)                                                2005       2004       2003
------------------------------------------------------------------------------------------
<S>                                                         <C>        <C>        <C>
Cash Flows from Operating Activities:
Net income                                                  $  5,230   $  2,399   $  1,094
Adjustments to reconcile net income to net cash
   used in operating activities:
      Depreciation and amortization                            1,159      1,202      1,405
      Provision for uncollectible accounts                        59        (44)       179
      Deferred income taxes                                    2,289        659        380
      Compensation expense--noncash                              329         --         --
      Cumulative effect of change in method of accounting         --         --        972
Changes in operating assets and liabilities:
   Accounts receivable                                       (25,237)    (4,408)   (12,070)
   Rough and polished inventories                            (31,207)   (15,140)    (3,936)
   Prepaid expenses and other current assets                  (5,779)       206        (66)
   Other assets                                                   45        107        220
   Accounts payable and other current liabilities             30,564     (6,771)     7,656
------------------------------------------------------------------------------------------
Net cash used in operating activities                        (22,548)   (21,790)    (4,166)
------------------------------------------------------------------------------------------

Cash Flows from Investing Activities:
Capital expenditures                                          (1,790)    (2,151)      (133)
------------------------------------------------------------------------------------------
Net cash used in investing activities                         (1,790)    (2,151)      (133)
------------------------------------------------------------------------------------------

Cash Flows from Financing Activities:
Increase in borrowings                                        35,119     24,863      4,667
Purchase of treasury stock                                    (1,973)      (212)      (934)
Proceeds from exercise of stock options                          258         24         10
                                                            ------------------------------
Net cash provided by financing activities                     33,404     24,675      3,743
------------------------------------------------------------------------------------------

Effect of exchange rate changes on cash                           45         (2)       (69)
                                                            ------------------------------
Net increase/(decrease) in cash and cash equivalents           9,111        732       (625)
Cash and cash equivalents at beginning of year                 1,209        477      1,102
                                                            ------------------------------
Cash and cash equivalents at end of year                    $ 10,320   $  1,209   $    477
==========================================================================================

Supplemental Disclosures of Cash Flow Information:
Cash paid during the year for:
Interest                                                    $  2,532   $    888   $    430
Income taxes                                                $    449   $    187   $    327
------------------------------------------------------------------------------------------
</TABLE>

See notes to consolidated financial statements.


                                      18




<PAGE>

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                             Additional    Cumulative                             Total
                                    Common     Paid-in    Translation   Retained   Treasury   Stockholders'
(In thousands, except share data)    Stock     Capital     Adjustment   Earnings     Stock        Equity
-----------------------------------------------------------------------------------------------------------
<S>                                 <C>        <C>           <C>         <C>       <C>           <C>
Balance, May 31, 2002                8,705      61,567        (215)       20,049        --        90,106

Comprehensive income:
   Net income                           --          --          --         1,094        --         1,094
   Foreign currency translation         --          --         (69)           --        --           (69)
                                                                                                 -------
Comprehensive income                                                                               1,025
Exercise of stock options, 1,654
   shares issued                         2           8          --            --        --            10

Purchase of treasury stock,
   180,100 shares                       --          --          --            --      (934)         (934)
-----------------------------------------------------------------------------------------------------------
Balance, May 31, 2003                8,707      61,575        (284)       21,143      (934)       90,207
Comprehensive income:
   Net income                           --          --          --         2,399        --         2,399

   Foreign currency translation         --          --          (2)           --        --            (2)
                                                                                                 -------
Comprehensive income                                                                               2,397
Exercise of stock options, 4,105
   shares issued                         4          20          --            --        --            24
Purchase of treasury stock,
   30,000 shares                        --          --          --            --      (212)         (212)
-----------------------------------------------------------------------------------------------------------
Balance, May 31, 2004               $8,711     $61,595       $(286)      $23,542   $(1,146)      $92,416

Comprehensive income:
   Net income                           --          --          --         5,230        --         5,230
   Foreign currency translation         --          --          45            --        --            45
                                                                                                 -------
Comprehensive income                                                                               5,275
Exercise of stock options, 92,060
   shares issued                        92         495          --            --        --           587
Purchase of treasury stock,
   197,273 shares                       --          --          --            --    (1,973)       (1,973)
-----------------------------------------------------------------------------------------------------------
Balance, May 31, 2005               $8,803     $62,090       $(241)      $28,772   $(3,119)      $96,305
===========================================================================================================
</TABLE>

See notes to consolidated financial statements.


                                      19




<PAGE>

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                     Years ended May 31, 2005, 2004 and 2003

1. Accounting Policies
--------------------------------------------------------------------------------

a. The Company and its Principles of Consolidation

     The Company and its subsidiaries are engaged in the cutting and polishing
of rough diamonds and selling of both polished and uncut rough diamonds. The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries. All material intercompany balances and transactions
have been eliminated. In these notes to consolidated financial statements, the
years "2005", "2004" and "2003" refer to the fiscal years ended May 31, 2005,
2004 and 2003, respectively.

b. Use of estimates

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

c. Sales and accounts receivable

Sales arrangements with customers:

     The Company's polished diamond and diamond jewelry customers consist
primarily of wholesale and retail clients. The Company's rough diamond customers
consist primarily of rough diamond cutters. The Company generally ships polished
diamond inventory to customers subject to verification of the diamond
particulars.

     The Company's policy is to recognize revenue when title and risk of
ownership have passed to the buyer, the earnings process is complete and the
sale price is fixed and determinable. In addition, in certain instances, the
Company may be entitled to receive incremental profits from its customers on the
sale of certain stones. Such profits are recognized as revenue when realized.
Where the Company acts as a principal in the sales transaction, takes title to
the product and has risks and rewards of ownership, the gross value of diamonds
invoiced is recorded as sales with the portion of profits allocable to others
(where applicable) included in cost of sales.

     Where the Company believes profitability can be maximized, the Company may
combine, and jointly sell, certain of its diamonds with those of other
wholesalers. In such instances, the Company is obligated to share profits it
realizes on the sale of such stones. Typically, the participating wholesaler is
required to advance funds to the Company equal to their proportional interest in
the underlying diamonds.

     The Company has an arrangement with a diamond producer whereby the Company
sells certain polished diamonds that are cut and polished in Russia. The risk
and rewards of ownership of these diamonds is transferred to the Company upon
delivery to the Company of the diamonds in polished form. Generally, upon
receipt, the Company pays a negotiated base price and the producer receives an
economic interest in future profits associated with the diamonds.

     The Company has a technical cooperation agreement with an entity
responsible for the development and marketing of diamonds produced in Angola.
Pursuant to this agreement the Company has established a joint buying and rough
diamond trading operation. The Company takes title to the diamonds upon
acquisition in Angola and assumes responsibility for risk of loss. Sales by the
Company are recorded at their gross invoice value. Profits in excess of
operating and rough acquisition costs as defined are allocated between parties
with such costs classified as cost of sales by the Company.

     The Company's net sales to customers in each of the following regions for
the years ended May 31, 2005, 2004 and 2003 are set forth below:

<TABLE>
<CAPTION>
                         ------------------
                         2005   2004   2003
-------------------------------------------
<S>                      <C>    <C>    <C>
United States             20%    30%    36%
Far East                   9%     9%     9%
Europe, Israel & Other    71%    61%    55%
-------------------------------------------
                         100%   100%   100%
                         ------------------
</TABLE>

     No single customer of the Company accounted for 10% or more of the
Company's net sales for the fiscal years ended May 31, 2005, 2004 and 2003.
Where the Company believes profitability can be maximized, the Company may
combine, and jointly sell, certain of its rough stones with those of other


                                      20




<PAGE>

wholesalers. Under certain circumstances, primarily related to foreign sales,
the wholesaler assumes responsibility for billing and collection efforts. While
the ultimate sales are made to multiple third parties the resulting accounts
receivable are aggregated for purposes of determining concentration of credit
risk. One customer accounted for 25.9% and 26.6% of accounts receivable at May
31, 2005 and 2004, respectively.

     Credit is extended based on an evaluation of each customer's financial
condition and generally collateral is not required on the Company's receivables.

d. Customer rebates

     From time to time the Company has had arrangements whereby it would rebate
to a customer a percentage of certain of its qualifying purchases. The Company
characterizes such rebates as a reduction of sales.

e. Cash and cash equivalents

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

f. Inventories

     Inventories, including amounts on consignment with customers, are stated at
the lower of cost or market, using either the first-in, first-out method, or
average cost method.

g. Property, plant and equipment

     Property, plant and equipment is stated at cost less accumulated
depreciation and amortization. Depreciation and amortization is computed using
the straight-line method over the shorter of asset lives or lease terms.

h. Asset impairments

     The Company records impairment losses on long-lived assets with finite
lives used in operations when events and circumstances indicate that the assets
might be impaired and the undiscounted cash flows estimated to be generated by
the related assets are less than the carrying amounts of those assets. If the
Company determines, based upon such measures, that the carrying amount is
impaired the long-lived asset will be written down to its recoverable value
based upon either the discounted future cash flows or appraised fair value.

i. Foreign currency

     All purchases of rough diamonds worldwide are denominated in U.S. dollars.
All of the Company's foreign sales are denominated in U.S. dollars, with the
exception of those sales made by the Company's subsidiary, Lazare Kaplan Japan,
which are denominated in Japanese yen. The functional currency for Lazare Kaplan
Japan is the Japanese yen and the Company recognizes foreign currency
translation adjustments with regard to the activities of Lazare Kaplan Japan as
a component of stockholders' equity in the accompanying balance sheets.

j. Advertising and incentive programs

     The Company participates in cooperative advertising arrangements with
customers in order to build brand awareness and product acceptance. Under such
an arrangement a customer is eligible to receive an allowance of up to a
specified percentage of its purchases from the Company if certain qualitative
advertising criteria are met and if specified amounts are spent on qualifying
advertising. The Company characterizes as selling, general and administrative
expense the consideration it pays to customers for cooperative advertising.

     In addition, the Company offers programs whereby certain sales staff
employed by the Company's customers can receive consideration for sales of the
Company's products. The Company characterizes as selling, general and
administrative expense the consideration it pays to the salesperson.

k. Consideration received from vendors

     Periodically, the Company negotiates agreements with vendors to share
certain promotional costs. The Company classifies amounts expended on such
promotions as selling general and administrative expense when incurred.
Similarly, amounts reimbursed by vendors are characterized as a reduction of
selling, general and administrative expense.

     Advertising costs are expensed as incurred and were $2.8, $2.1, and $1.7
million in 2005, 2004 and 2003, respectively.

l. Shipping and handling:

     Shipping and handling costs incurred by the Company to deliver product to
customers, $0.3 million in 2005, 2004 and 2003, are classified in the Company's
income statement as selling, general and administrative expense.


                                      21




<PAGE>

m. Income taxes

     The Company provides for income taxes in accordance with Statement of
Financial Accounting Standards No. 109, "Accounting for Income Taxes", whereby
deferred income taxes are determined based upon the enacted income tax rates for
the years in which these taxes are estimated to be payable or recoverable.
Deferred income taxes reflect the net tax effects of (a) temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes, and (b) operating loss
carryforwards. Realization of the net deferred tax assets is dependent on
generating sufficient taxable income prior to the expiration of net operating
loss carryforwards. Although realization is not assured, management believes it
is more likely than not that the net deferred tax asset will be realized. The
amount of the net deferred tax asset considered realizable, however, could be
reduced if estimates of future taxable income during the carryforward period are
reduced.

     The Company and its domestic subsidiaries file a consolidated income tax
return. The Company's foreign subsidiaries are not subject to Federal income
taxes and their provisions for income taxes have been computed based on the
effective tax rates, if any, in the foreign countries.

     Earnings from foreign subsidiaries are intended to be reinvested
indefinitely. Accordingly, no related U.S. income taxes have been provided.

n. Earnings/(Loss) per share

     The Company computes basic earnings per share based upon the weighted
average number of common shares outstanding, and diluted earnings per share
based upon the weighted average number of common shares outstanding including
the impact of dilutive stock options.

<TABLE>
<CAPTION>
                                            2005        2004        2003
--------------------------------------------------------------------------
<S>                                      <C>         <C>         <C>
Average number of shares outstanding
   during the period                     8,448,704   8,513,687   8,637,397

Effect of dilutive stock options
                                           204,518      86,267      20,999
--------------------------------------------------------------------------
Average number of shares outstanding
   during the period assuming dilution   8,653,222   8,599,954   8,658,396
==========================================================================
</TABLE>

     Antidilutive options of approximately 352,000, 373,000 and 841,000 were
not included in the computation of diluted earnings per share, for fiscal 2005,
2004 and 2003 respectively because the exercise price of the options were
greater than the average market price of the common shares.

o. Risks and Uncertainties

     The world's sources of rough diamonds are highly concentrated in a limited
number of countries. Varying degrees of political and economic risk exist in
many of these countries. As a consequence, the diamond business is subject to
various sovereign risks beyond the Company's control, such as changes in laws
and policies affecting foreign trade and investment. In addition, the Company is
subject to various political and economic risks, including the instability of
foreign economies and governments, labor disputes, war and civil disturbances
and other risks that could cause production difficulties or stoppages, restrict
the movement of inventory or result in the deprivation or loss of contract
rights or the taking of property by nationalization or expropriation without
fair compensation.

     The Company's business is dependent upon the availability of rough
diamonds. Based upon published reports, the Company believes that more than half
of the world's current diamond output is sold by the Diamond Trading Company
("DTC"), the rough diamond sales arm of the De Beers Group. Although the DTC has
historically been one of the Company's major suppliers of rough diamonds, the
Company has diversified its sources of supply by entering into arrangements with
other primary source suppliers and has been able to supplement its rough diamond
needs by purchasing supplies in the secondary market. While the Company believes
that it has good relationships with its suppliers and that its sources of supply
are sufficient to meet its present and foreseeable needs, the Company's rough
diamond supplies, and therefore, its manufacturing capacity, could be adversely
affected by political and economic developments in producing countries over
which it has no control. While the Company believes that alternative sources of
supply may be available, any significant disruption of the Company's access to
its primary source suppliers could have a material adverse effect on its ability
to purchase rough diamonds.

     In July 2000, the DTC announced significant changes in its approach to
rough diamond marketing. In brief, the DTC stated that it will stop open market
purchases and alter its market control and pricing policies. Henceforth, the DTC
has said it will focus on selling its own mining productions through its
"supplier of choice" marketing programs. These policy changes are intended to
drive consumer demand for diamond jewelry by fostering the development of
efficient distribution networks that stimulate demand, support the emergence of
internationally recognized brands to meet consumer needs, supply clients with a
consistent supply of rough diamonds and encourage and support additional
investment in marketing and advertising


                                      22




<PAGE>

programs with the goal of developing an industry led by advertising and
marketing support.

     Further, through its control of a significant portion of the world's
diamond output, the DTC could exert significant control over the pricing of
rough and polished diamonds. A large rapid increase in rough diamond prices
could materially adversely affect the Company's revenue and operating margins if
the increased cost of the rough diamonds could not be passed along to its
customers in a timely manner. Alternatively, any rapid decrease in the price of
rough or polished diamonds could have a material adverse affect on the Company
in terms of inventory losses and lower margins.

     The Company is currently a DTC Sightholder under the Supplier of Choice
Program. The Company believes it is well positioned to benefit from these
changes in the DTC approach to diamond marketing. However, there can be no
assurance that this policy change will not have a material adverse effect on the
Company's operations.

     The Company has agreements with AK ALROSA of Russia, which is the largest
producer of rough diamonds in Russia. The Company's cooperation arrangement with
ALROSA is a significant part of its operations. The Company believes it is well
positioned to benefit from the reorganization of the diamond industry in Russia.
However, there can be no assurance that the resulting changes will not have a
material adverse effect on the Company's operations.

     Pegasus Overseas Ltd. ("POL"), a wholly-owned subsidiary of the Company,
has an exclusive agreement expiring in 2009, with a formerly wholly-owned
subsidiary of General Electric Company ("GE"), subsequently renamed Diamond
Innovations Inc. ("DI"), under which POL markets natural diamonds that have
undergone a new high pressure, high temperature (HPHT) process to improve the
color of certain qualifying natural gem diamonds without reducing their
all-natural content. POL relies upon DI and GE for certain processing,
technology and financial support in connection with the preparation and sale of
Bellataire'r' HPHT diamonds.

p. Stock Incentive Plans

     The Company accounts for its stock-based compensation plans using the
intrinsic value method prescribed in Accounting Principles Board Opinion No.25
"Accounting for Stock Issued to Employees" and related interpretations. The
following disclosures are computed as if the Company recorded compensation
expense based on the fair value for stock -based awards or grants.

<TABLE>
<CAPTION>
                                       Year ended May 31,
                                    ------------------------
                                     2005     2004     2003
                                    ------------------------
<S>                                 <C>      <C>      <C>
Net income, as reported             $5,230   $2,399   $1,094
Add: Compensation expense, net of
related taxes                          184       --       --

Deduct: Stock-based employee
compensation expense determined
under fair value method,
net of related tax effects             509      329      367
                                    ------------------------
Proforma net income                 $4,905   $2,070   $  727

Earnings per share as
   reported:
Basic                               $ 0.62   $ 0.28   $ 0.13
Diluted                             $ 0.60   $ 0.28   $ 0.13

Basic and diluted earnings
   pro forma:
Basic                               $ 0.58   $ 0.24   $ 0.08
Diluted                             $ 0.57   $ 0.24   $ 0.08
</TABLE>

     In December 2004, the Financial Accounting Standards Board (FASB) revised
Statement of Financial Accounting Standards (SFAS) No. 123 "Share-Based
Payment". SFAS No. 123(R) will require the Company to expense stock options.
Adoption is required for the annual reporting periods beginning after June 15,
2005. The effect of expensing stock options on the Company's results of
operations using the Black-Scholes model is presented in the above table. The
pro forma effects presented above may not be representative of the effects on
reported net income and earnings per share for future periods since options vest
over several years and additional awards may be granted in future periods.

     During 2005 the Company's Stock Option Committee modified the vesting
period applicable to certain stock options granted in 2004. The effect of this
modification was to accelerate the vesting of options which would have vested on
December 15, 2006 to vest on May 31, 2006.

q. Comprehensive Income/(Loss)

     The Company reports "Comprehensive Income/(Loss)" in accordance with
Statement of Financial Accounting Standards No. 130, which requires foreign
currency translation adjustments to be included in other comprehensive
income/(loss).


                                      23




<PAGE>

For the years ended May 31, 2005, 2004 and 2003, total comprehensive income was
$5.3, $2.4, and $1.0 million, respectively.

r. Other Investments

     The Company has an investment with a carrying value of $0.1 million related
to certain mineral rights in Africa.

s. Reclassifications

     Certain prior year amounts have been reclassified to conform to current
year presentation.

2. Property, Plant and Equipment
--------------------------------------------------------------------------------

     Property, plant and equipment consists of (in thousands):

<TABLE>
<CAPTION>
                                     May 31,
                                -----------------
                                  2005      2004
                                -----------------
<S>                             <C>       <C>
Land and buildings              $ 1,470   $ 1,445
Leasehold improvements            2,631     2,955
Machinery, tools and
   equipment                      8,017     6,734
Furniture and fixtures            1,337     2,198
Computer hardware, software
   and equipment                  8,027     7,847
-------------------------------------------------
                                 21,482    21,179
Less accumulated depreciation
   and amortization              13,590    13,933
-------------------------------------------------
                                $ 7,892   $ 7,246
                                -----------------
</TABLE>

Depreciation and amortization rates:

<TABLE>
<S>                               <C>
Buildings                          2 to 3.7%
Leasehold improvements            3.7 to 20%
Machinery, tools and equipment     10 to 25%
Furniture and fixtures             10 to 20%
Computer hardware, software and
equipment                          10 to 33%
</TABLE>

     Depreciation expense for 2005, 2004 and 2003 was $1.1, $1.2 and $1.1
million, respectively.

3. Income Taxes
--------------------------------------------------------------------------------

     The items comprising the Company's net deferred tax assets are as follows
(in thousands):

<TABLE>
<CAPTION>
                                    May 31,
------------------------------------------------
                                2005      2004
------------------------------------------------
<S>                           <C>       <C>
Deferred tax assets:
   Operating loss and other
      carryforwards           $ 7,945   $  9,984
   Other                        1,667      1,568
Deferred tax liabilities:
      Depreciation             (1,533)    (1,184)
------------------------------------------------
                                8,079     10,368
Less: Valuation allowance        (133)      (133)
------------------------------------------------
Net deferred tax assets       $ 7,946   $ 10,235
------------------------------------------------
</TABLE>

     The income tax provision is comprised of the following (in thousands):

<TABLE>
<CAPTION>
                             Year ended May 31,
                           ----------------------
                            2005    2004    2003
                           ----------------------
<S>                        <C>      <C>    <C>
Current:
Federal                    $   98   $  4   $   68
State and local               117    165      201
Foreign                       136     46       40
-------------------------------------------------
                              351    215      309
Deferred:
Federal, state and local    2,289    659      881
-------------------------------------------------
                           $2,640   $874   $1,190
-------------------------------------------------
</TABLE>

     Income before income taxes and cumulative effect of change in accounting
principle from the Company's domestic and foreign operations (in thousands):

<TABLE>
<CAPTION>
              Year ended May 31,
-----------------------------------
            2005     2004     2003
-----------------------------------
<S>        <C>      <C>      <C>
Domestic   $6,008   $1,951   $2,523
Foreign     1,862    1,322      733
-----------------------------------
           $7,870   $3,273   $3,256
-----------------------------------
</TABLE>


                                      24




<PAGE>

     The tax provision is different from amounts computed by applying the
Federal income tax rate to the income before taxes as follows (in thousands):

<TABLE>
<CAPTION>
----------------------------------------------------------
                                   2005     2004     2003
----------------------------------------------------------
<S>                               <C>      <C>      <C>
Tax provision / (benefit) at
   statutory rate                 $2,676   $1,113   $1,107
(Decrease) / increase in
   taxes resulting from:
   Differential attributable to
      foreign operations            (497)    (403)    (209)
   State and local taxes,
      net of Federal benefit         443      146      274
   Permanent items                    18       18       18
----------------------------------------------------------
Tax provision                     $2,640   $  874   $1,190
----------------------------------------------------------
</TABLE>

     The Company has available Federal net operating losses to offset future
taxable income which expire as follows (in thousands):

<TABLE>
<CAPTION>
          Net
       Operating
Year    Losses
----------------
<C>     <C>
2019      9,858
2020        298
2021        120
2022     10,209
---------------
        $20,485
---------------
</TABLE>

     In addition, the Company has New York State and New York City net operating
loss carryforwards of approximately $10.6 million each, expiring from 2014
through 2017. The Company has Puerto Rico net operating loss carryforwards of
approximately $1.8 million expiring from 2008 through 2010.

4. Accounts Payable and Other Current Liabilities
--------------------------------------------------------------------------------

     Accounts payable and other current liabilities consist of (in thousands):

<TABLE>
<CAPTION>
                       2005      2004
--------------------------------------
<S>                  <C>       <C>
Accounts payable     $ 8,040   $ 7,191
Advances and other    62,065    34,199
Accrued expenses       7,136     5,287
--------------------------------------
                     $77,241   $46,677
--------------------------------------
</TABLE>

     Advances and other, primarily relating to the purchase, manufacture and
sale of inventory, includes $40.4 million and $21.6 million payable to two
parties for 2005. For 2004, $20.8 million and $13.4 million was payable to two
parties.

5. Lines of Credit
--------------------------------------------------------------------------------

     The Company has a $15.0 million and a $25.0 million unsecured, uncommitted
line of credit with a bank. Borrowings under both lines bear interest at a rate
160 basis points above the 90 day LIBOR. As of May 31, 2005 and 2004, the
balance outstanding under both lines was $14.5 million and $16.9 million,
respectively. Borrowings under these lines are available for the Company's
working capital requirements and are payable on demand. In July 2005 the
combined amount available under these lines was increased to $45.0 million.

     The Company has a long-term unsecured, revolving loan agreement. The
agreement provides that the Company may borrow up to $35.0 million (including up
to $1.0 million under letters of credit) in the aggregate through December 1,
2006. The loan term may be extended in one year increments commencing November
30, 2005, subject to the consent of the lending banks. Borrowings under this
agreement bear interest at (a) the higher of the banks base rate or one half of
one percent above the Federal Funds Effective Rate, or (b) 160 basis points
above LIBOR. The applicable interest rate is contingent upon the method of
borrowing selected by the Company. The proceeds of this facility are available
for working capital purposes. The loan agreement contains certain provisions
that require, among other things, (a) maintenance of defined levels of working
capital, net worth and profitability, (b) limitations on borrowing levels,
investments and capital expenditures and (c) limitations on dividends and the
repurchase of treasury shares. As of May 31, 2005 and 2004, the balance
outstanding under this facility was $33.0 million and $20.0 million,
respectively. In July 2005 the maximum amount available under this agreement was
increased to $45.0 million. In addition, at May 31, 2005 outstanding letters of
credit under this facility amounted to $0.7 million.

     During 2004, the Company entered into an additional long-term unsecured,
revolving loan agreement with a bank under which it may borrow up to $30.0
million in the aggregate through December 1, 2006. The loan term may be extended
in one year increments commencing November 30, 2005, subject to the consent of
the bank. Borrowings under this agreement bear interest at (a) the higher of the
banks


                                      25




<PAGE>

base rate or one half of one percent above the Federal Funds Effective Rate, or
(b) 160 basis points above LIBOR. The applicable interest rate is contingent
upon the method of borrowing selected by the Company. The proceeds of this
facility are available for working capital purposes. The loan agreement contains
certain provisions that require, among other things, (a) maintenance of defined
levels of working capital, net worth and profitability, (b) limitations on
borrowing levels, investments and capital expenditures and (c) limitations on
dividends and the repurchase of treasury shares. Borrowings under this loan
agreement amounted to $29.2 million at May 31, 2005.

     A subsidiary of the Company maintains a loan facility which enables it to
borrow up to 550 million Japanese yen (approximately $5.0 million U.S. dollars)
at an interest rate 1% above the Japanese yen LIBOR through November 2006.
Borrowings under the facility are available for working capital purposes. The
Company guarantees repayment of amounts borrowed. Borrowings under the loan are
used in support of its operations in Japan. As of May 31, 2004, the balance
outstanding under this facility was $4.7 million U.S. dollars. There were no
borrowings under this facility at May 31, 2005.

     The weighted average interest rate for all outstanding borrowings under the
Company's credit facilities was 4.50% at May 31, 2005.

     Long-term debt of $60.0 million outstanding at May 31, 2005 is scheduled to
be repaid in the fiscal year ended May 31, 2007. The Company was in compliance
with its debt covenants at May 31, 2005.

     The Company's long-term facilities do not contain subjective acceleration
clauses or require the Company to utilize a lock box whereby remittances from
the Company's customers reduce the debt outstanding.

6. Cumulative Effect of Change in Method of Accounting for Goodwill and Other
Intangible Assets
--------------------------------------------------------------------------------

     On June 1, 2002 the Company adopted Financial Accounting Standards Board
Standard No. 142, "Goodwill and Other Intangible Assets" ("Statement 142"). As a
result, the Company ceased amortization of goodwill and other indefinite lived
intangible assets. Under the transition provision of Statement 142 the Company
completed its evaluation of goodwill and indefinite lived assets during the
quarter ended November 30, 2002, using a discounted cash flow methodology. As a
result of testing goodwill impairment in accordance with Statement 142, as of
June 1, 2002, the Company recorded a non-cash charge of approximately $1.5
million ($1.0 million after tax, or $0.11 per share), which has been reported
under the caption "Cumulative Effect of a Change in Accounting Principle". The
charge relates to the Company's operations in Japan (Far East Segment).

7. Stock Incentive Plans
--------------------------------------------------------------------------------

     A Stock Option Incentive Plan was approved by the Board of Directors on
March 11, 1988 (the 1988 Plan). The 1988 Plan has reserved 650,000 shares of the
common stock of the Company for issuance to key employees of the Company and its
subsidiaries. No future grants may be made under the 1988 Plan, although
outstanding options may continue to be exercised.

     A Long-Term Stock Incentive Plan was approved by the Board of Directors on
April 10, 1997 (the 1997 Plan). The 1997 Plan has reserved 1,350,000 shares of
the common stock of the Company for issuance to directors, officers, key
employees and consultants of the Company and its subsidiaries.

     The purchase price of each share of common stock subject to an incentive
option under each of the plans is not to be less than 100 percent of the fair
market value of the stock on the day preceding the day the option is granted
(110 percent for 10 percent beneficial owners). The Stock Option Committee
determines the period or periods of time during which an option may be exercised
by the participant and the number of shares as to which the option is
exercisable during such period or periods, provided that the option period shall
not extend beyond ten years (five years in the case of 10 percent beneficial
owners) from the date the option is granted.

     The Company does not recognize compensation expense when the exercise price
of the Company's stock options equals the market price of the underlying stock
on the date of the grant. Under Statement of Financial Accounting Standards No.
123 "Accounting for Stock-Based Compensation", pro forma information regarding
net income and earnings per share is required as if the Company had accounted
for its employee stock options under the fair value method of the Statement. For
purposes of pro forma disclosures, the Company estimated the fair value of stock
options granted in 2004, 2003 and 2002 at the date of the grant using the
Black-Scholes option pricing model. The estimated fair value of the


                                      26




<PAGE>

options is amortized as an expense over the options' vesting period for the pro
forma disclosures.

     The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.

     The following summarizes the assumptions used to estimate the fair value of
stock options granted in each year and certain pro forma information:

<TABLE>
<CAPTION>
                          ---------------------------
                            2005      2004      2003
                          ---------------------------
<S>                       <C>       <C>       <C>
Risk-free interest rate      3.85%     2.50%     2.50%
Expected option life      5 years   5 years   5 years
Expected volatility         30.30%    39.60%    39.60%
Expected dividends
   per share               $   --    $   --     $  --
Weighted average
   estimated fair
   value per share
   of options granted
   at market price         $ 3.09    $ 2.96     $2.15
Weighted average
   estimated fair
   value per share
   of options granted
   above market price      $ 2.48    $ 2.49     $1.94
</TABLE>

     As any options granted in the future will also be subject to the fair value
pro forma calculations, the pro forma adjustments for 2005, 2004 and 2003 may
not be indicative of future years.

     A summary of the Plans' activity for each of the three years in the period
ended May 31, 2005 is as follows:

<TABLE>
<CAPTION>
                                                                Weighted
                              Number of                      average price
                                shares      Option Price       per share
                              --------------------------------------------
<S>                           <C>         <C>                    <C>
Outstanding - May 31, 2002    1,011,700   $4.350 - $14.750       $8.537
Options expired/cancelled       (88,950)  $5.000 - $14.750       $9.523
Options issued                  104,500   $5.480 - $ 5.480       $5.480
Options exercised               (14,833)  $5.000 - $ 7.000       $6.150
--------------------------------------------------------------------------
Outstanding - May 31, 2003    1,012,417   $4.350 - $14.750       $8.174
Options expired/cancelled       (56,600)  $5.000 - $14.750       $8.230
Options issued                  208,000   $7.000 - $ 8.800       $8.310
Options exercised                (5,134)  $5.125 - $ 6.375       $5.650
--------------------------------------------------------------------------
Outstanding - May 31, 2004    1,158,683   $4.350 - $14.750       $8.208
Options expired/cancelled        (9,300)  $5.000 - $14.750       $7.720
Options issued                  360,000   $7.770 - $10.560       $9.310
Options exercised              (169,265)  $4.350 - $10.375       $6.700
--------------------------------------------------------------------------
Outstanding - May 31, 2005    1,340,118   $5.000 - $14.750       $8.697
--------------------------------------------------------------------------
Exercisable options             966,784
---------------------------------------
</TABLE>

     In 2005, the Company had cashless exercise of certain options that
generated a compensation expense of $0.3 million.

     The following table summarizes information about stock options at May 31,
2005:

<TABLE>
<CAPTION>
           Outstanding Stock Options
------------------------------------------------------
                                Weighted                   Exercisable stock options
                                average       Weighted     -------------------------
                               remaining      average                   Weighted
                              contractual     exercise                   average
 Range of prices     Shares      life          price       Shares    exercise price
------------------------------------------------------     -------------------------
<S>       <C>       <C>           <C>         <C>         <C>           <C>
$ 5.000 - $ 6.600   339,617       5.03        $ 5.75       308,951       $ 5.76
$ 7.000 - $ 8.800   498,701       5.97        $ 7.80       316,035       $ 7.69
$ 9.000 - $11.412   343,300       6.01        $10.13       183,298       $10.17
$14.750             158,500       1.85        $14.75       158,500       $14.75
------------------------------------------------------------------------------------
</TABLE>


                                      27




<PAGE>

8. Commitments and Contingencies
--------------------------------------------------------------------------------

     Future minimum payments (excluding sub-lease income) under noncancelable
operating leases with initial terms of more than one year consist of the
following at May 31, 2005 (in thousands):

             Operating
   Year        Leases
----------------------
      2006    $  905
      2007       715
      2008       739
      2009       615
      2010       599
Thereafter     6,190
              ------
              $9,763
              ------

     In June 2003, the Company entered into a lease for office space which
serves as its corporate headquarters. The term of the lease is through September
30, 2019 at an average annual base rental rate of approximately $0.6 million per
year.

     Rental expense, including additional charges paid for increases in real
estate taxes and other escalation charges and credits for the years ended May
31, 2005, 2004, and 2003 was approximately, $0.9 million, $0.8 million and $0.6
million respectively.

As of May 31, 2005 approximately $17.6 million of POL inventory is subject to a
security interest by a third party.

     The Company has been apprised of the filing of a lawsuit alleging, among
other things, restraint of trade entitled "W.B. David & Co., Inc. plaintiff,
against De Beers Centenary A. G. , et al., defendants." United States District
Court, Southern District of New York, in which approximately 100 individuals and
entities, including De Beers Centenary A. G. , certain of its principals and
allegedly related companies, and various "sightholders" of De Beers, including
the Company, are named as defendants. The Company has not been served and does
not know if it will be served in this matter. If the Company is served it will
deny all allegations of wrongdoing and vigorously contest the lawsuit.

9. Profit Sharing Plan
--------------------------------------------------------------------------------

     The Company has a profit sharing and retirement plan subject to Section
401(k) of the Internal Revenue Code. The plan covers all full-time employees in
the United States and Puerto Rico who complete at least one year of service.
Participants may contribute up to a defined percentage of their annual
compensation through salary deductions. The Company intends to match employee
contributions in an amount equal to $0.50 for every pretax dollar contributed by
the employee up to 6% of the first $20,000 of compensation, provided the
Company's pretax earnings for the fiscal year that ends in the plan year exceed
$3.5 million. The Company anticipates making a matching contribution for the
2005 plan year of $0.1 million. The Company did not make a matching contribution
during 2004 or 2003.


                                      28




<PAGE>

10. Geographic Segment Information
--------------------------------------------------------------------------------

     Revenue, gross profit and income/(loss) before income tax provision and
cumulative effect of change in accounting principles for each of the three years
in the period ended May 31, 2005 and identifiable assets at the end of each of
those years, classified by geographic area, which was determined by where sales
originated from and where identifiable assets are held, were as follows (in
thousands):

<TABLE>
<CAPTION>
                                           North                             Far       Elimi-    Consoli-
                                          America     Europe     Africa      East     nations      dated
---------------------------------------------------------------------------------------------------------
<S>                                       <C>        <C>        <C>        <C>       <C>         <C>
Year ended May 31, 2005

   Net sales to unaffiliated customers    $108,378   $295,743   $     --   $17,290   $      --   $421,411
   Transfers between geographic areas      167,634      1,501    113,610        45    (282,790)        --
                                         ----------------------------------------------------------------
Total revenue                             $276,012   $297,244   $113,610   $17,335   $(282,790)  $421,411
                                         ----------------------------------------------------------------
Gross profit                              $ 28,189   $  2,601   $   (931)  $ 4,818   $      57   $ 34,734
                                         ----------------------------------------------------------------
Income/(loss) before income taxes         $  8,175   $    365   $ (1,231)  $   504   $      57   $  7,870
                                         ----------------------------------------------------------------
Identifiable assets at May 31, 2005       $153,640   $ 59,096   $ 29,964   $ 7,654   $     (70)  $250,284
=========================================================================================================

Year ended May 31, 2004

   Net sales to unaffiliated customers    $ 95,558   $125,788   $     --   $14,429   $      --   $235,775
   Transfers between geographic areas       40,260      1,459         --        --     (41,719)        --
                                         ----------------------------------------------------------------
Total revenue                             $135,818   $127,247   $     --   $14,429   $ (41,719)  $235,775
                                         ----------------------------------------------------------------
Gross profit                              $ 21,692   $  1,735   $   (555)  $ 3,334   $     (62)  $ 26,144
                                         ----------------------------------------------------------------
Income/(loss) before income taxes         $  5,065   $    109   $ (1,333)  $  (506)  $     (62)  $  3,273
                                         ----------------------------------------------------------------
Identifiable assets at May 31, 2004       $163,955   $  6,975   $    729   $ 9,180   $    (127)  $180,712
=========================================================================================================

Year ended May 31, 2003

   Net sales to unaffiliated customers    $102,192   $ 89,439   $     --   $11,528   $      --   $203,159
   Transfers between geographic areas       29,577        547         --        --     (30,124)        --
                                         ----------------------------------------------------------------
Total revenue                             $131,769   $ 89,986   $     --   $11,528   $ (30,124)  $203,159
                                         ----------------------------------------------------------------
Gross profit                              $ 19,586   $  1,384   $   (329)  $ 2,517   $      --   $ 23,158
                                         ----------------------------------------------------------------
Income/(loss) before income taxes and
   cumulative effect of change in
   accounting principle                   $  4,069   $     63   $   (526)  $  (350)  $      --   $  3,256
                                         ----------------------------------------------------------------
Identifiable assets at May 31, 2003       $142,217   $  4,629   $  6,626   $ 7,004   $     (65)  $160,411
=========================================================================================================
</TABLE>

Revenue and gross profit for each of the three years in the period ended May 31,
2005 classified by product were as follows (in thousands):

<TABLE>
<CAPTION>
                          Polished     Rough      Total
--------------------------------------------------------
<S>                       <C>        <C>        <C>
Year ended May 31, 2005
Net sales                 $156,904   $264,507   $421,411
                          ------------------------------
Gross profit              $ 25,480   $  9,254   $ 34,734
========================================================
Year ended May 31, 2004
Net sales                 $142,672   $ 93,103   $235,775
                          ------------------------------
Gross profit              $ 21,854   $  4,290   $ 26,144
========================================================
Year ended May 31, 2003
Net sales                 $135,025   $ 68,134   $203,159
                          ------------------------------
Gross profit              $ 20,507   $  2,651   $ 23,158
========================================================
</TABLE>


                                      29




<PAGE>

11. Sale of Common Stock
--------------------------------------------------------------------------------

     During 2005 and 2004 the Company purchased 197,273 and 30,000 shares,
respectively, of its common stock which was shown as a reduction of
stockholders' equity.

     In February 2002, pursuant to a stock purchase agreement ("SPA"), the
Company sold 1,305,000 shares of its common stock, consisting of 1,180,000 of
previously repurchased treasury shares and 125,000 authorized but unissued
shares, in a private transaction. The SPA provides for, among other things, a
ten-year standstill period whereby the purchaser and its affiliates will not
acquire 24.9% or more of the outstanding shares of common stock, participate in
any proxy disputes or transfer their stock except as provided for in the SPA. In
connection therewith, the purchaser delivered an irrevocable proxy to the
Chairman and President of the Company to vote the 1,180,000 shares, subject to
certain limitations, through February 2010.

     During 2004 the Company purchased approximately $0.3 million of inventory
from an entity affiliated with this investor.

12. Transactions with related parties
--------------------------------------------------------------------------------

     Through September 2003, the Company subleased space to an entity in which
its Chairman and President are the sole general partners. Rental payments under
the sublease amount to a base rent of $61,488 per annum (excluding amounts paid
for escalations). The sublease was prorated to the same rental rate per square
foot which the Company was paying the landlord at the same location.

     A member of the Company's Board of Directors is of counsel to a law firm
which serves as counsel to the Company. Amounts paid to the law firm during
2005, 2004 and 2003 were $0.5, $0.5 and $0.2 million, respectively.

     During 2005 the Company sold approximately $1.7 million of jewelry to a
relative of a non-employee member of the Company's Board of Directors. During
2004 and 2003 the Company sold approximately $0.1 and $1.3 million,
respectively, of jewelry to a non-employee member of the Company's Board of
Directors.

13. Quarterly Results of Operations (Unaudited)
--------------------------------------------------------------------------------

     The following is a summary of the results of operations for the years ended
May 31, 2005 and 2004 (in thousands, except per share data):

<TABLE>
<CAPTION>
------------------------------------------------------------------------------
                                        FIRST     SECOND     THIRD     FOURTH
------------------------------------------------------------------------------
<S>                                    <C>       <C>       <C>        <C>
2005
Net sales                              $78,307   $93,201   $120,013   $129,890
Gross profit                           $ 9,891   $ 8,066   $  7,809   $  8,968
Net income                             $ 2,507   $ 1,061   $  1,080   $    582
Basic earnings per share               $  0.30   $  0.13   $   0.13   $   0.07
Diluted earnings per share             $  0.29   $  0.12   $   0.12   $   0.07

2004
Net sales                              $54,108   $52,390   $ 64,800   $ 64,477
Gross profit                           $ 6,118   $ 5,557   $  7,149   $  7,320
Net income                             $   367   $   110   $    753   $  1,169
Basic and diluted earnings per share   $  0.04   $  0.01   $   0.09   $   0.14
</TABLE>


                                      30




<PAGE>

           Report of Independent Registered Public Accounting Firm

Board of Directors
Lazare Kaplan International Inc.
New York, NY


We have audited the accompanying consolidated balance sheet of Lazare Kaplan
International Inc. as of May 31, 2005 and the related consolidated statements
of income, stockholders' equity, and cash flows for the year then ended. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based
on our audit.

We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonsable assurance about whether the
financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting. An audit includes consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examinaing, on a test basis, evidence supporting the amounts and disclosures
in the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Lazare Kaplan
International Inc. at May 31, 2005, and the results of its operations and its
cash flows for the year then ended in conformity with accounting principles
generally accepted in the United States.



BDO Seidman, LLP

New York, NY
August 11, 2005


                                        31






<PAGE>


             Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders
Lazare Kaplan International Inc.

     We have audited the accompanying consolidated balance sheet of Lazare
Kaplan International Inc. and subsidiaries as of May 31, 2004 and the
related consolidated statements of income, stockholders' equity, and cash
flows for each of the two years in the period ended May 31, 2004. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

     We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those statements require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. We were not engaged
to perform an audit of the Company's internal control over financial reporting.
Our audits included consideration of internal control over financial reporting
as a basis for designing audit procedures that are appropriate in the
circumstance, but not for the purposes of expressing an opinion on the
effectiveness of the Company's internal control over financial reporting.
Accordingly, we express no such opinion. An audit also includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, 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 consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Lazare Kaplan International Inc. and subsidiaries at May 31, 2004 and the
consolidated results of their operations and their cash flows for each of the
two years in the period ended May 31, 2004 in conformity with U.S. generally
accepted accounting principles.

     As discussed in Note 6 to the consolidated financial statements, on June 1,
2002, the Company adopted Statement of Financial Accounting Standard No. 142,
"Goodwill and other Intangible Assets".

                                        /s/ Ernst & Young, LLP

New York, New York
August 19, 2004


                                      32




<PAGE>

                              Corporate Information

<TABLE>
<CAPTION>
Corporate Headquarters     Directors and Officers       Registrar and Transfer Agent
----------------------     ----------------------       ----------------------------
<S>                        <C>                          <C>
19 West 44th Street        Maurice Tempelsman           Mellon Investor Services
New York, New York 10036   Director;                    44 Wall Street
Telephone (212) 972-9700   Chairman of the Board        6th Floor
                                                        New York, NY 10005
                           Leon Tempelsman
                           Director;                    Counsel
                           Vice Chairman of the Board
                           and President                Warshaw Burstein Cohen
                                                        Schlesinger & Kuh, LLP
                           Lucien Burstein              555 Fifth Avenue
                           Director;                    New York, New York 10017
                           Secretary
                           Of Counsel                   Registered Public Accounting Firm
                           Warshaw Burstein Cohen
                           Schlesinger & Kuh, LLP       BDO Seidman, LLP
                           (attorneys)                  330 Madison Avenue
                                                        New York, New York 10017
                           Myer Feldman
                           Director;
                           Attorney,
                           self-employed

                           Richard A. Berenson
                           Director;
                           Former Managing Partner
                           Berenson & Company, LLP

                           Robert A. Del Genio
                           Director;
                           Co-Founder
                           Conway, Del Genio,
                           Gries & Company, LLC

                           William H. Moryto
                           Vice President and
                           Chief Financial Officer
</TABLE>


                                      33