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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                               ---------------
 
                                  FORM 10-K/A
 
             ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
 
FOR THE FISCAL YEAR ENDED DECEMBER         COMMISSION FILE NUMBER: 0-21579
             31, 1997
 
                               ---------------
 
                          SMARTALK TELESERVICES, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
<S>                                     <C>
            CALIFORNIA (1)                            95-4502740
     (STATE OR OTHER JURISDICTION                  (I.R.S. EMPLOYER
  OF INCORPORATION OR ORGANIZATION)              IDENTIFICATION NO.)
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  5080 TUTTLE CROSSING BLVD.,                            43016-3566
         DUBLIN, OHIO
     (ADDRESS OF PRINCIPAL                               (ZIP CODE)
      EXECUTIVE OFFICES)
 
Registrant's telephone number, including area code: (614) 789-8500
 
Securities registered pursuant to Section 12(b) of the Act: None
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
 
                          COMMON STOCK, NO PAR VALUE
                               (TITLE OF CLASS)
 
  Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
 
  The aggregate market value of the registrant's Common Stock held by non-
affiliates of the registrant as of March 5, 1998, was $571,283,991 based on
the last sale price on the NASDAQ National Market ("NASDAQ") on that date.
 
  As of March 27, 1998, 22,359,249 shares of the registrant's Common Stock
were outstanding.
 
 
(1) A proposal to effect the reincorporation of SmarTalk TeleServices, Inc.
    (the "Company") from California to Delaware was approved by the
    shareholders of the Company on December 31, 1997. Accordingly, subject to
    receipt of requisite regulatory approval, the Company's state of
    incorporation will change from California to Delaware and the Company will
    be a Delaware corporation.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Certain portions of the Company's proxy statement for the annual meeting of
shareholders held on June 18, 1998, to be filed with the Securities and
Exchange Commission (the "Commission") no later than 120 days after the end of
the Company's fiscal year ended December 31, 1997, are incorporated by
reference into Part III of this Form 10-K (Items 10 through 13).
 
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              RESTATEMENT OF FINANCIAL STATEMENTS AND CHANGES TO
                              CERTAIN INFORMATION
 
  Subsequent to the filing with the Securities and Exchange Commission of its
Annual Report on Form 10-K for the year ended December 31, 1997, SmarTalk
TeleServices, Inc.'s ("SmarTalk" or the "Company") management in conjunction
with the Company's independent accountants, PricewaterhouseCoopers LLP
("PwC"), determined that significant issues existed with regard to the
Company's accounting treatment for deferred revenue recorded in conjunction
with acquisitions that occurred during 1997, the restructuring reserve taken
during the fourth quarter of 1997, the charge for acquired research and
development in-process taken during the fourth quarter of 1997 as well as
certain other items. The Company's investigation into these issues ultimately
resulted in the restatement of the Company's revenues and financial results
for the year ended 1997 and for the first and second quarters of 1998. (See
Note 14 to the Company's consolidated financial statements.)
 
  This Annual Report on Form 10-K/A amends Items 1, 3, 6, 7, 8 and 14 of the
Company's Annual Report on Form 10-K previously filed for the year ended
December 31, 1997. This Annual Report on Form 10-K/A is filed in connection
with the Company's restatement of its financial statements for the year ended
December 31, 1997. Financial statement information and related disclosures
included in this amended filing reflect, where appropriate, changes as a
result of the restatements. Except as otherwise noted, information contained
in this Annual Report on Form 10-K/A is as of December 31, 1997.
 
  This Annual Report on Form 10-K/A contains statements that constitute
"forward-looking statements" within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended, which generally can be identified by the use of
forward-looking terminology such as "anticipate," "believe," "target,"
"estimate," "may," "will," "expect," "plan," "project" or "continue" or the
negative thereof or other variations thereon or similar terminology. Such
statements are based on information available to management as of the time of
such statements and relate to, among other things, expectations of the
business environment in which the Company operates, projections of future
performance, perceived opportunities in the market and statements regarding
the Company's mission and vision. Such statements are not guarantees of future
performance and involve certain risks, uncertainties and assumptions,
including risks related to the highly competitive market in which the Company
operates; the need to attract and retain qualified management personnel;
uncertainty in consumer acceptance of the Company's products and services,
including its prepaid cellular product; possible difficulty in obtaining
acceptable financing for the Company's continued expansion; and difficulty in
integrating the Company's operations acquired primarily through acquisitions.
These and other risks, uncertainties and assumptions identified from time to
time in the Company's filings with the Securities and Exchange Commission,
including without limitation, its annual reports on Form 10-K and its
quarterly reports on Form 10-Q, as amended, could cause the Company's future
results to differ materially from those expressed in any forward-looking
statements made by or on behalf of the Company. Many of such factors are
beyond the Company's ability to control or predict. These forward-looking
statements speak only as of the date for which they are made. The Company
disclaims any intent or obligation to update publicly any forward-looking
statements, whether as a result of new information, future events or
otherwise.
<PAGE>
 
                                    PART I
 
ITEM 1. BUSINESS
 
THE COMPANY
 
  SmarTalk was incorporated as a California corporation in 1994 and had
limited operations until June 1995. On October 23, 1996, SmarTalk completed a
public offering of 4,000,000 shares of its common stock, no par value (the
"Common Stock"), which are listed on the NASDAQ National Market. SmarTalk is
one of the largest providers of prepaid telecommunications products and
services in North America, offering convenient, easy-to-use and cost-effective
telecommunications solutions to individuals and businesses primarily through
the SmarTalk prepaid phone card (the "SmarTalk Card"). The SmarTalk Card
provides consumers with a single point of access to prepaid telecommunications
services at a fixed rate charge per minute regardless of the time of day or,
in the case of domestic calls, the distance of the call. SmarTalk's services
currently include domestic calling, international long distance calling
(outbound to more than 200 countries and inbound from more than 30 countries),
as well as enhanced features such as speed dial, message delivery, sequential
calling, conference calling, content delivery, and voice and fax mailboxes.
The SmarTalk Card may be recharged with a major credit card by calling
SmarTalk's customer service department or, in select retail locations, at
point-of-sale, allowing the user to add minutes as needed. Since its
inception, the Company has experienced rapid revenue growth from both internal
growth and through acquisitions. See "--Acquisitions." SmarTalk's revenues and
minutes decremented increased, respectively, from $453,916 and 2,774,157 for
the year ended December 31, 1995, to $15,021,060 and 67,317,886 for the year
ended December 31, 1996 and to $61,164,228 and 291,879,909 for the year ended
December 31, 1997.
 
  SmarTalk's primary marketing and distribution focus is to target individuals
and small businesses through major national and regional retailers. The
SmarTalk Card is sold at select leading U.S. retailers, including: American
Stores (which includes Jewel/Osco Combo Stores, Osco Drug Stores, Sav-On Drug
Stores, Lucky Stores and Acme Grocery), Bergen Brunswig Drug Company (Good
Neighbor Pharmacies), Best Buy, Bradlees, Builders Square, Dominick's Finer
Foods, Eckerd Drug, Food4Less, Future Shop, The Good Guys, King Soopers
supermarkets, BiLo, Cub Foods, Nix Check Cashing, Office Depot, Pamida, Penn
Daniels, Qwik Shops, Service Merchandise, Ralphs Supermarkets, Staples, Star
Market, Stop & Shop, Thrifty Oil, Bartell Drug, Schwegmann's, Fry's, Giant,
Goodings, Genovese Drugs, Wegmans, Winn-Dixie Stores, Emro Marketing
(Speedway, Starvin' Marvin, United, Bonded, Gastown, Cheker and Wake Up),
SuperAmerica, Spectrum Stores, Pick Kwik Food Stores, Weis Markets, Shoppers
Food Warehouse and Marathon Oil. SmarTalk has been able, and intends to
continue, to expand its retail network by: (i) leveraging its market position,
reputation and brand name recognition; (ii) providing consumers with high
quality, convenient and reliable products and services while continually
updating the convenience and enhanced features of its products and services;
(iii) increasing awareness among retailers as to the benefits of selling the
SmarTalk Card and providing retailers with effective merchandising solutions;
and (iv) increasing its international distribution channels.
 
  Through the acquisition of American Express Telecom, Inc. ("Amex Telecom"),
SmarTalk secured distribution rights to existing American Express phone card
resellers worldwide including distribution through the U.S. Postal Service,
the National Park Foundation and selected American Express Travel Related
Services Company, Inc. ("Amex TRS") offices. SmarTalk also entered into a
joint marketing and technology agreement with Amex TRS under which SmarTalk
became the exclusive provider of a co-branded prepaid calling card for
American Express, and was granted exclusive access to the American Express
point-of-sale system for activation and recharge of prepaid phone cards.
 
   During 1997, SmarTalk significantly expanded its global presence through
the acquisitions of Cardinal Voicecard Limited, an Ontario, Canada corporation
("Cardinal"), selected assets of DCI Telecommunications, Inc., a Colorado
corporation ("DCI"), and ConQuest Telecommunication Services Corp., a Delaware
corporation ("ConQuest"). The Cardinal acquisition helped SmarTalk gain entry
into Canada, providing access to over 1,700 Canadian storefronts. SmarTalk
acquired from DCI a distribution agreement with a subsidiary of WH Smith which
provides SmarTalk access to retail outlets in the United Kingdom. All network
and switching
 
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facilities for SmarTalk's United Kingdom traffic will be provided through an
agreement with Norweb Communications, which also provides SmarTalk with
additional potential distribution channels in the United Kingdom through
Norweb's customer base.
 
  In the tour and travel industry, SmarTalk has multi-year exclusive
agreements with HFS Incorporated ("HFS") (now Cendant Corporation) and Choice
Hotels ("Choice"), the two largest hotel franchisers in the United States, to
market SmarTalk products and services to such leading national franchises as
Avis, Choice, Clarion Hotels, Comfort Inn, Days Inn, EconoLodge, Howard
Johnson, Knights Inn, Quality Inn, Ramada, Sleep Inn and Travelodge. SmarTalk
also distributes its products through automated teller machines ("ATMs") and
vending machines. In addition, SmarTalk markets its products and services to
corporate customers by providing co-branded prepaid calling cards for use in
corporate and product promotions. SmarTalk has created promotional programs
for, among others, AirTouch Cellular, Alltel, American Stores (in conjunction
with Kodak and Hallmark Cards), Cellular One, Chase Manhattan Bank, Days Inn,
Gillette, the Greater Columbus Convention and Visitors Bureau, Hewlett-
Packard, Indiana University, JVC, Knights Inn, Mars Candy, Miller Brewing,
Nabisco, the Pittsburgh Symphony Orchestra, Prudential Securities, Ross
Laboratories, Smart & Final Iris, Pfizer and Wells Fargo Bank. SmarTalk also
markets the SmarTalk Card through direct marketing channels, including the
Internet and retailer catalog sales.
 
  SmarTalk's services are delivered through proprietary switching, application
and database access software running primarily on Company owned call switching
platforms. Additionally, SmarTalk buys platform switching services from West
Interactive Corporation ("WIC") on a per minute basis. The Company intends to
migrate its traffic to one call switching platform located in Ohio as part of
its restructuring program. The SmarTalk platforms and proprietary software
allow users in the system to access SmarTalk services, and provide SmarTalk
with the flexibility to customize and add features on a platform-wide basis.
 
  SmarTalk believes that its principal competitive advantages are its: (i)
leading market position and well established reputation and presence among
major retailers; (ii) advanced technological infrastructure; and (iii) strong
management team, which has extensive marketing, merchandising and
telecommunications experience.
 
RECENT DEVELOPMENTS
 
  In an effort to maximize the synergistic opportunities created through its
strategic acquisitions, SmarTalk consolidated its corporate functions from
nine different cities to Columbus, Ohio, the prior headquarters of ConQuest.
This consolidation was completed during the summer of 1998. In conjunction
with the consolidation, on February 25, 1998 Erich Spangenberg assumed the
post of Chief Executive Officer, formerly held by Chairman of the Board of
Directors of SmarTalk Robert Lorsch. Mr. Lorsch remains Chairman of the Board.
Additionally, SmarTalk's President, Jeff Lindauer, assumed the duties of Chief
Operating Officer, previously held by Erich Spangenberg.
 
  On February 28, 1998 (the "Board Resolution Date"), the Company's board of
directors adopted a plan to sell the Company's call center business located in
Butler, Pennsylvania. In the first quarter of 1998, the Company recorded a
$3,278,148 charge for the losses associated with operating the business up to
the Board Resolution Date and an estimated charge for operating this business
from the Board Resolution Date through the anticipated disposition date plus
the estimated transaction costs associated with the sale of the business. On
June 12, 1998 (the "Sale Date"), the Company sold the assets of the call
center business for $1,000,000 in cash and a note receivable (the "Call Center
Note") of $19,067,995. Interest on the Call Center Note is 12% per annum and
is payable quarterly beginning September 12, 1998. The principal on the Call
Center Note is due on June 12, 1999 (unless this date is extended to June 12,
2000 by the obligor) or upon completion of a financing transaction in excess
of $50,000,000 by the obligor. The assets of the obligor secure the Call
Center Note. Due to the thinly capitalized financial position of the obligor
and the resulting risk of collection, a valuation allowance was recorded
against the Call Center Note approximately equal to the difference between the
sales price and net book value of the tangible assets sold, or $14,684,978. No
gain or loss was recorded on the transaction.
 
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<PAGE>
 
  The results of the call center business have been classified as continuing
operations in 1997 as the decision to dispose of the operations was based on a
discrete, identifiable event in 1998. Results of the call center business will
be classified as discontinued operations beginning with the first quarter of
1998.
 
  On March 23, 1998, the Company acquired the outstanding stock of USA
Telecommunications Services, Inc. (d.b.a. The Debit Cellular Network) ("DCN"),
a North Carolina based prepaid cellular card company, for 81,302 shares of
Common Stock and $1,500,000 in cash. This acquisition was accounted for using
the purchase method of accounting and the results of the acquired business are
included in the Company's consolidated results of operations from the date of
acquisition.
 
  On April 30, 1998, the Company acquired the outstanding stock of Canada
Telecom Network Inc., a Montreal, Canada based prepaid calling card company,
for $3,000,000 in cash and $5,500,000 in a subordinated, 7.5% per annum note
which matures April 30, 2000. This acquisition was accounted for using the
purchase method of accounting and the results of the acquired business are
included in the Company's consolidated results of operations from the date of
acquisition.
 
  On June 10, 1998, the Company acquired the outstanding stock of Worldwide
Direct, Inc., a Framingham, Massachusetts based prepaid cellular
communications company, for 2,715,000 shares of Common Stock. The Company has
restructured this transaction to provide for the issuance of additional equity
and/or debt securities based on the occurrence of certain conditions. As a
result of this restructuring, the acquisition required the use of the purchase
method of accounting and the results of the acquired business are included in
the Company's consolidated results of operations from the date of acquisition.
 
  As of July 1, 1998, the Company issued a promissory note in the amount of
$5,000,000 and agreed to issue 1,000,000 shares of Common Stock to acquire a
distribution arrangement with a former distributor of Worldwide and certain
contractual relationships. The arrangement also provides for the issuance of
additional equity and/or debt securities upon the occurrence of certain
conditions.
 
  On July 9, 1998, the Company completed a private placement of 1,751,824
shares of its Common Stock, realizing proceeds before transaction costs of
$29,999,986. On August 28, 1998, the terms of the private placement were
restructured. In the event that the Company's Common Stock trades below the
initial purchase price during specified periods, the Company will be obligated
to issue up to $18,500,000 of additional Common Stock for no additional
consideration. In addition, the Company granted an option exercisable for a
period of two years commencing March 1, 1999 in connection with the private
placement pursuant to which an additional $20,000,000 of the Company's Common
Stock may be purchased. In the event the aggregate amount of Common Stock
issued by the Company pursuant to the private placement would exceed 20% of
the Company's total outstanding shares as of July 9, 1998 (the "20%
Threshold"), as a result of either the exercise of the option or the initial
purchase price adjustment, the Company would be required to obtain shareholder
approval of the private placement or issue a note in a principal amount equal
to the value of the Common Stock that otherwise would exceed the 20%
Threshold. The Company expects to use the proceeds from this private placement
to accelerate its entry into the prepaid cellular market and for general
corporate purposes.
 
  Since July 23, 1998, 19 putative class actions have been filed against the
Company and certain current and former members of its management and board of
directors in state and Federal courts alleging violations of state and Federal
securities laws with respect to certain alleged misrepresentations and/or
omissions in regard to the Company's projected and actual revenues and
earnings. These lawsuits seek unspecified damages on behalf of certain classes
of persons who purchased the Company's securities during periods between May,
1997 and August, 1998. The complaints generally allege that the Company made
material misrepresentations and omissions in regard to the Company's projected
and actual revenues and earnings. Although the Company intends to defend
against these lawsuits vigorously, it is not feasible to predict or determine
the final outcome of these proceedings at this time. An unfavorable outcome
with respect to such proceedings could have a material adverse effect on the
Company's financial condition and results of operations. (See Legal
Proceedings.)
 
INDUSTRY OVERVIEW
 
  The $87 billion U.S. long distance industry is dominated by the nation's
three largest long distance providers, AT&T, MCI and Sprint, which together
generated approximately 75.3% of the aggregate revenues of all U.S. long
distance interexchange carriers in 1996. While industry revenues have grown at
a compound annual
 
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<PAGE>
 
rate of 6.7% since 1984, the revenues of carriers other than AT&T, MCI and
Sprint have grown at a compound annual rate of 26.4% during the same period.
As a result, the aggregate market share of all interexchange carriers other
than AT&T, MCI and Sprint has grown from 2.6% in 1984 to 24.7% in 1996. During
the same period, the market share of AT&T declined from 90.1% to 46.2%.
 
  The changing market for telecommunications services created an opportunity
for the growth of alternative long distance and telecommunications services
providers, including prepaid calling card sales. SmarTalk believes that the
affordable pricing, convenience and enhanced features of prepaid calling cards
have attracted price sensitive consumers, business travelers, international
callers and other users of long distance services. The domestic prepaid
calling card industry has grown significantly in recent years. Prepaid calling
card revenues in the U.S. have grown from an estimated $20 million in 1990 to
an estimated $1 billion in 1997, making prepaid calling card services one of
the fastest growing segments of the telecommunications industry. Industry
sources project the total U.S. prepaid calling card market to reach $2.6
billion in 2001. SmarTalk believes that it is well positioned to capitalize
upon the expanding prepaid calling card market due to its strong presence in
national retail and alternative distribution channels.
 
PRODUCTS AND TELECOMMUNICATIONS SERVICES
 
  Prepaid Calling Card Services. The SmarTalk Card provides consumers with a
single point of access to convenient, easy to use, cost-effective
telecommunications products and services at a fixed rate charge per minute
regardless of the time of day or, in the case of domestic calls, the distance
of the call. The SmarTalk Card enables consumers to place local, long distance
and international calls from virtually any touch-tone phone, without the need
for coins, operator assistance, collect or other third party billed calls.
Consumers can use the SmarTalk Card to place international long distance calls
from the U.S. to more than 200 countries at rates that are generally lower
than the standard plan rates currently charged by AT&T, MCI and Sprint or the
rate charged for a direct call from a payphone or hotel room. A connection
through the SmarTalk platforms also costs less than a typical operator
assisted connection or a collect call. Consumers can also utilize the SmarTalk
Card to make international calls to the U.S. from more than 30 foreign
countries. SmarTalk eventually expects to enable consumers to place
international calls within, to and from most countries in the world.
 
  Consumers access the services of the SmarTalk Card by dialing a toll-free
number and entering a PIN printed on the back of the card. The system explains
the service on a user's first call and guides callers through all of the
card's features. Prior to any call being processed, the system informs the
caller of the time remaining on the card. The consumer is also notified when
there are five minutes and again when there are two minutes of calling time
remaining on the SmarTalk Card. Time spent on a call or using the card's
enhanced features is automatically deducted from the remaining time on the
card or billed to a pre-authorized corporate account. The SmarTalk Card is
paid for in advance and issued in specified time increments, typically 30, 60,
120 and 240 minutes, at favorable per minute rates. A SmarTalk Card expires
six months after the date such SmarTalk Card is first activated if not
recharged, or if not activated by the expiration date printed on such card.
 
  Consumers access SmarTalk's services through one of the SmarTalk platforms.
The SmarTalk platforms are designed in a manner which allows SmarTalk to
customize or add features and services to the SmarTalk Card on a platform-wide
basis. Generally, calls accessing enhanced telephonic features are charged for
such access as disclosed by computerized voice prompts at the time such
features are being accessed. SmarTalk attempts to design and develop enhanced
services in order to increase the marketability of the SmarTalk Card and
satisfy consumer requirements. SmarTalk believes that offering enhanced
services will attract additional consumers to SmarTalk's services, promote
brand loyalty and result in additional product usage. See "--The SmarTalk
Platforms."
 
  Consumers are currently provided with the option of accessing the following
services:
 
  Speed Dial. Consumers can create their own personal speed dial directory
which can then be accessed each time the consumer uses the PIN on which the
directory has been created. This feature permits consumers to place
 
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calls to any of nine frequently dialed numbers by pressing two buttons.
Currently, SmarTalk provides a first-time user of a particular PIN with a
limited amount of free time to set up their personal speed dial directory. The
personal speed dial directory created by the consumer is inaccessible to the
consumer once all of the prepaid minutes on the SmarTalk Card associated with
the directory have been utilized. SmarTalk believes that the speed dial
feature increases the likelihood that consumers will recharge their SmarTalk
Cards in order to retain their personal speed dial directory.
 
  Message Delivery. Consumers can record a message for the recipient of a call
if the recipient does not answer or if the line is busy. SmarTalk's system
will make multiple attempts to deliver the message over a period of six hours,
and then notify the consumer the next time the consumer accesses SmarTalk's
system whether the message was delivered and, if so, the time at which it was
delivered.
 
  Sequential Calling. Consumers can make additional calls without exiting the
platform and entering it again. SmarTalk believes that this feature encourages
users to place multiple phone calls each time they use their SmarTalk Cards.
 
  Conference Calling. Consumers can initiate conference calls from virtually
any touch-tone phone by adding a third party to the call. The conference
calling feature is automated and does not require operator assistance. Voice
prompts assist the consumer through the procedure to establish the conference
call. A consumer using the conference calling feature is deducted time on two
outbound calls, therefore leveraging the cost to SmarTalk of one inbound call.
See "--The SmarTalk Platforms."
 
  Content Delivery. Consumers are able to access headline news, sports
updates, weather reports and other information updates, provided by SmarTalk
through a digital feed from several selected on-line suppliers. These services
are frequently updated, and the information is accessible by a series of means
presented to the consumer via voice prompts. Information is first presented in
a general format, with the consumer then being given the option to retrieve
more detailed information on the topic selected.
 
  Voice and Fax Mailboxes. SmarTalk offers consumers a secure, personalized
voice mailbox on selected cards which allows them to receive, retrieve, save
and delete voice mail messages from virtually any touchtone phone. SmarTalk
also offers consumers fax mailbox capability on selected cards which allows
consumers to receive, store and retrieve facsimile transmissions at any time
by forwarding the facsimiled information to any facsimile machine or personal
computer in the U.S. and certain parts of the world. The fax mailbox provides
consumers with the convenience of controlling the time and location of receipt
of facsimile transmissions, enhancing the consumer's ability to receive
confidential facsimiles and receive facsimiles at multiple or changing
locations. Each time the consumer accesses his or her SmarTalk Card, the
consumer is notified if there are any new voice mail messages or facsimiles.
The consumer also has the ability to elect to be notified of waiting
facsimiles.
 
  Online Recharge. SmarTalk has developed on-line recharge of the SmarTalk
Card which allows consumers to increase the number of minutes available on the
SmarTalk Card without purchasing a new SmarTalk Card by using a major credit
card, at rates up to $.35 per minute. Online recharge is designed to enable
SmarTalk to make direct sales to consumers, to provide incentives to retailers
to maintain SmarTalk as the exclusive supplier to the retailer and to create
brand loyalty. With respect to recharge sales, SmarTalk continues to offer
volume discounts, whereby consumers from time to time receive "free minutes"
when recharging for the maximum time permitted and utilizes on-line
advertising, in which a consumer is prompted to recharge his or her card. The
SmarTalk Card may also be recharged with a major credit card by calling
SmarTalk's customer service department or, in select retail locations, at
point-of-sale, allowing the user to add minutes as needed.
 
  In addition to the SmarTalk Card, SmarTalk currently offers prepaid co-
branded and private label cards, which provide all or some of the services
available through the SmarTalk Card. SmarTalk also provides prepaid calling
card services to one of its strategic partners and certain other third
parties.
 
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<PAGE>
 
MARKETING AND DISTRIBUTION
 
  SmarTalk primarily markets its services through two distribution channels:
(i) sales to retailers; and (ii) sales through the alternate distribution
channel which includes tour and travel, vending and cash machines, stand alone
promotions and direct response sales.
 
  Retail Channel. SmarTalk's primary marketing and distribution focus is to
target individuals and small businesses through major national and regional
retailers. SmarTalk's retail distribution channel encompasses diverse
categories of retailers ranging from convenience stores to food and drug
stores, department stores, mass merchandisers, office superstores and consumer
electronics retailers. SmarTalk markets and distributes the SmarTalk Card
nationwide to retailers both through a direct sales force and through its
national sales organization of independent manufacturers' representatives
which utilizes its relationships with retailers to introduce the SmarTalk Card
and its services. SmarTalk believes that its broad retail distribution has
resulted in SmarTalk becoming a leading brand at the retail level.
 
  Currently, the SmarTalk Card is sold at selected retail locations throughout
the U.S., including locations operated by the following leading retailers:
American Stores (which includes Jewel/Osco Combo Stores, Osco Drug Stores and
Sav-On Drug Stores, Lucky Stores and Acme Grocery), Bergen Brunswig Drug
Company (Good Neighbor Pharmacies), Best Buy, Bradlees, Builders Square,
Dominick's Finer Foods, Eckerd Drug, Food4Less, Future Shop, The Good Guys,
King Soopers supermarkets, Nix Check Cashing, Office Depot, Pamida, Penn
Daniels, Qwik Shops, Service Merchandise, BiLo, Cub Foods, Ralphs
Supermarkets, Staples, Star Market, Stop & Shop, Thrifty Oil, Bartell Drug,
Schwegmann's, Fry's, Giant, Goodings, Genovese Drugs, and Wegmans. Through the
ConQuest acquisition, SmarTalk gained distribution through such leading
national and regional retailers as Winn-Dixie Stores, Emro Marketing
(Speedway, Starvin' Marvin, United, Bonded, Gastown, Cheker and Wake Up),
SuperAmerica, Spectrum Stores, Pick Kwik Food Stores, Weis Markets, Shoppers
Food Warehouse and Marathon Oil. Also, included in this channel is the
distribution gained through the Amex Telecom acquisition which gives the
company the right to market its products in U. S. Postal Service locations.
 
  SmarTalk believes its success to date in rapidly expanding its retail
network is attributable to management's ability to increase retailers'
awareness of the profit potential of offering telecommunications services, the
minimal space involved in offering the SmarTalk Card at retail and the ability
of the SmarTalk Card to generate ongoing residuals for retailers through
participation in recharge revenues. Unlike most products sold by retailers,
the SmarTalk Card allows retailers to generate revenues beyond the initial
sale of the SmarTalk Card by providing an ongoing revenue stream based on the
number of minutes recharged on any SmarTalk Card sold by that retailer, so
long as the retailer continues to offer the SmarTalk Card. SmarTalk believes
that this program increases retailer loyalty to SmarTalk and creates a barrier
for the retailer to switch to other prepaid calling cards. SmarTalk also uses
computerized voice prompts to encourage the consumer to utilize the recharge
option.
 
  In furtherance of its strategy, SmarTalk provides: (i) turnkey merchandising
materials that include the availability of customized cards and retail
packaging and complete display and signage systems making display of the
SmarTalk Card easy; (ii) in-store detailing teams to facilitate the use of
such packaging, display and signage systems; (iii) retail promotion programs
in which SmarTalk and the retailer share the costs of the promotion; and (iv)
access to marketing information from the proprietary platforms.
 
  SmarTalk uses a combination of in-house and independent sales
representatives to service its customers. Currently, SmarTalk is in the
process of refining its retail sales and marketing program further to increase
penetration of grocery, drug, convenience, office supplies and electronics
retailers, and has reorganized its retail sales force to support this
strategy. In-house and independent sales and marketing representatives will
focus on specific retail segments based upon their experience, expertise, and
relationships in those specific segments.
 
  SmarTalk's retail marketing programs include various forms of co-op
advertising ("co-op") and other incentive programs to access shelf space and
display areas. SmarTalk believes that these programs, together with
 
                                       7
<PAGE>
 
the residual revenues from recharge and SmarTalk's turnkey merchandising and
marketing programs, create ongoing retailer involvement in support of
marketing the SmarTalk Card.
 
  Tour and travel distribution: SmarTalk has entered into multi-year exclusive
agreements with HFS and Choice to market products and services to such leading
national franchises as Avis, Choice, Clarion Hotels, Comfort Inn, Days Inn,
EconoLodge, Howard Johnsons, Knights Inn, Quality Inn, Ramada, Sleep Inn, and
Travelodge.
 
  Vending and cash machine distribution: SmarTalk is supplying prepaid cards
to be distributed through vending machines located in certain Simon DeBartolo
Group properties, including the Mall of America and the Forum Shops. SmarTalk
also has arrangements with various financial institutions to distribute its
prepaid cards through ATMs.
 
  Stand alone promotions: SmarTalk markets the SmarTalk Card and co-branded
prepaid cards for use in promotional marketing, including sales for corporate
or product promotional campaigns, direct marketing programs, warranty
registration or customer service programs and premium rewards for consumers.
SmarTalk has created promotional programs for AirTouch Cellular, Alltel,
American Stores (in conjunction with Kodak and Hallmark Cards), Cellular One,
Chase Manhattan Bank, Days Inn, Gillette, the Greater Columbus Convention and
Visitors Bureau, Hewlett-Packard, Indiana University, JVC, Knights Inn, Mars
Candy, Miller Brewing, Nabisco, the Pittsburgh Symphony Orchestra, Prudential
Securities, Ross Laboratories, Smart & Final Iris, Pfizer and Wells Fargo
Bank. Similarly, corporate customers can utilize SmarTalk for warranty
registration programs by inviting consumers to phone in their information to a
dedicated toll free number rather than completing a warranty registration
card.
 
  Direct response distribution: SmarTalk maintains a home page on the Internet
to provide the consumer with information as to the benefits of the SmarTalk
Card, as well as to market directly the SmarTalk Card. SmarTalk also generates
revenue through retailer catalogue sales.
 
THE SMARTALK PLATFORMS
 
  Consumers access SmarTalk's network through the SmarTalk platforms. The
SmarTalk platforms are accessible from virtually any touch-tone telephone in
the U.S. and can communicate with telephones, personal computers, facsimile
machines and pagers. The SmarTalk platforms feature multiple switches,
thousands of inbound and outbound access ports for prepaid and corporate
calling services, as well as voice response applications, high-speed database
servers, voice recording capability and credit card verification software,
among other capabilities. This structure provides SmarTalk's consumers with
high capacity and reliable telecommunications products and services.
 
  The SmarTalk platforms are controlled by proprietary database access
software, designed to be versatile and adaptable and to work with the SmarTalk
platforms to provide users with efficient and reliable services. SmarTalk's
proprietary software allows the SmarTalk platforms to be easily expandable so
that, as usage increases or new SmarTalk services are developed, the SmarTalk
platforms may evolve with the rest of SmarTalk's services. SmarTalk believes
that the SmarTalk platforms will be capable of processing all of SmarTalk's
anticipated usage requirements. The modular and scaleable design of the
SmarTalk platforms and the related software allows expansion of network
capacity without requiring replacement of existing hardware of software or
interrupting service.
 
  SmarTalk acquired the VoiceChoice platform from Pacific Bell Information
Services ("PBIS") in 1996. Located in San Francisco, the VoiceChoice platform
supports the SmarTalk Card as well as other interactive voice response
applications. The VoiceChoice Platform is an integrated call processing
system, in which calls are carried on the VoiceChoice platform by T1 circuits
from MCI and are presented to either of two Summa Four switches. Traffic is
split evenly between the Summa switches to provide redundancy. Incoming calls
to the VoiceChoice platform are answered by a Summa Four switch, which is
connected to voice response units ("VRUs"). The VRUs, in turn, interact with
an Oracle database server that stores all user information. Resident
 
                                       8
<PAGE>
 
on the switch is the software and hardware necessary to allow the switch to
interact with, and accept input from consumers. The VoiceChoice platform
software prompts consumers for their PIN. The software validates this
information by querying the database of active PINs, and verifying that only
one consumer is connected to the SmarTalk platforms using this PIN. Once the
consumer has been identified, the software instructs the switch to present the
consumer with various options, which the consumer can access by responding to
voice prompts. If the consumer chooses to place an outbound telephone call,
the software transmits the call over lines provided by the resident long
distance provider. The voice response boxes are connected directly to
SmarTalk's outbound long distance services providing SmarTalk's consumers fast
processing of their telephone calls. The system is monitored by on-site
analysts 24 hours a day to detect any potential problem. This traffic will be
migrated to the Ohio platform pursuant to the Company's restructuring plan.
 
  SmarTalk acquired the Ohio platform through the ConQuest acquisition.
Located in Columbus, Ohio, the Ohio platform consists of one
domestic/international IXC switch, a Northern Telecom DMS 250 switch and five
programmable EXCEL LNX-2000 switches. These six all-digital switches are
linked together using ISDN, out-of-band signaling, DS-1 circuits and connected
to a Sun Microsystems UNIX switch server via multiple digital DS-1 circuits
and high-speed LAN connections.
 
  The San Antonio call processing platform and the back-up Omaha call
processing platform are owned and operated by WIC and are similarly configured
for high speed, capacity and reliability. WIC provides interstate and
international long distance services to SmarTalk through its agreement with
AT&T. In addition, SmarTalk has added access to MCI and Frontier service to
the platforms maintained by WIC. SmarTalk's call processing centers are
redundant within themselves and, in certain instances, with each other.
SmarTalk intends to develop database portability between the different
platforms, thus ensuring redundancy in the event of a major technical or
network problem at any of the facilities.
 
  SmarTalk intends to migrate a substantial portion of its traffic to one call
center switching platform located in Ohio as part of the consolidation of its
corporate functions.
 
SMARTALK CUSTOMER SERVICE
 
  SmarTalk believes that effective and convenient customer service is
essential to attracting and retaining consumers. SmarTalk's customer service
department is responsible for assisting consumers in using SmarTalk's
services, answering questions about usage and resolving billing related issues
and any technical problems. SmarTalk provides on-line customer support that is
available 24 hours a day, 7 days a week, at the touch of a button. Customer
service representatives can access detailed usage records through the SmarTalk
System in order to answer efficiently consumers' questions or resolve
consumers' concerns. In addition, SmarTalk can identify calling activity by
originating or destination phone numbers or other parameters. SmarTalk also
maintains a secondary corporate level customer service organization in
SmarTalk's offices to address unique customer service requests which are not
handled while a caller is in the system.
 
RESEARCH AND DEVELOPMENT
 
  SmarTalk plans to leverage its existing sales, marketing and technological
infrastructure to develop and market new products and services to consumers.
Currently, SmarTalk is developing for sale at retail a branded or co-branded
prepaid wireless product for use in conjunction with wireless handsets. This
product would give existing and new wireless consumers the opportunity to take
advantage of cost-effective and controlled wireless services on a prepaid
basis.
 
 
                                       9
<PAGE>
 
  SmarTalk is also developing a port-less prepaid switch which is a unique
technology within the telecommunications industry. It will enable SmarTalk to
transform its current interactive voice response prepaid network into a fiber
back-bone based switched network. The result is a transfer from a very port
intensive architecture that receives and sends calls through a main telephonic
switch to a switch which allows prepaid call control across fiber data
circuits.
 
  Both the prepaid wireless and the portless switching technologies were
acquired in the ConQuest acquisition. At the acquisition date this research
and development activity was considered to be in process and without
alternative future use. Accordingly, the Company recorded a $13,364,000 one-
time noncash charge during 1997 to record this expense. (See Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Acquired Research and Development In-Process.) Except for the charge for
acquired research and development in process for the year ended December 31,
1997, minimal additional expenditures were required for research and
development for the years ended December 31, 1997, 1996 and 1995.
 
  SmarTalk also plans to increase the enhanced features and services of the
SmarTalk Card by, for example, offering on selected cards a combined source
for voice and fax mailboxes and e-mail messaging. In addition, SmarTalk is
exploring the possibility of increasing the convenience of the SmarTalk Card
by introducing voice recognition technology.
 
COMPETITION
 
  As a service provider in the long distance telecommunications industry,
SmarTalk competes with numerous providers, including MCI, AT&T and Sprint.
These competitors have significantly greater financial resources than the
Company. SmarTalk attempts to differentiate itself from its competitors by
offering an integrated bundle of communications services through advanced
telecommunications hardware and proprietary software and distributing these
services primarily through retail channels, as well as a growing number of
additional distribution channels. SmarTalk believes that its principal
competitive advantages are its: (i) well-established presence among major
national and regional retailers; (ii) advanced telecommunications
infrastructure including the SmarTalk platforms; and (iii) management team,
which has extensive marketing and merchandising expertise. SmarTalk believes
that the principal competitive factors affecting the market for
telecommunications services are price, quality of service, reliability of
service, degree of service integration, ease of use, service features and name
recognition. The ability of SmarTalk to compete effectively in the
telecommunications services industry will depend upon SmarTalk's continued
ability to provide high quality services at prices generally competitive with,
or lower than, those charged by its competitors.
 
GOVERNMENT REGULATION
 
  SmarTalk is currently subject to federal and state government regulation of
its long distance telephone services. SmarTalk is regulated at the federal
level by the Federal Communications Commission ("FCC") and is currently
required to maintain both domestic interstate and international tariffs for
its services, each containing the currently effective rates, terms, and
conditions of service. SmarTalk is duly authorized under Section 214 of the
Communications Act of 1934, as amended, to provide international
telecommunications services. The intrastate long distance telecommunications
operations of SmarTalk are also subject to various state laws and regulations,
including prior certification, notification, registration requirements and
tariff approval. SmarTalk generally must obtain and maintain certificates of
public convenience and necessity from regulatory authorities in most states in
which it offers service. In most of these jurisdictions, SmarTalk must file
tariffs and obtain tariff approval prior to providing intrastate services. In
addition, SmarTalk must update or amend the tariffs and, in some cases, the
certificates of public convenience and necessity, when rates are adjusted or
new products are added to the long distance services offered by SmarTalk. The
FCC and numerous state agencies also impose prior approval requirements on
transfers of control and assignments of certain regulatory authorities.
 
  Federal. On February 8, 1996, President Clinton signed into law the
Telecommunications Act of 1996 (the "Telecommunications Act") which will allow
local exchange carriers, including the RBOCs, to provide inter-local access
and transport area ("inter-LATA") long distance telephone service and which,
after certain
 
                                      10
<PAGE>
 
criteria are fulfilled, also grants the FCC the authority to deregulate other
aspects of the telecommunications industry. This legislation may result in
increased competition in the industry, including from the RBOCs, in the
future. The Telecommunications Act has effectively opened the long distance
market to competition from the RBOCs. The entry of these well-capitalized and
well-known entities into the long distance market will likely increase
competition for long distance consumers. The Telecommunications Act also
grants the FCC the authority to deregulate other aspects of the
telecommunications industry, which in the future may, if authorized by the FCC
and authorized by the FCC and authorized by the courts, facilitate the
offering of telecommunications services by substantially larger regulated
entities, including the RBOCs, in competition with SmarTalk. Although the FCC
has promulgated rules to implement the Act's interconnection and pricing
provisions, several of the FCC's rules have been vacated by the Court of
Appeals for the Eighth Circuit, and are now pending review on appeal. If the
Eighth Circuit's decision is left to stand, the states would retain
significant authority to establish several of the Act's pricing provisions, in
particular.
 
  SmarTalk is classified by the FCC as a non-dominant carrier. The FCC has
jurisdiction to act upon complaints against any common carrier for failure to
comply with its statutory obligations. The FCC also has the authority to
impose more stringent regulatory requirements on SmarTalk and to change its
regulatory classifications, although such action is highly unlikely. SmarTalk
has applied for and received all necessary authority from the FCC to provide
domestic interstate and international telecommunications service. SmarTalk has
been granted authority by the FCC to provide international telecommunications
services through the resale of switched services of U.S. facilities-based
carriers. The FCC reserves the right to condition, modify or revoke such
international authority for violations of the Federal Communications Act or
its rules.
 
  Both domestic and international non-dominant carriers currently must
maintain tariffs on file with the FCC. Although the tariffs of non-dominant
carriers, and the rates and charges they specify, are subject to FCC review,
they are presumed to be lawful and are seldom contested. Prior to a recent
court decision, domestic non-dominant carriers were permitted by the FCC to
file tariffs with a "reasonable range of rates" instead of the detailed
schedules of individual charges required of dominant carriers. In reliance on
the FCC's past practice of allowing relaxed tariff filing requirements for
non-dominant domestic carriers, SmarTalk previously had filed reasonable range
of rates schedules in its FCC tariff. Currently, however, the Company files
tariffs with the FCC specifically describing rates and charges of its
products. As an international non-dominant carrier, SmarTalk is required to
include detailed rate schedules in its international tariffs. The Company is
also required to submit annual international service and revenue reports to
the FCC. Resale carriers are also subject to a variety of miscellaneous
regulations that, for instance, govern the documentation and verifications
necessary to change a consumer's long distance carriers, limit the use of
"800" numbers for pay-per-call services, require disclosure of operator
services and restrict interlocking directors and management.
 
  On March 21, 1996, the FCC initiated a rulemaking proceeding in which it
proposes to eliminate the requirement that non-dominant interstate carriers
such as SmarTalk maintain tariffs on file with the FCC for domestic interstate
services. These rules have been appealed and are currently stayed pending the
result of litigation.
 
  The Telecommunications Act of 1996 mandated the establishment of Universal
Service for the promotion of nationwide access to telecommunications services
in rural, insular and high cost areas that are reasonably comparable in price
and type to those found in urban areas and the promotion of access to advanced
services for schools, libraries and certain health care providers.
Telecommunications providers of interstate services, including payphone
aggregators and private network operators that offer service to others for a
fee on a non-common carrier basis, must contribute toward the funding of
Universal Service. Certain government and public safety entities are exempt,
as are entities whose contribution would be less than $100.00 per year.
Although the Company's competitors will be similarly situated, the Universal
Service Fund annual assessment may have a material adverse effect on the long
term financial condition of the Company.
 
  The Telecommunications Act (Section 276) further mandated that the FCC
promulgate rules to establish a per call compensation plan to ensure that all
payphone providers are fairly compensated for each completed
 
                                      11
<PAGE>
 
intrastate and interstate payphone initiated call, including calls on which
payphone providers had not heretofore received compensation. Such calls
included those placed to toll free numbers (800/888) such as operator-assisted
and prepaid calling card calls and calls placed through network access codes.
In September 1996, the FCC promulgated rules to implement Section 276 which
established a three-phase compensation plan for pay phone providers. Under the
first phase, interexchange carriers with annual toll revenues of more than
$100 million were to pay a total of $45.85 per payphone per month for all toll
free and access code calls for the first year, commensurate with their portion
of total interexchange revenues. All switched-based and facilities-based
interexchange carriers were to pay $.35 per call to each payphone provider
during the second year (although payments could subsequently be recovered from
resellers by the carriers), after which per call compensation rates were to be
left to individual market-driven rates negotiated between payphone providers
and interexchange carriers. On July 1, 1997, the D.C. Circuit Court of Appeals
vacated significant portions of the FCC's rules, including the $.35 per call
rate which was found to be arbitrary and capricious, and remanded the matter
to the FCC for reconsideration. On remand, the FCC, in September 1997,
established a two-year "default" compensation rate of $.284 per payphone-
originated toll free or access code call. At the end of the two year interim
period, the per call payphone compensation rate will be the deregulated
market-based local coin rate less $.066. This amount is payable by all
"switch-based" interexchange carriers (but again may be passed through to non-
facilities-based resellers). The revised FCC's rules became effective on
October 7, 1997, but continue to be subject to regulatory and legal
challenges. SmarTalk is unable to predict whether this regulation or other
potential changes in the regulatory environment could have a material adverse
effect on the Company.
 
  State. The intrastate long distance telecommunications operations of
SmarTalk are subject to various state laws and regulations, including prior
certification, notification, registration and/or tariff requirements. In
certain states, prior regulatory approval may be required for changes in
control of telecommunications operations. SmarTalk is currently subject to
varying levels of regulation in the states in which it provides card services
(which are generally considered "1+" services by the states). The vast
majority of states require SmarTalk to apply for certification to provide
telecommunications services, or at least to register or to be found exempt
from regulation, before commencing intrastate service. The vast majority of
the states require SmarTalk to file and maintain detailed tariffs listing
rates for intrastate service. Many states also impose various reporting
requirements and/or require prior approval for transfers of control of
certified carriers and assignments of carrier assets, including consumer
bases, carrier stock offerings and incurrence by carriers of significant debt
obligations. Certificates of authority can generally be conditioned, modified,
canceled, terminated or revoked by state regulatory authorities for failure to
comply with state law and/or the rules, regulations and policies of the state
regulatory authorities. Fines and other penalties, including, for example, the
return of all monies received for intrastate traffic from residents of a
state, may be imposed for such violations.
 
  SmarTalk has made the filings and taken the actions it believes are
necessary to become certified or tariffed to provide intrastate card services
to consumers throughout the U.S. SmarTalk has been certified to do business as
a foreign corporation in the 49 states outside of its state of incorporation,
and has received authorization to provide intrastate telecommunications
services in all states where certification is required. There can be no
assurance that SmarTalk's provision of services in states where it is not
licensed or tariffed to provide such services will not have a material adverse
effect on SmarTalk.
 
ACQUISITIONS
 
  Amex Telecom. On December 31, 1997, SmarTalk acquired Amex Telecom, a
provider of prepaid calling products, including the FirstClass Phonecard(TM)
sold through the U.S. Postal Service and the PhoneFunds(TM) card sold through
the National Park Foundation and Amex Travel and Foreign Exchange ("AmEx
TSO's") offices. In consideration for the outstanding shares of Amex Telecom,
SmarTalk paid $44 million in cash, which was provided from SmarTalk's working
capital, with a portion thereof held in escrow pending regulatory approval to
Amex Telecom's sole stockholder, Amex TRS. SmarTalk also purchased a profit
and cost sharing agreement between Amex Telecom and the U.S. Postal Service.
The Amex Telecom acquisition secured for SmarTalk distribution rights to AmEx
TSOs worldwide, distribution through the U.S. Postal Service and the National
Park
 
                                      12
<PAGE>
 
Foundation and an agreement with Amex TRS to be the exclusive provider of a
co-branded prepaid calling card for Amex TRS. In addition, SmarTalk was
granted exclusive access to the American Express point-of-sale system for
activation and recharge of prepaid phone cards. Under the purchase agreement
Amex TRS agreed to reimburse SmarTalk for the estimated unused minutes as of
December 31, 1997. The Company has recorded this amount as a reduction to the
purchase price and a receivable of $2,570,000 at December 31, 1997.
 
  ConQuest. On December 3, 1997, SmarTalk entered into an interim operating
agreement which transferred all risks and rewards from ConQuest to SmarTalk.
SmarTalk assumed responsibility for operating the ConQuest business and the
employees of ConQuest became employees of SmarTalk on this date. On December
31, 1997, SmarTalk acquired 100% of ConQuest's outstanding common stock. In
consideration for each outstanding share of ConQuest common stock, ConQuest
stockholders received 7.63 shares of Common Stock (approximately 4.5 million
shares of Common Stock in total). SmarTalk also assumed $6,139,679 of
ConQuest's debt. Additionally, in connection with this acquisition SmarTalk
paid $350,000 in cash in 1997 and issued 215,569 shares of Common Stock in
January 1998 to obtain an agreement and mutual release from a group of
individuals that had brought a lawsuit against ConQuest prior to the
acquisition. ConQuest is a developer and marketer of prepaid calling cards and
other enhanced telecommunication services and technology, including domestic
and international calling services for the tour and travel industry. The
acquisition of ConQuest added significantly to SmarTalk's technological
infrastructure, customer base, platform operations and management
infrastructure. At the acquisition date certain research and development
activity was considered to be in process and without alternative future use.
Accordingly, the Company recorded a $13,364,000 one-time noncash charge during
1997 to record this expense (See Management's Discussion and Analysis of
Financial Condition and Results of Operations--Acquired Research and
Development In-Process.)
 
  Frontier Selected Assets. On December 9, 1997, SmarTalk acquired selected
assets ("Frontier Selected Assets") of the retail prepaid phone card business
of Frontier Corporation, a New York corporation ("Frontier"). In consideration
for the Frontier Selected Assets, SmarTalk paid $35 million in cash and 65,568
shares of Common Stock which represented a contingent payment to Frontier. The
acquisition of the Frontier Selected Assets added to SmarTalk's size, scale
and scope, and helped establish SmarTalk's presence on the East Coast.
 
  Cardinal Voicecard Limited. On August 13, 1997, SmarTalk issued 115,000
shares of Common Stock to purchase this Toronto, Ontario based company. This
acquisition provided the Company with access to the Canadian marketplace.
 
  GTI Telecom, Inc. On May 31, 1997, SmarTalk issued 2,580,001 shares of
Common Stock and $26,500,000 in subordinated 10% per annum term notes which
mature June 1, 2001 (the "GTI Notes") to purchase GTI Telecom, Inc. ("GTI").
$25,970,000 of the GTI Notes were repaid in September 1997 at $20,614,686. The
difference of $5,355,314 was recorded as a reduction to goodwill. This
acquisition expanded the Company's customer base and added human resource,
technical and manufacturing infrastructure.
 
  SmarTel Communications, Inc. On May 28, 1997, the Company acquired SmarTel
Communications, Inc., a Delaware corporation ("SmarTel"), operating as a
Boston based prepaid promotions phone card company, for 714,286 shares of
Common Stock.
 
 
                                      13
<PAGE>
 
  The following table sets forth the relevant transactions recorded in
connection with each of the above acquisitions (As Restated--See Notes 12 and
14 to the Company's consolidated financial statements):
 
<TABLE>
<CAPTION>
                                                                    FRONTIER
                                                                    SELECTED
                            SMARTEL        GTI        CARDINAL       ASSETS     AMEX TELECOM    CONQUEST        TOTAL
                          -----------  ------------  -----------  ------------  ------------  ------------  -------------
<S>                       <C>          <C>           <C>          <C>           <C>           <C>           <C>
Issuance of Common
 Stock..................  $ 9,494,290  $34,259, 820  $ 2,170,625  $  1,594,155  $        --   $ 71,917,228  $ 119,436,118
Issuance of debt........          --     21,144,686          --            --            --            --      21,144,686
Cash payments...........          --            --           --     35,000,000    44,000,000           --      79,000,000
Litigation settlement...          --            --           --            --            --      4,500,003      4,500,003
Acquired research and
 development in process.          --            --           --            --            --    (13,364,000)   (13,364,000)
Acquired intangibles....   (2,569,000)  (24,998,000)         --    (23,883,000)  (40,234,000)  (17,936,000)  (109,620,000)
Acquisition related
 receivable.............         --             --           --            --     (2,570,000)          --      (2,570,000)
Acquisition related
 transaction costs......      707,732     1,579,140       55,252     1,331,951     1,014,225     1,545,335      6,233,635
                          -----------  ------------  -----------  ------------  ------------  ------------  -------------
                            7,633,022    31,985,646    2,225,877    14,043,106     2,210,225    46,662,566    104,760,442
Less: net assets
 acquired...............   (2,065,281)  (21,895,111)  (1,083,289)      555,614       699,385     1,900,935    (21,887,747)
                          -----------  ------------  -----------  ------------  ------------  ------------  -------------
Goodwill................  $ 9,698,303  $ 53,880,757  $ 3,309,166  $ 13,487,492  $  1,510,840  $ 44,761,631  $ 126,648,189
                          ===========  ============  ===========  ============  ============  ============  =============
</TABLE>
 
  LCN Assets. In January 1996, the Company entered into an agreement to
purchase certain assets of Lorsch Creative Network, Inc. ("LCN") that had
historical net book value of $35,972. LCN's sole shareholder was then the
majority shareholder of the Company's Common Stock. Minority shareholders of
the Company consented to the transaction. The purchase was consummated in
January 1996 for $500,000 cash plus a $2,000,000 subordinated term note which
was repaid in November 1996. Because the assets were purchased from a related
party, the assets are reflected on the Company's balance sheet at LCN's
historical depreciated cost as of the date of the acquisition. The excess of
acquisition cost over the historical cost less depreciation of the assets
acquired of approximately $2,464,028 was recorded as a charge to the Company's
accumulated deficit in a manner similar to a capital distribution.
 
  All of the Acquisitions (as defined below) have been accounted for using the
purchase method of accounting and accordingly the purchase price has been
allocated to tangible and intangible assets acquired and liabilities assumed
based on fair values as of the acquisition date. Additionally, the operating
results of the acquired companies have been included in the SmarTalk
consolidated results since the date of the Acquisitions.
 
  Approximately $13,364,000 of the aggregate ConQuest acquisition purchase
price was allocated to in-process technology and immediately charged to
expense because such in-process technology had not reached a stage of
technological feasibility and had no alternative future use. (See Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Acquired Research and Development In-Process.) Approximately $17,936,000 of
this acquisition's purchase price was allocated to specifically identifiable
intangible assets such as customer base, existing core technology and
assembled work force and is being amortized over four to ten years.
 
  There can be no assurance that the anticipated benefits of the Amex Telecom
acquisition, the ConQuest acquisition, the acquisition of the Frontier
Selected Assets, the Cardinal acquisition, the GTI acquisition or the SmarTel
acquisition (collectively, the "Acquisitions") will be realized or that the
combination of SmarTalk, Amex Telecom, ConQuest, the Frontier Selected Assets,
Cardinal, GTI and SmarTel will be successful.
 
                                      14
<PAGE>
 
  The following unaudited pro forma summary presents the Company's combined
results as if the Acquisitions occurred at the beginning of the respective
periods, after giving effect to certain adjustments including goodwill
amortization, depreciation and interest expense. These pro forma results are
not necessarily indicative of those that would have occurred had the
acquisitions occurred at the beginning of the respective periods:
 
<TABLE>
<CAPTION>
                                                            UNAUDITED
                                                          DECEMBER 31,
                                                  -----------------------------
                                                        1997           1996
                                                  ---------------- ------------
                                                  (AS RESTATED(1))
      <S>                                         <C>              <C>
      Revenue....................................   $148,008,432   $105,113,067
                                                    ============   ============
      Net loss...................................   $(39,490,050)  $(40,064,669)
                                                    ============   ============
      Net loss per share--basic and diluted......   $      (2.64)  $      (4.18)
                                                    ============   ============
</TABLE>
--------
(1) See Note 14 to the Company's consolidated financial statements.
 
  Pro forma results do not include the in-process research and development
charge of $13,364,000.
 
RAW MATERIALS
 
  Customers' calls are carried primarily by AT&T (accessed through WIC),
WorldCom, Telco, Frontier and MCI. The Company obtains long distances services
pursuant to supply agreements with MCI, WorldCom and Frontier. The Company
uses various vendors to manufacture its plastic phone cards. Management
believes the supply of raw materials is adequate to meet the Company's needs.
 
PATENTS AND TRADEMARKS
 
  The Company holds all patents, trademarks, and all other similar licenses
and rights to intellectual property which it believes are material to the
conduct of its business.
 
SEASONALITY
 
  The Company experiences increased usage of its products and services during
major holidays such as Christmas and Mother's Day. Christmas day was the
Company's highest use day in 1997, 1996 and 1995.
 
DEPENDENCE ON MAJOR CUSTOMERS
 
  Certain of the Company's retail customers have, from time to time, accounted
for a significant percentage of SmarTalk's revenue. Based upon the value of
shipments of SmarTalk Cards to retailers ("Retailer Shipment Value"), Eckerd
Drug accounted for approximately 16%, 0% and 0%, respectively, American Stores
accounted for approximately 6%, 13% and 78%, respectively, and Office Depot
accounted for approximately 6%, 19% and 0%, respectively, of the total
Retailer Shipment Value for the years ended December 31, 1997, 1996 and 1995.
No other retailer accounted for more than 10% of Retailer Shipment Value in
more than one quarter during any of such periods. Revenues from WIC were
approximately 30%, 37% and 0% of total revenues for the years ended December
31, 1997, 1996 and 1995, respectively.
 
BACKLOG
 
  The Company has no backlog.
 
EMPLOYEES
 
  As of March 26, 1998, SmarTalk employed approximately 540 persons on a full-
time basis. None of SmarTalk's employees are members of a labor union or are
covered by a collective bargaining agreement. SmarTalk believes that its
relations with its employees are good. Additionally, SmarTalk believes that
its future success will depend on its ability to attract and retain highly
skilled and qualified employees to meet management and other requirements from
time to time.
 
                                      15
<PAGE>
 
ENVIRONMENTAL PROTECTION
 
  SmarTalk believes that its operations do not present any significant risks
to the environment and, therefore, no material capital expenditures were or
are expected to be required for environmental protection.
 
ITEM 3. LEGAL PROCEEDINGS
 
  The description of the Company's Legal Proceedings has changed substantially
since the end of the period to which this Annual Report on Form 10-K/A
relates. The following is a description as of November 5, 1998.
 
  On April 20, 1998, Intrine Communications ("Intrine"), filed a complaint
against the Company and DCN in the Superior Court of California in Los Angeles
County. In the complaint, Intrine alleges that, by virtue of the Company's
acquisition of DCN, the Company and DCN breached written and oral agreements
not to circumvent and appropriate for themselves the benefits of a purported
deal by Intrine to acquire DCN. The lawsuit seeks damages and injunctive
relief. Management of the Company believes that the claims against the Company
and DCN are without merit and does not at present expect this lawsuit to have
a material adverse effect on the Company's financial position, liquidity, cash
flow or results of operations.
 
  Since July 23, 1998, 19 putative class actions have been filed against the
Company and certain current and former members of its management and Board of
Directors in state and Federal courts alleging violations of state and Federal
securities laws with respect to certain alleged misrepresentations and/or
omissions in regard to the Company's projected and actual revenues and
earnings. These lawsuits seek unspecified damages on behalf of certain classes
of persons who purchased the Company's securities during periods between May,
1997 and August, 1998. The complaints generally allege that the Company made
material misrepresentations and omissions in regard to the Company's projected
and actual revenues and earnings. Although the Company intends to defend
against these lawsuits vigorously, it is not feasible to predict or determine
the final outcome of these proceedings at this time. An unfavorable outcome
with respect to such proceedings could have a material adverse effect on the
Company's financial condition and results of operations.
 
                                      16
<PAGE>
 
                                    PART II
 
ITEM 6. SELECTED FINANCIAL DATA
 
<TABLE>
<CAPTION>
                                                                         FROM INCEPTION
                                                                         (OCT. 28, 1994)
                                  FOR THE YEAR ENDED DECEMBER 31,            THROUGH
                             ------------------------------------------   DECEMBER 31,
                                   1997           1996         1995           1994
                             ----------------- -----------  -----------  ---------------
                             (AS RESTATED (1))
   <S>                       <C>               <C>          <C>          <C>
   Revenue.................    $ 61,164,228    $15,021,060  $   453,916     $    444
   Net loss................    $(25,732,648)   $(3,112,548) $(1,329,302)    $(65,472)
   Net loss per share--
    basic and diluted......    $      (1.72)   $      (.32) $      (.23)    $   (.01)
   Total assets............    $368,301,077    $50,531,420  $ 3,841,752     $  4,023
   Total debt, less current
   portion.................    $150,874,753    $       --   $       --      $    --
</TABLE>
 
  See "Business--Acquisitions."
--------
(1) See Note 14 to the Company's consolidated financial statements.
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS
 
RESTATEMENT
 
  Subsequent to the filing with the Securities and Exchange Commission of its
Annual Report on Form 10-K for the year ended December 31, 1997, the Company's
management in conjunction with PwC determined that significant issues existed
with regard to the Company's accounting treatment for deferred revenue
recorded in conjunction with acquisitions that occurred during 1997, the
restructuring reserve taken during the fourth quarter of 1997, the charge for
acquired research and development in-process taken during the fourth quarter
of 1997 as well as certain other items. The Company's investigation into these
issues ultimately resulted in the restatement of the Company's financial
results for the year ended 1997 and for the first and second quarters of 1998.
The financial information contained herein has been restated to incorporate
all relevant information obtained from the aforementioned investigations. (See
Note 14 to the Company's consolidated financial statements.)
 
GENERAL
 
  The Company was formed in October 1994 and had limited operations until June
1995. On October 23, 1996, the Company completed the sale of 4,000,000 shares
of its stock in a public offering. The Company's Common Stock is listed on the
NASDAQ National Market.
 
  SmarTalk provides convenient, easy-to-use and cost-effective
telecommunications products and services to individuals and businesses
primarily through the SmarTalk Card. The SmarTalk Card provides customers with
a single point of access to prepaid telecommunications services at a fixed
rate charge per minute regardless of the time of day or, in the case of
domestic calls, the distance of the call. The Company's services currently
include domestic calling, inbound and outbound international long distance
calling, as well as enhanced features such as sequential calling, content
delivery, speed dial, message delivery and on selected cards, voice and fax
mail services. The SmarTalk Card may also be recharged with a major credit
card by calling SmarTalk's customer service department or, in select retail
locations, at point-of-sale, allowing the user to add minutes as needed.
 
  SmarTalk services are delivered through proprietary switching, application
and database access software which run on interactive call processing
platforms. The SmarTalk platforms and the Company's proprietary software allow
users in the system to access SmarTalk services, and provide the Company with
the flexibility to customize and add features to SmarTalk services on a
platform-wide basis.
 
 
                                      17
<PAGE>
 
  SmarTalk's revenue originates from: (i) Company and co-branded prepaid
calling card sales through retailers; (ii) sales of cards through alternate
distribution channels; (iii) recharges of existing prepaid calling cards; (iv)
prepaid calling card services provided to one of the Company's strategic
partners, WIC; and (v) call processing services.
 
  Under sales agreements with the majority of retailers, the Company sells
cards to the retailer at a set price. The Company generally invoices the
retailer upon shipment of the cards. The Company also offers pay-on-sale and
pay-on-activation programs to retailers whereby the retailers are invoiced
upon sale to or activation by a retailer's customer, respectively. Deferred
revenue is recorded when the retailer is invoiced. The Company recognizes
revenue and reduces deferred revenue as the customer utilizes calling time or
upon expiration of cards containing unused calling time ("breakage"). The
Company also records deferred revenue upon recharge of existing prepaid
calling cards and recognizes such revenue upon the usage or expiration of the
recharge minutes. Call processing revenues are recognized as these services
are rendered.
 
  SmarTalk's cost of revenue consists primarily of the cost of providing long
distance services and related enhanced services, as well as the cost of
manufacturing and delivering the cards and excise taxes. The cost of providing
long distance services represents obligations to carriers that provide minutes
of long distance over their networks in order to facilitate use of SmarTalk's
product.
 
  Sales and marketing expenses consist primarily of commissions and
advertising costs. The Company pays commissions to its sales representatives
based on sales to retailers. The Company also pays commissions to its sales
representatives and retailers based on the number of minutes recharged on the
SmarTalk Cards sold by each retailer. Advertising consists primarily of trade,
consumer and co-op advertising. Under the typical co-op advertising program,
the Company provides advertising funds to retailers to promote sales of
SmarTalk products and services. The amount of funds the Company provides in
co-op advertising is based on a percentage of sales of SmarTalk products to
retailers. Corporate advertising expense includes trade and consumer
advertising, trade show expenses, promotional goods and the costs of providing
to retailers the Company's turnkey merchandising supplies.
 
  General and administrative expenses consist primarily of salaries and
related benefits, sales and use taxes, rent, insurance, bank card processing
fees, and other general expenses including depreciation and amortization.
Sales and use taxes for the SmarTalk platforms are incurred based on customer
usage of long distance minutes which are processed through each of the
individual platforms.
 
  Part of the ConQuest acquisition included in process research and
development related to portless switching and prepaid cellular technologies.
At the acquisition date this research and development activity was considered
to be in-process and without alternate future use. Accordingly, the Company
recorded a $13,364,000 one time noncash charge during the year ended December
1997 to record this expense. (See --Acquired Research and Development In-
Process.)
 
YEAR ENDED DECEMBER 31, 1997 (AS RESTATED) COMPARED WITH YEAR ENDED DECEMBER
31, 1996
 
  Revenue. Revenue increased to $61,164,228 for the year ended December 31,
1997 from $15,021,060 for the year ended December 31, 1996. The substantial
increase in revenue reflects an increase in usage of SmarTalk services by
users of the SmarTalk Card, the effect of the Acquisitions, an increase in the
number of retail storefronts in which the Company's product is distributed,
greater brand awareness and consumer acceptance and revenue attributable to a
distribution and processing agreement entered into on June 1, 1996 with WIC.
Revenue attributable to the distribution and processing agreement was
$18,299,677 and $5,507,224 for the year ended December 31, 1997 and the same
period in 1996, respectively.
 
  In addition, the Company recorded $1,597,024 in revenue recognized on the
unused portion of expired cards (breakage revenue) for the year ended December
31, 1997 as compared to $1,774,972 for the same period in 1996. This
represented approximately 2.6% of total revenue for the year ended December
31, 1997 as compared to 11.8% for the same period in 1996. The reduction in
breakage as a percentage of revenue is due primarily to the Company's policy
of recognizing revenue only on actual minutes serviced relating to deferred
revenue
 
                                      18
<PAGE>
 
obtained through acquisitions. Recharge revenues for the year ended December
31, 1997 and the same period in 1996 were $4,256,630 and $1,168,105,
respectively. This increase was primarily attributable to the effect of the
Acquisitions and increased consumer demand.
 
  Cost of Revenue. Cost of revenue increased to $40,431,418 for the year ended
December 31, 1997 from $10,198,971 for the same period in 1996. The increase
was primarily attributable to greater use of the Company's services and the
effect of the Acquisitions. The gross profit percentage for the year ended
December 31, 1997 was 33.9% as compared to 32.1% for the same period in 1996.
The gross margin percentage increased primarily due to lower transport costs
associated with operating the Company's own platforms and the Company
leveraging its size, scale and scope to lower per-minute costs.
 
  Sales and Marketing Expenses. Sales and marketing expenses increased to
$14,390,230 (23.5% of revenue) for the year ended December 31, 1997 from
$4,511,291 (or 30.0% of revenue) for the same period in 1996. The increase in
dollar amount was primarily due to the effect of the Acquisitions, and
continued expansion of the Company's marketing activities, which include co-op
advertising, manufacturers development funds, and free promotional goods.
Additionally, commissions were higher in 1997 than in 1996 due to increased
sales activity. Sales and marketing expenses decreased as a percentage of
revenue due to certain synergies realized from the effect of the Acquisitions.
 
  General and Administrative Expenses. General and administrative expenses
increased to $18,330,769 (30.0% of revenue) for the year ended December 31,
1997 from $3,615,070 (24.1% of revenue) for the same period in 1996. The
increase in dollar amount and as a percentage of revenue was primarily due to
the effect of the Acquisitions, which includes intangible assets amortization,
depreciation expense, and the addition of personnel and costs associated with
the growth in the Company's business.
 
 
  Acquired Research and Development In-Process. In connection with the
acquisition of ConQuest, the Company has recorded a charge to operations of
$13,364,000 representing acquired research and development in-process relating
to prepaid wireless and port-less switching technologies that had not yet
reached technological feasibility and had no alternative future use (see Note
3 to the consolidated financial statements). The value was determined via an
independent appraisal by estimating the costs to develop the acquired research
and development in-process into commercially viable products, estimating the
resulting net cash flows from such projects, and discounting the net cash
flows back to their present value. As described below, the discount rate
utilized includes a factor that takes into account the uncertainty surrounding
the successful development of the acquired research and development in-
process. In addition, the Company has recorded an intangible asset of
$4,930,000 attributed to developed technology which is being amortized on a
straight-line basis over its expected useful life of four years.
 
  The Company anticipates that the acquired research and development in-
process will be successfully developed; however, there can be no assurance
that commercial viability of these projects will be achieved. If these
projects are not successfully developed, future revenue and profitability of
the Company will be adversely affected.
 
  The nature of the efforts required to develop the acquired research and
development in-process into commercially viable products principally relates
to the completion of all planning, design, prototyping, verification and
testing activities that are necessary to establish that the products can be
produced to meet their design specifications, including functions, features
and technical performance requirements. Since the Company's acquisition of
ConQuest on December 31, 1997 (effective December 3, 1997), the Company has
nearly completed development of its prepaid wireless technology and expects to
begin shipping to retailers early in 1999. The Company continues to develop
the port-less switching technology.
 
 
                                      19
<PAGE>
 
  The resulting forecasted net cash flows from such projects are based on
management's estimates of revenues, costs of sales, research and development
costs, selling, general and administrative costs, and income taxes from such
projects. These estimates are based on the following assumptions:
 
  Positive operating cash flow attributable to the acquired research and
development in-process relating to the prepaid wireless project was assumed to
begin in early 1999 and contribute approximately $2 million in operating cash
flow after taxes to the Company through the year 2000. The port-less switching
project was estimated to contribute approximately $75 million in operating
cash flow after taxes to the Company through the year 2001. Such projections
were based on assumed penetration of the existing customer base, new customer
transactions, historical retention rates and certain other factors.
 
  Discounting the forecasted net cash flows back to their present value was
based on the Company's weighted-average cost of capital (WACC). The WACC
calculation produces the average required rate of return of an investment in
an operating enterprise based on various required rates of return from
investments in various areas of that enterprise. The WACC assumed for the
Company was 18%. The discount rates used in discounting the net cash flows
from acquired research and development in-process were 35% for the prepaid
wireless technology and 70% for the port-less switching technology. The
discount rate was higher than the WACC due to the inherent uncertainties in
the estimates described above including the uncertainty surrounding the
successful development and implementation of the acquired research and
development in-process, the useful life of such technology, the profitability
levels of such technology and the uncertainty of technological advances that
are unknown at this time.
 
  The cost to complete the acquired research and development in-process will
be minimal as these costs are expected to be largely for personnel involved in
the planning, design, coding, integration, testing and modification of
products to be derived from the acquired research and development in-process.
Also reflected in the calculation is the Company's estimate that in-process
projects relating to the prepaid wireless product were 92% complete and
projects relating to the development of the port-less switching technology
were 58% complete at the December 31, 1997 acquisition date.
 
  The foregoing assumptions, estimates and projections are forward looking
statements based upon information presently available to the Company's
management. Actual results could differ materially from such forward looking
statements based on the following risks and uncertainties, among others:
operating cash flows relating to the acquired research and development in-
process technologies being lower than projected due to higher costs or other
factors, including changes in technology or other competitive issues; WACC
being higher than projected due to fluctuations in interest rates and other
economic factors; the discount rate used in calculating the discounted
operating cash flows being lower than appropriate due to the uncertainties
surrounding the successful development and implementation of the acquired
research and development in-process technologies.
 
  Interest Income (Expense). Net interest income (expense) for the year ended
December 31, 1997 was $(447,002) as compared to net interest income (expense)
of $191,724 for the same period in 1996. This decrease was primarily due to
interest expense on the Notes offering and Acquisition related indebtedness
partially offset by interest earned on the Company's cash investments from the
proceeds of the Notes offering.
 
  Income Taxes. The Company had losses for the year ended December 31, 1997
and the same period in 1996. Accordingly, there was no provision for income
taxes.
 
  Net Loss. As a result of the above items, net loss increased to $25,732,648
($1.72 per share) for the year ended December 31, 1997 from $3,112,548 ($.32
per share) for the same period in 1996. Excluding the effects of the acquired
research and development in-process charge, the net loss for the year ended
December 31, 1997 would have been $12,368,648, ($.83 per share).
 
  Decremented Minutes and PIN Activations. Decremented minutes, which
represent actual call traffic over the SmarTalk platforms, were 291,879,909
for the year ended December 31, 1997 as compared with 67,317,886 for the same
period in 1996. PIN activations were 5,286,250 and 924,449 for the year ended
December 31, 1997 and 1996, respectively. These increases are due to increased
usage of the Company's services and the effect of the Acquisitions.
 
                                      20
<PAGE>
 
YEAR ENDED DECEMBER 31, 1996 COMPARED WITH YEAR ENDED DECEMBER 31, 1995
 
  Revenue. Revenue increased to $15,021,060 for the year ended December 31,
1996 from $453,916 for the same period in 1995. The substantial increase in
revenue reflects an increase in usage of SmarTalk services by users of the
SmarTalk Card, an increase in the number of retail storefronts in which the
Company's product is distributed, greater brand awareness and consumer
acceptance, and revenue attributable to a distribution and processing
agreement entered into on June 1, 1996 with WIC. In addition, 11.8% of total
revenue for the year ended December 31, 1996 consisted of revenue recognized
on the unused portion of expired cards (breakage revenue) as compared to 7.9%
for the same period in 1995. Excluding the revenue from the distribution and
processing agreement and from breakage, the recharge percentage is 15.4% and
6.5% for the year ended December 31, 1996 and the same period in 1995,
respectively. Revenue generated from recharges comprised approximately 7.9% of
total revenue for the year ended December 31, 1996 as compared to 6.5% for the
same period in 1995. This increase in recharge revenue was due to a greater
number of SmarTalk Cards eligible for recharge in the marketplace.
 
  Cost of Revenue. Cost of revenue increased to $10,198,971 for the year ended
December 31, 1996 from $318,686 for the same period in 1995. The increase was
primarily attributable to the increased use of the Company's products and
services. The gross profit percentage for the year ended December 31, 1996 was
32.1% as compared to 29.8% for the same period in 1995. The gross margin
percentage increased primarily due to lower transport costs due to the
acquisition of the VoiceChoice platform on June 15, 1996 and the Company's
ability to recognize increased breakage revenue.
 
  Sales and Marketing Expenses. Sales and marketing expenses increased to
$4,511,291 (30.0% of revenue) for the year ended December 31, 1996 from
$842,306 (185.6% of revenue) for the same period in 1995. The decrease as a
percentage of revenue was due to increased revenue growth in 1996. The
increase in dollar amount was primarily due to the continued expansion of the
Company's marketing activities, which include co-op advertising, manufacturers
development funds and promotional goods. Additionally, commission expense was
higher in 1996 than in 1995 due to increased sales activity. The decrease as a
percentage of revenue was directly attributable to the increase in revenues
for the year ended December 31, 1996 as compared to the same period in 1995.
 
  General and Administrative Expenses. General and administrative expenses
increased to $3,615,070 (24.1% of revenue) for the year ended December 31,
1996 from $624,238 (137.5% of revenue) for the same period in 1995. The
increase in dollar amount was primarily due to the addition of personnel, the
costs associated with the growth in the Company's business and the operating
costs associated with the VoiceChoice platform which was purchased June 15,
1996. The decrease as a percentage of revenue was due to increased revenue
growth in 1996. Other general and administrative costs for the year ended
December 31, 1996 included rent associated with the Company's move into a new
office on March 1, 1996, credit card processing fees associated with the
Company's on-line recharge feature, as well as increased general operating
expenses. General and administrative costs for the year ended December 31,
1995 primarily included expenses related to establishing regulatory compliance
in all 50 states, the cost of developing the Company's product and packaging
concept and costs to file documentation related to the procurement of
corporate servicemarks and patents.
 
  Interest Income. Net interest income (expense) for the year ended December
31, 1996 was $191,724 as compared to $2,012 for the same period in 1995. This
increase was primarily due to the investment of the proceeds from the initial
public offering and the subsequent repayment of all of the Company's debt in
November 1996.
 
  Income Taxes. The Company had losses for the year ended December 31, 1996
and the same period in 1995. Accordingly, there was no provision for income
taxes.
 
  Net Loss. As a result of the above items, net loss increased to $3,112,548
($.32 per share) for the year ended December 31, 1996 from $1,329,302 ($.23
per share) for the same period in 1995.
 
 
                                      21
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES
 
  On December 31, 1997, the Company issued 4,488,935 shares of Common Stock to
purchase ConQuest.
 
  On December 31, 1997, the Company purchased Amex Telecom for $44,000,000 in
cash.
 
  On December 9, 1997, the Company purchased selected retail assets of
Frontier's prepaid phone card business for $35,000,000 in cash and 65,568
shares of Common Stock.
 
  In November 1997, the Company acquired a distribution agreement for
$1,000,000 in cash and 326,531 shares of Common Stock. In December 1997, an
additional 3,674 shares of Common Stock were issued for a referral associated
with the distribution agreement.
 
  On September 17, 1997, SmarTalk issued 5 3/4% per annum convertible
subordinated notes due September, 2004 with a principal amount of $150,000,000
(the "Notes"). The net proceeds to SmarTalk from the offering of the Notes
(after deducting the underwriting discounts and other expenses) was
$144,946,319. Interest on the Notes is payable semi-annually on March 15 and
September 15 of each year commencing March 15, 1998.
 
  On August 13, 1997, the Company issued 115,000 shares of Common Stock to
purchase Cardinal.
 
  On August 6, 1997, ConQuest entered into a revolving credit facility with
Star Bank, N.A. ("Star Line of Credit"). Pursuant to the terms of the Star
Line of Credit, ConQuest could borrow up to $9,500,000 as secured by various
accounts receivable. Interest is based on the ninety-day LIBOR plus one
percent. This credit facility was assumed by SmarTalk upon the acquisition of
ConQuest and had an outstanding balance of $7,193,575 at December 31, 1997.
This credit facility was subsequently paid in full and terminated on April 27,
1998.
 
  On May 31, 1997, the Company issued 2,580,001 shares of Common Stock and
$26,500,000 in subordinated 10% per annum term notes which mature June 1, 2001
to purchase GTI. Interest payments on the notes are due quarterly beginning
September 1, 1997. SmarTalk used a portion of the proceeds from the Notes
offering to repurchase $25,970,000 of the outstanding GTI Notes for
$20,614,686; the difference of $5,355,314 was recorded as a reduction to
goodwill.
 
  On May 28, 1997, the Company issued 714,286 shares of Common Stock to
purchase SmarTel.
 
  Throughout 1997, the Company has paid approximately $84,000,000 in cash,
issued $21,144,686 in debt (excluding the Notes offering) and has issued
approximately 8,300,000 shares of Common Stock for the Acquisitions and
distribution agreements.
 
  In December 1996, the Company entered into a revolving credit facility with
Southern California Bank ("SCB Line of Credit"). Pursuant to the terms of the
SCB Line of Credit, the Company can borrow up to $1,000,000 secured by an
assignment of a deposit account with Southern California Bank. Interest on the
outstanding principal balance, calculated from the date of each advance to the
repayment of each advance is at a fixed rate of 7.12%. The credit facility was
undrawn at December 31, 1997.
 
  On October 23, 1996, the Company completed a public offering of 4,000,000
shares of its Common Stock. The Company's Common Stock is listed on the NASDAQ
National Market. The Company raised proceeds of $53,940,000 after deducting
the underwriting discount. A portion of the proceeds were used to repay all of
the Company's then existing indebtedness.
 
  From inception through December 31, 1997, the Company has funded operations
primarily from borrowings under its debt agreements and the sale of its stock.
The Company's operating activities used net cash of $12,867,665 for the year
ended December 31, 1997. The cash used by operating activities is primarily
attributable to the Company's continued efforts to increase its penetration of
the retail and alternate distribution channels.
 
  Short-term and long-term funding needs for SmarTalk relate principally to
acquisitions, additional market penetration, liquidity, operations and capital
expenditures. These requirements principally have been met through
 
                                      22
<PAGE>
 
the proceeds of the initial public offering in October, 1996 and the Notes
offering in September 1997. The following table sets forth selected financial
data from the consolidated statements of cash flows. (As Restated--See Note 14
to the Company's consolidated financial statements.)
 
<TABLE>
<CAPTION>
                                             CASH (USED IN) PROVIDED BY:
                                        ----------------------------------------
   YEAR ENDED DECEMBER 31,               OPERATIONS    INVESTING     FINANCING
   -----------------------              ------------  ------------  ------------
   <S>                                  <C>           <C>           <C>
   1997 (As Restated--See Note 14)..... $(12,867,665) $(88,971,586) $119,765,627
   1996................................ $ (4,762,535) $ (1,169,110) $ 48,646,781
   1995................................ $  2,109,446  $     (4,486) $     10,000
</TABLE>
 
  WORKING CAPITAL CURRENT ASSETS AND CURRENT LIABILITIES ARE ILLUSTRATED IN
THE TABLE BELOW:
 
<TABLE>
<CAPTION>
                                            CURRENT      CURRENT     WORKING
   DECEMBER 31,                              ASSETS    LIABILITIES   CAPITAL
   ------------                           ------------ ----------- -----------
   <S>                                    <C>          <C>         <C>
   1997 (As Restated--See Note 14)....... $106,626,281 $71,316,035 $35,310,246
   1996.................................. $ 49,696,163 $ 6,715,989 $42,980,174
   1995.................................. $  3,821,166 $ 5,221,526 $(1,400,360)
</TABLE>
 
  The decrease in working capital from December 31, 1996 to December 31, 1997
was directly attributable to the proceeds raised from the Notes offering
netted against the related changes in deferred revenues recorded from the
Acquisitions, other current liabilities in excess of current assets and cash
expended for the Acquisitions and related costs.
 
  As of December 31, 1997, the Company believed that the net proceeds from the
Notes offering, together with existing sources of liquidity, would be
sufficient to fund its capital expenditures, working capital and other cash
requirements through the next twelve months. (See Notes 12 and 14 to the
Company's consolidated financial statements.)
 
  As described in Note 14 to the Company's consolidated financial statements,
the consolidated financial statements of the Company have been restated to
reflect, among other things, a revaluation of the Company's accounts
receivable. The ability of the Company to satisfy its cash requirements is
dependent in part on the Company's ability to timely collect its accounts
receivable. In the event that the Company is unable to collect such
receivables in a timely fashion, the Company may be required to consider other
financing sources, including the borrowing of additional funds or the issuance
of additional debt or equity securities of the Company. There can be no
assurance that the Company would be able to obtain such financing or that such
financing would be available on favorable terms.
 
IMPACT OF INFLATION
 
  SmarTalk does not consider inflation to have had a material impact on the
results of operations for the year ended December 31, 1997 and the same
periods in 1996 and 1995.
 
YEAR 2000
 
  The Company is aware of and is addressing the issues associated with the
programming code in existing computer systems as the year 2000 approaches (the
"Year 2000 Issue"). The Year 2000 Issue is pervasive and complex, as many
computer systems will be affected in some way by the rollover of the two-digit
year value to 00. Systems that do not properly recognize such information
could generate erroneous data or cause a system to fail. The Company utilizes
some software and related computer hardware technologies in its operations
that may be affected by the Year 2000 Issue. While the Company believes that
most of its proprietary software and platforms will be unaffected by the Year
2000 Issue, the Company is currently attempting to evaluate the impact of the
Year 2000 Issue on the systems of its vendors, suppliers and key customers.
The Company is currently reviewing what actions will be necessary to make its
computer systems and those of its vendors, suppliers and key customers year
2000 compliant. The impact of these actions has yet to be fully determined,
but could materially affect the Company's business.
 
                                      23
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
                          PART II. OTHER INFORMATION
 
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To the Board of Directors and Shareholders
of SmarTalk TeleServices, Inc.
 
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of shareholders' equity (deficit) and
of cash flows present fairly, in all material respects, the financial position
of SmarTalk TeleServices, Inc. and its subsidiaries at December 31, 1997 and
1996, and the results of their operations and their cash flows for each of the
three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for the opinion expressed above.
 
/s/ PricewaterhouseCoopers LLP
 
Dallas, Texas
 
March 30, 1998, except as to Notes 12 and
 14, which are as of November 4, 1998
 
                                      24
<PAGE>
 
                  SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                     -------------------------
                                                         1997         1996
                                                     ------------  -----------
                                                         (AS
                                                      RESTATED--
                                                     SEE NOTE 14)
<S>                                                  <C>           <C>
                       ASSETS
Current assets:
  Cash and cash equivalents......................... $ 62,900,673  $44,830,487
  Trade accounts receivable (net of allowance for
   doubtful accounts of $1,482,206 and $89,724,
   respectively)....................................   28,012,237    2,254,192
  Receivable from American Express Company..........    2,570,000          --
  Inventories.......................................    4,301,487      601,020
  Prepaid expenses..................................    1,377,844      327,696
  Other current assets..............................    7,464,040    1,682,768
                                                     ------------  -----------
    Total current assets............................  106,626,281   49,696,163
Non-current assets:
  Property and equipment, net.......................   14,208,975      744,748
  Intangibles, net..................................  235,506,706          --
  Note receivable from ACMI L.L.C., net.............    2,234,763          --
  Other non-current assets..........................    9,724,352       90,509
                                                     ------------  -----------
    Total assets.................................... $368,301,077  $50,531,420
                                                     ============  ===========
        LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable.................................. $ 15,081,532  $ 3,527,192
  Deferred revenue..................................   28,885,002    2,699,640
  Accrued marketing costs...........................    1,811,817      136,931
  Accrued interest payable..........................    2,615,480          --
  Other accrued expenses............................    5,571,728      352,226
  Excise and sales tax payable......................    5,565,072          --
  Accrued litigation settlement.....................    4,500,003          --
  Current portion of long term debt.................    7,285,401          --
                                                     ------------  -----------
    Total current liabilities.......................   71,316,035    6,715,989
Long term debt......................................  150,874,753          --
                                                     ------------  -----------
    Total liabilities...............................  222,190,788    6,715,989
                                                     ------------  -----------
Commitments and contingencies (See Note 9)
Shareholders' equity:
  Preferred stock, no par value; authorized
   10,000,000 shares; no shares issued and
   outstanding......................................          --           --
  Common stock, no par value; authorized 100,000,000
   shares; issued and outstanding 21,350,852 and
   12,829,459 shares, respectively..................  178,670,477   50,786,781
  Accumulated deficit...............................  (32,703,998)  (6,971,350)
  Cumulative translation adjustment.................      143,810          --
                                                     ------------  -----------
    Total shareholders' equity......................  146,110,289   43,815,431
                                                     ------------  -----------
    Total liabilities and shareholders' equity...... $368,301,077  $50,531,420
                                                     ============  ===========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       25
<PAGE>
 
                  SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                              YEAR ENDED DECEMBER 31,
                                        --------------------------------------
                                            1997         1996         1995
                                        ------------  -----------  -----------
                                            (AS
                                         RESTATED--
                                        SEE NOTE 14)
<S>                                     <C>           <C>          <C>
Revenue................................ $ 61,164,228  $15,021,060  $   453,916
Cost of revenue........................   40,431,418   10,198,971      318,686
                                        ------------  -----------  -----------
  Gross profit.........................   20,732,810    4,822,089      135,230
Sales and marketing....................   14,390,230    4,511,291      842,306
General and administrative.............   18,330,769    3,615,070      624,238
Acquired research and development in
 process...............................   13,364,000          --           --
                                        ------------  -----------  -----------
  Operating loss.......................  (25,352,189)  (3,304,272)  (1,331,314)
Interest income........................    3,143,185      443,352        5,290
Interest expense.......................    3,590,187      251,628        3,278
Other income...........................       66,543          --           --
                                        ------------  -----------  -----------
  Loss before income taxes.............  (25,732,648)  (3,112,548)  (1,329,302)
Provision for income taxes.............          --           --           --
                                        ------------  -----------  -----------
  Net loss............................. $(25,732,648) $(3,112,548) $(1,329,302)
                                        ============  ===========  ===========
  Net loss per share--basic and
   diluted............................. $      (1.72) $      (.32) $      (.23)
                                        ============  ===========  ===========
  Weighted average number of shares....   14,951,454    9,579,804    5,849,826
                                        ============  ===========  ===========
</TABLE>
 
 
                  The accompanying notes are an integral part
                  of these consolidated financial statements.
 
                                       26
<PAGE>
 
                  SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
           CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
 
<TABLE>
<CAPTION>
                                  COMMON STOCK                                  CUMULATIVE
                             -----------------------    STOCK     ACCUMULATED   TRANSLATION
                               SHARES      AMOUNT    SUBSCRIPTION   DEFICIT     ADJUSTMENT     TOTAL
                             ---------- ------------ ------------ ------------  ----------- ------------
<S>                          <C>        <C>          <C>          <C>           <C>         <C>
January 1, 1995.............  4,941,904 $      5,000  $     --    $    (65,472)  $    --    $    (60,472)
  Shares issued.............  1,235,481      310,000        --             --         --         310,000
  Shares subscribed.........  2,647,449          --    (300,000)           --         --        (300,000)
  Net loss..................        --           --         --      (1,329,302)       --      (1,329,302)
                             ---------- ------------  ---------   ------------   --------   ------------
December 31, 1995...........  8,824,834      315,000   (300,000)    (1,394,774)       --      (1,379,774)
  Issuance of subscribed
   shares...................        --           --     300,000            --         --         300,000
  Purchase of assets of
   related entity...........        --           --         --      (2,464,028)       --      (2,464,028)
  Compensation under stock
   options issued...........        --        24,000        --             --         --          24,000
  Proceeds from sale of
   stock, net of costs......  4,000,000   50,439,595        --             --         --      50,439,595
  Stock options exercised...      4,625        8,186        --             --         --           8,186
  Net loss..................        --           --         --      (3,112,548)       --      (3,112,548)
                             ---------- ------------  ---------   ------------   --------   ------------
December 31, 1996........... 12,829,459   50,786,781        --      (6,971,350)       --      43,815,431
  Stock options exercised...    227,398      851,485        --             --         --         851,485
  Distribution agreement....    330,205    7,596,093        --             --         --       7,596,093
Acquisitions:
  ConQuest Telecommunication
   Services Corp............  4,488,935   71,917,228        --             --         --      71,917,228
  GTI Telecom, Inc..........  2,580,001   34,259,820        --             --         --      34,259,820
  SmarTel Communications,
   Inc......................    714,286    9,494,290        --             --         --       9,494,290
  Cardinal Voicecard
   Limited..................    115,000    2,170,625        --             --         --       2,170,625
  Frontier Selected Assets..     65,568    1,594,155        --             --         --       1,594,155
  Cumulative translation
   adjustment...............        --           --         --             --     143,810        143,810
  Net loss..................        --           --         --     (25,732,648)       --     (25,732,648)
                             ---------- ------------  ---------   ------------   --------   ------------
December 31, 1997 (As
 Restated --
 See Note 14)............... 21,350,852 $178,670,477  $     --    $(32,703,998)  $143,810   $146,110,289
                             ========== ============  =========   ============   ========   ============
</TABLE>
 
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       27
<PAGE>
 
                  SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                               YEAR ENDED DECEMBER 31,
                                        ----------------------------------------
                                             1997          1996         1995
                                        --------------  -----------  -----------
                                        (AS RESTATED--
                                         SEE NOTE 14)
<S>                                     <C>             <C>          <C>
Cash flows from operating activities:
 Net loss.............................  $ (25,732,648)  $(3,112,548) $(1,329,302)
 Adjustments to reconcile net loss to
  net cash (used) provided by
  operating activities:
  Depreciation........................      1,104,989        89,820          --
  Amortization........................      5,622,674           --           --
  Amortization of debt issuance cost..        192,489           --           --
  Provision for bad debt..............            276        78,264       11,425
  Lease termination fee...............       (325,810)          --           --
  Acquired research and development in
   process............................     13,364,000           --           --
  Changes in assets and liabilities
   which increase (decrease) cash:
   Trade accounts receivable..........     (3,153,813)   (2,107,482)    (236,167)
   Inventories........................       (797,851)      117,025     (718,045)
   Receivable from related party......            --            --         3,400
   Prepaid expenses...................     (2,150,512)     (324,618)      (3,078)
   Other current assets...............       (643,047)     (923,050)    (759,718)
   Other non-current assets...........     15,460,627       (74,409)     (16,100)
   Accounts payable...................       (975,254)    2,603,292      896,898
   Deferred revenue...................    (18,798,761)     (996,875)   3,696,084
   Accrued marketing costs............      1,674,886      (244,498)     344,367
   Accrued interest...................      2,615,480           --           --
   Other accrued expenses.............      1,097,609       132,544      219,682
   Deposit from customer..............     (4,060,958)          --           --
   Excise and sales tax payable.......      2,637,959           --           --
                                        -------------   -----------  -----------
  Net cash (used) provided by
   operating activities...............    (12,867,665)   (4,762,535)   2,109,446
                                        -------------   -----------  -----------
Cash flows from investing activities:
  Cash paid for acquisitions, net of
   cash acquired......................    (79,000,000)          --           --
  Purchase of LCN, net of equipment
   acquired...........................            --       (464,027)         --
  Capital expenditures................     (5,270,710)     (705,083)      (4,486)
  Acquisition costs...................     (4,700,876)          --           --
                                        -------------   -----------  -----------
   Net cash used by investing
    activities........................    (88,971,586)   (1,169,110)      (4,486)
                                        -------------   -----------  -----------
Cash flows from financing activities:
  Common stock proceeds, net..........            --     50,771,781       10,000
  Note payable to related party.......            --      1,200,000          --
  Revolving line of credit with
   related party......................            --        500,000          --
  Term loan with related party........            --        250,000          --
  Repayment of note payable to related
   party..............................            --     (1,200,000)         --
  Repayment of line of credit with
   related party......................            --       (500,000)         --
  Repayment of term loan with related
   party..............................            --       (250,000)         --
  Repayment of subordinated term loan
   to LCN.............................            --     (2,000,000)         --
  Repayment of term loan with Pacific
   Bell Systems.......................            --       (125,000)         --
  Stock options exercised.............        851,485           --           --
  Issuance of convertible debt, net of
   costs..............................    144,946,319           --           --
  Repayment of note payable to
   Worldcom...........................     (6,383,691)          --           --
  Payments on capital lease
   obligations........................        (87,696)          --           --
  Repayment of notes issued for the
   GTI acquisition....................    (20,614,686)          --           --
  Borrowings under line of credit.....      1,053,896           --           --
                                        -------------   -----------  -----------
   Net cash provided by financing
    activities........................    119,765,627    48,646,781       10,000
                                        -------------   -----------  -----------
  Effect of currency exchange rate
   change.............................        143,810           --           --
                                        -------------   -----------  -----------
Increase in cash and cash equivalents.     18,070,186    42,715,136    2,114,960
Cash and cash equivalents at beginning
 of period............................     44,830,487     2,115,351          391
                                        -------------   -----------  -----------
Cash and cash equivalents at end of
 period...............................  $  62,900,673   $44,830,487  $ 2,115,351
                                        -------------   -----------  -----------
Supplemental disclosure of cash flow
 information:
  Cash paid for interest..............  $     974,707   $   251,628  $     3,278
                                        =============   ===========  ===========
  Note payable for LCN purchase.......  $         --    $ 2,000,000  $       --
                                        =============   ===========  ===========
  Issuance of stock for acquisitions..  $ 119,436,118   $       --   $       --
                                        =============   ===========  ===========
  Issuance of debt for acquisitions,
   net................................  $  21,144,686   $       --   $       --
                                        =============   ===========  ===========
  Issuance of stock for UK
   distribution agreement.............  $   7,596,093   $       --   $       --
                                        =============   ===========  ===========
  Debt assumed at ConQuest
   acquisition........................  $   6,139,679   $       --   $       --
                                        =============   ===========  ===========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       28
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1. THE COMPANY
 
  SmarTalk TeleServices, Inc. (the "Company") was incorporated on October 28,
1994. The Company provides prepaid telecommunication services to customers
throughout the United States and parts of Europe through its proprietary
switching platforms. The Company's revenues originate from customer usage of
the Company's services.
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
 Principles of Consolidation
 
  The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated.
 
 Accounting Estimates
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets, and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements, and reported amounts of revenues and expenses during the reporting
period. Actual results could differ from those estimates.
 
 Cash and Cash Equivalents
 
  Cash and cash equivalents primarily consist of highly liquid investments
with an original maturity of three months or less, and interest rates varying
from 2.1% to 7.4%. Restricted cash primarily related to the Company's merchant
accounts was $252,365 and $121,086 at December 31, 1997 and 1996,
respectively. Additionally, at December 31, 1997, $675,000 of cash was pledged
as collateral on a standby letter of credit related to inventory purchased.
 
 Accounts Receivable
 
  Accounts receivable are composed of amounts receivable from customers for
cards sold, net of allowance for doubtful debts and amounts due to Amex
Telecom under the cost sharing arrangement with the United States Postal
Service ("USPS") as outlined in Note 9.
 
 Other Assets
 
  Other assets consist primarily of deferred card costs and commissions
related to deferred revenue, manufacturer's development funds ("MDF"), prepaid
licensing fees and commission advances. Generally, the Company transfers the
costs of cards from inventory to deferred card costs upon shipment to the
retailer. Additionally, the Company records commissions as a percentage of the
value of goods shipped as deferred commissions. The deferred card costs and
commissions are expensed as services are utilized by the customer and,
accordingly, are matched with the revenues recognized under the Company's
revenue recognition policy. In some instances, the Company pays MDF to its
retailers to access shelf space and promote the SmarTalk product. These
payments which meet certain capitalization criteria are capitalized and
amortized over the life of the associated agreement. The Company prepays
minimum licensing fees to license certain technologies and its servicemark.
These fees are capitalized and amortized over the contractual life of the
obligation. The Company pays recoupable commission advances to certain
strategic partners to facilitate distribution and sale of the Company's
products. These advances are capitalized and recognized as expense as the
commissions are earned generally on a usage basis.
 
 Property and Equipment
 
  Assets of businesses purchased are recorded at their fair values at the date
of acquisition.
 
                                      29
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  All other property and equipment are recorded at cost. Depreciation is
computed using principally the straight-line method over the estimated useful
lives of the related assets, ranging from three to ten years. Expenditures for
new property and equipment and replacement property and equipment are
capitalized while expenditures for maintenance and repairs are charged against
earnings as incurred.
 
 Intangible Assets
 
  Goodwill represents costs in excess of fair value of net assets acquired and
is being amortized on a straight-line basis over a fifteen to twenty-year
period beginning at the date of acquisition. Other intangible assets are being
amortized on a straight-line basis over periods of two to ten years. For
additional information related to the Acquisitions, see Note 3,
"Acquisitions." Intangible assets will be written down to recoverable values
whenever recoverability through cash flows or sale of the acquired entity
becomes doubtful. The Company will periodically evaluate the recoverability of
the carrying value of intangible assets by assessing whether the projected
cash flows are sufficient to recover the unamortized costs of the asset.
 
  Debt issuance costs are being amortized over the seven year period of the
convertible subordinated notes.
 
 Note Receivable from ACMI, L.L.C.
 
  This represents a note receivable by ConQuest from the sale of the ConQuest
collector card business to ACMI, L.L.C. on April 1, 1997. The amount shown is
net of an allowance for doubtful debt of $729,787 due to uncertainty over the
recoverability of this amount.
 
 Accrued Marketing Costs
 
  Accrued marketing costs include trade and consumer advertising. These costs
are expensed as incurred except certain MDF payments which are amortized over
the life of the associated agreement.
 
  Advertising expense was $4,293,974, $1,577,794 and $425,271 for the years
ended December 31, 1997, 1996, and 1995, respectively.
 
 Revenue Recognition and Deferred Revenue
 
  The Company's revenue originates from customer usage of (i) Company and co-
branded prepaid calling cards sold through retailers, (ii) recharges of
existing calling cards, (iii) cards sold for promotional marketing campaigns,
(iv) corporate sales to businesses, (v) prepaid calling card services provided
to one of the Company's strategic partners, West Interactive Corporation
("WIC"); and (vi) call processing. Sales to WIC were approximately 30% and 37%
of revenues for the years ended December 31, 1997 and 1996, respectively. The
Company provided no services under this arrangement in 1995.
 
  Under the majority of agreements with retailers, the Company sells cards to
the retailer at a fixed price with normal credit terms. When the retailer is
invoiced, deferred revenue is recorded. The Company recognizes revenue and
reduces the deferred revenue account as the end user utilizes calling time and
upon expiration of cards containing unused calling time. For cards which have
no printed expiration date, revenue for unused minutes is recognized when
cards have been in circulation for greater than twelve months. The Company
also records deferred revenue upon recharge of existing phone cards and
recognizes revenue upon usage or expiration of the recharge minutes. Under the
current agreement with the USPS--See Note 9), the USPS's share of deferred
revenue of $2,439,443 at December 31, 1997 has been offset against the
deferred revenue.
 
                                      30
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  With respect to deferred prepaid calling card revenue on the books of an
acquired entity, the obligation to provide future service relating to unused
minutes is revalued as of the date of acquisition. The fair value of the
service obligation represents management's best estimate of the cost to
service acquired unused minutes plus a normal profit margin for this service
element (such margin intended to cover indirect costs and provide a reasonable
return). Deferred revenue is not recorded for acquired unused minutes for
which no future usage is anticipated. The acquired deferred revenue obligation
is periodically remeasured to reflect actual used and unused minutes which may
vary from original estimates. A reduction in acquired deferred revenue is
recorded based on actual minutes used during the post-acquisition period.
 
  Substantially all prepaid phone cards sold by the Company have expiration
dates and expire as of that date if never activated or six months after the
initial activation unless recharged. Revenue recognized due to expired cards
was $1,597,024 (as Restated--See Note 14), $1,774,972 and less than $36,000
for the years ended December 31, 1997, 1996 and 1995, respectively.
 
 Stock Split
 
  On February 15, 1996, the Board of Directors declared a 3,500 for 1 stock
split distributable on February 13, 1996 to shareholders of record on February
13, 1996. Further, on May 23, 1996, the Board of Directors declared a 2.51 to
1 stock split distributable on May 23, 1996 to shareholders of record on that
date. Further, on August 15, 1996, the Company effected a 0.5625 reverse stock
split distributable on August 15, 1996 to shareholders of record on that date.
In this report, all per share amounts and numbers of shares have been restated
to reflect the stock splits.
 
 Net Loss per Share
 
  In February 1997, Statement of Financial Accounting Standards No. 128,
"Earnings per Share" ("SFAS No. 128"), was issued which supersedes the old
methodology for calculation of earnings per share, as promulgated under
Accounting Principles Board ("APB") Opinion No. 15. The new Standard
simplifies the existing computational guidelines and revises the disclosure
requirements. SFAS No. 128 requires presentation of "basic" earnings per share
(which excludes dilution as a result of unexercised stock options and
convertible subordinated debentures) and "diluted" earnings per share. The
Statement has been adopted for the year ended 1997 and all prior periods have
been retroactively restated (including quarterly data included in Note 13).
 
 Fair Value of Financial Instruments
 
  Statement of Financial Accounting Standards ("SFAS") No. 107, "Disclosures
About Fair Value of Financial Instruments" requires the determination of fair
value for certain of the Company's assets and liabilities. The following
methods and assumptions were used to estimate the fair value of each class of
financial instrument for which it is practicable to estimate the fair value:
 
    Current assets and liabilities: The carrying value of cash and cash
  equivalents, marketable securities, receivables, payables, deferred revenue
  and accrued liabilities approximates fair value due to their short
  maturity.
 
    Long term debt: The fair value of the Company's outstanding debt is
  estimated based on the borrowing rates currently available to the Company
  for obligations with similar terms. Management believes that the fair value
  of the Company's outstanding debt approximates the recorded value.
 
                                      31
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 Long-Lived Assets
 
  In 1995, the Company adopted SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed of." SFAS No. 121
establishes accounting standards for the impairment of long-lived assets,
certain identifiable intangibles, and goodwill related to those assets to be
held and used for long-lived assets and certain identifiable intangibles to be
disposed of. The effect of adopting SFAS No. 121 was not material.
 
  The Company periodically reviews the values assigned to long-lived assets,
such as property and equipment, intangibles and software costs, to determine
whether any impairments are other than temporary. Management believes that the
long-lived assets in the accompanying balance sheets are appropriately valued.
 
 Regulation
 
  The Company is subject to regulation by the Federal Communications
Commission ("FCC") and by various state public service and public utility
commissions. The Company's management and regulatory legal counsel believe the
Company is in compliance with these regulations. In addition, the
Telecommunications Act (Section 276) mandated that the FCC promulgate rules to
establish a per call compensation plan to ensure that all payphone providers
are fairly compensated for each completed intrastate and interstate payphone
initiated call, including calls on which payphone providers had not heretofore
received compensation. Such calls included those placed to toll free numbers
(800/888) such as operator assisted and prepaid calling card calls, and calls
placed through network access codes. In September 1996, the FCC promulgated
rules to implement Section 276 of the Telecommunications Act which established
a three-phase compensation plan for pay phone providers. Under the first
phase, interexchange carriers with annual toll revenues of more than
$100 million were to pay a total of $45.85 per payphone per month for all toll
free and access code calls for the first year, commensurate with their portion
of total interexchange revenues. All switched-based and facilities-based
interexchange carriers were to pay $0.35 per call to each payphone provider
during the second year (although payments could subsequently be recovered from
resellers by the carriers), after which per call compensation rates were to be
left to individual market-driven rates negotiated between payphone providers
and interexchange carriers. On July 1, 1997 the D.C. Circuit Court of Appeals
vacated significant portions of the FCC's rules including the $0.35 per call
rate which was found to be arbitrary and capricious, and remanded the matter
to the FCC for reconsideration. On remand, the FCC in September 1997,
established a two-year "default" compensation rate of $0.284 per payphone-
originated toll free or access code call. At the end of the two year interim
period, the per call payphone compensation rate will be the deregulated
market-based local coin rate less $0.066. This amount is payable by all
"switched-based" interexchange carriers (but again may be passed through to
non-facilities-based resellers). The revised FCC's rules became effective on
October 7, 1997, but continue to be subject to regulatory and legal
challenges. SmarTalk is unable to predict whether this regulation or other
potential changes in the regulatory environment could have a material adverse
effect on the Company.
 
 Reclassifications
 
  Certain reclassifications have been made to the amounts presented for 1996
and 1995 to conform to the presentation for 1997.
 
3. ACQUISITIONS
 
  Amex Telecom. On December 31, 1997, SmarTalk acquired Amex Telecom, a
provider of prepaid calling products, including the FirstClass Phonecard(TM)
sold through the USPS and the PhoneFunds(TM) card sold through
 
                                      32
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

the National Park Foundation and Amex Travel and Foreign Exchange ("AmEx
TSOs") offices. In consideration for the outstanding shares of Amex Telecom,
SmarTalk paid $44 million in cash, which was provided from SmarTalk's working
capital with a portion thereof held in escrow pending regulatory approval to
Amex Telecom's sole stockholder, AmEx Travel Related Services, Inc. ("AmEx
TRS"). SmarTalk purchased the profit and cost sharing agreement between Amex
Telecom and the USPS. The Amex Telecom acquisition secured for SmarTalk
distribution rights to AmEx TSOs worldwide, distribution through the USPS and
the National Park Foundation and an agreement with American Express to be the
exclusive provider of a co-branded prepaid calling card for American Express.
In addition, SmarTalk was granted exclusive access to the American Express
point-of-sale system for activation and recharge of prepaid phone cards. Under
the purchase agreement American Express Company agreed to reimburse SmarTalk
for the estimated unused minutes as of December 31, 1997. The Company has
recorded this amount as a reduction to the purchase price and a receivable of
$2,570,000 December 31, 1997.
 
  ConQuest. On December 3, 1997, SmarTalk entered into an interim operating
agreement which transferred all risks and rewards from ConQuest to SmarTalk.
SmarTalk assumed responsibility for operating the ConQuest business and the
employees of ConQuest became employees of SmarTalk on this date. On December
31, 1997, SmarTalk acquired 100% of ConQuest's outstanding common stock. In
consideration for each outstanding share of ConQuest common stock, ConQuest
stockholders received 7.63 shares of SmarTalk Common Stock (approximately 4.5
million shares of Common Stock in total). SmarTalk also assumed $6,139,679 of
ConQuest's debt. Additionally, in connection with this acquisition SmarTalk
paid $350,000 in cash in 1997 and issued 215,569 shares of Common Stock in
January 1998 to obtain an agreement and mutual release from a group of
individuals that had brought a lawsuit against ConQuest prior to the
acquisition. ConQuest is a developer and marketer of prepaid calling cards and
other enhanced telecommunication services and technology, including domestic
and international calling services for the tour and travel industry. The
acquisition of ConQuest added significantly to SmarTalk's technological
infrastructure, customer base, platform operations and management
infrastructure.
 
  Frontier Selected Assets. On December 9, 1997, SmarTalk acquired selected
assets ("Frontier Selected Assets") of the retail prepaid phone card business
of Frontier Corporation, a New York corporation ("Frontier"). In consideration
for the Frontier Selected Assets, SmarTalk paid $35 million in cash and 65,568
shares of Common Stock which represented a contingent payment to Frontier. The
acquisition of the Frontier Selected Assets added to SmarTalk's size, scale
and scope, and helped establish SmarTalk's presence on the East Coast.
 
  Cardinal Voicecard Limited. On August 13, 1997, SmarTalk issued 115,000
shares of Common Stock to purchase this Toronto, Ontario based company. This
acquisition provided the Company with access to the Canadian marketplace.
 
  GTI Telecom, Inc. ("GTI") On May 31, 1997, SmarTalk issued 2,580,001 shares
of Common Stock and $26,500,000 in subordinated 10% per annum term notes which
mature June 1, 2001 (the "GTI Notes") to purchase this Florida based company.
$25,970,000 of the GTI Notes were repaid in September 1997 at $20,614,686. The
difference of $5,355,314 was recorded as a reduction to goodwill. This
acquisition expanded the Company's customer base and added human resource,
technical and manufacturing infrastructure.
 
  SmarTel Communications Inc. On May 28, 1997, the Company acquired SmarTel
Communications, Inc., a Delaware corporation ("SmarTel") operating as a Boston
based prepaid promotions phone card company, for 714,286 shares of Common
Stock.
 
  LCN Inc. Assets In January 1996, the Company entered into an agreement to
purchase certain of the fixed assets of Lorsch Creative Network, Inc. ("LCN")
that had historical net book value of $35,972. LCN's sole
 
                                      33
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
shareholder is the majority shareholder of the Company's Common Stock.
Minority shareholders of the Company consented to the transaction. The
purchase was consummated in January 1996 for $500,000 cash plus a $2,000,000
subordinated term note which was repaid in November 1996. Because the assets
were purchased from a related party, the assets are reflected on the Company's
balance sheet at LCN's historical depreciated cost as of the date of the
acquisition. The excess of acquisition cost over the historical cost less
depreciation of the assets acquired of approximately $2,464,028 was recorded
as a charge to the Company's accumulated deficit in a manner similar to a
capital distribution.
 
  The following table sets forth the relevant transactions recorded in
connection with each acquisition (as Restated--See Note 14):
 
<TABLE>
<CAPTION>
                                                                    FRONTIER
                                                                    SELECTED
                            SMARTEL        GTI        CARDINAL       ASSETS     AMEX TELECOM    CONQUEST        TOTAL
                          -----------  ------------  -----------  ------------  ------------  ------------  -------------
<S>                       <C>          <C>           <C>          <C>           <C>           <C>           <C>
Issuance of Common
 Stock..................  $ 9,494,290  $ 34,259,820  $ 2,170,625  $  1,594,155  $        --   $ 71,917,228  $ 119,436,118
Issuance of debt........          --     21,144,686          --            --            --            --      21,144,686
Cash payments...........          --            --           --     35,000,000    44,000,000           --      79,000,000
Litigation settlement...          --            --           --            --            --      4,500,003      4,500,003
Acquired research and
 development in process.          --            --           --            --            --    (13,364,000)   (13,364,000)
Acquired intangibles....   (2,569,000)  (24,998,000)         --    (23,883,000)  (40,234,000)  (17,936,000)  (109,620,000)
Acquisition related
 receivable.............          --            --           --            --     (2,570,000)          --      (2,570,000)
Acquisition related
 transaction costs......      707,732     1,579,140       55,252     1,331,951     1,014,225     1,545,335      6,233,635
                          -----------  ------------  -----------  ------------  ------------  ------------  -------------
                            7,633,022    31,985,646    2,225,877    14,043,106     2,210,225    46,662,566    104,760,442
Less: net assets
 acquired...............   (2,065,281)  (21,895,111)  (1,083,289)      555,614       699,385     1,900,935    (21,887,747)
                          -----------  ------------  -----------  ------------  ------------  ------------  -------------
Goodwill................  $ 9,698,303  $ 53,880,757  $ 3,309,166  $ 13,487,492  $  1,510,840  $ 44,761,631  $ 126,648,189
                          ===========  ============  ===========  ============  ============  ============  =============
</TABLE>
 
  All of the Acquisitions have been accounted for using the purchase method of
accounting and the operating results of the acquired companies have been
included in the SmarTalk consolidated statement of operations since the date
of the acquisitions.
 
  In connection with the acquisition of ConQuest, the Company has recorded a
charge to operations of $13,364,000 representing acquired research and
development in-process relating to prepaid wireless and port-less switch
technologies that had not yet reached technological feasibility and had no
alternative future use (see Note 3 to the consolidated financial statements).
The value was determined via an independent appraisal by estimating the costs
to develop the acquired research and development in-process into commercially
viable products, estimating the resulting net cash flows from such projects,
and discounting the net cash flows back to their present value. The discount
rate utilized includes a factor that takes into account the uncertainty
surrounding the successful development of the acquired research and
development in-process. In addition, the Company has recorded an intangible
asset of $4,930,000 attributed to developed technology which is being
amortized on a straight-line basis over its expected useful life of four
years.
 
  The valuation of the acquired research and development in-process is based
on management's estimates of revenues, costs of sales, research and
development costs, selling, general and administrative costs, and income taxes
from such projects. These estimates are based on the assumptions including the
penetration of the existing customer base, new customer transactions,
historical retention rates and certain other factors.
 
  Also reflected in the valuation is the Company's estimate that in-process
projects relating to the prepaid wireless product were 92% complete and
projects relating to the development of the port-less switch were 58% complete
at the December 31, 1997 acquisition date.
 
                                      34
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  Approximately $109,620,000 of the aggregate purchase prices of 1997
acquisitions was allocated to specifically identifiable intangible assets such
as customer base, existing core technology, non-compete agreements, other
agreements and assembled work force and is being amortized over periods of two
to ten years.
 
  There can be no assurance that the anticipated benefits of the Amex Telecom
acquisition, the ConQuest acquisition, the acquisition of the Frontier
Selected Assets, the Cardinal acquisition, the GTI acquisition or the SmarTel
acquisition (collectively the "Acquisitions") will be realized or that the
combination of SmarTalk, Amex Telecom, ConQuest, the Frontier Selected Assets,
Cardinal GTI and SmarTel will be successful.
 
  The following unaudited pro forma summary presents the Company's combined
results as if the Acquisitions occurred at the beginning of the respective
periods, after giving effect to certain adjustments including goodwill
amortization, depreciation and interest expense. These pro forma results are
not necessarily indicative of those that would have occurred had the
acquisitions occurred at the beginning of the respective periods:
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                    ---------------------------
                                                         1997          1996
                                                    -------------- ------------
                                                    (AS RESTATED--
                                                     SEE NOTE 14)
      <S>                                           <C>            <C>
      Revenue......................................  $148,008,432  $105,113,067
                                                     ============  ============
      Net (loss)...................................  $(39,490,050) $(40,064,669)
                                                     ============  ============
      Net (loss) per share--basic and diluted......  $      (2.64) $      (4.18)
                                                     ============  ============
 
  Pro forma results do not include in process research and development charge
of $13,364,000.
 
4. COMPOSITION OF CERTAIN BALANCE SHEET ACCOUNTS
 
  Composition of certain balance sheet accounts are as follows:
 
  Inventories:
 
    Inventories are stated at the lower of cost (using the first-in, first-
  out (FIFO) method) or market.
 
<CAPTION>
                                                           DECEMBER 31,
                                                    ---------------------------
                                                         1997          1996
                                                    -------------- ------------
                                                    (AS RESTATED--
                                                     SEE NOTE 14)
      <S>                                           <C>            <C>
      Phone cards..................................  $  4,097,810  $    499,636
      Displays.....................................       203,677       101,384
                                                     ------------  ------------
                                                     $  4,301,487  $    601,020
                                                     ============  ============
<CAPTION>
                                                           DECEMBER 31,
                                                    ---------------------------
                                                         1997          1996
                                                    -------------- ------------
                                                    (AS RESTATED--
                                                     SEE NOTE 14)
      <S>                                           <C>            <C>
      Other current assets:
        Deferred sales commissions.................  $    922,110  $    146,066
        Commission advances........................       254,426           --
        Prepaid licensing fees.....................       487,578       373,710
        Deferred card costs........................     2,766,519       440,911
        Manufacturer's development funds...........     3,033,407           --
        Other......................................           --        722,081
                                                     ------------  ------------
                                                     $  7,464,040  $  1,682,768
                                                     ============  ============
</TABLE>
 
                                      35
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  Included in other current assets for 1996 is a $666,048 deposit made to the
United States District Court in relation to a dispute with a supplier. The
dispute was settled in 1997 for an amount less than the deposit.
<TABLE>
 
<CAPTION>
                                                             DECEMBER 31,
                                                        -----------------------
                                                             1997        1996
                                                        -------------- --------
                                                        (AS RESTATED--
                                                         SEE NOTE 14)
      <S>                                               <C>            <C>
      Property and equipment:
        Computer equipment and software................  $  2,896,970  $187,242
        Telephone switching equipment..................     8,474,104   349,847
        Office equipment and furniture.................     2,924,134   292,349
        Manufacturing equipment........................       563,792       --
        Leasehold improvements.........................       544,784     5,130
                                                         ------------  --------
                                                           15,403,784   834,568
        Less: accumulated depreciation.................     1,194,809    89,820
                                                         ------------  --------
                                                         $ 14,208,975  $744,748
                                                         ============  ========
 
  Depreciation expense was $1,104,989, $89,820 and zero for the years ended
December 31, 1997, 1996 and 1995, respectively.
 
<CAPTION>
                                                             DECEMBER 31,
                                                        -----------------------
                                                             1997        1996
                                                        -------------- --------
                                                        (AS RESTATED--
                                                         SEE NOTE 14)
      <S>                                               <C>            <C>
      Intangibles:
        Goodwill.......................................  $126,648,189  $    --
        Acquired customer base.........................    83,525,000       --
        Technology and marketing agreement.............    10,000,000       --
        Acquired core technology.......................     4,930,000       --
        Agreements not to compete......................     7,165,000       --
        Acquired work force............................     4,000,000       --
        Debt issue costs...............................     5,053,680       --
                                                         ------------  --------
                                                          241,321,869       --
        Less: accumulated amortization.................    (5,815,163)      --
                                                         ------------  --------
                                                         $235,506,706  $    --
                                                         ============  ========
</TABLE>
 
                                      36
<PAGE>
 
                  SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  Amortization expense was $5,815,163 for the year ended December 31, 1997 and
zero for both the years ended December 31, 1996 and 1995.
<TABLE>
 
<CAPTION>
                                                             DECEMBER 31,
                                                        -----------------------
                                                             1997        1996
                                                        -------------- --------
                                                        (AS RESTATED--
                                                         SEE NOTE 14)
      <S>                                               <C>            <C>
      Other non-current assets:
        Prepaid license fees...........................  $   154,167   $    --
        Long-term portion prepaid expenses.............      707,883        --
        Security deposits..............................      495,353        --
        Manufacturer's development funds...............    8,271,659        --
        Other..........................................       95,290     90,509
                                                         -----------   --------
                                                         $ 9,724,352   $ 90,509
                                                         ===========   ========
<CAPTION>
                                                             DECEMBER 31,
                                                        -----------------------
                                                             1997        1996
                                                        -------------- --------
                                                        (AS RESTATED--
                                                         SEE NOTE 14)
      <S>                                               <C>            <C>
      Other accrued expenses:
        Accrued commissions............................  $   997,656   $140,990
        Inventory received, not yet invoiced...........      612,011        --
        Accrued franchise and property taxes...........      527,640        --
        Accrued employee costs.........................      548,304        --
        Accrued professional fees......................    1,642,803        --
        Accrued promotional expenses...................      192,952        --
        Other..........................................    1,050,362    211,236
                                                         -----------   --------
                                                         $ 5,571,728   $352,226
                                                         ===========   ========
</TABLE>
 
5. LONG TERM DEBT
 
  Long term debt consists of the following:
<TABLE>
<CAPTION>
                                                                   DECEMBER 31,
                                                                       1997
                                                                  --------------
                                                                  (AS RESTATED--
                                                                   SEE NOTE 14)
   <S>                                                            <C>
   Convertible subordinated notes due September 15, 2004,
    interest payable semi-annually beginning March 15, 1998 at 5
    3/4% per annum..............................................   $150,000,000
   Star Line of Credit 8.25% per annum line of credit...........      7,193,575
   Subordinated notes due June 1, 2001, interest payable
    quarterly beginning September 1, 1997 at 10% per annum......        530,000
   Capital lease obligations....................................        436,579
                                                                   ------------
     Total......................................................    158,160,154
   Less current portion.........................................     (7,285,401)
                                                                   ------------
   Long-term portion............................................   $150,874,753
                                                                   ============
</TABLE>
 
  There was no debt outstanding as of December 31, 1996.
 
 Convertible Subordinated Notes
 
  The notes are unsecured general obligations of the Company which are
subordinated in right of payment. At any time on or after the 90th day
following September 17, 1997, the date of issuance, and prior to the close
 
                                       37
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
of business on the stated maturity date, unless previously redeemed or
repurchased, at a conversion price of $26.25 per share (equivalent to a
conversion rate of 38.0952 per $1,000 principal amount of notes), the notes
may be converted at the option of the holder into shares of Common Stock of
the Company. The impact on the net loss per share for 1997 would be anti-
dilutive assuming conversion of the notes occurred. The notes are redeemable,
in whole or in part, at the option of the Company, at any time on or after
September 15, 2000, at a specified redemption price plus accrued and unpaid
interest and liquidated damages, if any, to the date of redemption. The
Company is required to offer to purchase the notes upon a change of control
(as defined) at 100% of the principal amount thereof, plus accrued and unpaid
interest and liquidated damages, if any, to the date of purchase. The notes
were issued through a 144A placement under the Securities Act of 1933. As of
December 31, 1997, the Company incurred $5,053,681 of debt issuance costs
associated with this placement. This amount is being amortized over the term
of the notes.
 
 Star Line of Credit
 
  On August 6, 1997, ConQuest entered into a revolving credit facility with
Star Bank, N.A. ("Star Line of Credit"). Pursuant to the terms of the Star
Line of Credit, ConQuest can borrow up to $9,500,000 as secured by various
accounts receivable. Interest is based on the ninety-day LIBOR plus one
percent. This credit-facility was assumed by SmarTalk upon the acquisition of
ConQuest and has an outstanding balance of $7,193,575 at December 31, 1997.
This line was fully drawn at December 31, 1997. The revolving credit facility
contains various restrictions and financial covenants.
 
 Subordinated notes due June 1, 2001
 
  The notes are unsecured general obligations of the Company which are
subordinated in right of payment. The notes were issued in connection with the
GTI acquisition.
 
 SCB Line of Credit
 
  In December 1996, the Company entered into a revolving credit facility with
Southern California Bank ("SCB Line of Credit"). Pursuant to the terms of the
SCB Line of Credit, the Company can borrow up to $1,000,000 secured by an
assignment of a deposit account with Southern California Bank. Interest on the
outstanding principal balance, calculated from the date of each advance to the
repayment of each advance, is at a fixed rate of 7.12%. There are no amounts
outstanding under this line at December 31, 1997.
 
6. INCOME TAXES
 
  The difference between the statutory federal income tax rate and the
Company's effective income tax rate applied to loss before income taxes was as
follows for the years ended December 31, 1997, 1996 and 1995:
 
<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31,
                                                     --------------------------
                                                          1997      1996   1995
                                                     -------------- ----   ----
                                                     (AS RESTATED--
                                                      SEE NOTE 14)
   <S>                                               <C>            <C>    <C>
   Statutory federal tax rate on loss...............      (34)%     (34)%  (34)%
   State tax provision, net of federal benefit......       (5)%      (6)%   (6)%
   Acquired research and development in process.....       18 %     --     --
   Other permanent differences......................        3 %     --     --
   Operating losses with no current tax benefit.....       18 %      40 %   40 %
                                                          ---       ---    ---
   Income taxes at the Company's effective rate.....        0 %       0 %    0 %
                                                          ===       ===    ===
</TABLE>
 
 
                                      38
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The major components of deferred tax assets arising from temporary
differences at December 31, 1997 and 1996 are as follows:
 
<TABLE>
<CAPTION>
                                                            DECEMBER 31,
                                                     --------------------------
                                                          1997         1996
                                                     -------------- -----------
                                                     (AS RESTATED--
                                                      SEE NOTE 14)
   <S>                                               <C>            <C>
   Deferred Tax Assets:
     Deferred revenue...............................  $  4,528,000  $   507,000
     Bad debt reserve...............................       278,000       36,000
     Other..........................................       321,000       25,000
     Net operating loss carryforwards...............    14,919,000    1,240,000
                                                      ------------  -----------
                                                        20,046,000    1,808,000
   Deferred Tax Liabilities:
     Acquired intangibles...........................   (16,400,000)           0
     Other intangibles..............................      (273,000)      25,000
     Fixed assets...................................      (545,000)     (12,000)
     Other..........................................      (467,000)           0
                                                      ------------  -----------
                                                       (17,685,000)      13,000
                                                      ------------  -----------
     Net Deferred Tax Asset.........................     2,361,000    1,821,000
     Valuation Allowance............................    (2,361,000)  (1,821,000)
                                                      ------------  -----------
     Total Deferred Taxes...........................  $          0  $         0
                                                      ============  ===========
</TABLE>
 
  The Company had net operating loss carryforwards of approximately
$38,629,000, $3,101,000, and $1,396,786 for federal and state purposes for the
years ended December 31, 1997, 1996 and 1995, respectively. To the extent not
used, net operating loss carryforwards expire in varying amounts beginning in
the year 2005 for federal tax purposes and 2002 for state purposes. The
utilization of these net operating loss carryforwards may be limited under IRC
Section 382.
 
  Under SFAS No. 109, the Company has recorded valuation allowances against
the realization of deferred tax assets. The valuation allowances are based on
management's estimates and analysis, which include the impact of tax laws
which may limit the Company's ability to utilize such deferred tax assets.
 
7. RELATED PARTIES
 
 Purchase of Assets of Related Entity
 
  In January 1996, the Company purchased certain of the assets of LCN that had
historical net book value of $35,972. LCN's sole shareholder was then the
majority shareholder of the Company's Common Stock. Minority shareholders of
the Company consented to the transaction. The purchase was consummated in
January 1996 for $500,000 cash plus a $2,000,000 subordinated term note which
was repaid in November 1996. Because the assets were purchased from a related
party, the assets are reflected on the Company's balance sheet at LCN's
historical depreciated cost as of the date of the acquisition. The excess of
acquisition cost over the historical cost less depreciation of the assets
acquired of approximately $2,464,028 was recorded as a charge to the Company's
accumulated deficit in 1996 in a manner similar to a capital distribution. In
addition, prior to the purchase, LCN provided consulting and other services to
the Company for which it billed approximately $415,000 for the year ended
December 31, 1995. Amounts were billed on an hourly basis for consulting and
other services performed by LCN employees on behalf of SmarTalk.
 
 
                                      39
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  Amounts billed and services rendered by LCN were as follows:
 
<TABLE>
<CAPTION>
                                                                         1995
                                                                       --------
      <S>                                                              <C>
      Marketing and product development............................... $ 85,000
      Software development............................................   70,000
      Management consulting...........................................  200,000
      Other...........................................................   60,000
                                                                       --------
        Total......................................................... $415,000
                                                                       ========
</TABLE>
 
8. STOCK PLANS
 
  The Company applies APB 25 and related interpretations in accounting for its
plans. Accordingly, no compensation expense has been recognized for its stock
option plans (except as noted below). Had compensation cost been determined in
accordance with the methodology prescribed by SFAS 123, the Company's net loss
(and net loss per share) would have been increased by approximately
$18,436,564 ($1.23 per share), $157,000 ($.02 per share) and $0 in 1997, 1996
and 1995, respectively. The weighted average fair value of the options granted
in 1997, 1996 and 1995 is estimated at $7.50, $3.43 and $0, respectively on
the date of grant calculated under the minimum value method using the
following assumptions:
 
<TABLE>
<CAPTION>
                                                                  1997 1996 1995
                                                                  ---- ---- ----
      <S>                                                         <C>  <C>  <C>
      . Risk Free Interest Rate..................................  6%  6.1% --
      . Expected Life (In Years)................................. 2.5     2 --
      . Expected Dividend Yield.................................. --    --  --
      . Expected Volatility...................................... 59%   --  --
</TABLE>
 
  Information concerning options outstanding under the Plans for the years
ended December 31, 1997 and 1996 is as follows:
 
<TABLE>
<CAPTION>
                                                        OPTION PRICE  NUMBER OF
                                                         PER SHARE     SHARES
                                                       -------------- ---------
      <S>                                              <C>            <C>
      Balance at December 31, 1995....................            --        --
        Options granted............................... $ 1.77--$ 4.44   510,514
        Options exercised............................. $         1.77    (4,625)
        Options cancelled or expired..................            --        --
                                                                      ---------
      Balance at December 31, 1996.................... $ 1.77--$ 4.44   505,889
        Options granted............................... $ 9.00--$14.00   886,240
        Options granted............................... $14.00--$21.25 2,368,775
        Options exercised............................. $ 1.77--$11.75  (227,398)
        Options cancelled or expired.................. $ 1.77--$13.13  (105,138)
                                                                      ---------
      Balance at December 31, 1997.................... $ 1.77--$21.25 3,428,368
                                                                      =========
</TABLE>
 
  Options outstanding at December 31, 1997 and 1996 had a weighted-average
exercise price of $17.52 and $3.72, respectively, and a weighted average-
remaining contractual life of 4.2 and 2.1 years, respectively.
 
  Options exercisable at December 31, 1997 and 1996 were 2,037,831 and 0,
respectively.
 
                                      40
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The Company has the following stock based plans at December 31, 1997. The
programs are described as follows:
 
 1996 Non-Qualified Stock Option Plan
 
  In March 1996, the Board of Directors adopted the Company's 1996 Non-
Qualified Stock Option Plan (the "Non-Qualified Plan"), whereby incentive
stock options and non-qualifying stock options may be granted to employees,
officers, directors, consultants, advisors, or agents of the Company. Options
to purchase the Company's common stock are exercisable at a price not less
than the fair market value of the stock at the date of grant and for a term
not to exceed 10 years. Further, the options vest over a period ranging from 1
day to 3 years from the anniversary of the grant. Pursuant to the Non-
Qualified Plan, the lesser of (i) 7,087,991 shares of common stock or (ii) the
number of shares of common stock equal to 9% of the total issued and
outstanding shares of Common Stock minus the number of shares of Common Stock
issued or issuable pursuant to options exercised or outstanding under any
other stock option plan of the Company.
 
  The Company vested 2,000 shares of an employee's options at an option price
of $2.50 per share in September of 1996 resulting in compensation expense of
$24,000.
 
  At December 31, 1997, no shares remain reserved for issuance under the plan
and the Company anticipates that it will not issue any additional options
under the Non-Qualified Plan.
 
 1996 Stock Incentive Plan
 
  In August, 1996, the board of directors adopted and the shareholders of the
Company approved the 1996 Stock Incentive Plan (the "Stock Incentive Plan"),
whereby the Compensation Committee may make awards to directors, employees,
advisors and consultants of the Company and its subsidiaries. Pursuant to the
Stock Incentive Plan, the Company has authorized and reserved a number of
shares of Common Stock for issuance equal to the lessor of: (i) 7,087,991
shares of common stock; and (ii) a number of shares of Common Stock equal to
9% of the total issued and outstanding shares of Common Stock minus the number
of shares of Common Stock issued or issuable pursuant to options exercised or
outstanding under the Non-Qualified Plan. On December 31, 1997, the Company's
shareholders approved a proposal which increased the number of shares of
common stock available for issuance under the Stock Incentive Plan by
3,000,000 shares.
 
  Non qualified stock options may be granted to employees, consultants, and
advisors of the Company and its subsidiaries and incentive stock options may
be only granted to employees of the Company and its subsidiaries. The exercise
price of an incentive stock option may not be less than the fair market value
of the Common Stock on the date of the grant. The value of Common Stock
(determined at the time of grant) that may be subject to incentive stock
options that become exercisable by any one employee in any one year is limited
by the Internal Revenue Code to $100,000. The maximum term of stock options
granted under the Stock Incentive Plan is 10 years from the date of grant. At
December 31, 1997, 2,649,346 shares remain reserved for issuance under the
Stock Incentive Plan.
 
 Stock Appreciation Rights
 
  A stock appreciation right may be granted in connection with an option,
either at the time of grant or at any time thereafter during the term of the
option. A stock appreciation right granted in connection with an option
entitles the holder, upon exercise, to surrender the related option and
receive a payment based on the difference between the exercise price of the
related option and the fair market value of the Company's Common Stock on the
date of exercise. A stock appreciation right granted in connection with an
option is exercisable only at such time or times as the related option is
exercisable and expires no later than when the related option expires. A stock
appreciation right also may be granted without relationship to an option and
will be exercisable as
 
                                      41
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
determined by the Committee but, in no event, after ten years from the date of
grant. A stock appreciation right granted without relationship to an option
entitles the holder, upon exercise, to a payment based on the difference
between the base price assigned to the stock appreciation right by the
Committee on the date of grant and the fair market value of the Company's
Common Stock on the date of exercise. Payment to the holder in connection with
the exercise of a stock appreciation right may be in cash or shares of Common
Stock or in a combination of cash and shares. At December 31, 1997, no stock
appreciation rights had been granted.
 
 Restricted Stock Awards
 
  The Compensation Committee may award shares of Common Stock to participants
under the 1996 Plan, subject to such restrictions on transfer and conditions
of forfeitures as it deems appropriate. Such conditions may include
requirements as to the continued service of the participant with the Company,
the attainment of specified performance goals or any other conditions
determined by the Committee. Subject to the transfer restrictions and
forfeiture restrictions relating to the restricted stock award, the
participant will otherwise have the rights of a stockholder of the Company,
including all voting and dividend rights, during the period of restriction. At
December 31, 1997, no restricted stock awards had been granted.
 
 Performance Awards
 
  The Compensation Committee may grant performance awards denominated in
specified units ("Performance Units") or in shares of Common Stock
("Performance Shares"). Performance awards are payable upon the achievement of
performance goals established by the Committee at the beginning of the
performance period, which may not exceed ten years from the date of grant. At
the time of grant, the Committee establishes the number of units or shares,
the duration of the performance period, the applicable performance goals and,
in the case of performance units, the potential payment or range of payments
for the performance awards. At the end of the performance period, the
Committee determines the payment to be made based on the extent to which the
performance goals have been achieved. The Committee may consider significant
unforeseen events during the performance period when making the final award.
Payments may be made in cash or shares of common stock or in a combination of
cash and shares. At December 31, 1997, no performance shares had been granted.
 
 Phantom Stock
 
  An award of phantom stock gives the participant the right to receive cash at
the end of a fixed vesting period based on the value of a share of Common
Stock at that time. Phantom stock units are subject to such restrictions and
conditions to payment as the Committee determines are appropriate. At the time
of grant, the Committee determines, at its sole discretion, the number of
units and the vesting period of the units, and it may also set a maximum value
of a unit. If the participants remain employed by the Company throughout the
applicable vesting period, they are entitled to receive payment of a cash
amount for each phantom stock unit equal in value to the fair market value of
one share of Common Stock on the last day of the vesting period, subject to
any maximum value limitation. At December 31, 1997, no phantom stock had been
granted.
 
9. COMMITMENTS
 
 Telecommunication Service Agreements
 
  The Company has a minute volume commitment with its service providers which,
if not met, could require the Company to pay a fee to such provider.
 
                                      42
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 License Agreements
 
  On November 1, 1996, the Company entered into an agreement with AudioFax IP
LLC to license certain fax technology patents. Under this agreement, the
Company paid a one-time license origination fee and is required to pay a per
transaction fee as fax services are provided. The license expires
contemporaneously with the patents. This license is applicable to all call
traffic including that of the acquisitions.
 
  On January 1, 1997, the Company entered into an agreement, as amended
January, 1998, with Ronald A. Katz Technology Licensing, L.P. to license
certain automated transaction processing utilizing telecommunication
facilities patents. Under this agreement, the Company paid a one-time license
origination fee and is required to pay a per transaction fee as services are
used. The license expires contemporaneously with the patents. This license is
applicable to all call traffic including that of the acquisitions.
 
 Employment Agreements
 
  The Company has entered into employment agreements with certain executive
personnel. The arrangements provide for the continuation of compensation for
up to three years from the date of hire.
 
 Distribution Agreement
 
  The Company acquired the assignment of a contract with W.H. Smith, UK in
November 1997. In addition to its entry into the overseas marketplace with the
establishment of SmarTalk Services (U.S.) Ltd, the Company announced a carrier
services and strategic alliance agreement with Norweb Communications in the
United Kingdom and a distribution agreement with D Services, a W.H. Smith
business which specializes in distribution to news trade outlets in the U.K.
 
  On December 31, 1997, as part of the acquisition of Amex Telecom, the
Company entered into a joint venture arrangement with the USPS, whereas the
USPS sells, among other functions, phone cards through its outlets. Under the
arrangement effective from January 1, 1998 (the "Arrangement"), revenues and
costs are shared pursuant to the Arrangement with the USPS functioning as the
principal distribution or selling agent.
 
 Marketing Agreement
 
  The Company has entered into a co-marketing and technology agreement with
Amex TRS in which Amex Telecom offers SmarTalk product to Amex TRS
cardholders.
 
 Leases
 
  The Company leases automobiles, office equipment and facilities under
various operating and capital lease arrangements. The most significant of
these leases are as follows:
 
  Lease agreement dated January 10, 1996 and amendments thereto to lease
approximately 13,400 square feet of office space in Los Angeles, California.
Lease payments under this lease commenced on March 1, 1996 and end March 31,
2002.
 
  Lease agreement dated May 8, 1996 to lease approximately 13,500 square feet
of office space in Butler, Pennsylvania. Lease payments under this lease
commenced on May 1, 1996 and end on April 30, 2001.
 
  Lease agreement dated May 28, 1996 to lease approximately 17,800 square feet
of office space in Dublin, Ohio. Lease payments under this lease commenced
July 1, 1996 and end on June 30, 1999.
 
                                      43
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The future minimum lease payments under these leases at December 31, 1997
are as follows: 1998--$1,100,810, 1999--$638,630, 2000--$378,150, 2001--
$194,182, 2002 and thereafter--$25,006.
 
  Rent expense for operating leases was approximately $511,000, $180,000 and
$12,000 for the years ended December 31, 1997, 1996 and 1995 respectively.
 
10. PURCHASE OF VOICECHOICE PLATFORM
 
  In June 1996, the Company acquired an interactive voice response platform
facility known as the VoiceChoice Platform from Pacific Bell Information
Services for total consideration of $325,000, plus other consideration
including the release of certain contractual obligations of Pacific Bell
Information Services to the Company. The purchase price was recorded at
$325,000, comprised of $200,000 in cash and a $125,000 note which was
subsequently paid in full prior to maturity. The Company was informed by
Pacific Bell Information Services that the platform facility was constructed
in 1994 at an original cost of approximately $1,648,000. The assets acquired
include multiple switches, inbound and outbound access ports for prepaid and
corporate calling services, voice response applications, high-speed database
servers, voice recording capability and credit card verification software. The
Company acquired the VoiceChoice Platform to enable it to provide additional
services, such as stand-alone interactive voice services, and to reduce call
handling costs.
 
11. INITIAL PUBLIC OFFERING
 
  On October 23, 1996, the Company completed the sale of 4,000,000 shares of
its stock in a public offering. The Company raised net proceeds of $50,471,781
after deducting the underwriting discount and other related costs. A portion
of the proceeds was used to repay all of the Company's outstanding debt.
 
12. SUBSEQUENT EVENTS
 
  In an effort to maximize the synergistic opportunities created through its
strategic acquisitions, SmarTalk consolidated its corporate functions from
nine different cities to Columbus, Ohio, the prior headquarters of ConQuest.
This consolidation was completed during the summer of 1998. In conjunction
with the consolidation, on February 25, 1998 Erich Spangenberg assumed the
post of Chief Executive Officer, formerly held by Chairman of the Board of
Directors of SmarTalk Robert Lorsch. Mr. Lorsch remains Chairman of the Board.
Additionally, SmarTalk's President, Jeff Lindauer, assumed the duties of Chief
Operating Officer, previously held by Erich Spangenberg.
 
  On February 28, 1998 (the "Board Resolution Date"), the Company's board of
directors adopted a plan to sell the Company's call center business located in
Butler, Pennsylvania. In the first quarter of 1998, the Company recorded a
$3,278,148 charge for the losses associated with operating the business up to
the Board Resolution Date and an estimated charge for operating this business
from the Board Resolution Date through the anticipated disposition date plus
the estimated transaction costs associated with the sale of the business. On
June 12, 1998 (the "Sale Date"), the Company sold the assets of the call
center business for $1,000,000 in cash and a note receivable (the "Call Center
Note") of $19,067,995. Interest on the Call Center Note is 12% per annum and
is payable quarterly beginning September 12, 1998. The principal on the Call
Center Note is due on June 12, 1999 (unless this date is extended to June 12,
2000 by the obligor) or upon completion of a financing transaction in excess
of $50,000,000 by the obligor. The assets of the obligor secure the Call
Center Note. Due to the thinly capitalized financial position of the obligor
and the resulting risk of collection, a valuation allowance was recorded
against the Call Center Note approximately equal to the difference between the
sales price and net book value of the tangible assets sold, or $14,684,978. No
gain or loss was recorded on the transaction.
 
                                      44
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The results of the call center business have been classified as continuing
operations in 1997 as the decision to dispose of the operations was based on a
discrete, identifiable event in 1998. Results of the call center business will
be classified as discontinued operations beginning with the first quarter of
1998.
 
  On March 23, 1998, the Company acquired the outstanding stock of USA
Telecommunications Services, Inc. (d.b.a. The Debit Cellular Network) ("DCN"),
a North Carolina based prepaid cellular card company, for 81,302 shares of
Common Stock and $1,500,000 in cash. This acquisition was accounted for using
the purchase method of accounting and the results of the acquired business are
included in the Company's consolidated results of operations from the date of
acquisition.
 
  On April 20, 1998, Intrine Communications ("Intrine"), filed a complaint
against the Company and DCN in the Superior Court of California in Los Angeles
County. In the complaint, Intrine alleges that, by virtue of the Company's
acquisition of DCN, the Company and DCN breached written and oral agreements
not to circumvent and appropriate for themselves the benefits of a purported
deal by Intrine to acquire DCN. The lawsuit seeks damages and injunctive
relief. Management of the Company believes that the claims against the Company
and DCN are without merit and does not at present expect this lawsuit to have
a material adverse effect on the Company's financial position, liquidity, cash
flow or results of operations.
 
  On April 27, 1998, the Star Line of Credit was paid in full and the credit
facility terminated.
 
  On April 30, 1998, the Company acquired the outstanding stock of Canada
Telecom Network Inc., a Montreal, Canada based prepaid calling card company,
for $3,000,000 in cash and $5,500,000 in a subordinated, 7.5% per annum note
which matures April 30, 2000. This acquisition was accounted for using the
purchase method of accounting and the results of the acquired business are
included in the Company's consolidated results of operations from the date of
acquisition.
 
  On June 10, 1998, the Company acquired the outstanding stock of Worldwide
Direct, Inc., a Framingham, Massachusetts based prepaid cellular
communications company, for 2,715,000 shares of Common Stock. The Company has
restructured this transaction to provide for the issuance of additional equity
and/or debt securities based on the occurrence of certain conditions. As a
result of this restructuring, the acquisition required the use of the purchase
method of accounting and the results of the acquired business are included in
the Company's consolidated results of operations from the date of acquisition.
 
  On June 19, 1998, the Company received payment for the ACMI, L.L.C. note
receivable. The note receivable had a net book value of $2,234,763 on such
date and the repayment amount was $1,000,000 in cash. Because this note was
acquired through the ConQuest acquisition, the devaluation of the note was
recorded as a reduction of goodwill. Additionally, the Company was required to
release 106,816 shares of its Common Stock that were held in escrow and used
as collateral to secure the note. The value of these shares had previously
been recorded as an increase to goodwill.
 
  As of July 1, 1998, the Company issued a promissory note in the amount of
$5,000,000 and agreed to issue 1,000,000 shares of Common Stock to acquire a
distribution arrangement with a former distributor of Worldwide and certain
contractual relationships. The arrangement also provides for the issuance of
additional equity and/or debt securities upon the occurrence of certain
conditions.
 
  On July 9, 1998, the Company completed a private placement of 1,751,824
shares of its Common Stock, realizing proceeds before transaction costs of
$29,999,986. On August 28, 1998, the terms of the private placement were
restructured. In the event that the Company's Common Stock trades below the
initial purchase price during specified periods, the Company will be obligated
to issue up to $18,500,000 of additional Common Stock for no additional
consideration. In addition, the Company granted an option excercisable for a
period of two years commencing March 1, 1999 in connection with the private
placement pursuant to which an additional $20,000,000 of the Company's Common
Stock may be purchased. In the event the aggregate amount of Common Stock
issued by the Company pursuant to the private placement would exceed 20% of
the Company's total
 
                                      45
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
outstanding shares as of July 9, 1998 (the "20% Threshold"), as a result of
either the exercise of the option or the initial purchase price adjustment,
the Company would be required to obtain shareholder approval of the private
placement or issue a note in a principal amount equal to the value of the
Common Stock that otherwise would exceed the 20% Threshold. The Company
expects to use the proceeds from this placement to accelerate entry into the
prepaid cellular market and for general corporate purposes.
 
  Since July 23, 1998, 19 putative class actions have been filed against the
Company and certain current and former members of its management and Board of
Directors in state and Federal courts alleging violations of state and Federal
securities laws with respect to certain alleged misrepresentations and/or
omissions in regard to the Company's projected and actual revenues and
earnings. These lawsuits seek unspecified damages on behalf of certain classes
of persons who purchased the Company's securities during periods between May,
1997 and August, 1998. The complaints generally allege that the Company made
material misrepresentations and omissions in regard to the Company's projected
and actual revenues and earnings. Although the Company intends to defend
against these lawsuits vigorously, it is not feasible to predict or determine
the final outcome of these proceedings at this time. An unfavorable outcome
with respect to such proceedings could have a material adverse effect on the
Company's financial condition and results of operations.
 
13. SUPPLEMENTARY DATA (UNAUDITED)
 
<TABLE>
<CAPTION>
                          FOR THE YEAR ENDED DECEMBER 31, 1997 (AS RESTATED--SEE NOTE
                                                      14)
                         -----------------------------------------------------------------
                            FIRST       SECOND        THIRD        FOURTH
                           QUARTER      QUARTER      QUARTER      QUARTER        TOTAL
                         -----------  -----------  -----------  ------------  ------------
<S>                      <C>          <C>          <C>          <C>           <C>
STATEMENT OF OPERATIONS
DATA:
  Revenue............... $ 7,368,332  $11,345,190  $18,644,561  $ 23,806,145  $ 61,164,228
  Gross profit.......... $ 2,607,585  $ 4,141,136  $ 6,848,074  $  7,136,015  $ 20,732,810
  Operating expenses
   (excluding acquired
   research and
   development in-
   process)............. $ 3,446,645  $ 5,902,413  $ 9,201,874  $ 14,170,067  $ 32,720,999
  Loss from operations.. $  (839,060) $(1,761,277) $(2,353,800) $(20,398,052) $(25,352,189)
  Net loss.............. $  (310,297) $(1,405,264) $(2,304,083) $(21,713,004) $(25,732,648)
  Net loss per share--
   basic and diluted.... $      (.02) $      (.10) $      (.14) $      (1.31) $      (1.72)
  Weighted average
   number of common
   shares--basic and
   diluted..............  12,897,674   13,940,285   16,846,271    16,597,729    14,951,454
<CAPTION>
                                     FOR THE YEAR ENDED DECEMBER 31, 1996
                         -----------------------------------------------------------------
                            FIRST       SECOND        THIRD        FOURTH
                           QUARTER      QUARTER      QUARTER      QUARTER        TOTAL
                         -----------  -----------  -----------  ------------  ------------
<S>                      <C>          <C>          <C>          <C>           <C>
STATEMENT OF OPERATIONS
DATA:
  Revenue............... $ 1,139,366  $ 2,538,655  $ 4,588,843  $  6,754,196  $ 15,021,060
  Gross profit.......... $   326,488  $   609,417  $ 1,129,404  $  2,756,780  $  4,822,089
  Operating expenses.... $ 1,358,347  $ 1,744,372  $ 2,209,324  $  2,814,318  $  8,126,361
  Loss from operations.. $(1,031,859) $(1,134,955) $(1,079,920) $    (57,538) $ (3,304,272)
  Net (loss) income..... $(1,076,672) $(1,194,514) $(1,162,184) $    320,822  $ (3,112,548)
  Net (loss) income per
   share--basic and
   diluted.............. $      (.12) $      (.14) $      (.13) $        .03  $       (.32)
  Weighted average
   number of common
   shares--basic........   8,824,834    8,824,834    8,824,834    11,871,831     9,579,804
  Weighted average
   number of common
   shares--diluted......         --           --           --     12,377,720           --
</TABLE>
 
                                      46
<PAGE>
 
                 SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
14. RESTATEMENT
 
  Subsequent to the issuance of the Company's consolidated financial
statements for the year ended December 31, 1997, the Company's management in
conjunction with PricewaterhouseCoopers LLP ("PwC"), determined that
significant issues existed with regard to the Company's accounting treatment
for deferred revenue recorded in connection with acquisitions that occurred
during 1997, the restructuring reserve taken during the fourth quarter of
1997, the charge for acquired research and development in-process taken during
the fourth quarter of 1997 as well as certain other items. As a result, the
accompanying consolidated financial statements as of December 31, 1997 and for
the year then ended have been restated.
 
  A summary of the significant effects of the restatement is as follows:
 
<TABLE>
<CAPTION>
                                                     AS OF AND FOR THE YEAR
                                                     ENDED DECEMBER 31, 1997
                                                    --------------------------
                                                         AS
                                                     PREVIOUSLY
                                                      REPORTED    AS RESTATED
                                                    ------------  ------------
<S>                                                 <C>           <C>
Statement of Operations Data:
  Revenue.......................................... $ 71,862,445  $ 61,164,228
  Gross profit.....................................   31,431,027    20,732,810
  Restructuring expense............................   25,000,000           --
  Acquired research and development in-process.....   39,186,000    13,364,000
  Operating expenses (including restructuring
   expense, excluding acquired research and
   development in-process).........................   53,764,042    32,720,999
  Loss from operations.............................  (61,519,015)  (25,352,189)
  Net loss.........................................  (61,899,474)  (25,732,648)
  Net loss per share--basic and diluted............        (4.14)        (1.72)
Statement of Cash Flows Data:
  Net cash used by operating activities............   (9,070,702)  (12,867,665)
  Net cash used by investing activities............  (92,768,549)  (88,971,586)
  Net cash provided by financing activities........  119,765,627   119,765,627
Balance Sheet Data:
  Trade accounts receivable, net...................   32,699,249    28,012,237
  Current assets...................................  111,487,102   106,626,281
  Intangibles, net.................................  222,536,934   235,506,706
  Total assets.....................................  360,502,826   368,301,077
  Deferred revenue.................................   40,248,400    28,885,002
  Restructuring reserve............................   23,943,070           --
  Current liabilities..............................  106,622,503    71,316,035
  Total liabilities................................  257,497,256   222,190,788
  Total shareholders' equity.......................  103,005,570   146,110,289
</TABLE>
 
                                      47
<PAGE>
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K
 
 
<TABLE>
 <C>    <S>                                                                    
 (a)(1) Consolidated Financial Statements
        Report of Independent Accountants
        Consolidated Balance Sheets as of December 31, 1997 and 1996
        Consolidated Statements of Operations for the years ended
         December 31, 1997, 1996 and 1995
        Consolidated Statements of Shareholders' Equity (Deficit) for the
         years ended December 31, 1997, 1996 and 1995
        Consolidated Statements of Cash Flows for the years ended
         December 31, 1997, 1996 and 1995
        Notes to Consolidated Financial Statements
 (a)(2) Financial Statement Schedules
 
  All Schedules are omitted since the required information is not present in
amounts sufficient to require submission of the Schedule, or because the
information required is included in the Consolidated Financial Statements and
notes thereto.
 
 (b)    Reports on Form 8-K
 
  Report on Form 8-K dated October 22, 1997, regarding the acquisition of
certain selected assets from Frontier.
 
  Report on Form 8-K dated November 24, 1997, setting forth restated financial
statements for SmarTel and GTI and pro forma combined financial statements.
 
  Report on Form 8-K dated December 3, 1997, regarding an Interim Operating
Agreement between the Company and ConQuest.
 
  Report on Form 8-K dated December 22, 1997, regarding the acquisition of
American Express Telecom, Inc. including financial statements and pro forma
combined financial statements.
 
  Report on Form 8-K dated December 31, 1997, regarding the acquisition of
ConQuest including financial statements and pro forma combined financial
statements.
 
 (c)    Exhibits:
</TABLE>
 
  The Exhibits listed on the accompanying Index to Exhibits are filed as part
of this Form 10-K. Management contracts or compensatory plans or arrangements
required to be filed as exhibits to this report pursuant to Item 14(c) of Form
10-K are identified on the Index to Exhibits by a double asterisk (**).
 
                                      48
<PAGE>
 
                                  SIGNATURES
 
  Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the registrant has duly caused this report
to be signed on its behalf by the undersigned, thereunto duly authorized, in
the City of Dublin, State of Ohio, on November 6, 1998.
 
                                          SMARTALK TELESERVICES, INC.
 
                                          By    /s/ Wayne Wooddell
                                          _____________________________________
                                                     Wayne Wooddell
                                           Vice President and Chief Financial
                                                         Officer
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed below by the following persons on behalf
of the registrant and in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
             SIGNATURE                           TITLE                    DATE
             ---------                           -----                    ----
<S>                                  <C>                           <C>
      /s/ Robert H. Lorsch           Chairman of the Board of       November 6, 1998
____________________________________  Directors
           Robert H. Lorsch

    /s/ Erich L. Spangenberg         Vice Chairman of the Board     November 6, 1998
____________________________________  of Directors and Chief
        Erich L. Spangenberg          Executive Officer
                                      (Principal Executive
                                      Officer)

       /s/ Wayne Wooddell            Vice President and Chief       November 6, 1998
____________________________________  Financial Officer
           Wayne Wooddell             (Principal Financial and
                                      Accounting Officer)

      /s/ Fred F. Fielding           Director                       November 6, 1998
____________________________________
          Fred F. Fielding

      /s/ Robert M. Smith            Director                       November 6, 1998
____________________________________
           Robert M. Smith

    /s/ Kenneth A. Viellieu          Director                       November 6, 1998
____________________________________
         Kenneth A. Viellieu
</TABLE>
 
 
                                      49
<PAGE>
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                DESCRIPTION
 -------                               -----------
 <C>     <S>
  2.1    Stock Purchase Agreement, dated as of December 22, 1997, by and among
          SmarTalk TeleServices, Inc., American Express Telecom, Inc. and
          American Express Travel Related Services Company, Inc. (without
          Schedules).(1)
  2.2    Asset Purchase Agreement, dated October 22, 1997, among SmarTalk
          TeleServices, Inc., SMTK NY-1 Corp. and Frontier Corporation.(2)
  2.3    Agreement and Plan of Reorganization and Merger, dated as of July 30,
          1997, by and among ConQuest Telecommunication Services Corp.,
          SmarTalk TeleServices, Inc. and SMTK Acquisition Corp. II.(3)
  2.4    Stock Purchase Agreement, dated as of May 31, 1997, by and among
          SmarTalk TeleServices, Inc., GTI Telecom, Inc. Waterton Investment
          Group I, LLC and William R. Harger.(4)
  2.5    Agreement and Plan of Merger, dated May 24, 1997, among SmarTalk
          TeleServices, Inc., SMTK Acquisition Corporation, SmarTel
          Communications, Inc., and each of the stockholders of SmarTel
          Communications, Inc.(5)
  3.1    Amended and Restated Articles of Incorporation.(6)
  3.2    Amended and Restated Bylaws.(6)
  4.1    Registration Rights Agreement.(6)
  4.2    Specimen Stock Certificate.(6)
  4.3    Terms of Contingent Value Rights.(5)
  4.4    Form of SmarTalk TeleServices, Inc. 10% Subordinated Note Due 2001.(4)
  4.5    Registration Rights Agreement, dated as of May 31, 1997, among
          SmarTalk TeleServices, Inc., William R. Harger and Waterton
          Investment Group I, LLC.(4)
  4.6    Indenture, dated as of September 17, 1997, between SmarTalk
          TeleServices, Inc. and Wilmington Trust Company, as Trustee.(7)
  4.7    Registration Rights Agreement, dated as of September 12, 1997, among
          SmarTalk TeleServices, Inc. Donaldson, Lufkin & Jenrette Securities
          Corporation and Salomon Brothers Inc.(7)
 10.1    Loan and Investment Agreement dated December 28, 1995 among SmarTalk
          TeleServices, Inc., SmarTalk Partners, LLC and Robert H. Lorsch.(6)
 10.2    Promissory Note in the amount of $1,200,000 dated December 28, 1995
          made by SmarTalk TeleServices, Inc. in favor of SmarTalk Partners,
          LLC.(6)
 10.3    Security Agreement dated December 28, 1995 between SmarTalk
          TeleServices, Inc. and SmarTalk Partners, LLC.(6)
 10.4    Revolving Line of Credit Note in the amount of $500,000 dated December
          28, 1995 made by SmarTalk TeleServices, Inc. in favor of SmarTalk
          Partners, LLC.(6)
 10.5    Subordinated Promissory Note in the amount of $2,000,000 dated January
          1, 1996 by SmarTalk TeleServices, Inc. in favor of Lorsch Creative
          Network, Inc.(6)
 10.6    Subordination Agreement dated January 1, 1996 between SmarTalk
          TeleServices, Inc. and Lorsch Creative Network, Inc.(6)
 10.7    Security Agreement dated August 9, 1996 between SmarTalk TeleServices,
          Inc. and Lorsch Creative Network, Inc.(6)
 10.8    Employment Agreement dated July 16, 1996 between SmarTalk
          TeleServices, Inc. and Richard M. Teich.(6) **
</TABLE>
 
 
                                       50
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                DESCRIPTION
 -------                               -----------
 <C>     <S>
 10.9    Form of Indemnification Agreement dated October 28, 1994 between
          SmarTalk TeleServices, Inc. and certain management personnel.(6) **
 10.10   1996 Nonqualified Stock Option Plan.(6) **
 10.11   1996 Stock Incentive Plan.(6) **
 10.12   Standard Office Lease by and between LAOP IV, LLC and SmarTalk
          TeleServices, Inc., dated January 10, 1996, as amended on January 16,
          1996, February 7, 1996 and April 19, 1996.(6)
 10.13   Carrier Agreement dated November 9, 1995 between the Registrant and
          MCI Telecommunications Corporation.(6)*
 10.14   First Amendment to Carrier Agreement dated March 2, 1996 between
          SmarTalk TeleServices, Inc. and MCI Telecommunications
          Corporation.(6)*
 10.15   Second Amendment to Carrier Agreement dated September 9, 1996 between
          SmarTalk TeleServices, Inc. and MCI Telecommunications
          Corporation.(6)*
 10.16   Agreement dated October 4, 1995 between SmarTalk TeleServices, Inc.
          and West Interactive Corporation.(6)*
 10.17   Security Agreement dated August 9, 1996 between SmarTalk TeleServices,
          Inc. and SmarTalk Partners, LLC.(6)
 10.18   Subordination Agreement dated August 9, 1996 among Lorsch Creative
          Network, Inc., SmarTalk TeleServices, Inc. and SmarTalk Partners,
          LLC.(6)
 10.19   Promissory Note in the amount of $250,000 dated August 9, 1996 between
          SmarTalk TeleServices, Inc. and SmarTalk Partners, LLC.(6)
 10.20   Prepaid Carrier Referral Program Agreement between MCI
          Telecommunications Corporation and SmarTalk TeleServices, Inc., dated
          June 21, 1996.(6)*
 10.21   Wholesale Distribution Agreement between West Interactive Corporation
          and SmarTalk TeleServices, Inc. dated June 1, 1996.(6)*
 10.22   Loan Agreement dated September 18, 1996 between Southern California
          Bank and SmarTalk TeleServices, Inc.(6)
 10.23   Promissory Note in the amount of $1,000,000 dated September 18, 1996
          between Southern California Bank and SmarTalk TeleServices, Inc.(6)
 10.24   Commercial Security Agreement in the amount of $1,000,000 dated
          September 18, 1996 between Southern California Bank and SmarTalk
          TeleServices, Inc.(6)
 10.25   Assignment of Lease by and between Pacific Bell Information Services
          and SmarTalk TeleServices, Inc. dated as of December 1, 1996.(8)
 10.26   Employment Agreement dated January 1, 1997 between SmarTalk
          TeleService, Inc. and Glen Andrew Folck.(9)**
 10.27   Employment Agreement dated March 17, 1997 between SmarTalk
          TeleServices, Inc. and David Andrew Hamburger.(9)**
 10.28   Telecommunications Services Agreement dated December 1, 1996 by and
          between WorldCom Network Services, Inc. and GTI Telecom Inc.(10)*
 10.29   Employment Agreement dated June 11, 1997 between SmarTalk
          Teleservices, Inc. and Gene Russell.(11)**
 10.30   Employment Agreement dated July 30, 1997 between SmarTalk
          Teleservices, Inc. and Lauren Becker.(11)**
 10.31   Employment Agreement dated February 26, 1998 between SmarTalk
          TeleServices, Inc. and Robert H. Lorsch.(13)**
</TABLE>
 
                                       51
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                           DESCRIPTION
 -------                          -----------
 <C>     <S>
 10.32   Employment Agreement dated February 26, 1998 between SmarTalk
          TeleServices, Inc. and Erich L. Spangenberg.(13)**
 10.33   Employment Agreement dated November 3, 1997 between SmarTalk
          Teleservices, Inc. and Jeff Lindauer.(13)**
 10.34   Employment Agreement dated March 9, 1998 between SmarTalk
          Teleservices, Inc. and Thaddeus Bereday.(13)**
 11.1    Statement regarding Computation of Per Share Earnings.
 
 
 21.1    Subsidiaries of the Registrant.(12)
 23.1    Consent of PricewaterhouseCoopers LLP.
 27.1    Financial Data Schedule.
</TABLE>
--------
 (1) Incorporated by reference to SmarTalk's Form 8-K, dated December 22,
     1997.
 (2) Incorporated by reference to SmarTalk's Form 8-K, dated October 22, 1997.
 (3) Incorporated by reference to SmarTalk's Form 8-K, dated July 30, 1997.
 (4) Incorporated by reference to SmarTalk's Form 8-K, dated June 1, 1997
     (amended on Form 8-K/A).
 (5) Incorporated by reference to SmarTalk's Form 8-K, dated May 28, 1997 (as
     amended on Form 8-K/A).
 (6) Incorporated by reference to SmarTalk's Registration Statement on Form S-
     1, registration number 333-10391, filed with the Securities and Exchange
     Commission on August 19, 1996 and the amendments thereto.
 (7) Incorporated by reference to SmarTalk's Form 8-K, dated September 17,
     1997.
 (8) Incorporated by reference to SmarTalk's Annual Report on Form 10-K for
     the year ended December 31, 1996.
 (9) Incorporated by reference to SmarTalk's Quarterly Report on Form 10-Q for
     the period ended March 31, 1997.
(10) Incorporated by reference to SmarTalk's Quarterly Report on Form 10-Q for
     the period ended June 30, 1997.
(11) Incorporated by reference to SmarTalk's Quarterly Report on Form 10-Q for
     the period ended September 30, 1997.
(12) Incorporated by reference to SmarTalk's Registration Statement on Form S-
     4, registration number 333-41317, filed with the Securities and Exchange
     Commission on December 2, 1997 and the amendments thereto.
(13) Incorporated by reference to SmarTalk's Annual Report on Form 10-K for
     the year ended December 31, 1997, as originally filed.
 *   Confidential treatment has been granted. The copy filed as an exhibit
     omits information subject to the confidentiality request.
 **  Management contracts or compensatory plans or arrangements required to be
     filed as exhibits to this report pursuant to Item 14(c) of Form 10-K.
 
 
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