<PAGE>   1

================================================================================
                       SECURITIES AND EXCHANGE COMMISSION

                              WASHINGTON, DC 20549

                                    FORM 10-K
         (Mark One)

[X]      Annual Report Under Section 13 of the Securities Exchange Act of 1934
         For the fiscal year ended January 2, 1999; or

[ ]      Transition report pursuant to Section 13 or 15(d) of the Securities
         Exchange Act of 1934 From the transition period from ________ to
         ________.

                              AAI.FOSTERGRANT, INC.
                              ---------------------
             (Exact Name of Registrant as Specified in Its Charter)

                       Rhode Island                          05-0419304
              ------------------------------             ------------------- 
              (State or Other Jurisdiction of               (IRS Employer
              Incorporation or Organization)             Identification No.) 
 
       500 George Washington Highway, Smithfield RI             02917
       --------------------------------------------          ---------
         (Address of Principal Executive Offices)            (Zip Code)

                                 (401) 231-3800
                ------------------------------------------------
                (Issuer's Telephone Number, Including Area Code)

     SECURITIES TO BE REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE

     SECURITIES TO BE REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE

      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 checkmark 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 statement
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]

      As of April 1, 1999, the aggregate market value of the voting equity held
by non-affiliates of the Registrant was none.

      As of April 1, 1999, 608,000 shares of Common Stock and 43,700 shares of
Series A Preferred Stock of the Registrant were issued and outstanding.
================================================================================
<PAGE>   2

                                Table of Contents

<TABLE>
<CAPTION>
Description                                                               Page Number
-----------                                                               -----------

<S>                                                                            <C>
Part I.   Item 1  --   Business.............................................   3
          Item 2  --   Properties...........................................   10
          Item 3  --   Legal Proceedings....................................   10
          Item 4  --   Submission of Matters to a Vote of Security Holders..   11

Part II.  Item 5  --   Market for the Company's Common Equity and
                       Related Stockholder Matters..........................   11
          Item 6  --   Selected Financial Data..............................   12
          Item 7  --   Management's Discussion and Analysis of Financial
                       Condition and Results of Operations..................   14
          Item 7A --   Quantitative and Qualitative Disclosures About
                       Market Risk .........................................   27
          Item 8  --   Financial Statements and Supplementary Data..........   27
          Item 9  --   Changes in and Disagreements with Accountants on
                       Accounting and Financial Disclosure..................   27

Part III. Item 10 --   Directors and Executive Officers of the Company......   28
          Item 11 --   Executive Compensation...............................   32
          Item 12 --   Security Ownership of Certain Beneficial Owners
                       and Management.......................................   37
          Item 13 --   Certain Relationships and Related Transactions.......   39

Part IV.  Item 14 --   Exhibits, Financial Statement Schedules and 
                       Reports on Form 8-K..................................   43

          Signatures   .....................................................   45
</TABLE>


                                        2
<PAGE>   3

================================================================================
                                     PART I
================================================================================

ITEM 1. BUSINESS

GENERAL

    AAi.FosterGrant, Inc. ("AAi" or the "Company") is a value-added distributor
of optical products, costume jewelry, watches, clocks and other accessories to
mass merchandisers, variety stores, chain drug stores and supermarkets in North
America and the United Kingdom. The Company sells its products in over 30,000
retail locations. The Company markets its products under its own brand names
such as Foster Grant(R) as well as customers' private labels and numerous
licensed brand names. The Company outsources all of its manufacturing.

    The Company's product lines contain a large number of stock keeping units
("SKUs") with low retail price points and typically represent a small percentage
of retailers' total sales. As a result, many of AAi's customers have chosen to
outsource the merchandising of these products to the Company. AAi's
award-winning service program provides retailers with customized displays and
product packaging and store-level merchandising designed to maximize sales and
inventory turnover. The Company employs over 1,400 field service representatives
who regularly visit program customers' stores to arrange, replenish and restock
displays, reorder product and attend to markdowns and allowances. By providing
retailers with in-store product management, the Company retains control of its
product marketing and pricing, allowing AAi to maximize product sales and
increase the floor space allocated to its product lines. In fiscal 1998, sales
to customers utilizing the Company's service program accounted for 69.0% of
AAi's net sales.

    On July 21, 1998, the Company sold $75.0 million of 10 3/4% Senior Notes due
2006 (the "Notes"). The net proceeds of approximately $71.0 million were used to
repay outstanding indebtedness, as described under Item 7, "Management's
Discussion and Analysis of Results of Operations and Financial Condition."

     AAi was incorporated in Rhode Island in December 1985 and is the successor
by merger to a Rhode Island corporation incorporated in 1962. The Company's
principal executive offices are located at 500 George Washington Highway,
Smithfield, Rhode Island 02917, and its telephone number is (401) 231-3800.

CAUTIONARY STATEMENT

     This annual report contains statements relating to future results of the
Company (including certain projections and business trends) that are considered
"forward-looking statements" as defined in the Private Securities Litigation
Reform Act of 1995. Actual results may differ materially from those projected as
a result of certain risks and uncertainties, including but not limited to,
changes in economic conditions and competitive product and pricing pressures
within the Company's market, as well as other risks and uncertainties detailed
from time to time in the filings of the Company with the Securities and Exchange
Commission.


                                       3
<PAGE>   4

DISTRIBUTION CHANNELS AND CUSTOMERS

    AAi sells its products to over 200 customers, primarily in three
distribution channels: (1) mass merchandisers, (2) chain drug stores, combo
stores (stores combining general merchandise, food and drug items) and
supermarkets and (3) variety stores. To a lesser extent, AAi also distributes
its products through department stores, military post exchanges, card and gift
shops, specialty stores and catalogues.

    The Company customizes its product and service program offerings to meet the
distinctive characteristics and requirements of each of these retail
distribution channels.

    Mass Merchandisers. AAi's sales to mass merchandisers accounted for
approximately $101.7 million, or 63.4%, of net sales in fiscal 1998. These
customers demand a high level of merchandise support as well as national and, as
they expand overseas, international distribution capability.

    Chain Drug Stores/Combo Stores/Supermarkets. AAi's sales to this channel
accounted for approximately $22.0 million, or 13.7%, of net sales in fiscal
1998. These stores tend to be smaller than mass merchandisers and attract a
broader class of trade, which is often less price sensitive and more
convenience-oriented than the mass merchandiser or variety store customer.

    Variety Stores. AAi's sales to variety stores accounted for approximately
$13.8 million, or 8.6%, of net sales in fiscal 1998. The Company's extensive
product lines enable it to provide service programs on a cost-effective basis,
which affords the Company a significant competitive advantage in this market.

    Department Stores and Others. The Company's sales to department stores,
armed forces' PX stores, boutique stores, gift shops, book stores and catalogue
sales accounted for $22.7 million, or 14.2%, of its fiscal 1998 net sales. Each
of these channels has different characteristics and product and service
requirements and caters to different types of consumers. For example, department
stores generally offer higher-end products with higher price points and sales of
accessories at such outlets represent a larger percentage of total store sales.

    Most of the Company's business is based upon annual contracts or open
purchase orders which are terminable at will. When establishing or expanding a
customer relationship, the Company generally enters into multi-year agreements
for the supply of specified product lines to specific customer stores. Such
agreements, in addition to identifying the stores and product lines to be
supplied, prescribe inventory and service levels and anticipated turnover rates
and sales volumes, as well as the amount of any fixed obligation due to the
customer in connection with establishing the relationship. The agreements
typically do not contain required minimum sales volumes, but may provide for
early termination penalties equal to the Company's unamortized cost of product
displays provided to the customer.


                                       4
<PAGE>   5

    With regard to new customers, many retailers require a new supplier to buy
back the retailer's existing inventory as a condition to changing vendors. These
inventory costs can be substantial and serve as a barrier to entry for the
Company in obtaining new customers.

    In fiscal 1998, Wal-Mart and Kmart accounted for approximately 27.3% and
11.4%, respectively, of the Company's net sales. No other customers accounted
for 10% or more of the Company's total net sales in 1998. The loss of any
significant customer, whether through competition or otherwise, could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, certain segments of the retail industry,
particularly mass merchandisers, variety stores, drug stores and supermarkets,
are experiencing significant consolidation. Further industry consolidation could
result in the Company's loss of customers that are acquired by retailers
serviced by other suppliers as well as further concentration of the Company's
credit risks. Such events could have a material adverse effect on the Company's
results of operations.

PRODUCTS

    The Company offers sunglasses, reading glasses, costume jewelry, small
synthetic leather goods, watches, clocks, and other accessories generally at
retail price points of $20 or less.

     Optical Products. The Company's optical product line includes sunglasses
and non-prescription reading glasses which are sold with and without the
Company's service program. As a result of its 1996 acquisition of Foster Grant
Group L.P. and related entities ("Foster Grant US"), AAi has become a leading
seller of popularly priced sunglasses (retail price points of $8 to $30). The
Company pursues co-branding opportunities for its Foster Grant name and also
sells sunglasses under other licensed brand names. The Company offers a variety
of styles as well as color options for both frames and lenses. Sunglasses have a
significant fashion component and positive or negative consumer response in any
year can impact not only that year's profitability but also sales for the
following year, since retailers' orders tend to mirror the prior year's sales.
Such sales are also highly seasonal, with initial orders placed in the first
quarter and, depending on consumer response, restocking orders in the second
quarter.

    The Company also offers a variety of styles of non-prescription reading
glasses marketed under Foster Grant, licensed brand names or private labels at
price points of $6 to $13. The reading glasses business has no significant
fashion component and is non-cyclical and non-seasonal. Since magnification
strength is the primary purchasing consideration for this product line, proper
stocking and restocking is essential to maximizing sales. As a result, reading
glasses are typically marketed through the Company's service program.

    Costume Jewelry. AAi offers a wide variety of ladies' and children's costume
jewelry with low retail price points (between $3 and $20), including earrings,
necklaces and bracelets. The Company's jewelry line includes private labeled
products and branded products distributed pursuant to arrangements with
licensors such as Disney Enterprises, Inc., Warner Bros. and Revlon Consumer
Products Corporation as well as under the Company's Tempo(TM) name. Tempo is the
opening retail price point costume jewelry line at J.C. Penney. Most of the
Company's 


                                       5
<PAGE>   6

jewelry line is basic (non-seasonal) and approximately one-third has a fashion
or holiday component. The Company's costume jewelry line is typically sold
through its service program.

    Small Synthetic Leather Goods and Other. Through a 1986 acquisition, AAi
expanded its product lines to include small synthetic leather goods with retail
price points of $6 to $10, such as small backpacks, handbags, wallets and
purses. Many of the lines of small accessories are designed to complement AAi's
costume jewelry and are likewise often sold under licensed brands. The bulk of
these products are sold on a non-program basis and are shipped direct from the
Company's suppliers to the customer. In June 1998, through the acquisition of
Fantasma, LLC ("Fantasma") the Company added watches and clocks (with average
retail price points between $10 and $20) to its product lines.

DISTRIBUTION

    During the fourth quarter of 1998, AAi closed its Texas distribution
facility and consolidated its distribution operations at its recently expanded
Smithfield, Rhode Island facility. The Company consolidated its distribution
facilities in order to optimize supply chain operations, improve customer
service, increase inventory turns and lower operating costs. A disruption of the
Company's distribution operations for any reason could cause the Company to
limit or cease its operations, which would have a material adverse effect on the
Company's business, financial condition and results of operations.

    AAi has made a substantial investment in the development and enhancement of
its computer and information systems. These systems enable the Company to
rapidly respond to marketplace demands, permitting the Company to restock
retailers' inventory on a just-in-time basis. The Company believes that this
technology-based system has been a significant factor in reducing its inventory
costs.

    The Company's flexible distribution systems are capable of processing
virtually any small package. AAi's Rhode Island facility utilizes a high
velocity fulfillment system that allows the Company to provide its customers
short delivery times and high order fulfillment rates. AAi typically delivers
its products to its high volume customers on a bi-weekly basis. A VNA (very
narrow aisle) facility configuration serviced by wire guided stock pickers
resupplies a rapid response order picking line. After receiving a customer
order, the Company's computer system automatically generates a list of the
ordered items, also known as a "picking" order, which the distribution staff
utilizes in packing the customer's shipment. With the planned improvements to
the Company's inventory management computer system, "picking" orders will be
arranged according to the location of the ordered items within the Company's
distribution center, which AAi anticipates will improve the efficiency of
employees in filling orders.

    The Company delivers ordered items to customers using unaffiliated delivery
companies, primarily UPS. The Company is attempting to establish multiple
delivery services to deal with the possibility of a future disruption in UPS
delivery services. There can be no assurance that the precautions taken by the
Company will be adequate or that alternate delivery services can be located or
developed by the Company in a timely manner. Any future interruption in service
by 


                                       6
<PAGE>   7

UPS may have a material adverse effect on the Company's business, financial
condition and results of operations.

    The Company also uses an electronic data interchange ("EDI") system between
the Company and certain of its major customers, particularly for the
distribution of its small synthetic leather goods. Using the EDI system, the
Company's computer system automatically generates orders based on point of sale
("POS") information received from customers and the products are sent directly
to the customer from the Company's joint venture in Hong Kong.

SERVICE PROGRAM

    The Company believes that an attractive, well-positioned display is critical
to maximizing sales to the ultimate consumer. The SKU-intensive nature of the
Company's product line and the low retail price points (ranging from $3 to $20
on costume jewelry) relative to the required display space has led many
retailers to outsource the merchandising function to the Company for these
product lines. To better serve these customers, in 1982 the Company initiated an
innovative sales program through which AAi provides its program customers with
store-level management of its products. In fiscal 1998, the sales to customers
who utilize the Company's service program accounted for approximately 69.0% of
net sales.

    Program customers select the products to be sold in their stores and, in
consultation with AAi sales and service personnel, determine the initial order
and display requirements. Thereafter, based on POS information, the Company's
management adjusts product mix, generates display planograms and determines
discounts and markdowns. This information is transmitted to AAi's field service
representatives who regularly visit the retailers' stores to replenish and
restock displays, reorder product and attend to markdowns and allowances,
thereby providing customers with a real-time response to the market. The
frequency of service visits is dictated by the size of the store and the number
of the Company's products carried by the retailer. The Company has over 1,400
field service representatives.

SALES AND MARKETING

    The Company's seven sales managers have an average of over 17 years of
industry experience. The sales force is organized by both distribution channel
and product line. The product-based sales approach is dictated by customers
since most retailers divide their buyers' responsibilities by product. Sales
representatives service existing customers and are responsible for increasing
product penetration and solving customer problems.

    The Company markets its products to the retailers by attending trade shows
and advertising in industry trade magazines. The Company also maintains
showrooms and sales offices domestically in New York City, New York, Cincinnati,
Ohio and Bentonville, Arkansas as well as internationally in Toronto, Canada,
Mexico City, Mexico, London, England and Hong Kong. The marketing staff is
responsible for sales and marketing efforts directed at new customers and for
negotiating contract terms for existing and prospective customers. Marketing
focuses on designing a customized product and service package for each customer
after determining the 


                                       7
<PAGE>   8

retailer's specific needs. Often, branded products provide AAi with initial
access to a new customer. The Company then leverages the strength of the
Company's field service and breadth of its product lines to increase product
penetration.

     In addition, since acquiring the Foster Grant brand, the Company has begun
to advertise directly to the end-consumer. This includes relaunching the "Who's
That Behind Those Foster Grants" campaign, featuring Cindy Crawford, global
promotions and public relations efforts aimed at increasing awareness of the
Foster Grant brand. Also, the Company has launched a co-branded line of Ironman
Triathlon(R) sports sunglasses.

INTELLECTUAL PROPERTY AND LICENSES

    Proprietary Trademarks. The Company owns trademarks in the words and designs
used on or in connection with many of its products. The Company has registered a
variety of trademarks under which it sells a number of its products, including
Foster Grant. The level of copyright and trademark protection available to the
Company for proprietary words, phrases and designs varies depending on several
factors including the degree of originality and the distinctiveness of the
associated trademarks and design.

    Licenses. In 1992, AAi began distributing licensed products pursuant to an
agreement with Disney Enterprises, Inc. The Company currently holds numerous
non-exclusive licenses from various licensors to market products with classic
cartoon characters and other images or under other brand names and trademarks.
Many of the Company's license agreements limit sales of products to certain
market categories. The Company pays each of these licensors a royalty on sales
of licensed products. The Company's licenses generally are for terms of one to
three years. The license agreements generally require minimum annual payments
and certain quality control procedures and give the licensor the right to
approve products licensed by the Company. Typically, the licensor may terminate
the license if specified minimum levels of annual net sales for licensed
products are not met or for failure by the Company to comply with the material
terms of the license. Certain licenses require minimum advertising expenditures
by the Company and also require the Company to make lump-sum payments in the
event of a change of ownership. Accordingly, the Company's licensing
arrangements are dependent primarily upon maintaining a good relationship
between the Company and its licensors. The Company believes it has good
relationships with its licensors and has generally been able to obtain renewals
of expired licenses and to obtain the required approval for licensed products.

     Most of the Company's license agreements are non-exclusive, of short
duration and may be terminated if the Company fails to comply with any material
terms thereof. There can be no assurance that any of these relationships with
licensors will continue, that such agreements will be renewed or that the
Company will be able to obtain licenses for additional brands. If the Company
were unable in the future to obtain such licenses on terms it deems reasonable,
it would be required to modify its marketing plans and could be forced to rely
more heavily on its proprietary brands or generic product sales, which could
materially adversely affect its business, financial condition and results of
operations.


                                       8
<PAGE>   9

PRODUCT DESIGN, SOURCING AND ASSEMBLY

    Product Design. AAi's in-house design staff develops new products in line
with the current and anticipated trends for each season. For licensed brands,
the Company works extensively with the licensor in approving each detail of the
new products. The Company believes that its future success will depend, in part,
on its ability to enhance its existing product lines and develop new styles and
products to meet an expanding range of customer and consumer requirements.

    Sourcing and Assembly. The Company outsources manufacturing for all of its
products, 75% of which is sourced to manufacturers in Asia through a joint
venture in Hong Kong, with the remainder outsourced to independent domestic
manufacturers. The joint venture is co-owned with a Hong Kong investor who
provides on-site management. The joint venture monitors production and ensures
that products meet the Company's quality standards. The Company also utilizes
domestic manufacturers to accommodate short delivery lead times or when
otherwise necessary. The Company believes that the quality and cost of the
products manufactured by its suppliers provide it with a significant competitive
advantage. In addition, sourcing the majority of its products through the joint
venture enables the Company to better control costs, monitor product quality,
manage inventory and provide efficient order fulfillment.

COMPETITION

    The optical products and accessories industries are highly competitive.
There are numerous competitors for each of its product lines both in the retail
channels serviced by the Company and in its other channels of distribution.
Competitors include numerous accessory vendors, including those with their own
retail stores, smaller independent specialty manufacturers, and in the case of
costume jewelry and reading glasses, divisions or subsidiaries of large
companies with greater financial or other resources than those of the Company.
Certain of these competitors control licenses for widely recognized images, such
as cartoon or movie characters which could provide them with a competitive
advantage. The Company may also experience increased competition from suppliers
of upscale fashion accessories seeking to enter the mass merchandise market.

    There are significant costs associated with the design, production and
installation of display fixtures for new customers. Furthermore, many retailers
require a new supplier to buy back the retailer's existing inventory as a
condition to changing vendors. These inventory costs can be substantial and
serve as a barrier to entry for both competitors attempting to reach the
Company's existing customers as well as for the Company in obtaining new
customers.

    AAi competes on the basis of diversity and quality of its product designs,
the breadth of its product lines, product availability, price and reputation as
well as customer service and support programs. The Company has many competitors
with respect to one or more of its products but believes that there are few
competitors that distribute products with the same product diversity and service
quality as the Company.


                                       9
<PAGE>   10

EMPLOYEES

    As of March 15, 1999, the Company had approximately 700 full-time employees
and 1,400 part-time employees, none of whom were represented by a labor union.
The Company considers its relationship with its employees to be good.

ITEM 2. PROPERTIES

    The Company's principal executive office is located at 500 George Washington
Highway, Smithfield, Rhode Island. AAi's primary distribution facilities are
adjacent to its recently expanded headquarters, which together are 180,000
square feet.

    The following table describes the material properties owned and leased by
AAi:

<TABLE>
<CAPTION>
                                                                           USE
                                                                           ---
    <S>                                       <C>
    OWNED PROPERTY:

                                              Warehousing & Distribution, Product Showroom and Sales
      Smithfield, Rhode Island                Office and Office Administration

    LEASED PROPERTIES:

      New York, New York                      Product Showroom and Sales Office

      Bentonville, Arkansas                   Product Showroom and Sales Office

      Cincinnati, Ohio                        Sales Office

      Warren Avenue, Providence,
          Rhode Island (a)                    Warehousing

      Carpenter St., Providence,
         Rhode Island (a)                     Warehousing

      Toronto, Canada                         Product Showroom and Sales Office

      Newcastle Under Lyme,
         Staffordshire, United Kingdom        Warehousing & Distribution and Office Administration
</TABLE>

----------
(a) Leased to AAi from related parties. See "Certain Relationships and Related
Transactions."

ITEM 3. LEGAL PROCEEDINGS

    The Company is subject to legal proceedings in the ordinary course of
business. While the outcome of law suits or other proceedings cannot be
predicted with certainty, management does 


                                       10
<PAGE>   11

not expect these matters to have a material adverse effect on the financial
condition, results of the operation or cash flow of the Company.

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

    There were no matters submitted to a vote of security holders in the fourth
quarter of 1998.

================================================================================
                                    PART II
================================================================================

ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

    All of the Common Stock of the Company is held by affiliates and certain
directors and officers of the Company; thus, no trading market exits for such
stock.


                                       11
<PAGE>   12

ITEM 6. SELECTED FINANCIAL DATA

         The following table contains selected consolidated financial data for
the Company and is qualified in its entirety by the more detailed consolidated
financial statements of the Company included herein. The data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements and Notes
thereto included elsewhere herein.

<TABLE>
<CAPTION>
                                                         YEAR ENDED DECEMBER 31,
                                          ----------------------------------------------------      YEAR ENDED
                                             1994        1995         1996(a)        1997(a)    JANUARY 2, 1999(a)
                                          ----------- ----------- -------------  -------------  ------------------
                                                                    (DOLLARS IN THOUSANDS)

<S>                                         <C>         <C>          <C>            <C>               <C> 
STATEMENT OF OPERATIONS DATA:
  Net sales...........................      $76,611     $88,050      $ 86,336       $149,411          $160,325
  Cost of goods sold..................       37,096      43,690        47,871         77,928            88,823
                                            -------     -------      --------       --------           -------
  Gross profit........................       39,515      44,360        38,465         71,483            71,502
  Operating expenses..................       36,441      34,782        37,524         65,323            78,135
                                            -------     -------      --------       --------           -------
  Income from operations..............        3,074       9,578           941          6,160           (6,633)
  Interest expense....................         (342)     (1,031)       (1,469)        (4,214)          (7,010)
  Other (expense) income, net.........           88         (80)         (331)            31               490
                                            -------     -------      --------       --------        ----------
  Income before taxes.................        2,820       8,467          (859)         1,977          (13,153)
  Income tax benefit (expense)........           --         (42)          948         (1,162)               --
                                            -------     -------      --------       --------        ----------
  Net income..........................        2,820       8,425            89            815          (13,153)
  Dividends and accretion
    on preferred stock(b).............           --          --         1,123          2,496             2,779
                                            -------     -------      --------       --------            ------
  Net income (loss) applicable to
    common shareholders...............        2,820       8,425        (1,034)        (1,681)         (15,932)
  Pro forma income tax adjustment(c)..       (1,128)     (3,370)         (604)            --                --
                                            -------     -------      --------       --------        ----------
  Pro forma net income (loss)
    applicable to common shareholders       $ 1,692     $ 5,055      $ (1,638)      $ (1,681)       $ (15,932)
                                            =======     =======      ========       ========         =========

OTHER DATA:
  Depreciation and amortization.......      $   628     $   783      $  1,868       $  8,248           $12,792
  Cash flow from operating activities.        2,265       1,818        (1,892)         1,886           (3,903)
  Cash flow from investing activities.       (1,891)     (2,104)      (12,825)        (9,363)         (29,753)
  Cash flow from financing activities.         (600)        259        16,159          8,779            33,084
  EBITDA(d)...........................        3,790      10,281         2,488         14,439             6,649
  Capital expenditures(e).............        1,552       1,555         1,572          7,583            16,882

<CAPTION>
                                                                  AS OF DECEMBER 31,
                                               -------------------------------------------------------         AS OF
                                                  1994           1995           1996           1997          JANUARY 2, 1999
                                               ----------     ----------     ----------     ----------   -------------------
                                                                              (IN THOUSANDS)
<S>                                             <C>            <C>            <C>            <C>               <C> 
BALANCE SHEET DATA:
  Working capital.....................          $  4,436       $  7,795       $    687       $  5,936          $ 31,346
  Total assets........................            16,773         25,187         82,010         93,746           126,498
  Total debt(f).......................             2,593          5,542         35,588         44,960            78,982
  Preferred securities(g).............                --             --         24,338         26,918            29,771
  Total shareholders' equity(deficit).             4,890         11,523         (5,281)        (7,359)          (23,502)
</TABLE>

----------

(a) Includes the results of operations of the acquired businesses from the
    respective dates of acquisition: Tempo Division of Allison Reed Group, Inc.
    ("Tempo") in June 1996, Foster Grant US in December 1996, Superior 


                                       12
<PAGE>   13

    Jewelry Company ("Superior") in July 1997, Eyecare Products UK Ltd. ("Foster
    Grant UK") in March 1998 and Fantasma, LLC ("Fantasma") in June 1998.

(b) Reflects a reduction from net income for the accretion and noncash dividends
    on Series A Preferred Stock. See Note 10 of the Notes to the Company's
    Consolidated Financial Statements.

(c) The Company was an S corporation under Section 1362 of the Internal Revenue
    Code until May 31, 1996. Pro forma income taxes, assuming the Company was
    subject to C corporation income taxes, have been provided, in the
    accompanying statement of operations for 1994, 1995 and 1996, at an
    estimated statutory rate of 40%.

(d) "EBITDA" is defined as earnings before interest, taxes, depreciation and
    amortization. Although EBITDA is not a measure of performance calculated in
    accordance with GAAP, AAi believes that EBITDA is accepted as a generally
    recognized measure of performance in the distribution industry because it is
    an indicator of the earnings available to meet the Company's debt service
    obligations. Nevertheless, this measure should not be considered in
    isolation or as a substitute for operating income, net income, net cash
    provided by operating activities or any other measure for determining AAi's
    operating performance or liquidity which is calculated in accordance with
    GAAP.

(e) Does not include capital assets acquired in connection with the acquisitions
    of the Tempo, Foster Grant US, Superior, Foster Grant UK and Fantasma.

(f) Includes amounts outstanding under a revolving credit facility, various
    long-term obligations and subordinated promissory notes payable to
    shareholders at each applicable period.

(g) Includes preferred stock of Foster Grant Holdings, Inc.


                                       13
<PAGE>   14

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

         The following discussion may contain "forward-looking" statements and
are subject to risks and uncertainties that could cause actual results to differ
significantly from expectations. In particular, statements contained in this
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" section which are not historical facts, including, but not limited
to, statements regarding the anticipated adequacy of cash resources to meet the
Company's working capital and capital expenditure requirements and statements
regarding the anticipated proportion of revenues to be derived from a limited
number of customers, may constitute forward-looking statements. Although the
Company believes the expectations reflected in such forward-looking statements
are reasonable, it can give no assurance that such expectations will prove to
have been correct. These risks and uncertainties include the substantial
leverage of the Company, customer concentration and consolidation, dependence on
licensed brands, a single site distribution facility, a limited number of
delivery companies, operating in international economies, unpredictability of
discretionary consumer spending, competition, susceptibility to changing
consumer preferences and successful conversion of computer systems and
implementation of Year 2000 readiness programs, as well as those described in
the Company's Registration Statement on Form S-4 declared effective on November
16, 1998 (SEC File No. 333-61119). The following discussion and analysis of
financial condition and results of operations should be read in conjunction with
the Consolidated Financial Statements and related Notes thereto included
elsewhere.

OVERVIEW

     The Company is a value-added distributor of optical products, costume
jewelry, watches, clocks and other accessories primarily to mass merchandisers,
chain drug stores/combo stores/supermarkets and variety stores in North America
and the United Kingdom. As a value-added distributor, the Company provides
customized store displays, merchandising management and a store-level field
service force to replenish and restock displays, reorder product and attend to
markdowns and allowances. Upon shipment to the customer, the Company estimates
agreed upon future allowances, returns and discounts, taking into account
historical experience, and reflects revenue net of these estimates.

     When establishing or expanding a customer relationship, the Company
generally enters into multi-year agreements for the supply of specified product
lines to specific customer stores. The agreements typically do not contain
required minimum sales volumes, but may provide for termination penalties equal
to the Company's unamortized cost of product displays provided to the customer.
The Company believes its relationships with retailers are dependent upon its
ability to efficiently utilize allocated floor space to generate satisfactory
returns for its customers. To meet this end, the Company strives to consistently
deliver competitively priced products and service programs which provide
retailers with attractive gross margins and inventory turnover rates. The
Company has historically retained customers from year to year, although
retailers may drop or add product lines supplied by the Company. Generally,
customer loss has been attributable to such customer going out of business or
being acquired by a company which does 


                                       14
<PAGE>   15

not carry the Company's product line or has prior relationships with a
competitor of the Company.

     Certain segments of the retail industry, particularly mass merchandisers,
variety stores, drugstores and supermarkets, are experiencing significant
consolidation and in recent years many major retailers have experienced
financial difficulties. These industry wide developments have had and may
continue to have an impact on the Company's results of operations. For example,
net sales were adversely affected in 1997 by the loss of two customers, one as a
result of a merger into a retail chain that does not carry costume jewelry and
the other due to the retailer ceasing operations. In addition, also as a result
of financial pressures, many major retailers have sought to reduce inventory
levels in order to reduce their operating costs which has had a negative effect
on the Company's results of operations.

     During the first quarter of 1998, the Company elected to change its fiscal
year end from December 31 to the Saturday closest to December 31.

     Net Sales. The Company offers optical products, costume jewelry, small
synthetic leather goods, watches, clocks and other accessories, generally at
retail price points of $20 or less. In December 1996, the Company acquired
Foster Grant US, a major marketer and distributor of sunglasses and reading
glasses, product lines in which the Company had only minimal sales before the
acquisition. Accordingly, the Company's product mix changed dramatically as a
result of this acquisition. Net sales of the Company's optical products
accounted for approximately 47.3%, 50.7% and 17.4% of the Company's net sales in
fiscal 1998, 1997 and 1996, respectively; net sales of the Company's costume
jewelry accounted for approximately 40.3%, 43.4% and 74.6% of the Company's net
sales in fiscal 1998, 1997 and 1996, respectively, and the balance represented
sales of synthetic leather goods, watches, clocks and other accessories.

     Cost of Goods Sold. The Company outsources manufacturing for all of its
products, 75% of which is sourced to manufacturers in Asia through its joint
venture in Hong Kong, with the remainder outsourced to independent domestic
manufacturers. Accordingly, the principal element comprising the Company's cost
of goods sold is the price of manufactured goods purchased through the Company's
joint venture or from independent manufacturers. The Company believes
outsourcing manufacturing allows it to reliably deliver competitively priced
products to the retail market while retaining considerable flexibility in its
cost structure.

     Operating Expenses. Operating expenses are comprised primarily of payroll
and occupancy costs related to the Company's selling, general and administrative
activities as well as depreciation and amortization. The Company incurs various
costs in connection with the acquisition of new customers and new stores for
existing customers, principally the cost of new product display fixtures and
costs related to the purchase of the customer's existing inventory. The Company
makes substantial investments in the design, production and installation of
display fixtures in connection with establishing and maintaining customer
relationships. The Company capitalizes the production cost of these display
fixtures as long as it retains ownership of them. These costs are amortized to
selling expenses on a straight-line basis over their estimated useful life,
which is 


                                       15
<PAGE>   16

one to three years. If the Company does not retain title to the displays, the
display costs are expensed as shipped.

     The Company incurs direct and incremental costs in connection with the
acquisition of certain new customers and new store locations from existing
customers under multi-year agreements. The Company may also receive the previous
vendor's merchandise from the customer in connection with most of these
agreements. In these situations, the Company values this inventory at its fair
market value, representing the lower of cost or net realizable value, and
records that value as inventory. The Company sells this inventory through
various liquidation channels. Except as provided below, the excess costs over
the fair market value of the inventory received is charged to selling expenses
when incurred. The Company expensed customer acquisition costs of $0.9 million,
$1.6 million and $2.7 million in fiscal 1998, 1997 and 1996, respectively.

     The excess costs over the fair market value of the inventory received is
capitalized as deferred costs and amortized over the agreement period if the
Company enters into a minimum purchase agreement with the customer and the
estimated gross profits from future minimum sales during the term of the
agreement are sufficient to recover the amount of the deferred costs. During
fiscal 1998, the Company capitalized approximately $2.3 million of these costs.
No such costs were capitalized during fiscal 1996 and 1997. Amortization expense
related to these costs was approximately $219,000 for the year ended January 2,
1999.

     Dividends and Accretion on Preferred Stock. The Company has 43,700 shares
of Series A Redeemable Convertible Preferred Stock ("Series A Preferred Stock")
outstanding, of which 34,200 were issued in May 1996 for gross proceeds of $18.0
million, and an additional 9,500 shares were issued for gross proceeds of $5.0
million in connection with the December 1996 acquisition of Foster Grant US.
Beginning on June 30, 2002, shares of the Series A Preferred Stock are
redeemable at the option of the holder for an amount equal to the original issue
price plus accrued and unpaid dividends yielding a 10% compounded annual rate of
return, provided, however, that the right to require redemption is suspended as
long as any Restrictive Indebtedness (as defined in the Articles of
Incorporation) is outstanding. Net loss applicable to common shareholders
represents net loss less accretion of original issuance costs and cumulative
dividends due on the Series A Preferred Stock.

     Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).
Although EBITDA is not a measure of performance calculated in accordance with
Generally Accepted Accounting Principles (GAAP), the Company believes that
EBITDA is accepted as a generally recognized measure of performance in the
distribution industry and provides an indicator of the earnings available to
meet the Company's debt service obligations. EBITDA should not be considered in
isolation or as a substitute for operating income, net income, net cash provided
by operating activities or any other measure for determining the Company's
operating performance or liquidity which is calculated in accordance with GAAP.
EBITDA was $6.6 million, $14.4 million and $2.5 million in fiscal 1998, 1997 and
1996, respectively.


                                       16
<PAGE>   17

RECENT SIGNIFICANT ACQUISITIONS

     The Company has grown rapidly through strategic acquisitions in recent
years. In June 1998, the Company acquired 80% of the membership interests of
Fantasma for $4.1 million in cash. The remaining 20% membership interest of
Fantasma is held by Roger Dreyer, president of Fantasma. In connection with the
acquisition, Mr. Dreyer and another officer of Fantasma received options to
acquire in the aggregate an additional 13% membership interest in Fantasma
subject to satisfaction of certain earnings targets in 1998, 1999 and 2000.
Based on fiscal 1998 results of operations, options to acquire 3% of Fantasma
expired resulting in options to acquire an additional 10% membership interest
outstanding at January 2, 1999. AAi's acquisition of Fantasma added watches and
clocks to AAi's product lines and Disney and Warner Bros. stores to its customer
base. As a result of this transaction, the Company recorded approximately $4.6
million in intangible assets which will be amortized over 10 years.

     In March 1998, the Company acquired certain assets of Foster Grant UK for
the aggregate book value of certain acquired assets, including inventory items
of $3.3 million and accounts receivable of $1.7 million, less the aggregate
amount of trade payables assumed of $1.1 million and bank debt assumed of $1.7
million. In addition, the Company acquired the Foster Grant trademark in the
United Kingdom and Europe for $0.7 million, which amount is subject to upward
adjustment at the end of 1998 and 1999 based on annual sales, up to a maximum
additional payment of $0.7 million. No adjustment to the purchase price is
required as result of 1998 sales. As a result of this acquisition, the Company
recorded approximately $1.1 million of intangible assets which are being
amortized over 20 years.

     In July 1997, the Company acquired the assets of Superior, a distributor of
costume jewelry to chain drug stores and mass merchandisers in the United
States. The Company paid $2.7 million in cash, including a contingent cash
payment of $875,000 and assumed certain liabilities in the amount of $4.1
million. The purchase price is subject to upward adjustment based on 1998
earnings attributable to Superior operations, up to a maximum amount of $2.0
million. No adjustment is required as a result of 1998 operating results to the
purchase price. As a result of this acquisition, the Company recorded
approximately $3.5 million of goodwill which is being amortized over 10 years.

     In December 1996, the Company, through a newly-formed subsidiary, Foster
Grant Holdings, Inc. ("FG Holdings") acquired Foster Grant US, a marketer and
distributor of sunglasses, reading glasses and eyewear accessories in the United
States and Canada. The consideration consisted of $10.0 million in cash, assumed
liabilities in the amount of $34.0 million and 100 shares of redeemable
non-voting preferred stock of FG Holdings (the "FG Preferred Stock") initially
valued at $750,000. The redemption value of the FG Preferred Stock is subject to
an upward adjustment, based on annual sales of the Foster Grant US operations
through the year ending January 1, 2000 or, upon the occurrence of certain
specified capital transactions, based upon the valuation of the Company at the
time of the transaction. The maximum redemption amount is $4.0 million. As a
result of this acquisition, the Company recorded approximately $11.0 million of
intangible assets which are being amortized over 40 years. Any difference in the
redemption amount from the 


                                       17
<PAGE>   18

carrying value of the FG Preferred Stock immediately prior to redemption may be
recorded as additional purchase price.

EFFECTS OF ACQUISITIONS

    Historically, the Company has selected acquisition candidates based, in
part, on the opportunity to improve their operating results. The Company seeks
to leverage its purchasing power, distribution capabilities and lower operating
costs to improve the financial performance of its acquired businesses. Results
of operations reported herein for each period only include the results of
operations for acquired businesses from their respective dates of acquisition.
Full year operating results, therefore, could differ materially from those
presented.

    The Company has accounted for its acquisitions using the purchase method of
accounting. As a result, these acquisitions have affected, and will
prospectively affect, the Company's results of operations in certain significant
respects. The aggregate acquisition costs are allocated to the tangible and
intangible assets acquired and liabilities assumed by the Company based upon
their respective fair values as of the acquisition date. The cost of such assets
are then amortized according to the classes of assets and the useful lives
thereof. The acquisitions necessitating payment of purchase price in excess of
the fair value of the net assets acquired results in intangible assets
consisting of goodwill and trademarks which are being amortized on a
straight-line basis over a period of 10 to 40 years. Similar future acquisitions
or additional consideration paid for existing acquisitions may result in
additional amortization expense. In addition, due to the effects of the
increased borrowing to finance any future acquisitions, the Company's interest
expense may increase in future periods. As of January 2, 1999, net intangible
assets as a result of acquisitions was $20.9 million.

CONSOLIDATION OF DISTRIBUTION OPERATIONS

    In the fourth quarter of 1998, the Company closed its Texas distribution
center and consolidated distribution operations at its expanded Rhode Island
facility. AAi expects this restructuring will generate permanent annual
operating expense savings of approximately $2.8 million commencing in 1999. In
1998, the Company incurred $5.0 million of expenses related to the closing of
the Texas distribution center, including a restructuring charge of $2.6 million
for the write-down of disposed assets, the payment of severance benefits and
expenses relating to operating inefficiencies.


                                       18
<PAGE>   19

RESULTS OF OPERATIONS

    The following table sets forth, for the periods indicated, the percentage
relationship to net sales of certain items included in the Company's Statement
of Operations:

<TABLE>
<CAPTION>
                                                                YEAR ENDED        YEAR ENDED DECEMBER 31,
                                                             JANUARY 2, 1999        1997          1996
                                                             ---------------        ----          ----

<S>                                                                <C>             <C>             <C> 
Net sales.............................................             100.0%          100.0%          100.0%

Cost of goods sold....................................              55.4            52.2            55.4
                                                                 -------         -------         -------
Gross profit..........................................              44.6            47.8            44.6
Operating expenses....................................              47.1            43.7            43.5
Restructuring Charge..................................               1.6              --              --
                                                                 -------         -------         -------
(Loss) income from operations.........................              (4.1)            4.1             1.1
Interest expense......................................               4.4             2.8             1.7
Other income (expense), net...........................               0.3              --            (0.4)
                                                                 -------         -------         -------
(Loss) income before taxes and dividends and
  accretion on preferred stock........................              (8.2)            1.3            (1.0)
Income tax (expense) benefit..........................                --            (0.7)            1.1
                                                                 -------         -------         -------
Net (loss) income before dividends and
  accretion on preferred stock........................              (8.2)            0.6             0.1
Dividends and accretion on preferred
  stock...............................................               1.7             1.7             1.3
                                                                 -------         -------         -------
Net loss applicable to
  common shareholders.................................              (9.9)           (1.1)           (1.2)
                                                                 =======         =======         =======

Pro forma tax expense.................................                --              --            (0.7)
                                                                 -------         -------         -------
Pro forma net loss applicable to
  common shareholders.................................              (9.9)%          (1.1)%          (1.9)%
                                                                 =======         =======         =======
</TABLE>

YEAR ENDED JANUARY 2, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1997

     Net Sales. Consolidated net sales were $160.3 million for the year ended
January 2, 1999 as compared to $149.4 million for the year ended December 31,
1997, an increase of 7.3% or $10.9 million. The $10.9 million increase in net
sales relates to the 1998 acquisitions of Fantasma and Foster Grant UK which
contributed $18.0 million of net sales. This increase was partially offset by a
decline of $7.1 million of net sales with chain drug stores/combo
stores/supermarkets, primarily related to sales of optical products which were
adversely impacted by disruptions associated with the relocation of optical
distribution activities to the Company's expanded Smithfield, Rhode Island
facility.

     Gross Profit. Gross profit was $71.5 million for the year ended January 2,
1999 which was the same as for the year ended December 31, 1997. Gross profit
from the aforementioned acquisitions accounted for an $8.0 million increase
offset by a decline in net sales in chain drug 


                                       19
<PAGE>   20

stores/combo stores/supermarkets, primarily related to optical products. Gross
profit as a percentage of net sales decreased to 44.6% from 47.8% due to the
decline in sales of optical products (which carry higher margins) and increased
shipments of lower margin seasonal and promotional products as well as from the
lower margins on Fantasma products.

     Operating Expenses. Operating expenses were $78.1 million for the year
ended January 2, 1999 as compared to $65.3 million for the year ended December
31, 1997, an increase of 19.6% or $12.8 million. The increase is attributable to
$6.9 million of operating expenses associated with the acquired entities and
$5.0 million of expenses related to the closing of the Texas distribution center
including the write-down of disposed assets, the payment of severance benefits
and operating inefficiencies incurred subsequent to the announcement of the
planned closure.

     Interest Expense. Interest expense was $7.0 million for the year ended
January 2, 1999 as compared to $4.2 million for the year ended December 31,
1997, an increase of 66.4% or $2.8 million. This resulted from additional
borrowings under the Company's credit facilities to fund acquisitions and
expanded operations and a higher effective interest rate related to the Notes.

     Income Tax Benefit (Expense). No income tax benefit was recorded for the
year ended January 2, 1999 as compared to $1.2 million of expense for the year
ended December 31, 1997. During 1998, based on actual and anticipated results,
the Company determined that a greater valuation reserve was required.
Accordingly, the Company increased the valuation allowance by approximately $3.7
million which offset any benefit that was recognized.

     Net Income (Loss). As a result of the factors discussed above, net loss
before dividends and accretion on preferred stock was $13.2 million for the year
ended January 2, 1999 as compared to net income before dividends and accretion
on preferred stock of $815,000 for the year ended December 31, 1997, a decrease
of $14.0 million.

     Net Loss Applicable to Common Shareholders. Net loss applicable to common
shareholders was $15.9 million for the year ended January 2, 1999 as compared to
a loss of $1.7 million for the year ended December 31, 1997, an increase of
$14.2 million. The increase was attributable to the $14.0 million decrease in
earnings and an increase of $283,000 in dividends and accretion on Series A
Preferred Stock due to the compounding of accrued dividends.

YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996

     Net Sales. Consolidated net sales were $149.4 million for 1997 compared to
$86.3 million for 1996, an increase of 73.1% or $63.1 million. The increase was
primarily due to a full year of sales attributable to Foster Grant US operations
and six months of sales attributable to Superior operations in 1997, which
accounted for $60.6 million and $5.2 million of the increase, respectively. This
increase was partially offset by the loss of two customers in 1997, one as a
result of the customer's merger into a retailer that does not offer costume
jewelry and the other due to a retailer ceasing operations, which together
accounted for an estimated $5.1 million decrease in net sales.


                                       20
<PAGE>   21

     Gross Profit. Gross profit was $71.5 million for the 1997 as compared to
$38.5 million for 1996, an increase of 85.8% or $33.0 million. Gross profit from
sales generated from the aforementioned acquisitions accounted for a $35.3
million increase which was partially offset by the decline in gross profit on
the two lost customers. Gross profit increased as a percentage of net sales from
44.6% to 47.8%, primarily as a result of an increase in the net sales of optical
products (which carry higher margins) and savings related to consolidating
purchasing efficiencies. These purchasing efficiencies were a result of
increased purchasing volume with selected vendors and the combination of the
Company's optical product sourcing with the sourcing of Foster Grant US
following the Company's acquisition of Foster Grant US in December 1996.

     Operating Expenses. Operating expenses were $65.3 million or 43.7% of net
sales in 1997 compared to $37.5 million or 43.5% of net sales in 1996, an
increase of 74.1% or $27.8 million. The increase resulted from the acquisition
of entities with $29.0 million of operating expenses, offset by a decrease of
$1.2 million of operating expenses in existing businesses.

     Interest Expense. Interest expense was $4.2 million in 1997 compared to
$1.5 million in 1996, an increase of 186.9% or $2.7 million. This resulted from
interest charged on additional borrowings under the Company's credit facilities
to fund acquisitions and expanded working capital and capital expenditure
requirements.

     Income Tax Benefit (Expense). Income tax expense was $1.2 million in 1997
compared to an income tax benefit of $948,000 in 1996, an increase of $2.1
million. The Company's consolidated effective income tax rate was 58.8% for
1997, reflecting the impact of nondeductible amortization of intangilble assets
for income tax purposes. The Company was operated as a subchapter S corporation
under Section 1362 of the Internal Revenue Code until May 31, 1996, and as a
result, taxable income or loss of the Company was passed through to the
shareholders and reported on their individual tax returns. Accordingly, the
Company did not incur federal and state income taxes (except with respect to
certain states) for the period prior to June 1, 1996.

     Net Income (Loss). As a result of the factors discussed above, net income
before dividends and accretion on preferred stock was $815,000 in 1997 as
compared to net income before dividends and accretion on preferred stock of
$89,000 in 1996, an increase of 815.7% or $726,000.

     Net Loss Applicable to Common Shareholders. Net loss applicable to common
shareholders was $1.7 million for the year ended December 31, 1997, compared to
a net loss of $1.0 million for the year ended December 31, 1996, an increase of
$647,000. The increase was primarily attributable to the $1.4 million increase
in dividends and accretion on Series A Preferred Stock offset by a $726,000
increase in net income over 1996. The increase in dividends and accretion on
Series A Preferred Stock is due to an increased number of shares (43,700) being
outstanding for the entire year in 1997, as compared to fewer shares (34,200)
being outstanding for less than seven months in 1996.


                                       21
<PAGE>   22

LIQUIDITY AND CAPITAL RESOURCES

     At January 2, 1999 the Company had cash and cash equivalents of $2.2
million and working capital of $36.1 million. To date, the Company has funded
its operations through credit facilities, issuance of equity and debt
securities, and cash generated from operations.

     The Company used $3.9 million of cash for operations during fiscal 1998
compared to generating $1.6 million of cash from operations in fiscal 1997. The
cash used in operations in fiscal 1998 was used primarily to fund losses from
operations and increases in accounts receivable.

     The Company used $29.8 million in investing activities during fiscal 1998,
compared to $9.1 million in 1997. Cash used in investing activities increased in
fiscal 1998 as compared to 1997 as a result of cash used in acquisitions and
additional expenditures for property and equipment. The cash used in investing
activities in fiscal 1998 included $6.4 million for the purchase and expansion
of the Company's Smithfield, Rhode Island headquarters, $9.4 million for display
fixtures, $5.5 million to acquire certain assets of Foster Grant UK and the
Foster Grant trademark for the United Kingdom and Europe, and $4.1 million to
acquire an 80% interest in Fantasma. The Company expects its capital expenditure
level (excluding cost of display fixtures) to be approximately $1.5 million for
fiscal 1999.

     The Company generated $33.1 million from financing activities during fiscal
1998, compared to $8.8 million in 1997. Cash generated from financing activities
increased in fiscal 1998 compared to 1997 primarily as a result of the Company's
sale of the Notes. On July 21, 1998, substantially all of the net proceeds from
the sale of $75.0 million of 10 3/4% Senior Notes were used to pay existing
debt.

     The 43,700 shares of Series A Preferred Stock has a redemption value of
$28.9 million at January 2, 1999. Shares of Series A Preferred Stock are
convertible into Common Stock at a rate of 10 to 1, adjustable for certain
dilutive events. Conversion is at the option of the shareholder, but is
automatic upon consummation of a qualified public offering. The holders of the
Series A Preferred Stock have the right to require redemption for cash for any
unconverted shares, beginning June 30, 2002, provided, however, that the right
to require redemption is suspended as long as any Restrictive Indebtedness is
outstanding. The Notes constitute Restrictive Indebtedness. The redemption price
of the Series A Preferred Stock is an amount equal to the original issue price,
$526.32 per share, plus any accrued and unpaid dividends yielding a 10%
compounded annual rate of return.

     In connection with the purchase of Foster Grant US, the Company's
wholly-owned subsidiary, FG Holdings issued 100 shares of FG Preferred Stock,
which are redeemable on February 28, 2000, or earlier upon the occurrence of
certain specified capital transactions. The redemption price will range between
$1.0 million and $4.0 million depending upon the net sales of sunglasses,
reading glasses and accessories by FG Holdings and the Company, and upon the
total transaction value.


                                       22
<PAGE>   23

     The Company is continually engaged in evaluating potential acquisitions.
The Company expects that funding for future acquisitions may come from a variety
of sources, depending on the size and nature of any such acquisition. Potential
sources of capital include cash generated from operations, borrowings under the
Company's senior credit facility with NationsBank, N.A., as agent and lender
(the "Senior Credit Facility"), or other external debt or equity financings.
There can be no assurance that such additional capital sources will be available
to the Company, if at all, on terms that the Company finds acceptable.

     The Company has substantial indebtedness and significant debt service
obligations. As of January 2, 1999, the Company had total indebtedness,
including borrowings under the Senior Credit Facility, in the aggregate
principal amount of $79.0 million. The Company had current liabilities of
approximately $43.0 million. In addition, the Company has significant annual
obligations that include interest on the Notes of approximately $8.1 million,
minimum royalty obligations over the next two years of approximately $2.7
million and minimum payments under its operating leases of approximately $1.9
million. The Indenture permits the Company to incur additional indebtedness,
including secured indebtedness, subject to certain limitations.

         The Company had up to $47.3 million available for borrowings under the
Senior Credit Facility as of January 2, 1999. Interest rates on the revolving
loans under the Senior Credit Facility are based, at the Company's option, on
the Base Rate (as defined) or LIBOR plus an applicable margin. The Senior Credit
Facility contains certain restrictions and limitations, including financial
covenants that require the Company to maintain and achieve certain levels of
financial performance and limit the payment of cash dividends and similar
restricted payments. As of January 2, 1999, the Company was not in compliance
with certain financial covenants under the Senior Credit Facility. The Company
received a waiver of such non-compliance from its lenders and is currently
negotiating an amendment to the Senior Credit Facility which will modify the
financial covenants going forward. If the Company does not successfully
negotiate an amendment to the Senior Credit Facility, the Company expects that
it will not be in compliance with certain financial covenants in the Senior
Credit Facility for fiscal 1999. The Company has received a letter from the 
Bank stating that it intends to modify the covenants so they are amounts which 
the Company believes it can attain. The Company believes it will successfully
negotiate the amendment, however, there can be no assurance that it will be
able to do so.

         The Company's ability to make scheduled payments of principal of, or to
pay the interest on, or to refinance, its indebtedness (including the Notes), or
to fund planned capital expenditures will depend on its future performance,
which, to a certain extent, is subject to general economic, financial,
competitive, legislative, regulatory and other factors that are beyond its
control. Based upon the current level of operations and anticipated cost savings
and revenue growth, the Company believes that cash flow from operations and
available cash, together with available borrowings under the Senior Credit
Facility, will be adequate to meet the Company's future liquidity needs for at
least the next several years. The Company may, however, need to refinance all or
a portion of the principal of the Notes on or prior to maturity. There can be no
assurance that the Company's business will generate sufficient cash flow from
operations, that anticipated cost savings and revenue growth will be realized or
that future borrowings will be available under the Senior Credit Facility in an
amount sufficient to enable the Company to service its indebtedness, including
the Notes, or to fund its other liquidity needs. In


                                       23
<PAGE>   24

addition, there can be no assurance that the Company will be able to effect any
such refinancing on commercially reasonable terms or at all.


                                       24
<PAGE>   25

IMPACT OF INFLATION

    The Company believes that inflation has not had a material effect on its
results of operations or financial condition during the past three years.

SEASONALITY AND QUARTERLY INFORMATION

    Significant portions of the Company's business are seasonal. Sunglasses are
shipped primarily during the first half of the fiscal year as retailers build
inventory for the spring and summer selling seasons, while costume jewelry and
other accessories are shipped primarily during the second half of the fiscal
year as retailers build inventory for the holiday season. Reading glasses sales
are generally uniform throughout the year. As a result of these shipping trends,
the Company's historical working capital requirements grow through the first
three quarters of the year to fund inventory purchases and the growth in
accounts receivable. Historically, in the fourth quarter, the Company's working
capital requirements have decreased as accounts receivable are collected.

    Quarterly results may also be materially affected by the timing and
magnitude of acquisitions, costs related to acquisitions, fluctuations in
product cost, changes in product mix, timing of customer orders and shipments
and general economic conditions.

YEAR 2000

    The Company uses several application programs written over many years using
two-digit fields to define the applicable year, rather than four-digit year
fields. Programs that are time-sensitive may recognize a date using "00" as the
year 1900 rather than the year 2000. This misinterpretation of the year could
result in an incorrect computation or a computer shutdown.

    As a result of the Company's growth, AAi is implementing a new information
management system which is expected to be Year 2000 compliant. The new system is
scheduled for completion by mid-1999. Accordingly, the Company believes that
with the successful conversion to the new software, the Year 2000 issue will not
pose significant operational problems for the Company's systems. The Company
will evaluate the need for contingency planning in the second quarter of 1999
based on the status of the system installation.

    Since Year 2000 compliance is being addressed with the implementation of the
Company's new system, the costs of addressing the Year 2000 issue are not
separately identifiable. No material additional costs are anticipated at this
time.

    The Company has completed a compliance review of its property which uses
embedded technology. Although the Company believes that the Year 2000 issue will
not pose a significant problem for any of the Company's systems or property
utilizing embedded technology, there can be no assurance that the Year 2000
issue will not interfere with the function and use of such property.


                                       25
<PAGE>   26

         The Company has engaged in formal communications with its major
customers and most significant vendors to determine the extent to which the
Company's interface systems are vulnerable to those third parties' failure to
remediate their own Year 2000 issues. These major customers and vendors have
informed the Company that they are currently addressing the Year 2000 issue and
expect to be Year 2000 compliant by mid-1999. While there can be no guarantee
that the systems of other companies on which the Company's systems rely will be
timely converted and will not have an adverse effect on the Company's systems,
the Company does not believe that its operations are materially vulnerable to
the failure of any vendor or customer to properly address the Year 2000 issue.
The Company's contingency plan in the event other parties are unable to provide
Year 2000 compliant electronic data is to revert to paper documentation from
these parties.

         The failure to correct a material Year 2000 problem could result in an
interruption in, or failure of, certain normal business activities or
operations. Such failures could materially and adversely affect the Company's
results of operations, liquidity and financial condition. Due to the general
uncertainty inherent in the Year 2000 problem, resulting in part from the
uncertainty of the Year 2000 readiness of third-party suppliers and customers,
the Company is unable to determine at this time whether the consequences of Year
2000 failures will have a material impact on the Company's results of
operations, liquidity or financial condition. The aforementioned steps being
undertaken by the Company are expected to significantly reduce the Company's
level of uncertainty about the Year 2000 problem and, in particular, about the
Year 2000 compliance and readiness of its material customers and vendors. The
Company believes that, with the implementation of its new information management
system and the other steps being taken, the possibility of significant
interruptions of normal operations should be reduced.

RECENT ACCOUNTING PRONOUNCEMENTS

    In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities. SFAS No. 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. It requires
that an entity recognize all derivatives as either assets or liabilities in the
statement of financial position and measure those instruments at fair value.
SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning
after June 15, 1999. The Company does not believe that the adoption of SFAS No.
133 will have a material impact on its financial statements.

    In April 1998, the American Institute of Certified Public Accountants issued
Statement of Position 98-5 Reporting on the Costs of Start Up Activities, (SOP
98-5). SOP 98-5 provides guidance on the financial reporting of start up
activities and organization costs to be expensed as incurred. The Company does
not believe that the adoption of SOP 98-5 will have a material impact on its
financial statements.


                                       26
<PAGE>   27

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

    The following discussion about the Company's market risk disclosures
includes forward-looking statements. Actual results could differ materially from
those projected in the forward-looking statements. The Company is exposed to
market risk related to changes in interest rates and foreign currency exchange
rates. The Company does not use derivative financial instruments for speculative
or trading purposes.

    INTEREST RATE RISK. The Company is exposed to market risk from changes in
interest rates primarily through its borrowing activities. In addition, the
Company's ability to finance future acquisition transactions may be impacted if
the Company is unable to obtain appropriate financing at acceptable interest
rates.

    The Company manages its borrowing exposure to changes in interest rates by
optimizing the use of fixed rate debt with extended maturities. At January 2,
1999, approximately 99% of the carrying values of the Company's long-term debt
was at fixed interest rates.

    FOREIGN CURRENCY RISK. The Company's results of operations are affected by
fluctuations in the value of the U.S. dollar as compared to the value of
currencies in foreign markets primarily related to changes in the British Pound,
the Canadian Dollar, the Mexican Peso and the Hong Kong Dollar. In fiscal 1998,
the net impact of foreign currency changes was not material to the Company's
financial condition or results of operations. The Company manages its exposure
to foreign currency exchange risk by trying to minimize the Company's net
investment in its foreign subsidiaries. At January 2, 1999, the Company's net
investment in foreign assets was approximately $6.2 million. The Company
generally does not enter into derivative financial instruments to manage foreign
currency exposure.

    The Company's operations in Europe are not significant and, therefore, the
Company does not expect to be materially impacted by the introduction of the
Euro dollar.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

    The index to financial statements is included on page F-1 of this Annual
Report and is incorporated by reference herein.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

    There are no changes in or disagreements with accountants on accounting and
financial disclosure as defined by Item 304 of Regulation S-K.


                                       27
<PAGE>   28

================================================================================
                                    PART III
================================================================================

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY

DIRECTORS AND EXECUTIVE OFFICERS

    Each director of the Company is elected for a period of one year at the
Company's annual meeting of shareholders and serves until his successor is duly
elected by the shareholders. Vacancies and newly created directorships resulting
from any increase in the number of authorized directors may be filled by a
majority vote of directors then remaining in office. The holders of the Series A
Preferred Stock (the "Preferred Holders," or individually, a "Preferred Holder")
have the right, at their option, to designate up to two directors to the Board
of Directors, as well as the right to vote on the election of directors at the
annual meeting of shareholders. In addition, AAi's Articles of Incorporation
provide that, in addition to other events, if the Company is in default of any
of its covenants thereunder, the Preferred Holders shall have the right to elect
a majority of the members of the Board of Directors. The Company is currently in
default of one such covenant. However, the Preferred Holders have not exercised
their right to elect a majority of the members of the Board of Directors.

    The Company's shareholders have entered into an agreement that requires
them, subject to the rights of Preferred Holders to elect additional directors
in the event of default, to vote to fix the number of directors of the Company
at seven and elect as directors two persons designated by the Preferred Holders
and five persons designated by certain management shareholders. In addition,
Weston Presidio Capital II, L.P., the record holder of 17,100 shares (39.1%) of
the Series A Preferred Stock, has agreed to vote in favor of Martin E. Franklin
(or in the event of his death or disability, the designee of Marlin Capital,
L.P.) as a director. See "Certain Relationships and Related Transactions --
Shareholders Agreement." Officers are elected by and serve at the discretion of
the Board of Directors.


                                       28
<PAGE>   29

    The following table sets forth information with respect to each person who
is currently a director or executive officer of the Company.

<TABLE>
<CAPTION>
     NAME                             AGE             POSITION WITH THE COMPANY
     ----                             ---             -------------------------

     <S>                              <C>     <C>
     Gerald F. Cerce .............    51      Chairman, President and Chief Executive Officer

     John H. Flynn, Jr ...........    48      Director and Executive Vice President Sales and 
                                              Customer Service

     Stephen J. Carlotti .........    56      Director and Secretary (a)

     Michael F. Cronin * .........    45      Director (a), (b)

     Martin E. Franklin * ........    34      Director

     George Graboys ..............    66      Director (a), (b)

     Felix A. Porcaro, Jr ........    43      Executive Vice President - Marketing and 
                                              Product Development

     Robert V. Lallo .............    58      Executive Vice President - Distribution

     Daniel A. Triangolo .........    64      Executive Vice President - International

     Duane M. DeSisto ............    44      Chief Financial Officer, Treasurer, and 
                                              Assistant Secretary 
</TABLE>

----------

*   Designated by the Preferred Holders. All other directors were designated by
    certain management shareholders pursuant to the Shareholders Agreement. See
    "Certain Relationships and Related Transactions -- Shareholders Agreement."

(a) Member of the Compensation Committee.
(b) Member of the Audit Committee.

    The following is a brief summary of the background of each director and
executive officer. Unless otherwise indicated, each individual has served in his
current position for at least the past five years.

    Gerald F. Cerce co-founded the Company in 1985 with Mr. Porcaro and has
served as the Company's Chairman of the Board since that time. Mr. Cerce also
served as Chairman of the Board of AAi's predecessor company, Femic, Inc., a
Rhode Island jewelry manufacturer which 


                                       29
<PAGE>   30

Mr. Cerce and Mr. Porcaro acquired in 1972. Mr. Cerce serves on the Board of
Trustees of Bryant College and is a former member of the Advisory Board of
Citizens Savings Bank.

    John H. Flynn, Jr. joined AAi's predecessor company in 1981 as Vice
President. He served as President and Chief Executive Officer of the Company
from 1985 to 1998 and has been a Director since 1985. As Executive Vice
President of Sales and Customer Service, Mr. Flynn directly manages all sales
and service operations for the Company in the U.S. Prior to joining the Company,
Mr. Flynn was a service director for K&M Associates, a costume jewelry
distributor, and also served as Vice President of Puccini Accessories where he
supervised all sales and service operations.

    Stephen J. Carlotti has been a Director of the Company since June 1996. He
is an attorney and has been a partner of the firm Hinckley, Allen & Snyder since
1992 and from 1972 to 1989. From 1989 to 1992, he served as Chief Operating
Officer and General Counsel of The Mutual Benefit Life Insurance Company. He is
also a director of WPI Group, Inc. (a manufacturer of hand held computers and
electronic components) and Fleet National Bank.

    Michael F. Cronin has been a Director of the Company since June 1996. Mr.
Cronin also serves on the boards of directors of Casella Waste System, Inc. (an
integrated waste management company), Tekni Plex, Inc. (a manufacturer of
packaging materials), Tweeter Home Entertainment Group, Inc. (a retailer of
audio and video consumer electronics products) and several other private growth
companies. Since 1991, Mr. Cronin has been the Managing General Partner of
Weston Presidio Capital, a venture capital investment firm. He is a graduate of
Harvard College and Harvard Business School.

    Martin E. Franklin has been a Director of the Company since 1996. Mr.
Franklin has been Chairman and Chief Executive Officer of Marlin Holdings, Inc.,
the general partner of Marlin Capital, L.P., a private investment partnership,
since October 1996. He also serves as Chairman of the Board of Directors of
Bolle Inc., a NASDAQ listed company, and as a Director of Specialty Catalog
Corp. From May 1996 until March 1998, Mr. Franklin served as Chairman and Chief
Executive Officer of Lumen Technologies, Inc., a NYSE company, and served as
Executive Chairman from March 1998 until December 1998. Mr. Franklin was
Chairman of the Board and Chief Executive Officer of Lumen's predecessor, Benson
Eyecare Corporation from October 1992 to May 1996 and President from November
1993 until May 1996. Mr. Franklin was non-executive Chairman and a Director of
Eyecare Products plc, a London Stock Exchange company, from December 1993 until
February 1999. Mr. Franklin also serves on the boards of a number of privately
held companies and charitable organizations. Mr. Franklin received a B.A. in
political science from the University of Pennsylvania in 1986.

    George Graboys has served as a Director of the Company since 1996. Mr.
Graboys served as Chief Executive Officer of Citizens Bank and Citizens
Financial Group, Inc. until he retired in October 1992. From January 1993 to
June 1995, Mr. Graboys was Adjunct Professor and Executive-in-Residence at the
University of Rhode Island School of Business. From March 1995 to June 1998, Mr.
Graboys served as Chairman of the Board of Governors for Higher Education. 


                                       30
<PAGE>   31

The Board oversees the state's three institutions of higher education conducted
on eight campuses throughout the state.

    Felix A. Porcaro, Jr. co-founded the Company with Mr. Cerce (his
brother-in-law) in 1985, and served as its Vice Chairman of the Board of
Directors until 1996. Mr. Porcaro is now the Executive Vice President of
Marketing and Product Development and is responsible for the design and
merchandising departments and all advertising and public relations activities.

    Robert V. Lallo joined AAi's predecessor company in 1978 as Vice President.
He served as the Company's Chief Operating Officer from 1985 to 1998. As
Executive Vice President -- Distribution, Mr. Lallo is responsible for all
manufacturing, distribution and internal operations of the Company's facilities.
Prior to his association with AAi and its predecessor company, Mr. Lallo was
Production and Inventory Control Manager, Materials Manager and Director of
Operations for Uncas Manufacturing Company.

    Daniel A. Triangolo has been the Executive Vice President of AAi's
international operations since 1995. Mr. Triangolo was the founder and President
of Danal Jewelry Corporation prior to its acquisition by AAi in 1983.

    Duane M. DeSisto has served as the Company's Vice President and Chief
Financial Officer since 1995. Prior to joining AAi, Mr. DeSisto was Chief
Financial Officer of Zoll Medical Corporation for nine years.

DIRECTOR COMPENSATION

    Directors who are not employees of AAi receive an annual fee of $10,000, as
well as reimbursement for their reasonable expenses. Messrs. Cerce and Flynn do
not receive any directors' fees.


                                       31
<PAGE>   32

ITEM 11. EXECUTIVE COMPENSATION

    Compensation of Executive Management. The following table summarizes the
compensation paid or accrued by the Company to its Chief Executive Officer and
each of its most highly compensated executive officers who earned more than
$100,000 in salary and bonus in fiscal 1998 (together, the "NAMED EXECUTIVE
OFFICERS") for the years ended December 31, 1997 and January 2, 1999:

                           SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                                            ANNUAL COMPENSATION(a)    LONG TERM
                                              FISCAL        ----------------------   COMPENSATION          ALL OTHER
      NAME AND PRINCIPAL POSITION              YEAR         SALARY($)      BONUS      OPTIONS(#)        COMPENSATION(b)
      ---------------------------              ----         ---------      -----      ----------        ---------------

    <S>                                        <C>          <C>          <C>                               <C> 
    Gerald F. Cerce,.........................  1998         $651,342     $145,000          --              $245,576
      Chairman, President and Chief            1997          661,024        --             --               211,988
         Executive Officer

    John H. Flynn, Jr.,......................  1998          309,236       75,000          --                12,905
      Executive Vice President-Sales and       1997          299,898         --            --                11,151
 
    Felix A. Porcaro, Jr.,...................  1998          211,673       50,000          --                13,138
      Executive Vice President-Product         1997          204,213         --            --                14,695
         Development and Marketing 
 
    Robert V. Lallo..........................  1998          165,229       45,000          --                 6,069
      Executive Vice President-Distribution    1997          161,131         --            --                 4,988
 
    Duane M. DeSisto.........................  1998          164,495       45,000          --                 4,460
      Chief Financial Officer, Treasurer and   1997          160,118         --           2,000               3,709
      Assistant Secretary 
</TABLE>

----------

(a) The aggregate amount of perquisites and other personal benefits received
    from the Company by each of the Named Executive Officers was less than the
    lesser of $50,000 or 10% of the total of annual salary and bonus reported.
(b) Amounts paid in fiscal 1998 represent the following: (1) medical payments
    reimbursed by the Company to Mr. Cerce ($2,950), Mr. Flynn ($5,225), Mr. 
    Porcaro ($9,270) and Mr. Lallo ($475); (2) the Company's matching 
    contributions under its Qualified 401(k) Plan and Non-Qualified 401(k)
    Excess Plan for Named Executive Officers as follows: Mr. Cerce ($9,662), Mr.
    Flynn ($6,090), Mr. Porcaro ($2,500), Mr. Lallo ($4,141) and Mr. DeSisto
    ($3,206); (3) premiums paid by the Company for term life insurance purchased
    for the Named Executive Officers and not made available generally to
    salaried employees in the amount of $150 for each of Messrs. Cerce, Flynn
    and Porcaro; and (4) premium of $230,000 paid with respect to life insurance
    purchased by the Company in connection with Mr. Cerce's Supplemental
    Executive Retirement Plan.


                                       32
<PAGE>   33

STOCK PLAN

    The Company has established the 1996 Incentive Stock Plan (the "1996 Plan")
which provides for the grant of awards covering a maximum of 150,000 shares of
Common Stock to officers and other key employees of the Company and
non-employees who provide services to the Company or its subsidiaries. Awards
under the 1996 Plan may be granted in the form of incentive stock options,
non-qualified stock options, shares of common stock that are restricted, units
to acquire shares of Common Stock that are restricted, or in the form of stock
appreciation rights or limited stock appreciation rights.

    No options were granted to the Named Executed Officers in fiscal 1998. The
following table contains information with respect to aggregate stock options
held by the Named Executive Officers as of January 2, 1999. Messrs. Cerce,
Flynn, Porcaro and Lallo do not hold any stock options. All such options were
exercisable as of such date. No stock options were exercised by any Named
Executive Officers during fiscal 1998.

                        AGGREGATE YEAR-END OPTION VALUES

<TABLE>
<CAPTION>
                                             NUMBER OF SECURITIES          VALUE OF UNEXERCISED
                                       UNDERLYING UNEXERCISED OPTIONS          IN-THE-MONEY
NAME                                           AT FISCAL YEAR 1998           OPTION/SARS($)(a)
----                                           -------------------           -----------------

<S>                                                  <C>                              <C>
Duane M. DeSisto..................                   4,000                             0
</TABLE>

----------
(a) Based on the January 2, 1999, price of the Common Stock being equal to the
exercise price of $50.

EMPLOYMENT AGREEMENTS

    The Company has entered into employment agreements, dated as of May 31,
1996, with certain of its executive officers, including Messrs. Cerce, Flynn,
Porcaro, Lallo and DeSisto (collectively, the "Executives," each an
"Executive").

    Each employment agreement provides that during the term of the contract the
Executive's base salary will not be reduced, will be increased on each
anniversary date of the agreement based upon the consumer price index and may be
increased based on the Company's performance and the Executive's particular
contributions. The employment agreements also stipulate that the Executives will
remain eligible for participation in the Company's Executive Bonus Plan and
other benefit programs, and that the Company will provide each Executive with an
automobile consistent with past practice. The employment agreement of Mr. Cerce
further provides for the reimbursement of certain membership and service fees as
well as reasonable expenses associated with the performance of his duties in New
York City and specifies that the Company will make all annual payments for his
Supplemental Employment Retirement Plan.

    Mr. Cerce's agreement provides for an initial ten year term expiring on May
31, 2006, and the employment agreements of Messrs. Flynn, Porcaro, Lallo and
DeSisto each stipulate an initial three year term expiring on May 31, 1999, with
automatic renewals for successive one year terms 


                                       33
<PAGE>   34

thereafter (the "Employment Period"). Upon prior written notice to the
Executive, the Company may terminate the agreement "with cause" for (a) the
conviction of the Executive for a crime involving fraud or moral turpitude; (b)
deliberate dishonesty of the Executive with respect to the Company or its
subsidiaries; or, (c) except under certain circumstances as specified in the
agreement, the Executive's refusal to follow the reasonable and lawful written
instructions of the Board of Directors with respect to the services to be
rendered and the manner of rendering such services by the Executive. In
addition, an Executive may terminate his agreement at any time by providing
written notice to the Company, and the Company may terminate the agreement at
any time "without cause" by providing written notice to the Executive. Mr.
Cerce's agreement provides that the Company must provide such written notice at
least six months prior to termination. Termination "without cause" means
termination for any reason other than "cause" as defined and specifically
includes the Company's material reduction of the Executive's duties or
authority, the disability of the Executive or the Executive's death.

    Under the employment agreements, if the Company terminates an agreement
"without cause," the Company is obligated to provide the Executive monthly
severance benefits consisting of one-twelfth of the sum of Executive's then
current annual base salary and the Executive's most recent bonus and to continue
coverage under the Company's insurance programs and any ERISA benefit plans.
Such payments, insurance coverage and plan participation will continue for at
least two years from the date of the Executive's termination, and may be
extended for a longer period depending on the Executive's "Non-compete Period"
as described below. For Messrs. Cerce and Flynn, the maximum period for
severance benefits is five years, for Messrs. Lallo and DeSisto, the comparable
maximum period is four years, and for Mr. Porcaro, the comparable maximum period
is three years.

    The employment agreements contain confidentiality provisions and provide
that during the Employment Period and after termination of the agreement, the
Company may restrict the Executive's subsequent involvement in Restricted
Business Activities for two years for Messrs. Cerce, Flynn and Lallo and for one
year for Messrs. Porcaro and DeSisto following the date of the termination (the
"Non-compete Period"). As used in the agreements, "Restricted Business
Activities" means the marketing and sale of ladies' and men's consumer soft
lines to retail stores, which the Company sold and marketed during the
Executive's employment with the Company. Other than with the written approval of
the Company, the Executive may not enter into or engage in or have a proprietary
interest in the Restricted Business Activities other than the ownership of (a)
the stock of the Company held by the Executive, and (b) no more than five
percent of the securities of any other company which is publicly held. The
Non-compete Period may be extended, at the Company's option, by three years for
Messrs. Cerce and Flynn and by two years for Messrs. Porcaro, Lallo and DeSisto,
provided that the Company continues to make the payments and provide the
benefits described in the preceding paragraph.


                                       34
<PAGE>   35

EXECUTIVE BONUS PLAN

    The Company maintains an Executive Bonus Plan for the purpose of providing
incentives in the form of an annual cash bonus to officers and other key
employees. Awards are equal to a percentage of base salaries specified in an
annual plan by reference to the Company's target for sales and net income.
Bonuses awarded to senior executives are equal to 50% of compensation if the
sales and income targets are met. If the targets are not met, the amount of the
bonuses, if any, is subject to the discretion of the Board of Directors.

QUALIFIED 401(k) PLAN

    The Company has a qualified 401(k) plan (the "Qualified Plan") that permits
all employees to defer, on an elective basis, up to 15% of their salary or
wages. Presently, the Company matches 25% of the first 6% of compensation that
an employee defers under the Qualified Plan. The amount of elective deferrals
for any one employee under the Qualified Plan is limited by the Internal Revenue
Code of 1986, as amended (the "Code"). In addition, the amount that an executive
employee may defer is subject to nondiscrimination rules which may prevent the
executive from deferring the maximum amount. Further, the Qualified Plan may not
take into account compensation in excess of specified amounts for any employee
in computing contributions under the Qualified Plan. If an employee's elective
contributions are reduced or capped under the Qualified Plan, the amount of
matching employer contribution also is restricted.

NON-QUALIFIED EXCESS 401(k) PLAN

    In May 1997, the Company established the Non-Qualified Excess 401(k) Plan
(the "Non-Qualified Plan") effective as of June 1, 1997. The purpose of the
Non-Qualified Plan is to provide deferred compensation to a select group of
management or highly compensated employees of the Company as designated by the
Board of Directors. Presently, all the Named Executive Officers participate in
the Non-Qualified Plan. Under the Non-Qualified Plan, a participant may elect to
defer up to 15% of his or her compensation on an annual basis. This amount is
credited to the employee's deferred compensation account (the "Deferred
Amount"). Under the Non-Qualified Plan, the Company also credits the
participant's deferred compensation account for the amount of the matching
contribution the Company would have made under the Qualified Plan with respect
to the Deferred Amount. All amounts contributed by the employee and by the
Company under the Non-Qualified Plan are immediately vested.

    A participant under the Non-Qualified Plan is entitled to receive a
distribution of his or her account upon retirement, death, disability or
termination of employment. An executive also is eligible to withdraw funds
credited to the executive's deferred compensation account in the event of
unforeseeable financial hardship. This policy is consistent with the ability of
an employee to obtain hardship withdrawals under the Qualified Plan.

    The amount deferred under the Non-Qualified Plan is not includable in the
income of the executive until paid and, accordingly, the Company is not entitled
to a deduction for any liabilities 


                                       35
<PAGE>   36

established under the Non-Qualified Plan until the amount credited to the
participant's deferred compensation account is paid to him or her.

    The Company has established a grantor trust effective June 1, 1997 to hold
assets to be used for payment of benefits under the Non-Qualified Plan. In the
event of the Company's insolvency, any assets held by the trust are subject to
claims of general creditors of the Company under federal and state law.

SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN

    The Company has entered into a Supplemental Executive Retirement Plan (the
"Supplemental Plan") with Mr. Cerce the purpose of which is to provide
supplemental retirement, death, disability and severance benefits to Mr. Cerce
in consideration for his performance of services as a key executive of the
Company. In order to fund the Company's obligations under the Supplemental Plan,
the Company has purchased an insurance policy insuring the life of Mr. Cerce
(the "Policy").

    Under the terms and subject to the conditions contained in the Supplemental
Plan, upon Mr. Cerce's voluntary termination of employment for any reason on or
after age 60 ("Retirement") or by reason of disability, the Company will pay to
Mr. Cerce the existing cash surrender value of the Policy. At the discretion of
the Board of Directors of the Company, payment may be made either in a single
lump sum or in monthly installments over a ten year period; provided, however,
in the event that Retirement occurs within one year after a change of control,
the retirement benefit will be paid in a single lump sum.

    In the event that Mr. Cerce dies while employed by the Company, the Company
will pay a death benefit to Mr. Cerce's surviving spouse or designated
beneficiary equal to the death benefit payable under the Policy. The death
benefit will be paid in monthly installments over a fifteen year period unless
Mr. Cerce's death occurs within one year after a change of control, in which
event, the death benefit will be paid in a single lump sum no later than ninety
days after his death.

    In the event that Mr. Cerce's employment with the Company is terminated for
any reason other than Retirement, death or disability, Mr. Cerce will be
entitled to receive the existing cash surrender value of the Policy, payable at
the discretion of the Board of Directors of the Company in a single lump sum or
in monthly installments over a ten year period. However, if Mr. Cerce's
termination occurs within one year after a change of control, the severance
benefit will be paid in a single lump sum.


                                       36
<PAGE>   37

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

SECURITY OWNERSHIP OF 5% BENEFICIAL OWNERS AND DIRECTORS AND OFFICERS

    The following table sets forth certain information regarding beneficial
ownership of the Company's capital stock as of March 15, 1999, by (i) each
person who is known by the Company to beneficially own more than 5% of the
outstanding shares of Common Stock or Series A Preferred Stock; (ii) each of the
Company's directors and Named Executive Officers; and (iii) all directors and
executive officers of the Company as a group:

<TABLE>
<CAPTION>
                                                 SERIES A                                                 COMMON STOCK
                                              PREFERRED STOCK               COMMON STOCK                   DILUTED (b)
                                        ---------------------------  ---------------------------  -------------------------
                                           NUMBER OF                    NUMBER OF                   NUMBER OF
                                            SHARES                       SHARES                      SHARES
                                         BENEFICIALLY      PERCENT    BENEFICIALLY     PERCENT    BENEFICIALLY     PERCENT
NAME AND ADDRESS (a)                         OWNED        OF CLASS        OWNED       OF CLASS        OWNED       OF CLASS
--------------------                    -------------  ------------  -------------   ----------  --------------  -----------

<S>                                        <C>              <C>         <C>             <C>          <C>            <C> 
Gerald F. Cerce (c).....................       --            --         305,906         50.3%        305,906        29.3%
Felix A. Porcaro, Jr. (c)...............       --            --         171,000         28.1         171,000        16.4
John H. Flynn, Jr.......................       --            --          28,500          4.7          28,500         2.7
Stephen J. Carlotti (d)(e)..............       --            --          36,094          5.9          36,094         3.5
Michael F. Cronin (f)...................   17,100           39.1%        19,000          3.1         190,000        18.2
Martin E. Franklin (g)..................    4,750           10.9             --          --           47,500         4.5
George Graboys..........................       --            --              --          --               --         --
David J. Syner (e)(h)...................       --            --          36,094          5.9          36,094         3.5
Robert V. Lallo ........................       --            --          28,500          4.7          28,500         2.7
Duane M. DeSisto (i)....................       --            --           4,000           *            4,000          *
Weston Presidio Capital II, L.P. (j)....   17,100           39.1         19,000          3.1         190,000        18.2
St. Paul Fire and Marine Insurance 
  Company (k)...........................    6,840           15.7          7,600          1.3          76,000         7.3
BancBoston Ventures, Inc. (l)...........    6,840           15.7          7,600          1.3          76,000         7.3
Marlin Capital, L.P. (m)................    4,750           10.9             --           --          47,500         4.5
National City Capital
  Corporation (n).......................    3,420            7.8          3,800           *           38,000         3.6
Brahman Group (o).......................    3,117            7.1             --           --          31,170         3.0
All executive officers and directors 
  as a group (10 persons) (p)...........   21,850           50.0        597,000         96.9         815,500        78.0
</TABLE>

----------

*   Less than one percent

(a) If applicable, beneficially owned shares include shares owned by the spouse,
    children and certain other relatives of the director or officer, as well as
    shares held by trusts of which the person is a trustee or in which he has a
    beneficial interest. All information with respect to beneficial ownership
    has been furnished by the respective directors and officers.

(b) Includes full conversion of all outstanding shares of Series A Preferred
    Stock into Common Stock at the current ratio of 1 for 10.

(c) Messrs. Cerce's and Porcaro's business address is 500 George Washington
    Highway, Smithfield, Rhode Island 02917.


                                       37
<PAGE>   38

(d) Mr. Carlotti's business address is 1500 Fleet Center, Providence, Rhode
    Island 02903.

(e) Represents shares of Common Stock held by Mr. Carlotti and David J. Syner,
    as trustees of the benefit of Mr. Cerce's children.

(f) Mr. Cronin's business address is 1 Federal Street, 21st Floor, Boston,
    Massachusetts 02110. Includes 19,000 shares of Common Stock and 17,100
    shares of Series A Preferred Stock held in the name of Weston Presidio
    Capital II, L.P. of which Mr. Cronin is a general partner.

(g) Mr. Franklin's business address is 555 Theodore Fremd Avenue, Suite B-302,
    Rye, New York 10580. Includes 4,750 shares of Series A Preferred Stock held
    in the name of Marlin Capital, L.P., of which Mr. Franklin's majority-owned
    company is the sole general partner.

(h) Mr. Syner's business address is 35 Sockanesset Crossroads, Cranston, Rhode
    Island 02920.

(i) Represents shares that may be acquired pursuant to options which are or will
    become exercisable within 60 days.

(j) The address of Weston Presidio Capital II, L.P. is 1 Federal Street, 21st
    Floor, Boston, Massachusetts 02110.

(k) The address of St. Paul Fire and Marine Insurance Company is c/o St. Paul
    Venture Capital, Inc., 8500 Normandale Lake Boulevard, Suite 1940,
    Bloomington, Minnesota 55437.

(l) The address of BancBoston Ventures, Inc. is 175 Federal Street, 10th Floor,
    Boston, Massachusetts 02110.

(m) The address of Marlin Capital, L.P. is 555 Theodore Fremd Avenue, Suite
    B-302, Rye, New York 10580.

(n) The address of National City Capital Corporation is 1965 E. 6th Street,
    Suite 1010, Cleveland, Ohio 44114.

(o) The Brahman Group includes Brahman Partners II, L.P., Brahman Institutional
    Partners, L.P., B.Y. Partners, L.P. and Brahman Partners II Offshore Ltd.,
    which are a "group" as that term is used in Section 13(d)(3) of the Exchange
    Act of 1934, as amended (the "Exchange Act"). The address for these
    shareholders is c/o Brahman Capital Corp., 277 Park Avenue, New York, New
    York 10172.

(p) Includes 8,000 shares that may be acquired pursuant to options which are or
    will become exercisable within 60 days.

    All of the Company's shareholders are party to an agreement that requires
the parties thereto, subject to the right of the Preferred Holders to elect
additional directors in the event of the Company's default on certain covenants,
to vote to fix the number of directors of the Company at seven and elect as
directors two persons designated by the Preferred Holders and five persons
designated by certain management shareholders. See "Certain Relationships and
Related Transactions -- Shareholders Agreement."


                                       38
<PAGE>   39

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

NOTES PAYABLE TO PREFERRED HOLDERS

    On May 31, 1996, in connection with the Company's sale of shares of its
Series A Preferred Stock, the Company issued subordinated promissory notes in
the aggregate amount of $2.0 million to certain holders of its Series A
Preferred Stock (Weston Presidio Capital II, L.P., BancBoston Ventures, Inc.,
St. Paul Fire and Marine Insurance Company and National City Capital
Corporation). BancBoston Ventures, Inc., an affiliate of BancBoston Securities
Inc. and one of the initial purchasers of the Notes, was a holder of a
subordinated note in the principal amount of $400,000. The subordinated notes
bore interest at an annual rate of 7.04% and were due in 2002. These notes were
repaid with a portion of the net proceeds from the sale of the Notes in 1998.

TERMINATION OF S CORPORATION STATUS

    Until the issuance of its Series A Preferred Stock on May 31, 1996, the
Company was an S corporation under the Code and comparable state tax laws. As an
S corporation, earnings through the date of termination of S corporation status
were taxed directly to the S corporation shareholders (Messrs. Cerce, Flynn,
Lallo and Porcaro). Upon termination of its S corporation status, the Company
issued to the S corporation shareholders previously taxed undistributed earnings
in the aggregate amount of $13.3 million. Of the $13.3 million, $10.3 million
was paid in cash and $3.0 million was paid by the issuance of subordinated
promissory notes, which bore interest at an annual rate of 7.04% and were due in
2006. These notes were also repaid with a portion of the net proceeds of the
sale of the Notes in 1998.

    The Company has entered into an indemnification agreement with the S
Corporation shareholders relating to potential income tax liabilities resulting
from adjustments to reported S corporation taxable income. The S corporation
shareholders will continue to be liable for personal income taxes on the
Company's income for all periods during which the Company was an S corporation,
while the Company will be liable for all income taxes for subsequent periods.
The indemnification agreement provides that the Company will distribute to the S
corporation shareholders 40% of the amount of additional deductions permitted to
be taken by the Company as a C corporation for expenditures made while an S
corporation, which result from adjustments initiated by tax authorities.

    During the first and second quarters of 1998, in connection with an income
tax audit, the Company made advances totaling $3.4 million to the S corporation
shareholders to pay a portion of the income tax owed by them with respect to the
Company's S corporation earnings. Upon completion of the sale of the Notes, the
shareholders repaid these advances.


                                       39
<PAGE>   40

LEASES OF RHODE ISLAND WAREHOUSE SITES

    The Company has an operating lease agreement for warehouse facilities with
Sunrise Properties, LLC ("Sunrise Properties"), a Rhode Island limited liability
company, of which Mr. Porcaro and Linda Cerce, wife of Mr. Cerce and sister of
Mr. Porcaro, are members. The Company also has an operating lease agreement for
warehouse facilities with 299 Carpenter Street Associates, LLC, a Rhode Island
limited liability company of which Sunrise Properties and Messrs. Lallo and
Flynn are members. The leased properties are located at 4 Warren Avenue, North
Providence, Rhode Island and at 299 Carpenter Street, Providence, Rhode Island.
The present annual rental rates for the Warren Avenue and Carpenter Street
properties are $191,412 and $279,840, respectively. The Company is responsible
for real estate taxes and utilities. Each lease has a three year term ending on
December 31, 2001, and grants the Company an option to extend the lease for an
additional three year term at the greater of the then fair market rent or the
current rent adjusted for the cumulative increase in the consumer price index.

GUARANTY OF MORTGAGE NOTE

    The Company has guaranteed a mortgage note payable by Sunrise Properties in
the aggregate amount of $200,000, the outstanding balance of which was
approximately $114,000 as of March 15, 1999. The mortgage note has a remaining
maturity of three years, and bears interest at a rate of 9.5% annually.

LEASE OF DALLAS, TEXAS SITE

    In December 1996, in conjunction with the purchase of Foster Grant US, the
Company entered into a property lease with Lumen Technologies, Inc. (formerly
named BEC Group, Inc.) ("Lumen"), the former owner of the Foster Grant US office
and distribution center. Martin E. Franklin, a director of the Company, is the
chairman of Lumen and Bolle, Inc. The aggregate rental expense for this property
was approximately $494,000 per year in both 1997 and 1998. In March 1998, Lumen
transferred the Texas property to Bolle, Inc., an affiliated corporation at the
time of transfer. In May 1998, Bolle, Inc. sold the Texas property to an
independent third party. The Company terminated this lease effective December
1998.

SHAREHOLDERS AGREEMENT

    The Company, the current shareholders and Daniel A. Triangolo, Duane M.
DeSisto and Thomas McCarthy are parties to a Tag-along, Transfer Restriction and
Voting Agreement (the "Shareholders Agreement") which requires the parties
thereto, subject to the right of the Preferred Holders to elect additional
directors in the event of the Company's default on certain covenants, to vote to
fix the number of directors at seven and to elect as directors two persons
nominated by the Preferred Holders and five persons nominated by the other
parties to the Shareholders Agreement (the "Management Shareholders"). In a
related Letter Agreement, Weston Presidio Capital II, L.P., a Preferred Holder,
has agreed to use its best efforts to cause the nomination of and to vote all of
its shares of Series A Preferred Stock for the election of Martin E. Franklin
(or, in the event of his death or incapacity, the designee of Marlin Capital,
L.P.) as a director of the Company, for so long as the 


                                       40
<PAGE>   41

Preferred Holders, in the aggregate, own at least 10% or 4,750 shares of Series
A Preferred Stock.

    The Shareholders Agreement also provides that upon the death of a Management
Shareholder, the Company will purchase, at an appraised value determined by an
independent investment banker, all or a portion of the shares owned by the
Management Shareholder at his death. The Company has funded its obligations
under the Shareholders Agreement with life insurance policies on the lives of
the Management Shareholders in the aggregate amount of $27 million. The
Company's obligation to purchase shares upon the death of a Management
Shareholder is limited to the life insurance proceeds received upon the death of
such Management Shareholder. The Company may not decrease the amount of life
insurance coverage without the prior written consent of the affected Management
Shareholder.

    The Shareholders Agreement terminates on the earlier of the following: (i)
the time immediately prior to the consummation of a Qualified Public Offering as
defined in the Articles of Incorporation or (ii) when no shares of the Series A
Preferred Stock and no warrants issuable to the Preferred Holders are
outstanding, except as a result of the conversion, exchange or exercise of the
Series A Preferred Stock or warrants.

OWNERSHIP OF PREFERRED SHARES OF FOSTER GRANT US BY LUMEN

    In connection with the purchase of Foster Grant US, the Company's
wholly-owned subsidiary, issued Lumen 100 shares of Preferred Stock of Foster
Grant US (the "FG Preferred Stock") which represents all of the issued and
outstanding shares of FG Preferred Stock. By its terms, the FG Preferred Stock
must be redeemed on February 28, 2000 (the "FG Redemption Date") by payment of
an amount ranging from $10,000 to $40,000 per share (the "FG Redemption
Amount"), determined with reference to the combined net sales of sunglasses,
reading glasses and accessories by Foster Grant US and the Company for the year
ending January 1, 2000, excluding an amount equal to the net sales by the
Company for such items for the year ending December 31, 1996.

    The Certificate of Incorporation of Foster Grant US also provides for early
redemption of the FG Preferred Stock if the Company completes either (i) an
initial public offering where the pre-money valuation of the Company equals or
exceeds $75.0 million, (ii) a merger or similar transaction where the
transaction value equals or exceeds $75.0 million or (iii) a private placement
of equity securities representing more than 50% of the outstanding capital stock
for consideration of not less than $37.5 million (each a "Redemption Event")
prior to the FG Redemption Date. Upon completion of a Redemption Event, in lieu
of the FG Redemption Amount, holders of FG Preferred Stock will receive a
payment ranging from $35,000 to $40,000 per share (the "Redemption Event
Amount"), to be determined with reference to, as the case may be, either the
pre-money valuation of the Company immediately prior to the initial public
offering or the proceeds of the merger or similar transaction or private equity
placement. If a Redemption Event occurs after the FG Redemption Date, in
addition to the FG Redemption Amount, holders of FG Preferred Stock will receive
a supplemental payment equal to the difference, if any, between the FG
Redemption Amount paid to such holders on the FG Redemption Date and Redemption
Event 


                                       41
<PAGE>   42

Amount that would have been received had the Redemption Event occurred on or
prior to the FG Redemption Date.

INITIAL PURCHASERS OF THE 10 3/4% SENIOR NOTES DUE 2006

    BancBoston Ventures, Inc., an affiliate of BancBoston Securities Inc. and
one of the initial purchasers of the Notes, is the beneficial owner of 15.7% of
the Company's Series A Preferred Stock and 1.3% of the Common Stock.
NationsBank, N.A., an agent and lender under the Company's Senior Credit
Facility, is an affiliate of NationsBanc Montgomery Securities LLC, one of the
initial purchasers of the Notes. The Company used a portion of the net proceeds
from the sale of the Notes to repay all of the outstanding indebtedness under a
$400,000 subordinated note due to BancBoston Ventures, Inc. and under the senior
credit facility and certain term loans due to NationsBank, N.A.

LEGAL SERVICES

    Stephen J. Carlotti, a partner of Hinckley, Allen & Snyder, is a director
and the secretary of the Company and, as trustee, is the holder of 5.9% of the
Common Stock. Hinckley, Allen & Snyder provides legal services to the Company.


                                       42
<PAGE>   43

================================================================================
                                     PART IV
================================================================================

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K

(a)      (1)      FINANCIAL STATEMENTS
         
         Financial Statements are listed in the index on Page F-1 of this Annual
         Report.

         (2)      FINANCIAL STATEMENT SCHEDULE

         Schedule II - Valuation and Qualifying Accounts

         (3)      EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT NO.  DESCRIPTION
-----------  -----------

  <S>        <C>
  3.1.1*     Restated Articles of Incorporation of AAi.FOSTERGRANT, Inc.
  3.1.2*     Amended and Restated By-laws of AAi.FOSTERGRANT, Inc.
  4.1*       Indenture dated as of July 21, 1998, by and among AAi.FOSTERGRANT,
             Inc. ("AAi"), its domestic subsidiaries named therein (the
             "Guarantors") and IBJ Schroder Bank & Trust Company, as Trustee,
             with respect to the Series A and Series B 10 3/4% Senior Notes due
             2006.
  4.2*       Purchase Agreement dated as of July 16, 1998, by and among AAi, the
             Guarantors and NationsBanc Montgomery Securities LLC, Prudential
             Securities Incorporated and BancBoston Securities Inc..
  9.1*       Letter Agreement of Weston Presidio Capital II, L.P. regarding
             voting of the Preferred Stock of AAi dated December 9, 1996.
  9.2*       Tag-Along Transfer Restriction and Voting Agreement among AAi,
             Weston Presidio Capital, II, L.P. and certain other investors and
             certain shareholders of the Company dated May 31, 1996, as amended
             on December 11, 1996.
</TABLE>


                                       43
<PAGE>   44

<TABLE>
<S>          <C>
 10.1*       Second Amended and Restated Financing and Security Agreement by and
             among AAi, certain of its Subsidiaries, NationsBank, N.A., as
             agent, and other lenders party thereto, dated July 21, 1998.
 10.2*       Agreement of Amendment, Termination & Modification between AAi,
             Bolle, Inc., Foster Grant Group, LP and Foster Grant Holdings, Inc.
             dated June 1998.
 10.3*       Stock Purchase Agreement by and among AAi, BEC Group, Inc., Foster
             Grant Group, L.P. and Foster Grant Holdings, Inc., dated May 31,
             1996, as amended by a side letter dated December 11, 1996.
 10.4.1*     Securities Purchase Agreement among AAi, Weston Presidio Capital
             II, L.P. and certain other investors, dated May 31, 1996.
 10.4.2      First Amendment to Securities Purchase Agreement among AAi, Weston
             Presidio Capital II, L.P. and certain other investors, dated
             October 1, 1998.
 10.5*       Registration Rights Agreement among AAi, Weston Presidio Capital
             II, L.P. and certain other investors and certain shareholders of
             the Company dated May 31, 1996, as amended on December 11, 1996.
 10.6*       Incentive Stock Plan of AAi.+
 10.7*       Employment Agreement between AAi and Gerald F. Cerce dated May 31,
             1996.+
 10.8*       Employment Agreement between AAi and Duane M. DeSisto dated May 31,
             1996.+
 10.9*       Employment Agreement between AAi and John H. Flynn, Jr. dated
             May 31, 1996.+
 10.10*      Employment Agreement between AAi and Robert V. Lallo dated May 31,
             1996.+
 10.11*      Employment Agreement between AAi and Felix A. Porcaro, Jr. dated
             May 31, 1996.+
 10.12*      Supplemental Executive Retirement Plan between AAi and Gerald F.
             Cerce dated September 29, 1994, as amended on December 29, 1995 and
             May 31, 1996.+
 10.13       Executive Bonus Plan.+
 10.14       Non-Qualified Excess 401(k) Plan.+
 21.1*       Subsidiaries of AAi.
 27.1        Financial Data Schedule for the fiscal year ended January 2, 1999.
</TABLE>

----------
*   Previously filed as an exhibit to the Company's Registration Statement No.
    333-61119 on Form S-4 and by this reference is incorporated herein.

+  Management or compensatory plan or arrangement.

(b)      REPORTS ON FORM 8-K

         None.


                                       44
<PAGE>   45

                              AAI.FOSTERGRANT, INC.

                                   SIGNATURES

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

                                          AAI.FOSTERGRANT, INC.

                                               /s/ Gerald F. Cerce
Date: April 2 , 1999                       By:_______________________________
                                               Gerald F. Cerce
                                               President and Chief Executive 
                                               Officer

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


/s/ Gerald F. Cerce                       /s/ Duane M. DeSisto
_____________________________             ___________________________
Gerald F. Cerce                           Duane M. DeSisto
President, Chief Executive Officer        Chief Financial Officer
and Chairman of the Board                 (Principal Financial Officer)
(Principal Executive Officer)             Date: April 2, 1999
Date: April 2, 1999

                                          
/s/ Stephen J. Korotsky                   /s/ Stephen J. Carlotti
_____________________________             _____________________________
Stephen J. Korotsky, Controller           Stephen J. Carlotti, Director
(Principal Accounting Officer)            Date: April 2, 1999
Date: April 2, 1999


/s/ Michael F. Cronin                     /s/ John H. Flynn, Jr.
_____________________________             ___________________________
Michael F. Cronin, Director               John H. Flynn, Jr., Director
Date: April 2, 1999                       Date: April 2, 1999


/s/ Martin E. Franklin                    /s/ George Graboys
_____________________________             ___________________________
Martin E. Franklin, Director              George Graboys, Director
Date: April 2, 1999                       Date: April 2, 1999


                                       45

<PAGE>   46


                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                              FINANCIAL STATEMENTS
                   AS OF DECEMBER 31, 1997 AND JANUARY 2, 1999
                         TOGETHER WITH AUDITORS' REPORT
<PAGE>   47

                                      INDEX

<TABLE>
<CAPTION>
                                                                         PAGE

<S>                                                                      <C>
AAI.FOSTERGRANT, INC.:

     REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS                                F-1

     CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1997
     AND JANUARY 2, 1999                                                     F-2

     CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE YEARS ENDED
     DECEMBER 31, 1996 AND 1997 AND JANUARY 2, 1999                          F-3

     CONSOLIDATED STATEMENTS OF REDEEMABLE PREFERRED STOCK,
     SHAREHOLDERS' EQUITY (DEFICIT) AND COMPREHENSIVE NET INCOME (LOSS)
     FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1997 AND JANUARY 2, 1999      F-4

     CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED
     DECEMBER 31, 1996 AND 1997 AND JANUARY 2, 1999                          F-5

     NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                              F-6

FANTASMA, LLC:

     REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS                               F-39

     BALANCE SHEETS AS OF DECEMBER 31, 1997 AND JANUARY 2, 1999             F-40

     STATEMENTS OF OPERATIONS FOR THE YEARS ENDED
     DECEMBER 31, 1996 AND 1997 AND JANUARY 2, 1999                         F-41

     STATEMENTS OF MEMBERS' EQUITY FOR THE YEARS ENDED
     DECEMBER 31, 1996 AND 1997 AND JANUARY 2, 1999                         F-42

     STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED
     DECEMBER 31, 1996 AND 1997 AND JANUARY 2, 1999                         F-43

     NOTES TO FINANCIAL STATEMENTS                                          F-44
</TABLE>


<PAGE>   48

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Shareholders of
AAi.FosterGrant, Inc. and Subsidiaries:

We have audited the accompanying consolidated balance sheets of AAi.FosterGrant,
Inc. (a Rhode Island corporation) and subsidiaries as of December 31, 1997 and
January 2, 1999, and the related consolidated statements of operations,
redeemable preferred stock, shareholders' equity (deficit) and comprehensive net
income (loss) and cash flows for each of the three years in the period ended
January 2, 1999. These consolidated financial statements are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
AAi.FosterGrant, Inc. and subsidiaries as of December 31, 1997 and January 2
1999, and the consolidated results of their operations and their cash flows for
each of the three years in the period ended January 2, 1999, in conformity with
generally accepted accounting principles.


                             /S/ ARTHUR ANDERSEN LLP

Boston, Massachusetts
February 19, 1999


                                       F-1
<PAGE>   49

                     AAI. FOSTERGRANT, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS
                 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

<TABLE>
<CAPTION>
                                     ASSETS

                                                                                      DECEMBER 31,       JANUARY 2,
                                                                                          1997              1999
<S>                                                                                  <C>              <C>            
CURRENT ASSETS:
   Cash and cash equivalents                                                         $         2,779  $         2,207
   Accounts receivable, less reserves of approximately $10,338 and $9,975                     18,323           29,317
   Inventories                                                                                32,795           37,162
   Prepaid expenses and other current assets                                                     734            1,918
   Deferred tax assets                                                                         9,707            3,743
                                                                                     ---------------  ---------------
         Total current assets                                                                 64,338           74,347
                                                                                     ---------------  ---------------

PROPERTY, PLANT AND EQUIPMENT, AT COST:
   Land                                                                                            -            1,233
   Building and improvements                                                                       -            5,211
   Display fixtures                                                                           11,009           18,755
   Furniture, fixtures and equipment                                                           7,427            8,209
   Leasehold improvements                                                                      2,819            2,824
   Equipment under capital leases                                                                361              918
                                                                                     ---------------  ---------------
                                                                                              21,616           37,150

LESS--ACCUMULATED DEPRECIATION AND AMORTIZATION                                               11,431           19,607
                                                                                      ---------------  ---------------
                                                                                              10,185           17,543
                                                                                     ---------------  ---------------
OTHER ASSETS:
   Advances to officers/shareholders                                                              53               69
   Deferred costs                                                                                  -            2,090
   Deferred tax assets                                                                             -            5,319
   Investments in affiliates                                                                   1,426            1,337
   Intangible assets, net of accumulated amortization of $1,306 and $2,725                    16,600           20,874
   Other assets, net of accumulated amortization of $0 and $219                                1,144            4,919
                                                                                     ---------------  ---------------
                                                                                              19,223           34,608
                                                                                     ---------------  ---------------
         Total assets                                                                $        93,746  $       126,498
                                                                                     ===============  ===============

                                        LIABILITIES AND SHAREHOLDERS' DEFICIT

CURRENT LIABILITIES:
   Borrowings under revolving note payable                                           $        27,598  $         2,576
   Current maturities of long-term obligations                                                 3,331              626
   Deferred compensation-Current portion                                                          30               30
   Accounts payable                                                                           14,117           14,899
   Accrued expenses                                                                           11,221           22,740
   Accrued income taxes                                                                        2,105            2,130
                                                                                     ---------------  ---------------
         Total current liabilities                                                            58,402           43,001
                                                                                     ---------------  ---------------

10 3/4% SERIES B SENIOR NOTES DUE 2006                                                             -           75,000
LONG-TERM OBLIGATIONS, LESS CURRENT MATURITIES                                                 8,544              780
DEFERRED COMPENSATION, LESS CURRENT PORTION                                                    1,109            1,448
DEFERRED TAX LIABILITIES                                                                         645                -
SUBORDINATED PROMISSORY NOTES PAYABLE TO SHAREHOLDERS                                          5,487                -
COMMITMENTS AND CONTINGENCIES (NOTES 6 AND 15)
REDEEMABLE PREFERRED STOCK OF A SUBSIDIARY                                                       835              909
PREFERRED STOCK, $.01 PAR VALUE:
     Authorized--200,000 shares
     Designated, issued and outstanding-43,700 shares of  Series A Redeemable
       Convertible Preferred Stock, stated at redemption value                                26,083           28,862
                                                                                     ---------------  ---------------

SHAREHOLDERS' DEFICIT:
   Common stock, $.01 par value
     Authorized--4,800,000 shares
     Issued and outstanding--608,000 shares                                                        6                6
   Additional paid-in capital                                                                    270              270
   Accumulated other comprehensive loss                                                          (78)            (289)
   Accumulated deficit                                                                        (7,557)         (23,489)
                                                                                     ---------------  ---------------
         Total shareholders' deficit                                                          (7,359)         (23,502)
                                                                                     ---------------  ---------------
         Total liabilities and shareholders' deficit                                 $        93,746  $       126,498
                                                                                     ===============  ===============
</TABLE>

              The accompanying notes are an integral part of these
                       consolidated financial statements.


                                       F-2
<PAGE>   50

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS
                 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

<TABLE>
<CAPTION>
                                                                   --------------------YEARS ENDED-------------------
                                                                             DECEMBER 31,                JANUARY 2,
                                                                         1996             1997              1999

<S>                                                                <C>               <C>              <C>            
NET SALES                                                          $        86,336   $       149,411  $       160,325

COST OF GOODS SOLD                                                          47,871            77,928           88,823
                                                                   ---------------   ---------------  ---------------

         Gross profit                                                       38,465            71,483           71,502

SELLING EXPENSES                                                            26,613            43,589           49,315

GENERAL AND ADMINISTRATIVE EXPENSES                                         10,911            21,734           26,220

RESTRUCTURING CHARGE                                                             -                 -            2,600
                                                                   ---------------   ---------------  ---------------

         Income (loss) from operations                                         941             6,160           (6,633)

EQUITY IN LOSSES OF INVESTMENTS IN AFFILIATES                                 (345)              (63)             (76)

MINORITY INTEREST IN INCOME OF CONSOLIDATED SUBSIDIARY                           -               (83)            (187)

INTEREST EXPENSE                                                            (1,469)           (4,214)          (7,010)

OTHER INCOME, NET                                                               14               177              753
                                                                   ---------------   ---------------  ---------------

         (Loss) income before income tax benefit (expense) and
         dividends and accretion on preferred stock                           (859)            1,977          (13,153)

INCOME TAX BENEFIT (EXPENSE)                                                   948            (1,162)               -
                                                                   ---------------   ---------------  ---------------

         Net income (loss) before dividends and accretion on
         preferred stock                                                        89               815          (13,153)

DIVIDENDS AND ACCRETION ON PREFERRED STOCK                                   1,123             2,496            2,779
                                                                   ---------------   ---------------  ---------------

         Net loss applicable to common shareholders                $        (1,034)  $        (1,681) $       (15,932)
                                                                   ===============   ===============  ===============

PRO FORMA INCOME TAX ADJUSTMENT                                    $          (604)  $             -  $             -
                                                                   ===============   ===============  ===============

PRO FORMA NET LOSS APPLICABLE TO COMMON SHAREHOLDERS               $        (1,638)  $        (1,681) $       (15,932)
                                                                   ===============   ===============  ===============

BASIC AND DILUTED NET LOSS PER SHARE APPLICABLE TO COMMON
SHAREHOLDERS                                                       $         (1.75)  $         (2.76) $        (26.20)
                                                                   ===============   ===============  ===============

BASIC AND DILUTED PRO FORMA NET LOSS PER SHARE APPLICABLE TO
COMMON SHAREHOLDERS                                                $         (2.77)  $         (2.76) $        (26.20)
                                                                   ===============   ===============  ===============

BASIC AND DILUTED WEIGHTED AVERAGE SHARES OUTSTANDING                      591,000           608,000          608,000
                                                                   ===============   ===============  ===============
</TABLE>

              The accompanying notes are an integral part of these
                       consolidated financial statements.


                                      F-3
<PAGE>   51

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

             CONSOLIDATED STATEMENTS OF REDEEMABLE PREFERRED STOCK,
       SHAREHOLDERS' EQUITY (DEFICIT) AND COMPREHENSIVE NET INCOME (LOSS),
                        (IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
                                                                                                             ACCUMULATED    
                                                                                                                OTHER       
                                           SERIES A REDEEMABLE CONVERTIBLE                                 COMPREHENSIVE
                                                   PREFERRED STOCK                                         INCOME (LOSS)    
                                                                                                            (ALL FOREIGN 
                                                           REDEMPTION                           ADDITIONAL    CURRENCY   
                                                 SHARES       VALUE          COMMON STOCK         PAID-IN    TRANSLATION 
                                                                          SHARES    PAR VALUE     CAPITAL    ADJUSTMENT) 
<S>                                               <C>      <C>            <C>       <C>         <C>          <C>         
BALANCE, DECEMBER 31, 1995                             -   $       -      570,000   $       6   $     115    $       7   
   Issuance of Series A Preferred Stock, net                                                                             
     of  issuance costs of $536,000               43,700      22,464            -           -           -            -   
   Dividends and accretion on Series A                                                                                   
   Preferred Stock                                     -       1,123            -           -           -            -   
   Issuance of common stock                            -           -       38,000           -         100            -   
   Retirement of treasury stock                        -           -            -           -          (2)           -   
   Proceeds from previously issued common                                                                                
   stock                                               -           -            -           -          57            -   
   Foreign currency translation adjustment                                                                               
   (not  tax effected)                                 -           -            -           -           -            1   
   Distributions to shareholders                       -           -            -           -           -            -   
   Net income                                          -           -            -           -           -            -   
                                                                                                                         
   Comprehensive net income for the year                                                                                 
     ended December 31, 1996                                                                                             
                                               ---------   ---------    ---------   ---------   ---------    ---------   
BALANCE, DECEMBER 31, 1996                        43,700      23,587      608,000           6         270            8   
   Dividends and accretion on Series A                                                                                   
   Preferred Stock                                     -       2,496            -           -           -            -   
   Foreign currency translation adjustment                                                                               
   (not  tax effected)                                 -           -            -           -           -          (86)  
   Distributions to shareholders                       -           -            -           -           -            -   
   Net income                                          -           -            -           -           -            -   
                                                                                                                         
   Comprehensive net income for the year                                                                                 
     ended  December 31, 1997                                                                                            
                                               ---------   ---------    ---------   ---------   ---------    ---------   
BALANCE, DECEMBER 31, 1997                        43,700      26,083      608,000           6         270          (78)  
   Dividends and accretion on Series A                                                                                   
   Preferred Stock                                     -       2,779            -           -           -            -   
   Foreign currency translation adjustment                                                                               
   (not tax effected)                                  -           -            -           -           -         (211)  
   Net loss                                            -           -            -           -           -            -   

   Comprehensive net loss for the year ended                                                                             
   January 2,1999                                                                                                        
                                               ---------   ---------    ---------   ---------   ---------    ---------   
BALANCE, JANUARY 2, 1999                          43,700   $  28,862      608,000   $       6   $     270    $    (289)  
                                               =========   =========    =========   =========   =========    =========   
</TABLE>


<TABLE>                                     
<CAPTION>                                   
                                               RETAINED                              TOTAL                      
                                               EARNINGS                          SHAREHOLDERS   COMPREHENSIVE   
                                             (ACCUMULATED      TREASURY STOCK       EQUITY       NET INCOME     
                                               DEFICIT)      SHARES       COST     (DEFICIT)       (LOSS)       
<S>                                          <C>             <C>       <C>         <C>            <C>           
BALANCE, DECEMBER 31, 1995                   $  11,520        47,538   $    (125)  $  11,523      $       -     
   Issuance of Series A Preferred Stock, net                                                                    
     of  issuance costs of $536,000                  -             -           -           -              -     
   Dividends and accretion on Series A                                                                          
   Preferred Stock                              (1,123)            -                  (1,123)             -     
   Issuance of common stock                          -             -           -         100              -     
   Retirement of treasury stock                   (123)      (47,538)        125           -              -     
   Proceeds from previously issued common                                                                       
   stock                                             -             -           -          57              -     
   Foreign currency translation adjustment                                                                      
   (not  tax effected)                               -             -           -           1              1     
   Distributions to shareholders               (15,928)            -           -     (15,928)             -     
   Net income                                       89             -           -          89             89     
                                                                                                  ---------     
   Comprehensive net income for the year                                                                        
     ended December 31, 1996                                                                      $      90     
                                             ---------     ---------   ---------   ---------      =========     
BALANCE, DECEMBER 31, 1996                      (5,565)            -           -      (5,281)     $       -     
   Dividends and accretion on Series A                                                                          
   Preferred Stock                              (2,496)            -           -      (2,496)             -     
   Foreign currency translation adjustment                                                                      
   (not  tax effected)                               -             -           -         (86)           (86)    
   Distributions to shareholders                  (311)            -           -        (311)             -     
   Net income                                      815             -           -         815            815     
                                                                                                  ---------     
   Comprehensive net income for the year                                                                        
     ended  December 31, 1997                                                                     $     729     
                                             ---------     ---------   ---------   ---------      =========     
BALANCE, DECEMBER 31, 1997                      (7,557)            -           -      (7,359)     $       -     
   Dividends and accretion on Series A                                                                          
   Preferred Stock                              (2,779)            -           -      (2,779)             -     
   Foreign currency translation adjustment                                                                      
   (not tax effected)                                -             -           -        (211)          (211)    
   Net loss                                    (13,153)            -           -     (13,153)       (13,153)    
                                                                                                  ---------     
   Comprehensive net loss for the year ended                                                                    
   January 2,1999                                                                                 $ (13,364)    
                                             ---------     ---------   ---------   ---------      =========     
                                                                                                                
BALANCE, JANUARY 2, 1999                     $ (23,489)            -   $       -   $ (23,502)                   
                                             =========     =========   =========   =========                    
</TABLE>                                    

              The accompanying notes are an integral part of these
                       consolidated financial statements.


                                      F-4
<PAGE>   52

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                   ------------------------YEAR ENDED----------------
                                                                             DECEMBER 31,                JANUARY 2,
                                                                         1996             1997              1999
<S>                                                                <C>               <C>              <C>             
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net income (loss)                                               $            89   $           815  $       (13,153)
   Adjustments to reconcile net income (loss) to net cash (used
     in) provided by  operating activities, net of acquisitions--
   Depreciation and amortization                                             1,868             8,248           12,792
   Equity in losses of investments in affiliates                               345                63               76
   Minority interest in income of consolidated subsidiary                        -                83              187
   Loss on barter transaction                                                    -                 -              187
   Cumulative foreign currency translation adjustment                            1               (86)            (211)
   Amortization of interest costs related to issuance of 10 3/4%
     senior notes due 2006                                                       -                 -              212
   Deferred interest on subordinated promissory notes payable                  205               282              140
   Deferred taxes                                                           (1,695)             (339)               -
   Changes in assets and liabilities, net of effect of
     acquisitions-
     Accounts receivable                                                    (5,087)           (7,410)          (7,706)
     Inventories                                                              (463)            3,797             (199)
     Prepaid expenses and other current assets                                (477)              912               73
     Deferred costs                                                              -                 -           (2,309)
     Accounts payable                                                        3,502            (5,323)          (3,844)
     Accrued expenses                                                       (1,097)             (923)          10,006
     Accrued income taxes                                                      590             1,481             (154)
                                                                   ---------------   ---------------  ---------------
         Net cash (used in) provided by operating activities                (2,219)            1,600           (3,903)
                                                                   ---------------   ---------------  ---------------
CASH FLOWS FROM INVESTING ACTIVITIES:
   Acquisitions, net of cash received                                       (9,842)           (1,834)          (9,464)
   Purchase of property, plant and equipment                                (1,572)           (7,583)         (16,882)
   Advances to officers/shareholders                                           (32)               (1)          (3,511)
   (Increase) decrease in investments in affiliates                           (761)              460               13
   (Increase) decrease in other assets                                        (266)              (95)              91
                                                                   ---------------   ---------------  ---------------
         Net cash used in investing activities                             (12,473)           (9,053)         (29,753)
                                                                   ---------------   ---------------  ---------------
CASH FLOWS FROM FINANCING ACTIVITIES:
   Net borrowings (repayments) under revolving note payable                  3,311             7,697          (25,022)
   Proceeds from term note payable                                               -                 -           13,222
   Payments on term note payable                                                 -                 -          (13,222)
   Proceeds from issuance of subordinated promissory notes
     payable to shareholders                                                 2,000                 -                -
   Payments on subordinated notes                                                -                 -           (2,132)
   Proceeds from 10 3/4% senior notes due 2006                                   -                 -           75,000
   Costs related to issuance of 10 3/4% senior notes due 2006                    -                 -           (3,713)
   Proceeds from issuance of long-term obligations                           3,445             8,943                -
   Payments on long-term obligations                                        (2,292)           (7,551)         (11,026)
   Payments on deferred compensation                                           (23)              (23)             (23)
   Distributions to shareholders                                           (12,928)             (311)               -
   Proceeds from issuance of preferred stock, net of issuance
   costs                                                                    22,464                 -                -
   Proceeds from issuance of common stock                                      100                 -                -
   Proceeds from previously issued common stock                                 57                 -                -
                                                                   ---------------   ---------------  ---------------
         Net cash provided by financing activities                          16,134             8,755           33,084
                                                                   ---------------   ---------------  ---------------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                         1,442             1,302             (572)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                                  35             1,477            2,779
                                                                   ---------------   ---------------  ---------------
CASH AND CASH EQUIVALENTS, END OF PERIOD                           $         1,477   $         2,779  $         2,207
                                                                   ===============   ===============  ===============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
   Cash paid during the year for-
     Interest                                                      $         1,042   $         4,074  $         3,936
                                                                   ===============   ===============  ===============
     Income taxes                                                  $            57   $            50  $           597
                                                                   ===============   ===============  ===============
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING ACTIVITIES:
   Conversion of leasehold improvements to building improvements   $             -   $             -  $         1,393
                                                                   ===============   ===============  ===============
   Acquisition of equipment under capital lease obligations        $             -   $           361  $           557
                                                                   ===============   ===============  ===============
   Offset of advances to officers/shareholders against
     subordinated promissory notes payable to
     officers/shareholders                                         $             -   $             -  $         3,495
                                                                   ===============   ===============  ===============
   Increase in cash surrender value of officers life insurance
     policy                                                        $           304   $           263  $           361
                                                                   ===============   ===============  ===============
   Exchange of inventory for barter credits                        $             -   $             -  $           947
                                                                   ===============   ===============  ===============
   Distribution of notes payable to shareholders                   $         3,000   $             -  $             -
                                                                   ===============   ===============  ===============
   Repayment of revolving note payable with term loan              $             -   $         5,972  $             -
                                                                   ===============   ===============  ===============

SUPPLEMENTAL DISCLOSURE OF CASH FLOWS RELATED TO ACQUISITIONS:
   During fiscal 1996, 1997 and 1998, the Company acquired
     Tempo, Foster Grant US, Superior, Foster Grant UK and
     Fantasma as described in Note 2.  These acquisitions are
     summarized as follows-
     Fair value of assets acquired, excluding cash                 $        48,635   $         5,950  $        15,672
     Payments in connection with the acquisitions, net of cash
     acquired                                                               (9,842)           (1,834)          (9,464)
                                                                   ---------------   ---------------  ---------------
     Liabilities assumed and notes issued                          $        38,793   $         4,116  $         6,208
                                                                   ===============   ===============  ===============
</TABLE>

              The accompanying notes are an integral part of these
                       consolidated financial statements.


                                      F-5
<PAGE>   53

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

(1)    OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

       AAi.FosterGrant, Inc. and Subsidiaries (the Company) is a value added
       distributor of accessories such as; optical products, costume jewelry,
       watches, clocks and other accessories to mass merchandisers, variety
       stores, chain drug stores and supermarkets in North America and the
       United Kingdom.

       In April 1998, the Company adopted a formal plan to close its Texas
       distribution center. The Company recorded a restructuring charge of $2.6
       million during the year ended January 2, 1999 in connection with this
       plant closing. The components of this charge, which is included in
       operating expenses in the accompanying fiscal 1998 statement of
       operations, are as follows (in thousands):

<TABLE>
<S>                                              <C>         
              Severance accrual                  $      1,084
              Write down of assets to be
                 disposed                               1,516
                                                 ------------
                                                 $      2,600
                                                 ============
</TABLE>

       The severance accrual represents severance payments due to 40 office and
       distribution employees. Through January 2, 1999, all of these 40
       employees were terminated and severance benefits of $431,000 were paid.
       The remaining severance accrual at January 2,1999 was $654,000, which
       will be paid during fiscal 1999.

       On July 21, 1998, the Company issued $75.0 million of 10 3/4% Senior
       Series A Notes (the Notes) through a Rule 144A offering (see Note 7). The
       net proceeds received by the Company from the issuance and sale of the
       Notes, approximately $71.0 million, was used to repay outstanding
       indebtedness under the credit facility with a bank (see Note 5) and the
       Subordinated Promissory Notes to shareholders (see Note 9), net of
       amounts due the Company from certain of these shareholders (see Note 3).

       The accompanying consolidated financial statements reflect the
       application of certain significant accounting policies, as discussed
       below and elsewhere in the notes to consolidated financial statements.
       The preparation of financial statements in conformity with generally
       accepted accounting principles requires management to make estimates and
       assumptions that affect the reported amounts of assets and liabilities
       and disclosure of contingent assets and liabilities at the date of the
       financial statements and the reported amounts of revenues and expenses
       during the reporting period. Actual results could differ from those
       estimates.

       (a)    Principles of Consolidation

              The accompanying consolidated financial statements include the
              results of operations of the Company and its majority-owned
              subsidiaries. All material intercompany balances and transactions
              have been eliminated in consolidation.


                                      F-6
<PAGE>   54

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

       (b)    Change in Fiscal Year-End

              During 1998, the Company elected to change its fiscal year-end
              from December 31, to the Saturday closest to December 31.

       (c)    Cash and Cash Equivalents

              The Company considers all highly liquid investments with original
              maturities of three months or less at the time of purchase to be
              cash equivalents.

       (d)    Inventories

              Inventories are stated at the lower of cost (first-in, first-out)
              or market and consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                 DECEMBER 31,        JANUARY 2,
                                                     1997               1999
<S>                                             <C>                <C>          
               Finished goods                   $      28,229      $      31,037
               Work-in-process and raw
                 materials                              4,566              6,125
                                                -------------      -------------
                                                $      32,795      $      37,162
                                                =============      =============
</TABLE>

              Finished goods inventory consists of material, labor and
              manufacturing overhead.

       (e)    Advertising Costs

              Advertising costs, which are included in selling expense, are
              expensed when the advertisement first takes place. Advertising
              expense was approximately $364,000, $873,000 and $1,061,000 for
              the years ended December 31, 1996 and 1997 and January 2, 1999,
              respectively. Prepaid advertising production costs were $132,000
              at January 2, 1999 and are included in prepaid expenses and other
              current assets in the accompanying consolidated balance sheets.
              The Company had no prepaid advertising production costs reported
              as assets at December 31, 1997.


                                      F-7
<PAGE>   55

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

       (f)    Depreciation and Amortization

              The Company provides for depreciation and amortization by charges
              to operations in amounts that allocate the cost of these assets on
              the straight-line basis over their estimated useful lives as
              follows:

<TABLE>
<CAPTION>
                                                            ESTIMATED USEFUL 
              ASSET CLASSIFICATION                                LIFE
              <S>                                            <C>

              Building and improvements                         20 years
              Display fixtures                                 1-3 years
              Furniture, fixtures and equipment                3-10 years
              Leasehold improvements                         Term of lease
              Equipment under capital leases                 Term of lease
</TABLE>

              The Company has adopted the provisions of Statement of Position
              No. 98-1, Accounting for the Costs of Computer Software Developed
              or Obtained for Internal Use. The adoption of this pronouncement
              did not have a material effect on the Company's financial position
              or financial results.

       (g)    Intangible and Other Long-Lived Assets

              Intangible assets consist of goodwill and trademarks, which are
              being amortized on the straight-line basis over estimated useful
              lives of 10 to 40 years. Intangible assets primarily relate to the
              Company's acquisitions of various businesses as discussed in Note
              2 to these consolidated financial statements. In determining the
              estimated lives of these intangible assets, the Company evaluates
              various factors including but not limited to: nature of business,
              existing distribution channels, brand recognition of acquired
              products, customer base and length of time in which an acquired
              business has been in existence. Amortization expense was
              approximately $0.2 million, $1.1 million and $1.4 million for the
              years ended December 31, 1996 and 1997 and January 2, 1999,
              respectively.

              In accordance with Statement of Financial Accounting Standards
              (SFAS) No. 121, Accounting for Impairment of Long-Lived Assets and
              For Long-Lived Assets To Be Disposed Of, the Company reviews its
              long-lived assets (which include intangible assets, deferred costs
              and property and equipment) for impairment as events and
              circumstances indicate the carrying amount of an asset may not be
              recoverable. The Company evaluates the realizability of its
              long-lived assets based on profitability and cash flow
              expectations for the related asset or subsidiary. Management
              believes that, as of each of the balance sheet dates presented,
              none of the Company's long-lived assets were impaired.


                                      F-8
<PAGE>   56

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

       (h)    Revenue Recognition

              The Company recognizes revenue from product sales, net of
              estimated agreed-upon future allowances and anticipated returns
              and discounts, taking into account historical experience, upon
              shipment to the customer.

       (i)    Customer Acquisition Costs

              The Company incurs direct and incremental costs in connection with
              the acquisition of certain new customers and new store locations
              from existing customers under multi-year agreements. The Company
              may also receive the previous vendor's merchandise from the
              customer in connection with most of these agreements. In these
              situations, the Company values this inventory at its fair market
              value, representing the lower of cost or net realizable value, and
              records that value as inventory. The Company sells this inventory
              through various liquidation channels. Except as provided below,
              the excess costs over the fair market value of the inventory
              received is charged to selling expenses when incurred. The Company
              expensed customer acquisition costs of approximately $2.7 million,
              $1.6 million, and $0.9 million for the years ended December 31,
              1996 and 1997 and January 2, 1999, respectively.

              The excess costs over the fair market value of the inventory
              received is capitalized as deferred costs and amortized over the
              agreement period if the Company enters into a minimum purchase
              agreement with the customer and the estimated gross profits from
              future minimum sales during the term of the agreement are
              sufficient to recover the amount of the deferred costs. During
              fiscal 1998, the Company capitalized approximately $2.3 million of
              these costs in the accompanying consolidated balance sheet. No
              such costs were capitalized during fiscal 1996 and 1997.
              Amortization expense related to these costs was approximately
              $219,000 for the year ended January 2, 1999.

       (j)    Concentration of Credit Risk

              Financial instruments that potentially subject the Company to
              concentrations of credit risk are principally accounts receivable.
              A significant portion of its business activity is with domestic
              mass merchandisers whose ability to meet their financial
              obligations is dependent on economic conditions germane to the
              retail industry. During recent years, many major retailers have
              experienced significant financial difficulties and some have filed
              for bankruptcy protection; other retailers have begun to
              consolidate within the industry. The Company sells to certain
              customers in bankruptcy as well as those consolidating within the
              industry. To reduce credit risk, the Company routinely assesses
              the financial strength of its customers and purchases credit
              insurance as it deems appropriate.


                                      F-9
<PAGE>   57

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

       (k)    Disclosure of Fair Value of Financial Instruments

              The Company's financial instruments consist mainly of cash and
              cash equivalents, accounts receivable, accounts payable and debt.
              The carrying amounts of the Company's financial instruments,
              excluding the Notes, approximate fair value. The Company's Notes
              had a carrying value of approximately $75.0 million at January 2,
              1999. The Company has determined the fair value of the Notes based
              on the current trading prices to be approximately $66.0 million at
              January 2, 1999.

       (l)    Net Loss Per Share

              In March 1997, the Financial Accounting Standards Board (FASB)
              issued SFAS No. 128, Earnings per Share. This statement
              established standards for computing and presenting net income
              (loss) per share. This statement is effective for fiscal years
              ending after December 15, 1997.

              Basic net loss per share applicable to common shareholders was
              determined by dividing net loss attributable to common
              shareholders by the weighted average common shares outstanding
              during the period. Diluted net loss per share applicable to common
              shareholders is the same as basic net loss per share applicable to
              common shareholders as the effects of the Company's potential
              common stock equivalents are antidilutive. Accordingly, options to
              purchase a total of 8,000, 14,000 and 12,000 common shares for
              fiscal 1996, 1997 and 1998, respectively, have been excluded from
              the computation of diluted weighted average shares outstanding.
              The 437,000 shares of common stock issuable upon the conversion of
              the 43,700 shares of Series A Redeemable Convertible Preferred
              Stock (Series A Preferred Stock) have also been excluded for all
              periods presented as they are antidilutive.

              Pro forma net loss per share applicable to common shareholders,
              which reflects the effects of the pro forma tax provision (see
              Note 3), was determined by dividing pro forma net loss applicable
              to common shareholders by the basic and diluted weighted average
              shares outstanding.

       (m)    New Accounting Standards

              In June 1998, the FASB issued SFAS No. 133, Accounting for
              Derivative Instruments and Hedging Activities. This statement
              establishes accounting and reporting standards for derivative
              instruments, including certain derivative instruments embedded in
              other contracts, and for hedging activities. It requires that an
              entity recognize all derivatives as either assets or liabilities
              in the statement of financial position and measure those
              instruments at fair value. This statement is effective for all
              fiscal quarters of fiscal years beginning after June 15, 1999. The
              Company does not believe that the adoption of SFAS No. 133 will
              have a material impact on its financial statements.


                                      F-10
<PAGE>   58

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

              In April 1998, the American Institute of Certified Public
              Accountants issued Statement of Position 98-5, (SOP 98-5)
              Reporting on the Costs of Start-up Activities. SOP 98-5 provides
              guidance on the financial reporting of start-up activities and
              organization costs to be expensed as incurred. The Company does
              not believe that the adoption of SOP 98-5 will have a material
              impact on its financial statements.

       (n)    Reclassifications

              Certain balances from prior years consolidated financial
              statements have been reclassified to conform with the current
              year's presentation.

(2)     ACQUISITIONS

       In June 1998, the Company acquired an 80% interest in Fantasma, LLC
       (Fantasma) for approximately $4.1 million in cash. The remaining 20%
       interest in Fantasma is held by a previous member of Fantasma. This
       member and an employee of Fantasma have options to acquire up to an
       additional 13% interest if certain earnings targets for Fantasma are met
       in fiscal 1998, 1999 and 2000.

       The acquisition was accounted for using the purchase method; accordingly,
       the results of operations of Fantasma from the date of acquisition are
       included in the Company's consolidated statements of operations. The
       purchase price was allocated based on the estimated fair market value of
       assets and liabilities at the date of acquisition. In connection with the
       purchase price allocation, the Company recorded approximately $4.6
       million of goodwill, which is being amortized ratably over 10 years.

       On March 5, 1998, the Company acquired certain assets and liabilities of
       Eyecare Products UK Ltd. (Foster Grant UK), including the Foster Grant
       trademark in territories not previously owned, for approximately $5.5
       million in cash. Foster Grant UK is a marketer and distributor of
       sunglasses and reading glasses in Europe. The purchase price may be
       increased by approximately $0.7 million in fiscal 1998 and 1999 based on
       Foster Grant UK performance. Based on fiscal 1998 activity, there was no
       increase in the purchase price.

       The acquisition has been accounted for using the purchase method of
       accounting; accordingly, the results of operations of Foster Grant UK
       from the date of the acquisition are included in the accompanying
       consolidated statements of operations. The purchase price was allocated
       based on estimated fair values of assets and liabilities at the date of
       acquisition. In connection with the purchase price allocation, the
       Company recorded goodwill of approximately $1.1 million, which is being
       amortized on the straight-line basis over 20 years.

       In July 1997, the Company acquired the assets of Superior Jewelry Company
       (Superior), a distributor of costume jewelry to retail drug stores and
       discount mass merchandisers in the United States. The Company paid
       approximately $1.8 million in cash and assumed certain liabilities in the
       amount of approximately $4.0 million. In addition, the purchase price had
       a contingent element based on Superior's earnings during fiscal 1997 and
       1998. Based on fiscal 1997 activity, the purchase price increased $0.9
       million. This amount was accrued for as of December 31, 1997 and recorded
       as additional goodwill. There was no increase in the purchase price based
       on fiscal 1998 activity.


                                      F-11
<PAGE>   59

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

       The acquisition was accounted for using the purchase method of
       accounting; accordingly, the results of operations of Superior from the
       date of the acquisition are included in the accompanying consolidated
       statements of operations. The purchase price was allocated based on
       estimated fair values of assets and liabilities at the date of
       acquisition. In connection with the purchase price allocation, the
       Company recorded goodwill of approximately $3.5 million, adjusted to
       include the additional purchase price for fiscal 1997 activity, which is
       being amortized on the straight-line basis over 10 years.

       In December 1996, the Company's subsidiary, Foster Grant Holdings, Inc.
       (FG Holdings), acquired Foster Grant Group, L.P. (Foster Grant US), a
       subsidiary of BEC Group, Inc. (BEC), and related entities. Foster Grant
       US is a marketer and distributor of sunglasses, reading glasses and
       eyewear accessories located in Dallas, Texas. The Company paid $10.0
       million in cash and assumed certain liabilities in the amount of
       approximately $34.0 million. In addition, FG Holdings issued 100 shares
       of Series A redeemable nonvoting preferred stock (FG Preferred Stock)
       initially valued at approximately $0.8 million. As discussed in Note 4,
       the redemption value of this preferred stock is subject to upward
       adjustment based on annual sales of the FG Holdings operations, as
       defined, through the years ending January 1, 2000 or upon the occurrence
       of certain specified capital transactions based upon the transaction
       value. The maximum redemption amount, as amended, is $4.0 million. Any
       increase in the redemption amount may be recorded as goodwill when paid.
       The $10.0 million cash investment was financed by $5.0 million of
       borrowings through the Company's credit facility and a $5.0 million
       equity investment in the Company by an investment group led by Marlin
       Capital, L.P., a related party to BEC (see Note 10).

       The acquisition was accounted for using the purchase method of
       accounting; accordingly, the results of operations of Foster Grant US
       from the date of the acquisition are included in the accompanying
       consolidated statements of operations. The original purchase price was
       allocated based on the preliminary estimated fair values of assets and
       liabilities at the date of acquisition. In connection with the purchase
       price allocation, the Company recorded intangible assets of approximately
       $11.0 million, which are being amortized on the straight-line basis over
       40 years. During fiscal 1997, the preliminary purchase price allocation
       was finalized. This resulted in (i) a reduction of certain asset carrying
       amounts of approximately $4.9 million, (ii) an increase in certain
       liabilities of approximately $2.2 million and (iii) a decrease in the
       valuation reserve related to the deferred tax assets of approximately
       $7.0 million resulting in an immaterial increase in goodwill.

       In June 1996, the Company acquired certain assets of the Tempo Division
       (Tempo) of Allison Reed Group, Inc. The Company paid $1.0 million in
       cash, assumed certain liabilities in the amount of $0.6 million and
       issued a $2.0 million non-interest-bearing term note payable to Allison
       Reed Group, Inc (see Note 6). The payments on this note were subject to
       potential future downward adjustments based on fiscal 1997 or 1998 sales
       of Tempo; no such adjustment was required.

       The acquisition was accounted for using the purchase method of
       accounting; accordingly, the results of operations of Tempo from the date
       of the acquisition are included in the accompanying consolidated
       statements of operations. The purchase price was allocated entirely to
       intangible assets and is being amortized on the straight-line basis over
       10 years.

       The following unaudited pro forma summary information presents the
       combined results of operations of the Company, Foster Grant US, Tempo,
       Superior, Foster Grant UK and Fantasma as if the acquisitions had
       occurred at the beginning of 1996, 1997 and 1998. This unaudited pro
       forma financial information is


                                      F-12
<PAGE>   60

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

       presented for informational purposes only and may not be indicative of
       the results of operations as they would have been if the Company, Foster
       Grant US, Tempo, Superior, Foster Grant UK and Fantasma had been a single
       entity, nor is it necessarily indicative of the results of operations
       that may occur in the future. Anticipated efficiencies from the
       consolidation of the Company, Foster Grant US, Tempo, Superior, Foster
       Grant UK and Fantasma have been excluded from the amounts included in the
       unaudited pro forma summary presented below.

<TABLE>
<CAPTION>
                                                                     -----------------------YEARS ENDED------------------
                                                                                DECEMBER 31,               JANUARY 2,
                                                                           1996              1997             1999   
                                                                              (In thousands, except per share data)

<S>                                                                  <C>               <C>               <C>            
          Net sales                                                  $       195,231   $       181,992   $       166,457
          Net loss applicable to common shareholders                         (14,683)           (1,794)          (16,285)
          Basic and diluted net loss per share applicable to
             common shareholders                                             (24.84)            (2.95)           (26.78)
</TABLE>

(3)    INCOME TAXES

       Income taxes, including pro forma computations, are provided using the
       liability method of accounting in accordance with SFAS No. 109. A
       deferred tax asset or liability is recorded for all temporary differences
       between financial and tax reporting. Deferred tax expense (benefit)
       results from the net change during the year of the deferred tax asset and
       liability.

       The Company was an S corporation under Section 1362 of the Internal
       Revenue Code until May 31, 1996 when it issued Series A Preferred Stock.
       As an S Corporation, the taxable income or loss of the Company was passed
       through to the shareholders and reported on their individual federal and
       certain state tax returns. Dividend distributions of approximately $2.9
       million in 1996 were made to the shareholders primarily to fund payment
       of the taxes related to the Company's income. In addition, $10.3 million
       of cash and $3.0 million of subordinated notes payable (see Note 9) were
       distributed to the shareholders in 1996 to distribute the previously
       undistributed after-tax earnings. During 1997, a cash distribution of
       $0.3 million was made to the S corporation shareholders to distribute a
       portion of the remaining undistributed after-tax earnings.

       During fiscal 1998, the Company made advances to the S corporation
       shareholders to pay a portion of the income tax owed by them with respect
       to the Company's S corporation earnings resulting from an income tax
       audit. The Company agreed to make advances to these shareholders to pay
       their tax liabilities, the aggregate amount of which is approximately
       $3.4 million. These advances are evidenced by promissory notes and bear
       interest at an annual rate equal to the Applicable Federal Rate (5.21% at
       January 2, 1999). Principal and accrued interest are payable on demand.
       These advances and their related interest were offset against the
       subordinated notes payable to shareholders that were due to these
       shareholders of approximately $3.5 million. The remaining amounts have
       been included in long-term other assets in the accompanying consolidated
       balance sheets.

       Pro forma income taxes, assuming the Company was subject to C corporation
       income taxes, have been provided in the accompanying statements of
       operations for 1996 at an estimated statutory rate of 40%.


                                      F-13
<PAGE>   61

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

       Upon termination of the S corporation election, deferred income taxes
       were recorded for the tax effect of cumulative temporary differences
       between the financial reporting and tax bases of certain assets and
       liabilities, primarily deferred costs, accrued expenses and depreciation.
       These temporary differences resulted in a net deferred income tax asset
       of approximately $1.9 million. The Company recorded this tax asset as a
       deferred tax benefit in the 1996 tax provision.

       The components of the income tax benefit (expense) are as follows (in
       thousands):

<TABLE>
<CAPTION>
                                                                       FOR THE YEARS ENDED
                                                                 DECEMBER 31,                 JANUARY 2,
                                                             1996             1997               1999
       <S>                                             <C>               <C>               <C>            
       Current-                                                                           
          Federal                                      $             -   $          (700)  $             -
          State                                                    (51)             (124)              (33)
                                                       ---------------   ---------------   ---------------
                                                                   (51)             (824)              (33)
       Deferred-                                                                          
          Federal                                                 (766)             (286)           (3,054)
          State                                                   (130)              (52)             (625)
                                                       ---------------   ---------------   ---------------
                                                                  (896)             (338)           (3,679)
                                                       ---------------   ---------------   ---------------
       Increase in valuation allowance                               -                 -             3,712
                                                       ---------------   ---------------   ---------------
       Effect of change in tax status                            1,895                 -                 -
                                                       ---------------   ---------------   ---------------
                                                       $           948   $        (1,162)  $             -
                                                       ===============   ===============   ===============
</TABLE>                                                       


                                      F-14
<PAGE>   62

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

       A reconciliation of the federal statutory rate to the Company's effective
       tax rate is as follows:

<TABLE>
<CAPTION>
                                                                           FOR THE YEARS ENDED
                                                                  DECEMBER 31,               JANUARY 2,
                                                             1996              1997             1999
       <S>                                                     <C>               <C>              <C>    
       Income tax provision at federal statutory rate          (34.0)%           34.0%            (34.0)%
       Increase (decrease) in tax resulting from-
          State tax provision, net of federal
            benefit                                             (6.0)             6.0              (4.1)
          Nondeductible expenses                                    -            18.7               1.5
          Increase in valuation allowance and other,
            net                                                     -                -             36.6
          Effect of change in tax status                       (70.3)                -                -
                                                        ------------     -------------     -------------
       Actual effective tax rate (benefit) expense            (110.3)            58.7%                -%
                                                        ------------     -------------     -------------
       Pro forma adjustment                                     70.3
       Pro forma effective tax rate                            (40.0)%
                                                        ============
</TABLE>

       Deferred income taxes relate to the following temporary differences (in
       thousands):

<TABLE>
<CAPTION>
                                                                          DECEMBER 31,        JANUARY 2,
                                                                              1997                1999      
       <S>                                                               <C>                <C>            
       Nondeductible reserves                                            $         6,633    $         5,486
       Nondeductible accruals                                                      2,207              1,107
       Customer acquisition costs                                                    714             (1,226)
       Net operating loss carryforwards                                              703                421
       Other                                                                         402               (119)
                                                                         ---------------    ---------------
                Gross deferred tax assets                                         10,659              5,669
       Less--Valuation allowance                                                    (952)            (1,926)
                                                                         ---------------    ---------------
                Net current deferred tax assets                          $         9,707    $         3,743
                                                                         ===============    ===============
       Net operating loss carryforwards                                  $             -    $         7,455
       Tax basis of property and equipment                                          (740)               382
       Other                                                                          95                220
                                                                         ---------------    ---------------
                Gross long term deferred tax (liabilities) assets                   (645)             8,057
       Less--Valuation allowance                                                       -             (2,738)
                                                                          ---------------    ---------------

                Net long term deferred tax (liabilities) assets          $          (645)   $         5,319
                                                                         ===============    ===============
</TABLE>

       A valuation allowance is provided when it is more likely than not that
       some portion or all of the deferred tax assets will not be recognized.
       During 1998, based on the actual and anticipated results, the Company


                                      F-15
<PAGE>   63

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

       determined that a greater valuation reserve was required. Accordingly,
       the Company increased the valuation allowance by approximately $3.7
       million. The Company has approximately $23.4 million of net operating
       loss carryforwards which expire through 2018.

       The Company has entered into an indemnification agreement with the
       shareholders of the Company prior to its conversion to a C corporation
       relating to potential income tax liabilities resulting from adjustments
       to reported S corporation taxable income. The shareholders will continue
       to be liable for personal income taxes on the Company's income for all
       periods prior to the time the Company ceased to be an S corporation,
       while the Company will be liable for all income taxes subsequent to the
       time it ceased to be an S corporation. The indemnification agreement
       provides that the Company shall distribute to the individual shareholders
       40% of the amount of additional deductions permitted to be taken by the
       Company after its conversion to a C corporation for expenditures made
       prior to becoming a C corporation, which result from adjustments in the
       form of a final determination by tax authorities.

(4)    REDEEMABLE NONVOTING PREFERRED STOCK OF A SUBSIDIARY

       In connection with the purchase of Foster Grant US, the Company's wholly
       owned subsidiary, FG Holdings, issued 100 shares of FG Preferred Stock,
       which represents all of the issued and outstanding shares of FG Preferred
       Stock. The FG Preferred Stock, as amended in June 1998 (Note 2), must be
       redeemed on February 28, 2000 (the FG Redemption Date) by payment of an
       amount ranging from $1.0 million to $4.0 million (the FG Redemption
       Amount), determined based on the combined net sales of sunglasses,
       reading glasses and accessories by Foster Grant US and the Company for
       the year ending January 1, 2000, excluding an amount equal to the net
       sales by the Company for such items for the year ended December 31, 1996.
       Any increase in the redemption amount will be recorded as goodwill.

       The FG Preferred Stock also provides for early redemption of the FG
       Preferred Stock if the Company completes (i) an initial public offering
       where the pre-money valuation of the Company equals or exceeds $75.0
       million, (ii) a merger or similar transaction where the transaction value
       equals or exceeds $75.0 million, or (iii) a private placement of equity
       securities representing more than 50% of the outstanding capital stock
       for consideration of not less than $37.5 million (each a Redemption
       Event) prior to the FG Redemption Date. Upon completion of a Redemption
       Event, in lieu of the FG Redemption Amount, holders of FG Preferred Stock
       will receive a payment ranging from $3.5 million to $4.0 million (the
       Redemption Event Amount), to be determined with reference to, as the case
       may be, either the pre-money valuation of the Company immediately prior
       to the initial public offering or the proceeds of the merger or similar
       transaction or private equity placement. If a Redemption Event occurs
       after the FG Redemption Date, in addition to the FG Redemption Amount,
       holders of FG Preferred Stock will receive a supplemental payment equal
       to the difference, if any, between the FG Redemption Amount paid to such
       holders on the FG Redemption Date and Redemption Event Amount that would
       have been received had the Redemption Event occurred on or prior to the
       FG Redemption Date.

       The value of FG Preferred Stock has been recorded as part of the initial
       purchase of Foster Grant US and was based on the present value of
       management's best estimate of the expected payment of $1.0 million upon
       redemption. The accretion of the original value to the $1.0 million
       estimated redemption value is being recorded as a charge to minority
       interest in income of subsidiaries in the accompanying consolidated
       statements of operations. Accretion of this discount for the years ended
       December 31, 1997 and January 2,1999 was approximately $75,000 and
       $74,000, respectively.


                                      F-16
<PAGE>   64

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

(5)    CREDIT FACILITIES WITH A BANK

       In July 1998, the Company amended its credit facility with a bank (the
       Bank Agreement). The amended facility provides for a $60.0 million
       revolving credit facility, including a $3.0 million letter of credit
       facility. Use of the proceeds from the facility are limited to
       refinancing existing term debt, support letters of credit, fund working
       capital and finance permitted acquisitions and tax distributions, as
       defined.

       Borrowings under the revolving credit arrangement are limited to the
       lesser of $60.0 million or the borrowing base, which is defined as a
       percentage of eligible accounts receivable and the lesser of (i)
       inventories or (ii) $30.0 million less the interest rate protection
       reserve and the foreign exchange exposure, reduced by outstanding letters
       of credit. Revolving credit borrowings bear interest at the bank's prime
       rate (7.75% at January 2, 1999) plus .5% or LIBOR (5.07% at January 2,
       1999) plus 2.25%. The Company has the option of electing the rate;
       however, the use of the LIBOR is limited. The revolving credit facility
       expires in July 2003. As of January 2, 1999, the Company had
       approximately $47.3 million available under this revolving credit
       facility.

       If the Bank Agreement is terminated by the Company earlier than the
       expiration date, the Company will be required to pay a termination fee of
       $0.5 million if terminated within the first year, $0.3 million if
       terminated within the second year and $0.1 million thereafter. The
       termination fee will be waived if the debt is refinanced with the bank or
       if repayment is from proceeds of the Company's initial public offering.

       The credit facility is subject to certain restrictive covenants,
       including a fixed charge coverage ratio, leverage ratio and minimum
       EBITDA. As of January 2, 1999, the Company was not in compliance with the
       above financial covenants. The Company received a waiver for such
       noncompliance from the Bank and is currently negotiating an amendment to
       the Bank Agreement which will modify the financial covenants going
       forward. If the Company does not successfully negotiate the amendment,
       the Company expects that it will not be in compliance with these
       financial covenants for fiscal 1999. The Company has received a letter
       from the Bank stating that it intends to modify the covenants so they are
       amounts which the Company believes it can attain. Amounts due under this
       credit facility are secured by the accounts receivable and inventory of
       the Company and its domestic subsidiaries.

       In October 1998, Foster Grant UK entered into a credit facility with a
       different bank. The facility provides for a (pound)1.5 million
       (approximately $2.5 million at January 2, 1999) overdraft line to finance
       working capital. Repayments under this facility are fluctuating with
       interest at the bank's base rate (6.25% at January 2, 1999) plus 1.25% if
       below the facility limit of (pound)1.5 million and 2.25% if in excess of
       the agreed limit. The facility expires in September 1999. The Company had
       no borrowings outstanding under this facility at January 2, 1999 and was
       in compliance with all covenants.


                                      F-17
<PAGE>   65

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

(6)    LONG-TERM OBLIGATIONS

       Long-term obligations consist of the following at December 31, 1997 and
January 2, 1999 (in thousands):

<TABLE>
<CAPTION>
                                                          DECEMBER 31,     JANUARY 2,
                                                             1997             1999
<S>                                                    <C>               <C>           
Debt refinanced to a three-year term note, 
   interest at prime rate plus .5% or LIBOR plus 
   2.5% (paid in full in July 1998)                    $       10,000    $            -

Financing lease obligation, payable in monthly 
   installments of principal and interest of 
   $6,500 through September 2000, interest at 8.75% 
   per annum, secured by certain office equipment                 190               126

Capital lease obligation, payable in monthly 
   installments of principal and interest of 
   $10,903 through November 2000, interest at 
   9.0% per annum                                                 335               230

Promissory notes, payable in monthly 
   installments of principal and interest through
   February 2000, interest at 7.07% to 9.9% per 
   annum, secured by certain factory equipment                    159                55

Capital lease obligation, payable in monthly 
   installments of principal and interest through 
   November 2001, interest at 8.0% per annum                        -               538

Financing lease obligations, payable in monthly 
   installments of principal and interest through 
   January 2001, interest at 8.76% to 8.82% per 
   annum, secured   by certain factory and office
   equipment                                                      604               433

Term loan payable in connection with Tempo
   acquisition                                                    331                 -
                                                    
Other                                                             256                24
                                                       --------------    --------------
                                                               11,875             1,406
Less--Current maturities                                        3,331               626
                                                       --------------    --------------
                                                       $        8,544    $          780
                                                       ==============    ==============
</TABLE>


                                      F-18
<PAGE>   66

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

       In connection with the acquisition of Tempo (see Note 2), the Company
       entered into a note payable agreement with Allison Reed Group, Inc.
       whereby the Company is obligated to pay $55,555 a month for 36 months.
       The present value of this note, $1.8 million, was recorded as part of the
       initial purchase price allocation. Payments under this note were subject
       to potential downward adjustments based on sales of the Tempo division,
       as defined. This note was settled in full during 1998.

       Future maturities of the Company's long-term obligations as of January 2,
       1999 are as follows (in thousands):

<TABLE>
<CAPTION>
                  YEAR                               AMOUNT
                  <S>                            <C>           
                  1999                           $          626
                  2000                                      443
                  2001                                      337
                                                 --------------
                                                 $        1,406
                                                 ==============
</TABLE>

(7)    10 3/4% SENIOR NOTES OFFERING DUE 2006

       On July 21, 1998, the Company sold $75.0 million of 10 3/4% Senior Series
       A Notes due 2006 (the Notes) through a Rule 144A offering. The net
       proceeds of approximately $71.0 million received by the Company from the
       issuance and sale of the Notes were used to repay outstanding
       indebtedness under the credit facility with a bank and the Subordinated
       Promissory Notes to shareholders, net of amounts due the Company from
       certain of these shareholders. The Company incurred issuance costs of
       approximately $3.7 million in relation to the Notes. These costs are
       being amortized over the life of the Notes and are included in other
       assets in the accompanying consolidated balance sheets. In December 1998
       the Notes were exchanged for 10 3/4% Series B Notes due 2006 registered
       with the SEC. Interest on the Notes is payable semiannually on January 15
       and July 15, commencing January 15, 1999.

       The Notes are general unsecured obligations of the Company, rank senior
       in right of payment to all future subordinated indebtedness of the
       Company and rank pari passu in right of payment to all existing and
       future unsubordinated indebtedness of the Company including the bank
       credit facility described in Note 5. The bank credit facility is secured
       by accounts receivable and inventory of the Company and its domestic
       subsidiaries. Accordingly, the Company's obligations under the bank
       credit facility will effectively rank senior in right of payment to the
       Notes to the extent of the assets subject to such security interest. The
       Notes are fully and unconditionally guaranteed, on a senior and joint and
       several basis, by each of the Company's current and future Domestic
       Subsidiaries (as defined) (the Guarantors). The Indenture under which the
       Notes were issued (the Indenture) imposes certain limitations on the
       ability of the Company, and its subsidiaries to, among other things,
       incur indebtedness, pay dividends, prepay subordinated indebtedness,
       repurchase capital stock, make investments, create liens, engage in
       transactions with shareholders and affiliates, sell assets and engage in
       mergers and consolidations.

       The Notes are redeemable at the option of the Company on or after July
       15, 2002. The Notes will be subject to redemption at the option of the
       Company, in whole or in part, at various redemption prices, declining
       from 105.375% of the principal amount to par on and after July 15, 2004.
       In addition, on or prior to July 15, 2001, the Company may use the net
       cash proceeds of one or more equity offerings to redeem up to 35% of the
       aggregate principal amount of the Notes originally issued at a redemption
       price of 110.750% of the principal amount thereof plus accrued interest
       to the date of redemption. Upon a change of control, each Note holder has
       the right to require the Company to repurchase such holder's Notes at a
       purchase price of 101% of the principal amount plus accrued interest.

(8)    DEFERRED COMPENSATION

                                      F-19
<PAGE>   67

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      The Company has deferred compensation agreements with several key
      employees. The agreements provide for deferred compensation based on
      increases in net book value, as defined, and for one executive, the cash
      surrender value of a life insurance policy owned by the Company. The
      amounts due under these agreements are payable in a lump sum or in annual
      installments upon certain defined events. The Company incurred
      approximately $200,000 in expense related to the insurance policy during
      the years ended December 31, 1996 and 1997 and January 2, 1999. At January
      2, 1999, the cash surrender value of the life insurance policy was
      approximately $1.1 million and is included in other assets in the
      accompanying consolidated balance sheet.

      The Company also has an obligation to four former employees under a
      nonqualified deferred compensation plan. Payments of principal and
      interest are to be made monthly through August 2007. The obligation at
      January 2, 1999 was $101,418, of which $29,660 is due prior to January 1,
      2000. These amounts are included as deferred compensation in the
      accompanying consolidated balance sheets.

(9)   SUBORDINATED PROMISSORY NOTES PAYABLE TO SHAREHOLDERS

      Coincident with the sale of Series A Preferred Stock (Note 10) and the
      concurrent change in the Company's tax status (Note 3), the Company issued
      $2.0 million of subordinated notes payable to the preferred shareholders
      and made a distribution of $3.0 million in subordinated notes payable to
      the original common shareholders. These notes bore interest at an annual
      rate of 7.04%. Approximately 50% of the interest was payable annually and
      the remaining balance was deferred and payable with the principal on June
      1, 2002 for the preferred shareholders and June 1, 2006 for the original
      common shareholders, subject to acceleration on the closing of an initial
      public offering. Upon the closing of the Notes offering, the Company paid
      the amounts due to the preferred shareholders and offset the amounts due
      to the shareholders with the related advances to these
      officers/shareholders (see Note 3).

(10)  PREFERRED STOCK

      The Company has 200,000 shares of preferred stock, $.01 par value,
      authorized and issuable in one or more series with such voting powers,
      designations, preferences and other special rights and such
      qualifications, limitations or restrictions, as may be stated in the
      resolution or resolutions adopted by the Company's Board of Directors
      providing for the issue of such series and as permitted by the Rhode
      Island Business Corporation Act. The Company has created one series of
      preferred stock designated Series A Redeemable Convertible Preferred Stock
      (Series A Preferred Stock). A total of 43,700 shares of Series A Preferred
      Stock are designated for issuance, all of which are issued and
      outstanding.

      In May 1996, the Company sold 34,200 shares of Series A Preferred Stock
      for gross proceeds of $18.0 million. In connection with the acquisition of
      Foster Grant US (see Note 2) in December 1996, the Company issued an
      additional 9,500 shares of the Series A Preferred Stock for gross proceeds
      of $5.0 million.

      The rights, preferences and privileges of Series A Preferred Stock, as
      amended in June 1998, are as follows:

      CONVERSION


                                      F-20
<PAGE>   68

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      Shares of the Series A Preferred Stock are convertible into common stock
      at a rate of 10 shares of common stock for each share of Series A
      Preferred Stock, adjustable for certain dilutive events. As amended by the
      Company's shareholders in June 1998, conversion is at the option of the
      shareholder, but is automatic upon the consummation of an initial public
      offering resulting in gross proceeds to the Company of at least $20.0
      million and at an offering price of at least 137.8% of the original
      conversion price if the offering is consummated on or before May 31, 1999
      and at least 175% of the original conversion price if the offering is
      consummated after May 31, 1999.

      REDEMPTION

      The holders of the Series A Preferred Stock have the right to require
      redemption for cash of any unconverted shares, beginning June 30, 2002.
      The Company will redeem the Series A Preferred Stock equal to 5% of the
      total number of shares issued and outstanding as of March 31, 2002 on the
      last day of each March, June, September and December as follows:

<TABLE>
<CAPTION>
                   YEAR ENDING
                   DECEMBER 31,                           PERCENTAGE
<S>                                                           <C>
                        2002                                  15%
                        2003                                  35
                        2004                                  55
                        2005                                  75
                        2006                                  95
                        2007                                 100
</TABLE>

      The Series A Preferred Stock will be redeemed at an amount equal to the
      original stock price, $526.32 per share, plus accrued and unpaid dividends
      yielding a 10% compounded annual rate of return (the Redemption Amount).
      Accordingly, the Series A Preferred Stock has been recorded at its
      redemption value in the accompanying consolidated balance sheets.

      The holders of the Series A Preferred Stock may require the Company to
      redeem all or any portion of the Series A Preferred Stock upon certain
      events such as the sale, merger or dissolution of the Company. In
      addition, the Company may voluntarily redeem the Series A Preferred Stock
      at the Redemption Amount as defined above. If the Company voluntarily
      redeems the Series A Preferred Stock, it must issue the holders of Series
      A Preferred Stock a warrant to purchase common stock equal to the number
      of shares the shareholder would have received upon conversion, at a strike
      price equal to the redemption price at the time of redemption.

      In connection with the proposed issuance of the Notes the preferred
      shareholders agreed, in June 1998, to suspend their redemption rights
      until 91 days after the date that any Restrictive Indebtedness, as
      defined, is no longer outstanding. Restrictive Indebtedness is defined as
      indebtedness the terms of which restrict the Company's ability to redeem,
      in whole or part, the Series A Preferred Stock. Restrictive Indebtedness
      can not exceed $150.0 million or such greater amount as may be approved by
      the directors designated by the preferred shareholders.


                                      F-21
<PAGE>   69

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      LIQUIDATION PREFERENCES

      The holders of Series A Preferred Stock have preference in the event of a
      liquidation, dissolution or winding up of the corporation equal to the
      Redemption Amount. If the assets of the Company are insufficient to pay
      the full preferential amounts to the holders of Series A Preferred Stock,
      the assets shall be distributed ratably among such shareholders in
      proportion to their aggregate liquidation preference amounts.

      VOTING RIGHTS AND DIVIDENDS

      The holders of the Series A Preferred Stock shall be entitled to vote on
      all matters based on the number of votes equal to the number of shares
      into which the shares of Series A Preferred Stock are convertible after
      December 1, 1996. The holders of a majority of the Series A Preferred
      Stock shares are entitled to elect two directors. In certain events,
      defined as Remedy Events, the number of directors of the Company
      automatically increases to the minimum number sufficient to allow the
      holders of Series A Preferred Stock to elect a majority of the directors.
      In June 1998, the preferred shareholders agreed to change the definition
      of Remedy Events to reduce the minimum amount of consolidated
      shareholders' equity which the Company is required to maintain dollar for
      dollar by any payments of certain subordinated notes payable to
      shareholders (see Note 9).

      Dividends will not be paid on the common stock unless the Series A
      Preferred Stock receives the same dividends that such shares would have
      received had they been converted into common stock immediately prior to
      the record date for such dividend.

(11)  1996 INCENTIVE STOCK PLAN

      In May 1996, the Company adopted the 1996 Incentive Stock Plan (the Plan)
      under which it may grant incentive stock options (ISOs), nonqualified
      stock options (NSOs), restricted stock and other stock rights to purchase
      up to 50,000 shares of common stock. In May 1998, the Company increased
      the number of shares of common stock authorized for issuance under the
      Plan to 150,000. Under the Plan, ISOs may not be granted at less than fair
      market value on the date of grant and vest in a method determined by the


                                      F-22
<PAGE>   70

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      Board of Directors, over a term not to exceed 10 years. All options have
      been granted with exercise prices equal to the fair market value of the
      Company's common shares as determined by the Board of Directors. Stock
      option activity for each of the three years in the period ended January 2,
      1999, is as follows:

<TABLE>
<CAPTION>
                                                                                                                    WEIGHTED
                                                                                      WEIGHTED                      AVERAGE
                                                                                       AVERAGE                     REMAINING
                                                     NUMBER OF SHARES              EXERCISE PRICE               CONTRACTUAL LIFE
<S>                                                  <C>                          <C>                           <C>
Outstanding, December 31, 1995                                    -                $            -                            -
   Granted                                                    8,000                            50                           10
                                                     --------------                --------------               --------------

Outstanding, December 31, 1996                                8,000                            50                           10
   Granted                                                    6,000                            50                           10
                                                     --------------                --------------               --------------

Outstanding, December 31, 1997                               14,000                            50                          9.5
   Canceled                                                  (2,000)                           50                            -
                                                     --------------                --------------               --------------

Outstanding, January 2, 1999                                 12,000                $           50                          8.5
                                                     ==============                ==============               ==============

Exercisable, December 31, 1996                                8,000                $           50                           10
                                                     ==============                ==============               ==============

Exercisable, December 31, 1997                               14,000                $           50                          9.5
                                                     ==============                ==============               ==============

Exercisable, January 2, 1999                                 12,000                $           50                          8.5
                                                     ==============                ==============               ==============
</TABLE>

      In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-Based
      Compensation. SFAS No. 123 requires the measurement of the fair value of
      stock options granted to employees be included in the statement of
      operations or disclosed in the notes to financial statements. The Company
      has determined that it will continue to account for stock-based
      compensation for employees under Accounting Principles Board Opinion No.
      25, Accounting for Stock Issued to Employees, and elect the
      disclosure-only alternative under SFAS No. 123.

      In connection with the acquisition of Fantasma the Company issued options
      to two employees of Fantasma. The options provide that the employees may
      purchase up to 13% of Fantasma at the fair market value based upon the
      purchase price. Certain of these options contain performance criteria and,
      therefore, will be accounted for as variable options. Based on fiscal 1998
      activity, options to purchase 3% of Fantasma had expired resulting in
      options to purchase 10% of Fantasma outstanding at January 2, 1999.


                                      F-23
<PAGE>   71

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      Had compensation cost for the Company's and Fantasma's stock plans been
      determined based on the fair value at the grant dates, as prescribed in
      SFAS No. 123, the Company's net loss and net loss per share applicable to
      common shareholders for the years ended December 31, 1996 and 1997 and
      January 2, 1999 would have been as follows:

<TABLE>
<CAPTION>
                                                                         DECEMBER 31,                                  JANUARY 2,
                                                              1996                         1997                           1999
<S>                                                     <C>                           <C>                           <C>
Net loss applicable to common
shareholders (in thousands)-
   As reported                                         $      (1,034)                 $      (1,681)                $     (15,932)
   Pro forma                                                  (1,201)                        (1,806)                      (15,999)

 Net loss per share applicable to common
shareholders-
   As reported                                         $      (1.75)                  $      (2.76)                 $     (26.20)
   Pro forma                                                  (2.03)                         (2.97)                       (26.31)
</TABLE>

      The fair value of each option grant is estimated on the date of grant
      using the Black-Scholes option pricing model with the following
      assumptions used for grants during the applicable period: dividend yield
      of 0.0% for all periods; volatility of 35.53% for all periods; risk-free
      interest rates of 6.07% for options granted during fiscal 1996, 5.77% for
      all options granted during fiscal 1997 and 6.00% for all options granted
      during fiscal 1998 and a weighted average expected option term of 5 years
      for all periods. The weighted average fair value per share of options
      granted during the years ended December 31, 1996 and 1997 was $20.87 and
      $20.60, respectively. The weighted average grant date fair value for an
      option to purchase a 1% membership interest in Fantasma granted during the
      year ended January 2, 1999 was approximately $14,400.

(12)  INVESTMENTS

      (a)   Hong Kong

            The Company has an ownership interest in four entities in Hong Kong.
            These entities provide various services to the Company and each
            other in connection with purchasing and distributing products. The
            Company accounts for these investments using the equity method. The
            net investment in these entities is recorded as investment in
            affiliates in the accompanying consolidated


                                      F-24
<PAGE>   72

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

            balance sheets. The following table summarizes certain financial
            information for these entities (in thousands):

<TABLE>
<CAPTION>
                                    ---------------FISCAL YEAR-------------
                                          1996         1997          1998
<S>                                 <C>           <C>          <C>
Ownership Interest-
  AAi Hong Kong Limited                    49%           49%          49%
  Milagros (Far East) Limited              49            49           49
  Honest Lion Limited                      49            50           50
  Milagros AAi Asia Limited                 -            49           49

Sales to AAi                        $  11,661     $  15,171    $  35,270
Equity in losses(1)                      (163)          (63)         (76)
Investment balance                      1,455         1,426        1,337
</TABLE>

      (1)   Amounts relate only to Hong Kong entities and do not include other
            investments accounted for under the equity method.

      The following table summarizes certain consolidated financial information
      of the four Hong Kong entities (in thousands):

<TABLE>
<CAPTION>
                                       -------------FISCAL YEAR-------------
                                          1996           1997         1998
<S>                                    <C>           <C>          <C>       
Current assets                         $    4,407    $    5,687   $    5,453
Noncurrent assets                           6,608         2,187        6,814
Current liabilities                         8,421         9,978        8,165
Noncurrent liabilities                      1,557         1,563        3,087
Net sales                                  24,454        37,037       22,193
Gross profit                                4,847         1,876        5,273
Loss from operations                         (406)         (129)        (156)
Net loss                                     (406)         (129)        (156)
</TABLE>

      (b)   Mexico

            In 1996, the Company acquired a 50% ownership in AAi Joske's S.A. de
            R.L. De CV (Joske's), an entity engaged in the purchasing and
            distribution of accessories in Mexico for $0.5 million of inventory.
            This investment was accounted for under the equity method. In
            January 1997, the Company acquired an additional 5% ownership
            interest in Joske's and accordingly has consolidated its financial
            results in the Company's consolidated financial statements
            subsequent to December 31, 1996.


                                      F-25
<PAGE>   73

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

(13)  EMPLOYEE BENEFIT PLANS

      (a)   Qualified 401(k) Plan

            The Company has a defined contribution profit sharing plan covering
            substantially all employees. Under the terms of the profit sharing
            plan, contributions are made at the discretion of the Company. No
            contributions were made for the years ended December 31, 1996 and
            1997 and January 2, 1999. The profit sharing plan also allows
            eligible participants to make contributions in accordance with
            Internal Revenue Code Section 401(k). The Company matches employee
            contributions equal to 25% of the first 6% of compensation that an
            employee defers. These matching contributions totaled approximately
            $87,000, $95,000 and $117,000 for the years ended December 31, 1996
            and 1997 and January 2, 1999, respectively.

      (b)   Non-Qualified Excess 401(k) Plan

            In May 1997, the Company established the Non-Qualified Excess 401(k)
            Plan (the Non-Qualified Plan) effective as of June 1, 1997. The
            purpose of the Non-Qualified Plan is to provide deferred
            compensation to a select group of management or highly compensated
            employees of the Company as designated by the Board of Directors.
            Under the Non-Qualified Plan, a participant may elect to defer up to
            15% of his or her compensation on an annual basis. This amount is
            credited to the employee's deferred compensation account (the
            Deferred Amount). Under the Non-Qualified Plan, the Company also
            credits the participant's deferred compensation account for the
            amount of the matching contribution the Company would have made
            under the qualified 401(k) plan with respect to the Deferred Amount.
            The matching contributions totaled approximately $10,000 and $13,000
            for the years ended December 31, 1997 and January 2, 1999,
            respectively. All amounts contributed by the employee and by the
            Company under the Non-Qualified Plan are immediately vested. A
            participant under the Non-Qualified Plan is entitled to receive a
            distribution of his or her account upon retirement, death,
            disability or termination of employment.

(14)  RELATED PARTY TRANSACTIONS

      The Company has operating lease agreements with Sunrise Properties, LLC
      and 299 Carpenter Street Associates, LLC, of which certain officers and
      shareholders of the Company are partners. The related rental expense
      charged to operations was approximately $554,000, $471,000 and $471,000 in
      the years ended December 31, 1996 and 1997 and January 2, 1999,
      respectively.

      The Company has guaranteed a mortgage note payable by Sunrise Properties,
      LLC aggregating $200,000. As of January 2, 1999, the outstanding balance
      of this note was approximately $114,000.

      During 1984, the Company sold 5% of its shares to an officer in exchange
      for a $100,000 non-interest-bearing promissory note. The proceeds from the
      note are credited to the common stock account as received. During 1996,
      the remaining balance under this promissory note was paid to the Company.


                                      F-26
<PAGE>   74

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      In conjunction with the purchase of Foster Grant US, the Company entered
      into a lease of the building from which FG Holdings operates with BEC, the
      former owners of Foster Grant US. A member of the Marlin Capital, L.P.
      (see Note 2) is the chief executive officer of BEC and a director of the
      Company. The lease was established in December 1996 and extends for one
      year with automatic renewal for successive one-year periods unless either
      party provides notice. Rent expense was approximately $494,000, and
      $165,000 in the year ended December 31, 1997 and January 2, 1999,
      respectively. The Company terminated this lease as of January 2, 1999.

      On May 31, 1996, the Company, and its shareholders, including the
      management shareholders (Management Shareholders), entered into a
      tag-along, transfer restriction and voting agreement (the Shareholders
      Agreement). The Shareholders Agreement requires that any Management
      Shareholder wishing to transfer or sell common stock of the Company to
      provide right of first refusal and tag-along rights, on a pro rata basis,
      as defined, to all other shareholders' party to the Shareholders Agreement
      upon receipt of a third party offer to purchase the applicable restricted
      shares.

      Upon the death of a Management Shareholder, the personal representative of
      such Management Shareholder shall sell to the Company such Management
      Shareholder's shares based on an appraisal value, as defined, provided
      that the Company's obligation to purchase shares is limited to the amount
      of any proceeds paid to the Company under insurance policies insuring the
      life of the Management Shareholder.

      The Shareholders Agreement shall terminate upon the earlier of a qualified
      public offering, as defined, or when no shares of Series A Preferred Stock
      and warrants are outstanding, except as a result of the conversion,
      exchange or exercise of the Series A Preferred Stock or warrants.

(15)  COMMITMENTS AND CONTINGENCIES

      (a)   Letters of Credit

            At January 2, 1999, the Company had irrevocable letters of credit
            outstanding for the purchase of inventory of approximately $95,000.


                                      F-27
<PAGE>   75

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      (b)   Operating Leases

            In addition to the operating leases described in Note 14, the
            Company also has operating leases for its other locations. Future
            minimum rental payments are as follows (in thousands):

<TABLE>
<S>                                                      <C>       
                 1999                                    $      605
                 2000                                           549
                 2001                                           542
                 2002                                            72
                 2003                                            74
                 Thereafter                                     102
                                                         ----------
                                                         $    1,944
                                                         ==========
</TABLE>

            The Company had an option to purchase its Smithfield, Rhode Island,
            facility for $2.3 million. This option became exercisable in April
            1993 and extended throughout the term of the lease. On February 10,
            1998, the Company exercised this option. During fiscal 1998, the
            Company expanded this facility resulting in costs of the facility
            and expansion totaling approximately $6.4 million.

      (c)   Royalties

            The Company has several agreements that require royalty payments
            based on a percentage of certain net product sales, subject to
            specified minimum payments. Minimum royalty obligations relating to
            these agreements as of January 2, 1999 totaled $2.2 million and $0.5
            million for 1999 and 2000, respectively. In addition, certain of
            these agreements require the Company pay additional fees based on a
            percentage of net product sales. These fees are not subject to
            minimum payment obligations. In the event the Company transfers its
            rights under certain of these agreements, a transfer fee would be
            payable. At January 2, 1999, the minimum aggregate transfer fee due
            would be no less than $2.6 million.

      (d)   Supply Agreement

            The Company has a supply agreement with a display manufacturer. The
            agreement requires that the Company purchase 70% of Foster Grant
            US's annual display purchases, as defined, from this supplier
            through December 2005. If the Company does not purchase 70% of
            Foster Grant US's displays from this manufacturer, it is required to
            make a payment equal to 30% of the annual shortfall. In addition,
            the Company and BEC are required to cumulatively purchase $32.3
            million of displays over the term of this agreement. To the extent
            that total purchases do not meet this dollar level, the Company is
            required to make a payment equal to 30% of $32.3 million, less the
            Company's purchases, BEC's purchases and any amounts paid as a
            result of the annual shortfall discussed above. As of January 2,
            1999, no amounts were due under this agreement as a result of a
            shortfall.


                                      F-28
<PAGE>   76

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      (e)   Litigation

            In the ordinary course of business, the Company is party to various
            types of litigation for which it has purchased insurance to mitigate
            certain of these risks. The Company believes it has meritorious
            defenses to all claims, and, in its opinion, all litigation
            currently pending or threatened will not have a material effect on
            the Company's financial position or results or operations.

            In November 1998, the Company reached a favorable settlement with a
            customer related to the customer not honoring its purchase
            commitments under a 1997 agreement. As a result of this settlement,
            the Company received $950,000 for lost revenues. This settlement is
            included in other income, net in the accompanying fiscal 1998
            consolidated statement of operations.

(16)  SIGNIFICANT CUSTOMERS AND SUPPLIERS

      During the years ended December 31, 1996 and 1997 and January 2, 1999 one
      customer accounted for approximately 26.8%, 24.7%, and 27.3% of net sales,
      respectively. This customer's accounts receivable balance represented
      approximately 23.6% and 32.4% gross accounts receivable as of December 31,
      1997 and January 2, 1999, respectively. In addition, another customer
      accounted for approximately 11.4% of the Company's net sales for the year
      ended January 2, 1999 and approximately 10.6% of gross accounts receivable
      as of January 2, 1999. No other customer accounted for 10% or more of the
      Company's net sales or gross accounts receivable in fiscal 1996, 1997 and
      1998.

      The Company currently purchases a significant portion of its inventory
      from certain suppliers in Asia. Although there are other suppliers of the
      inventory items purchased, and management believes that these suppliers
      could provide similar inventory at fairly comparable terms, a change in
      suppliers could cause a delay in the Company's distribution process and a
      possible loss of sales, which would adversely affect operating results.

(17)  ACCRUED EXPENSES

      Accrued expenses consist of the following (in thousands):

<TABLE>
<CAPTION>
                                               DECEMBER 31,      JANUARY 2,
                                                   1997             1999
<S>                                          <C>               <C>            
       Accrued payroll and payroll related
          items                              $         2,010   $         2,164
       Accrued interest                                  140             3,636
       Accrued royalties                                 663             2,190
       Accrued intransit inventory                       852             3,038
       Other accrued expenses                          7,556            11,712
                                             ---------------   ---------------

                                             $        11,221   $        22,740
                                             ===============   ===============
</TABLE>


                                      F-29
<PAGE>   77

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

(18)  SEGMENT REPORTING

      In July 1997, the FASB issued SFAS No. 131, Disclosures About Segments of
      an Enterprise and Related Information. SFAS No. 131 requires certain
      financial and supplementary information to be disclosed on an annual and
      interim basis for each reportable segment of an enterprise. SFAS No. 131
      is effective for fiscal years beginning after December 15, 1997.

      The Company has determined it has three reportable segments: mass
      merchandisers, chain drug stores/combo stores/supermarkets, and variety
      stores. The Company distributes accessories such as, costume jewelry,
      optical products, watches, clocks and other accessories.

      The Company's reportable segments are strategic business units that sell
      the Company's products to distinct distribution channels. They are managed
      separately because each business requires different marketing strategies.
      The Company's approach is based on the way that management organizes the
      segments within the enterprise for making operating decisions and
      assessing performance.

      The accounting policies of the segments are the same as those described in
      the summary of significant accounting policies. The Company evaluates
      performance based on profit or loss from operations before income taxes
      not including nonrecurring gains and losses.

<TABLE>
<CAPTION>
                                                    CHAIN DRUG
                                                   STORES/COMBO
                                    MASS              STORES/
        FISCAL 1996             MERCHANDISERS      SUPERMARKETS         VARIETY           OTHER            TOTAL
<S>                             <C>              <C>                <C>              <C>              <C>            
Net sales                       $      59,055    $         8,742    $        10,981  $         7,558  $        86,336
                                =============    ===============    ===============  ===============  ===============

Interest expense                $       1,005    $           149    $           187  $           128  $         1,469
                                =============    ===============    ===============  ===============  ===============

Depreciation and
   amortization expense         $       1,478    $           125    $           157  $           108  $         1,868
                                =============    ===============    ===============  ===============  ===============

Customer acquisition costs      $       2,495    $             -    $             -  $           205  $         2,700
                                =============    ===============    ===============  ===============  ===============

Segment (loss) profit           $      (1,172)   $          (135)   $        (1,546) $         2,325  $          (528)
                                =============    ===============    ===============  ===============  ===============
</TABLE>


                                      F-30
<PAGE>   78

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

<TABLE>
<CAPTION>
                                                       CHAIN DRUG
                                                      STORES/COMBO
                                                        STORES/
         FISCAL 1997            MASS MERCHANDISERS    SUPERMARKETS        VARIETY           OTHER            TOTAL
<S>                                <C>              <C>               <C>              <C>              <C>            
Net sales                          $     84,343     $        39,545   $        16,243  $         9,280  $       149,411
                                   ============     ===============   ===============  ===============  ===============

Interest expense                   $      2,379     $         1,115   $           458  $           262  $         4,214
                                   ============     ===============   ===============  ===============  ===============

Depreciation and amortization
   expense                         $      4,775     $         1,995   $         1,010  $           468  $         8,248
                                   ============     ===============   ===============  ===============  ===============

Customer acquisition costs         $      1,043     $            --   $           552  $            --  $         1,595
                                   ============     ===============   ===============  ===============  ===============

Segment (loss) profit              $     (1,953)    $         6,099   $        (2,711) $           511  $         1,946
                                   ============     ===============   ===============  ===============  ===============

<CAPTION>
                                                       CHAIN DRUG
                                                     STORES/ COMBO
                                                        STORES/
         FISCAL 1998            MASS MERCHANDISERS    SUPERMARKETS        VARIETY           OTHER            TOTAL
<S>                                <C>              <C>               <C>              <C>              <C>            
Net sales                          $    103,559     $        29,801   $        13,835  $        13,130  $       160,325
                                   ============     ===============   ===============  ===============  ===============

Interest expense                   $      4,528     $         1,303   $           605  $           574  $         7,010
                                   ============     ===============   ===============  ===============  ===============

Depreciation and amortization
   expense                         $      8,260     $         1,777   $         1,457  $         1,298  $        12,792
                                   ============     ===============   ===============  ===============  ===============

Customer acquisition costs         $        822     $            --   $            50  $            --  $           872
                                   ============     ===============   ===============  ===============  ===============

Segment (loss) profit              $     (9,013)    $           736   $        (5,603) $           237          (13,643)
                                   ============     ===============   ===============  ===============  ===============
</TABLE>

      Revenue from segments below the quantitative thresholds are attributable
      to five operating segments of the Company. Those segments include
      department stores, armed forces' PX stores, boutique stores, gift shops,
      bookstores and catalogues. None of these segments have ever met any of the
      quantitative thresholds for determining reportable segments and their
      combined results are presented as other.

      Segment profit (loss) differs from the income (loss) before income tax
      (expense) benefit and dividends and accretion on preferred stock by the
      amount of equity in losses of investments in affiliates, minority interest
      in income of consolidated subsidiary and other income, which are not
      allocated by segment. Segment assets are not reviewed by the chief
      operating decision maker.

      Total assets specifically identifiable with each reportable segment are as
      follows:


                                      F-31
<PAGE>   79

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

<TABLE>
<CAPTION>
                                                         DECEMBER 31,              JANUARY 2,
                                                     1996             1997            1999
<S>                                             <C>              <C>             <C>          
Mass merchandisers                              $      11,339    $      13,244   $      25,248
Chain drug stores/combo stores/supermarkets             5,720            6,128           6,368
Variety                                                   991            2,351           1,246
Other                                                   1,560            1,903           5,068
Unassigned assets                                      62,400           70,120          88,568
                                                -------------    -------------   -------------

                                                $      82,010    $      93,746   $     126,498
                                                =============    =============   =============
</TABLE>

      The following table identifies sales and long-lived assets by geographic
      region. Sales are attributed to countries based on location of customer.
      Assets are attributed based on location.

<TABLE>
<CAPTION>
                                       -------------------------------------FISCAL------------------------------------
                                             1996                            1997                             1998
                                          NET SALES                        NET SALES                       NET SALES
<S>                                    <C>                              <C>                             <C>
United States                          $       84,075                   $      142,655                  $      144,540
Canada                                          2,261                            5,310                           6,162
Europe                                              -                                -                           7,757
Mexico                                              -                            1,446                           1,866
                                       --------------                   --------------                  --------------

   Total                               $       86,336                   $      149,411                  $      160,325
                                       ==============                   ==============                  ==============
</TABLE>

<TABLE>
<CAPTION>
                                                                                LONG-LIVED ASSETS
                                                            DECEMBER 31,                                    JANUARY 2,
                                                                1997                                           1998
<S>                                                      <C>                                             <C>
      United States                                      $       27,423                                  $       49,112
      Canada                                                        541                                             192
      Europe                                                          -                                           1,492
      Asia                                                        1,426                                           1,337
      Mexico                                                         18                                              18
                                                         --------------                                  --------------

         Total                                           $       29,408                                  $       52,151
                                                         ==============                                  ==============
</TABLE>


                                      F-32
<PAGE>   80

                     AAi.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

(19)  SUPPLEMENTAL CONSOLIDATING FINANCIAL INFORMATION

      The following is summarized consolidating financial information for the
      Company, segregating the Company, wholly owned guarantor subsidiaries,
      mostly owned guarantor subsidiaries and non-guarantor subsidiaries as they
      relate to the Notes. The guarantor subsidiaries, both mostly and wholly
      owned are domestic subsidiaries of the Company and they guarantee the
      notes on a full, unconditional and joint and several basis. Separate
      financial statements of the wholly owned guarantor subsidiaries have not
      been included because management believes that they are not material to
      investors. Separate financial statements of the mostly owned guarantor
      subsidiary, Fantasma LLC, in which the Company holds an 80% interest, are
      included after this supplemental consolidating financial information.

      The Company and guarantor subsidiaries account for investments in
      subsidiaries on the equity method for the purposes of the consolidating
      financial data. Earnings of subsidiaries are therefore reflected in the
      Company's and guarantor subsidiary's investment accounts and earnings. The
      principal elimination entries eliminate investments in subsidiaries and
      intercompany balances and transactions.


                                      F-33
<PAGE>   81

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

<TABLE>
<CAPTION>
                          -----------------------------DECEMBER 31, 1997---------------------------       
                                             WHOLLY                                                       
                                              OWNED      NON-GUARANTOR                                    
                            COMPANY       SUBSIDIARIES    SUBSIDIARIES  ELIMINATIONS    CONSOLIDATED      
                          -------------------------------(IN THOUSANDS)----------------------------      
                                                             ASSETS
<S>                       <C>             <C>              <C>           <C>            <C>               
CONSOLIDATING BALANCE
SHEETS
CURRENT ASSETS:
   Cash and cash
   equivalents            $     2,354     $       183      $      242    $         -    $     2,779       
   Accounts                                                                                               
   receivable, net              9,756           7,778             789              -         18,323       
   Inventories                 18,922          13,547             326              -         32,795       
   Prepaid expenses                                                                                       
   and other current                                                                                      
   assets                         224             233             277              -            734       
   Deferred tax assets          4,798           4,908               -              -          9,707       
                          -----------     -----------      ----------    -----------    -----------       
                                                                                                          
         Total                                                                                            
         current                                                                                          
         assets                36,054          26,649           1,635              -         64,338       
                                                                                                          
PROPERTY, PLANT  AND                                                                                      
  EQUIPMENT,                                                                                              
  NET                           3,727           6,421              37              -         10,185       
                                                                                                          
OTHER ASSETS                   25,394          10,433             460        (17,064)        19,223       
                          -----------     -----------      ----------    -----------    -----------       
                                                                                                          
                          $    65,175     $    43,503      $    2,132    $   (17,064)   $    93,746       
                          ===========     ===========      ==========    ===========    ===========       
                                                                                                          
                                       LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)

CURRENT LIABILITIES:                                                                                      
   Borrowings under                                                                                       
   revolving note                                                                                         
   payable                $    12,883     $    14,715      $        -    $         -    $    27,598       
   Current maturities                                                                                     
   of long-term                                                                                           
   obligations                  3,361               -               -              -          3,361       
   Accounts payable             5,253           8,060             804              -         14,117       
   Accrued expenses             7,651           5,283             392              -         13,326       
   Due (from) to                                                                                          
   affiliate                      876           2,313             661         (3,850)             -       
                          -----------     -----------      ----------    -----------    -----------       
         Total                                                                                            
         current                                                                                          
         liabilities           30,024          30,371           1,857         (3,850)        58,402       
                                                                                                          
10 3/4% SENIOR NOTES                -               -               -              -              -       
                                                                                                          
LONG-TERM                                                                                                 
OBLIGATIONS, LESS                                                                                         
CURRENT MATURITIES              9,653               -               -              -          9,653       
                                                                                                          
DEFERRED TAX                                                                                              
LIABILITIES                         -             645               -              -            645       
                                                                                                          
SUBORDINATED                                                                                              
PROMISSORY  NOTES                                                                                         
PAYABLE TO                                                                                                
SHAREHOLDERS                    5,487               -               -              -          5,487       
                                                                                                          
REDEEMABLE PREFERRED                                                                                      
STOCK OF A SUBSIDIARY               -               -               -            835            835       
                          -----------     -----------      ----------    -----------    -----------       
                                                                                                          
         Preferred                                                                                        
         stock                 26,083             835               -           (835)        26,083       
                          -----------     -----------      ----------    -----------    -----------       
                                                                                                          
                                                                                                          
         Shareholders'                                                                                    
         equity                                                                                           
         (deficit)             (6,072)         11,652             275        (13,214)        (7,359)      
                          -----------     -----------      ----------    -----------    -----------       
                                                                                                          
                          $    65,175     $    43,503      $    2,132    $   (17,064)   $    93,746       
                          ===========     ===========      ==========    ===========    ===========       
                                                                                                             

<CAPTION>
                          ----------------------------------------JANUARY 2, 1999--------------------------------------   
                                                                                                                          
                                            WHOLLY                                                                        
                                             OWNED        MOSTLY OWNED   NON-GUARANTOR                                    
                             COMPANY      SUBSIDIARIES    SUBSIDIARIES    SUBSIDIARIES     ELIMINATIONS    CONSOLIDATED   
                          -----------------------------------------(IN THOUSANDS)--------------------------------------  
                                                                       ASSETS
<S>                       <C>             <C>             <C>              <C>             <C>             <C>            
CONSOLIDATING BALANCE                                                                                                     
SHEETS                                                                                                                    
CURRENT ASSETS:                                                                                                           
   Cash and cash                                                                                                          
   equivalents            $        68     $        66     $       104      $     1,969     $         -     $     2,207    
   Accounts                                                                                                               
   receivable, net             20,699               2           5,088            3,528               -          29,317    
   Inventories                 28,643               -           3,878            4,641               -          37,162    
   Prepaid expenses                                                                                                       
   and other current                                                                                                      
   assets                       1,403             132             203              180               -           1,918    
   Deferred tax assets          3,743               -               -                -               -           3,743    
                          -----------     -----------     -----------      -----------     -----------     -----------    
                                                                                                                          
         Total                                                                                                            
         current                                                                                                          
         assets                54,556             200           9,273           10,318               -          74,347    
                                                                                                                          
PROPERTY, PLANT  AND                                                                                                      
  EQUIPMENT,                                                                                                              
  NET                          16,206               -              24            1,313               -          17,543    
                                                                                                                          
OTHER ASSETS                   41,512           7,652           4,357              402         (19,315)         34,608    
                          -----------     -----------     -----------      -----------     -----------     -----------    
                                                                                                                          
                          $   112,274     $     7,852     $    13,654      $    12,033     $   (19,315)    $   126,498    
                          ===========     ===========     ===========      ===========     ===========     ===========    
                                                                                                                          

                                                 LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)

CURRENT LIABILITIES:                                                                                                      
   Borrowings under                                                                                                       
   revolving note                                                                                                         
   payable                $     2,576     $         -     $         -      $         -     $         -     $     2,576    
   Current maturities                                                                                                     
   of long-term                                                                                                           
   obligations                    656               -               -                -               -             656    
   Accounts payable            10,961             998             406            2,534               -          14,899    
   Accrued expenses            16,726           5,622           1,554              968               -          24,870    
   Due (from) to                                                                                                          
   affiliate                        -           3,757           7,088            2,380         (13,225)              -    
                          -----------     -----------     -----------      -----------     -----------     -----------    
         Total                                                                                                            
         current                                                                                                          
         liabilities           30,919          10,377           9,048            5,882         (13,225)         43,001    
                                                                                                                          
10 3/4% SENIOR NOTES           75,000               -               -                -               -          75,000    
                                                                                                                          
LONG-TERM                                                                                                                 
OBLIGATIONS, LESS                                                                                                         
CURRENT MATURITIES              2,228               -               -                -               -           2,228    
                                                                                                                          
DEFERRED TAX                                                                                                              
LIABILITIES                         -               -               -                -               -               -    
                                                                                                                          
SUBORDINATED                                                                                                              
PROMISSORY  NOTES                                                                                                         
PAYABLE TO                                                                                                                
SHAREHOLDERS                        -               -               -                -               -               -    
                                                                                                                          
REDEEMABLE PREFERRED                                                                                                      
STOCK OF A SUBSIDIARY               -               -               -                -             909             909    
                          -----------     -----------     -----------      -----------     -----------     -----------    
                                                                                                                          
         Preferred                                                                                                        
         stock                 28,845             926               -                -            (909)         28,862    
                          -----------     -----------     -----------      -----------     -----------     -----------    
                                                                                                                          
                                                                                                                          
         Shareholders'                                                                                                    
         equity                                                                                                           
         (deficit)            (24,718)         (3,451)          4,606            6,151          (6,090)        (23,502)   
                          -----------     -----------     -----------      -----------     -----------     -----------    
                                                                                                                          
                          $   112,274     $     7,852     $    13,654      $    12,033     $   (19,315)    $   126,498    
                          ===========     ===========     ===========      ===========     ===========     ===========    
</TABLE>


                                      F-34
<PAGE>   82

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

<TABLE>
<CAPTION>
                                             ---------------------------DECEMBER 31, 1996-----------------------   
                                                              WHOLLY                                               
                                                              OWNED      NON-GUARANTOR                             
                                               COMPANY     SUBSIDIARIES  SUBSIDIARIES  ELIMINATIONS  CONSOLIDATED  
                                             ---------------------------(IN THOUSANDS)--------------------------
<S>                                          <C>           <C>           <C>           <C>           <C>           
  CONSOLIDATING STATEMENTS OF OPERATIONS

NET SALES                                    $    78,740   $     5,127   $     2,461   $         8   $    86,336   
COST OF GOODS SOLD                                43,920         2,778         1,289          (116)       47,871   
                                             -----------   -----------   -----------   -----------   -----------   

         Gross profit                             34,820         2,349         1,172           124        38,465   

SELLING, GENERAL AND ADMINISTRATIVE EXPENSE       33,402         2,745         1,253           124        37,524   
                                             -----------   -----------   -----------   -----------   -----------   

         Income (loss) from operations             1,418          (396)          (81)            -           941   

INTEREST EXPENSE                                  (1,324)          (52)          (93)            -        (1,469)  
OTHER INCOME (EXPENSE), NET                         (337)            -             6             -          (331)  
EQUITY IN INCOME (LOSS) OF SUBSIDIARIES             (617)            -             -           617             -   
                                             -----------   -----------   -----------   -----------   -----------   

         Income (loss) before income tax
         (expense) benefit and dividends
         and accretion on preferred stock           (860)         (448)         (168)          617          (859)  

INCOME TAX (EXPENSE) BENEFIT                         948             -             -             -           948   
                                             -----------   -----------   -----------   -----------   -----------   

         Net income (loss) before
         dividends and accretion on
         preferred stock                              88          (448)         (168)          617            89   

DIVIDENDS AND ACCRETION ON PREFERRED STOCK         1,123             -             -             -         1,123   
                                             -----------   -----------   -----------   -----------   -----------   

         Net income (loss) applicable to
         common shareholders                 $    (1,035)  $      (448)  $      (168)  $       617   $    (1,034)  
                                             ===========   ===========   ===========   ===========   ===========   

<CAPTION>
                                              -------------------------DECEMBER 31, 1997-------------------------    
                                                              WHOLLY                                                 
                                                               OWNED     NON-GUARANTOR                               
                                                COMPANY     SUBSIDIARIES  SUBSIDIARIES  ELIMINATIONS  CONSOLIDATED   
                                             ---------------------------(IN THOUSANDS)--------------------------
<S>                                           <C>           <C>           <C>           <C>           <C>            
  CONSOLIDATING STATEMENTS OF OPERATIONS                                                                             

NET SALES                                     $    78,723   $    63,992   $     6,696   $         -   $   149,411    
COST OF GOODS SOLD                                 47,323        27,538         3,067             -        77,928    
                                              -----------   -----------   -----------   -----------   -----------    
                                                                                                                     
         Gross profit                              31,400        36,454         3,629             -        71,483    
                                                                                                                     
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE        31,432        31,130         2,761             -        65,323    
                                              -----------   -----------   -----------   -----------   -----------    
                                                                                                                     
         Income (loss) from operations                (32)        5,324           868             -         6,160    
                                                                                                                     
INTEREST EXPENSE                                   (2,562)       (1,613)          (39)            -        (4,214)   
OTHER INCOME (EXPENSE), NET                           200           (49)         (120)            -            31    
EQUITY IN INCOME (LOSS) OF SUBSIDIARIES             2,622             -             -        (2,622)            -    
                                              -----------   -----------   -----------   -----------   -----------    
                                                                                                                     
         Income (loss) before income tax                                                                             
         (expense) benefit and dividends                                                                             
         and accretion on preferred stock             228         3,662           709        (2,622)        1,977    
                                                                                                                     
INCOME TAX (EXPENSE) BENEFIT                          587        (1,743)           (6)            -        (1,162)   
                                              -----------   -----------   -----------   -----------   -----------    
                                                                                                                     
         Net income (loss) before                                                                                    
         dividends and accretion on                                                                                  
         preferred stock                              815         1,919           703        (2,622)          815    
                                                                                                                     
DIVIDENDS AND ACCRETION ON PREFERRED STOCK          2,496             -             -             -         2,496    
                                              -----------   -----------   -----------   -----------   -----------    
                                                                                                                     
         Net income (loss) applicable to                                                                             
         common shareholders                  $    (1,681)  $     1,919   $       703   $    (2,622)  $    (1,681)   
                                              ===========   ===========   ===========   ===========   ===========    
</TABLE>


                                      F-35
<PAGE>   83

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

<TABLE>
<CAPTION>
                                             ----------------------------------JANUARY 2, 1999--------------------------------
                                                              WHOLLY        MOSTLY
                                                              OWNED         OWNED      NON-GUARANTOR
                                               COMPANY     SUBSIDIARIES  SUBSIDIARIES  SUBSIDIARIES  ELIMINATIONS  CONSOLIDATED
                                             ---------------------------------(IN THOUSANDS)----------------------------------
<S>                                          <C>           <C>           <C>           <C>           <C>           <C>        
   CONSOLIDATING STATEMENT OF OPERATIONS

NET SALES                                    $    89,832   $    44,140   $    10,306   $    16,047   $         -   $   160,325
COST OF GOODS SOLD                                54,566        19,887         6,712         7,658             -        88,823
                                             -----------   -----------   -----------   -----------   -----------   -----------

         Gross profit                             35,266        24,253         3,594         8,389             -        71,502

SELLING, GENERAL AND ADMINISTRATIVE EXPENSE       40,362        28,235         2,747         6,791             -        78,135
                                             -----------   -----------   -----------   -----------   -----------   -----------

         Income (loss) from operations            (5,096)       (3,982)          847         1,598             -        (6,633)

INTEREST EXPENSE                                  (5,970)         (586)         (292)         (162)            -        (7,010)
OTHER INCOME (EXPENSE), NET                          612            16             2          (140)            -           490
EQUITY IN LOSS OF SUBSIDIARIES                    (2,583)            -             -             -         2,583             -
                                             -----------   -----------   -----------   -----------   -----------   -----------

         Income (loss) before income tax
         (expense) benefit and dividends
         and accretion on preferred stock        (13,037)       (4,552)          557         1,296         2,583       (13,153)

INCOME TAX (EXPENSE) BENEFIT                           -             -             -             -             -             -
                                             -----------   -----------   -----------   -----------   -----------   -----------

         Net income (loss) before
         dividends and accretion on
         preferred stock                         (13,037)       (4,552)          557         1,296         2,583       (13,153)

DIVIDENDS AND ACCRETION ON PREFERRED STOCK         2,779             -             -             -             -         2,779
                                             -----------   -----------   -----------   -----------   -----------   -----------

         Net income (loss) applicable to
         common shareholders                 $   (15,816)  $    (4,552)  $       557   $     1,296   $     2,583   $   (15,932)
                                             ===========   ===========   ===========   ===========   ===========   ===========
</TABLE>


                                      F-36
<PAGE>   84

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

<TABLE>
<CAPTION>
                                             ---------------------------DECEMBER 31, 1996-----------------------   
                                                              WHOLLY
                                                              OWNED      NON-GUARANTOR                             
                                               COMPANY     SUBSIDIARIES  SUBSIDIARIES  ELIMINATIONS  CONSOLIDATED  
                                             ---------------------------(IN THOUSANDS)--------------------------
<S>                                          <C>           <C>           <C>           <C>           <C>           
  CONSOLIDATING STATEMENTS OF CASH FLOWS

CASH FLOWS FROM OPERATING ACTIVITIES         $    (3,131)  $     1,283   $      (371)  $         -   $    (2,219)  

CASH FLOWS FROM INVESTING ACTIVITIES:
   Purchase of property, plant and
   equipment                                      (1,434)         (135)           (3)            -        (1,572)  
   Acquisitions, net of cash acquired             (9,842)            -             -             -        (9,842)  
   Advances to affiliates                            504        (1,679)            -         1,175             -   
   Other investing activities                     (2,338)        1,572          (293)            -        (1,059)  
                                             -----------   -----------   -----------   -----------   -----------   

         Net cash used in investing
         activities                              (13,110)         (242)         (296)        1,175       (12,473)  
                                             -----------   -----------   -----------   -----------   -----------   

CASH FLOWS FROM FINANCING ACTIVITIES:
   Net borrowings under revolving note
   payable                                         3,411          (100)            -             -         3,311   
   Proceeds from issuance of subordinated
     promissory notes payable to
     shareholders                                  2,000             -             -             -         2,000   
   Proceeds from issuance of long-term
   obligations                                     3,445             -             -             -         3,445   
   Payments on long-term obligations              (2,292)            -             -             -        (2,292)  
   Proceeds from issuance of preferred
     stock, net of issuance costs                 22,464             -             -             -        22,464   
   Due to affiliates                                   -             -         1,175        (1,175)            -   
   Other financing activities                    (12,794)            -             -             -       (12,794)  
                                             -----------   -----------   -----------   -----------   -----------   

         Net cash provided by (used in)
         financing activities                     16,234          (100)        1,175        (1,175)       16,134   
                                             -----------   -----------   -----------   -----------   -----------   

NET (DECREASE) INCREASE IN CASH AND CASH
EQUIVALENTS                                           (7)          941           508             -         1,442   

CASH AND CASH EQUIVALENTS, BEGINNING OF
PERIOD                                                 7             -            28             -            35   
                                             -----------   -----------   -----------   -----------   -----------   

CASH AND CASH EQUIVALENTS, END OF PERIOD     $         -   $       941   $       536   $         -   $     1,477   
                                             ===========   ===========   ===========   ===========   ===========   

<CAPTION>
                                              -------------------------DECEMBER 31, 1997-------------------------   
                                                                                                                     
                                                            WHOLLY OWNED  NON-GUARANTOR                              
                                                COMPANY     SUBSIDIARIES  SUBSIDIARIES  ELIMINATIONS  CONSOLIDATED   
                                              ---------------------------(IN THOUSANDS)--------------------------
                                                                                                                     
<S>                                           <C>           <C>           <C>           <C>           <C>            
  CONSOLIDATING STATEMENTS OF CASH FLOWS                                                                             
                                                                                                                     
CASH FLOWS FROM OPERATING ACTIVITIES          $    (4,119)  $     4,697   $     1,022   $         -   $     1,600    
                                                                                                                     
CASH FLOWS FROM INVESTING ACTIVITIES:                                                                                
   Purchase of property, plant and                                                                                   
   equipment                                       (2,860)       (4,686)          (37)            -        (7,583)   
   Acquisitions, net of cash acquired              (1,834)            -             -             -        (1,834)   
   Advances to affiliates                          (3,546)        1,594             -         1,952             -    
   Other investing activities                         952          (545)          (43)            -           364    
                                              -----------   -----------   -----------   -----------   -----------    
                                                                                                                     
         Net cash used in investing                                                                                  
         activities                                (7,288)       (3,637)          (80)        1,952        (9,053)   
                                              -----------   -----------   -----------   -----------   -----------    
                                                                                                                     
CASH FLOWS FROM FINANCING ACTIVITIES:                                                                                
   Net borrowings under revolving note                                                                               
   payable                                         11,826        (4,129)            -             -         7,697    
   Proceeds from issuance of subordinated                                                                            
     promissory notes payable to                                                                                     
     shareholders                                       -             -             -             -             -    
   Proceeds from issuance of long-term                                                                               
   obligations                                      8,943             -             -             -         8,943    
   Payments on long-term obligations               (7,551)            -             -             -        (7,551)   
   Proceeds from issuance of preferred                                                                               
     stock, net of issuance costs                       -             -             -             -             -    
   Due to affiliates                                  877         2,311        (1,236)       (1,952)            -    
   Other financing activities                        (334)            -             -             -          (334)   
                                              -----------   -----------   -----------   -----------   -----------    
                                                                                                                     
         Net cash provided by (used in)                                                                              
         financing activities                      13,761        (1,818)       (1,236)       (1,952)        8,755    
                                              -----------   -----------   -----------   -----------   -----------    
                                                                                                                     
NET (DECREASE) INCREASE IN CASH AND CASH                                                                             
EQUIVALENTS                                         2,354          (758)         (294)            -         1,302    
                                                                                                                     
CASH AND CASH EQUIVALENTS, BEGINNING OF                                                                              
PERIOD                                                  -           941           536             -         1,477    
                                              -----------   -----------   -----------   -----------   -----------    
                                                                                                                     
CASH AND CASH EQUIVALENTS, END OF PERIOD      $     2,354   $       183   $       242   $         -   $     2,779    
                                              ===========   ===========   ===========   ===========   ===========    
</TABLE>


                                      F-37
<PAGE>   85

                     AAI.FOSTERGRANT, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

<TABLE>
<CAPTION>
                                             ----------------------------------JANUARY 2, 1999--------------------------------
                                                              WHOLLY        MOSTLY
                                                              OWNED         OWNED      NON-GUARANTOR
                                               COMPANY     SUBSIDIARIES  SUBSIDIARIES  SUBSIDIARIES  ELIMINATIONS  CONSOLIDATED
                                             ----------------------------------(IN THOUSANDS)---------------------------------
<S>                                          <C>           <C>           <C>           <C>           <C>           <C>         
  CONSOLIDATING STATEMENTS OF CASH FLOWS

CASH FLOWS FROM OPERATING ACTIVITIES         $   (23,955)  $    19,698   $    (3,527)  $     3,881   $         -   $    (3,903)

CASH FLOWS FROM INVESTING ACTIVITIES:
   Purchase of property, plant and
   equipment                                     (12,479)         (792)          (15)       (3,596)            -       (16,882)
   Acquisitions, net of cash acquired             (9,464)            -             -             -             -        (9,464)
   Advances to affiliates                         (8,117)            -             -           113         8,004             -
   Other investing activities                      6,154        (5,752)          (15)       (3,794)            -        (3,407)
                                             -----------   -----------   -----------   -----------   -----------   -----------

         Net cash used in investing
         activities                              (23,906)       (6,544)          (30)       (7,277)        8,004       (29,753)
                                             -----------   -----------   -----------   -----------   -----------   -----------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Net borrowings under revolving note
   payable                                       (10,307)      (14,715)            -             -             -       (25,022)
   Proceeds from term note payable                13,222             -             -             -             -        13,222
   Proceeds on term note payable                 (13,222)            -             -             -             -       (13,222)
   Proceeds from issuance of 10 3/4%
     senior notes                                 75,000             -             -             -             -        75,000
   Payments on subordinated notes                 (5,487)            -             -         3,355             -        (2,132)
   Payments on long-term obligations             (10,130)            -             -          (896)            -       (11,026)
   Due to affiliates                                   -         1,444         3,588         2,972        (8,004)            -
   Other financing activities                     (3,501)            -             -          (235)            -        (3,736)
                                             -----------   -----------   -----------   -----------   -----------   -----------

         Net cash provided by financing
         activities                               45,575       (13,271)        3,588         5,196        (8,004)       33,084
                                             -----------   -----------   -----------   -----------   -----------   -----------

NET (DECREASE) INCREASE IN CASH AND CASH
EQUIVALENTS                                       (2,286)         (117)           31         1,800             -          (572)

CASH AND CASH EQUIVALENTS, BEGINNING OF
PERIOD                                             2,354           183            73           169             -         2,779
                                             -----------   -----------   -----------   -----------   -----------   -----------

CASH AND CASH EQUIVALENTS, END OF PERIOD     $        68   $        66   $       104   $     1,969   $         -   $     2,207
                                             ===========   ===========   ===========   ===========   ===========   ===========
</TABLE>


                                      F-38
<PAGE>   86

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Members of
Fantasma LLC:

We have audited the accompanying balance sheets of Fantasma LLC as of December
31, 1997 and January 2, 1999 and the related statements of operations, members'
equity and cash flows for each of the three years in the period ended January 2,
1999. These financial statements are the responsibility of Fantasma LLC's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the 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. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Fantasma LLC as of December 31,
1997 and January 2, 1999 and the results of its operations and its cash flows
for each of the three years in the period ended January 2, 1999, in conformity
with generally accepted accounting principles.


                                               /s/ Arthur Andersen LLP

Boston, Massachusetts
February 19, 1999


                                      F-39
<PAGE>   87

                                  FANTASMA LLC

                                 BALANCE SHEETS

                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                     ASSETS

                                                                                     DECEMBER 31,       JANUARY 2,
                                                                                         1997              1999
<S>                                                                                 <C>              <C>            
CURRENT ASSETS:
   Cash                                                                             $           238  $           104
   Accounts receivable, less reserves of approximately $402 and $373                          5,108            5,088
   Inventory                                                                                  1,908            3,878
   Prepaids and other current assets                                                             72              203
                                                                                    ---------------  ---------------

         Total current assets                                                                 7,326            9,273
                                                                                    ---------------  ---------------

PROPERTY AND EQUIPMENT, AT COST:
   Equipment                                                                                     68               29
   Furniture and fixtures                                                                        11               --
                                                                                    ---------------  ---------------

                                                                                                 79               29

   Less--Accumulated depreciation                                                                (13)              (5)
                                                                                     ---------------  ---------------

                                                                                                 66               24
OTHER ASSETS:
   Intangible assets, net of accumulated amortization of $0 and $270                              3            4,357
                                                                                    ---------------  ---------------

         Total assets                                                               $         7,395  $        13,654
                                                                                    ===============  ===============

                         LIABILITIES AND MEMBERS' EQUITY

CURRENT LIABILITIES:
   Note payable to member                                                           $         3,764  $         7,088
   Advances payable to member                                                                 1,661               --
   Accounts payable and accrued expenses                                                      1,657            1,960
                                                                                    ---------------  ---------------

         Total current liabilities                                                            7,082            9,048

COMMITMENTS AND CONTINGENCIES (NOTE 1)

MEMBERS' EQUITY                                                                                 313            4,606
                                                                                    ---------------  ---------------

         Total liabilities and members' equity                                      $         7,395  $        13,654
                                                                                    ===============  ===============
</TABLE>

   The accompanying notes are an integral part of these financial statements.


                                      F-40
<PAGE>   88

                                  FANTASMA LLC

                            STATEMENTS OF OPERATIONS

                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                 -------------------- YEARS ENDED -----------------
                                                                           DECEMBER 31,                JANUARY 2,
                                                                       1996             1997              1999
<S>                                                              <C>               <C>              <C>            
NET SALES                                                        $        10,815   $        17,163  $        14,645

COST OF GOODS SOLD                                                         8,838            12,562           10,186
                                                                 ---------------   ---------------  ---------------

         Gross profit                                                      1,977             4,601            4,459

OPERATING EXPENSES:
   Selling expenses                                                          643             1,501            2,197
   General and administrative expenses                                     1,023             2,259            1,612
                                                                 ---------------   ---------------  ---------------

         Income from operations                                              311               841              650

INTEREST EXPENSE                                                             236               480              453
                                                                 ---------------   ---------------  ---------------

INCOME BEFORE INCOME TAXES                                                    75               361              197

PROVISION FOR INCOME TAXES                                                   (17)              (58)              --
                                                                 ---------------   ---------------  ---------------

         Net income                                              $            58   $           303  $           197
                                                                 ===============   ===============  ===============
</TABLE>

   The accompanying notes are an integral part of these financial statements.


                                      F-41
<PAGE>   89

                                  FANTASMA LLC

                          STATEMENTS OF MEMBERS' EQUITY

                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                      PARENT 
                                                                      COMPANY         MEMBERS'
                                                                    INVESTMENT         EQUITY            TOTAL
<S>                                                              <C>               <C>              <C>            
BALANCE, DECEMBER 31, 1995                                       $         1,838   $           --   $         1,838
  Capital contribution                                                        --                1                 1
  Additional parent company investment                                       807               --               807
  Conversion of parent company investment to note payable to
    member                                                                (2,498)              --            (2,498)
  Net (loss) income                                                         (147)             205                58
                                                                 ---------------   --------------   ---------------

BALANCE, DECEMBER 31, 1996                                                    --              206               206
  Distribution to members                                                     --             (196)             (196)
  Net income                                                                  --              303               303
                                                                 ---------------   --------------   ---------------

BALANCE, DECEMBER 31, 1997                                                    --              313               313
  Distribution to members                                                     --             (531)             (531)
  Pushdown of purchase price related to AAi.FosterGrant's
    investment in Fantasma                                                    --            4,627             4,627
  Net income                                                                  --              197               197
                                                                 ---------------   --------------   ---------------

BALANCE, JANUARY 2, 1999                                         $            --   $        4,606   $         4,606
                                                                 ===============   ==============   ===============
</TABLE>

   The accompanying notes are an integral part of these financial statements.


                                      F-42
<PAGE>   90

                                  FANTASMA LLC

                            STATEMENTS OF CASH FLOWS

                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                 -------------------- YEARS ENDED -----------------
                                                                           DECEMBER 31,                JANUARY 2,
                                                                       1996             1997              1999
<S>                                                               <C>               <C>              <C>            
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net income                                                     $            58   $           303  $           197
   Adjustments to reconcile net income to net cash provided by
   (used in) operating activities-
     Depreciation and amortization                                             15                11              277
     Write-off of property and equipment                                       20                --               49
     Change in assets and liabilities-
       Accounts receivable                                                 (1,811)           (1,700)              20
       Inventory                                                           (1,178)               87           (1,970)
       Prepaid expenses and other current assets                             (121)               49             (131)
       Advances payable to member                                           1,078               674           (1,661)
       Accounts payable and accrued liabilities                                54               861              303
                                                                  ---------------   ---------------  ---------------

         Net cash (used in) provided by operating activities               (1,885)              285           (2,916)
                                                                  ---------------   ---------------  ---------------

CASH FLOWS FROM INVESTING ACTIVITIES:
   Purchase of equipment                                                       --               (40)             (14)
   Decrease in other assets                                                    --                --                3
                                                                  ---------------   ---------------  ---------------

         Net cash used in investing activities                                 --               (40)             (11)
                                                                  ---------------   ---------------  ---------------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Proceeds from note payable to member                                     1,266                --            7,088
   Repayments of note payable to member                                        --                --           (3,764)
   Parent company investment                                                  807                --               --
   Member contributions (distributions)                                         1              (196)            (531)
                                                                  ---------------   ---------------  ---------------

         Net cash provided by (used in) financing activities                2,074              (196)           2,793
                                                                  ---------------   ---------------  ---------------

NET INCREASE (DECREASE) IN CASH                                               189                49             (134)

CASH, BEGINNING OF PERIOD                                                      --               189              238
                                                                  ---------------   ---------------  ---------------

CASH, END OF PERIOD                                               $           189   $           238  $           104
                                                                  ===============   ===============  ===============

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
   Interest paid                                                  $           156   $           480  $            --
                                                                  ===============   ===============  ===============
   Taxes paid                                                     $            --   $            27  $            --
                                                                  ===============   ===============  ===============

SUPPLEMENTAL DISCLOSURE OF NONCASH ACTIVITIES:
   Conversion of parent company investment to note payable to
     member                                                       $         2,498   $            --  $            --
                                                                  ===============   ===============  ===============
   Pushdown of purchase price related to AAi.FosterGrant's
     investment in Fantasma                                       $            --   $            --  $         4,627
                                                                  ===============   ===============  ===============
</TABLE>

   The accompanying notes are an integral part of these financial statements.


                                      F-43
<PAGE>   91

                                  FANTASMA LLC

                          NOTES TO FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

(1)   OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

      Organization and Business Activity

      Fantasma LLC (Fantasma) was organized under the laws of the State of
      Delaware on August 22, 1996 and began business operations on September 1,
      1996. Fantasma imports and wholesales licensed watches, clocks, and other
      novelties, and grants credit to customers located primarily in the United
      States.

      Prior to September 1, 1996, Fantasma operated as a division (the Fantasma
      division) of Overdrive Capital Corp. (formerly known as Good Stuff Corp.).
      Overdrive Capital Corp. (Overdrive) sold the Fantasma division's operating
      assets to Fantasma LLC in exchange for a two-year $3,764,366 note.
      Overdrive maintained a 67% ownership interest in Fantasma, with a former
      stockholder of Overdrive holding a 33% ownership interest. The assets were
      transferred at historical book value and consisted of the following (in
      thousands):

                  Unexpired royalties                       $       289
                  Accounts receivable                               798
                  Inventory                                       2,600
                  Prepaid expenses                                   49
                  Furniture and equipment                            25
                  Trademarks                                          3
                                                            -----------
                           Total assets transferred         $     3,764
                                                            ===========

      The accompanying financial statements prior to the formation of Fantasma
      LLC represent the financial results of the Fantasma division as included
      in the financial statements of Overdrive from January 1, 1995 to August
      31, 1996.

      In June 1998, AAi.FosterGrant, Inc. (AAi.FosterGrant) acquired an 80%
      interest in Fantasma for approximately $4.1 million in cash (the
      Acquisition). The operating agreement under which Fantasma is managed
      provides AAi.FosterGrant with sole voting rights on numerous significant
      matters. The Acquisition was accounted for using the purchase method. The
      purchase price was allocated based on estimated fair market value of
      assets and liabilities at the date of acquisition, as follows (in
      thousands):

                  Cash                                      $        73
                  Accounts receivable                             1,603
                  Inventory                                       2,002
                  Other current assets                              165
                  Furniture and equipment                            15
                  Goodwill                                        4,626
                  Notes payable                                  (3,500)
                  Other current liabilities                        (934)
                                                            -----------
                           Cash paid                        $     4,050
                                                            ===========


                                      F-44
<PAGE>   92

                                  FANTASMA LLC

                          NOTES TO FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      The book value of Fantasma's assets and liabilities immediately prior to
      the Acquisition approximated fair market value. Goodwill is being
      amortized ratably over 10 years.

      Basis of Accounting

      The accompanying financial statements reflect the application of certain
      significant accounting policies, as discussed below and elsewhere in the
      notes to financial statements. The preparation of financial statements in
      conformity with generally accepted accounting principles requires
      management to make estimates and assumptions that affect the reported
      amounts of assets and liabilities and disclosure of contingent assets and
      liabilities at the date of the financial statements and the reported
      amounts of revenues and expenses during the reporting period. Actual
      results could differ from those estimates.

      Inventory

      Inventories are stated at the lower of cost (first-in, first-out) or
      market and consist of finished goods for all years presented. Finished
      goods inventory consists of material and overhead.

      Property and Equipment

      Fantasma provides for depreciation and amortization by charges to
      operations in amounts that allocate the cost of these assets on the
      straight-line and accelerated bases over their estimated useful lives as
      follows:

                    ASSET CLASSIFICATION           ESTIMATED USEFUL LIFE

                 Equipment                                5 years
                 Furniture and fixtures                   7 years

      Fantasma has adopted the provisions of Statement of Position No. 98-1,
      Accounting for the Costs of Computer Software Developed or Obtained for
      Internal Use. The adoption of this pronouncement did not have a material
      effect on Fantasma's financial position or financial results.

      Royalties

      Fantasma has several agreements that require royalty payments based on a
      percentage of certain net product sales, subject to specified minimum
      payments. Minimum future royalty obligations relating to these agreements
      total $849,000. Royalty expense was approximately $1,049,000, $1,734,000
      and $1,477,000 for the years ended December 31, 1996 and 1997 and January
      2, 1999, respectively. Accrued royalties, which are included in accounts
      payable and accrued expenses on the accompanying balance sheets, totaled
      $732,000 and $707,000 at December 31, 1997 and January 2, 1999,
      respectively.

      Revenue Recognition

      Fantasma recognizes revenue from product sales, net of anticipated returns
      and discounts, taking into account historical experience, upon shipment to
      the customer.

      Concentration of Credit Risk


                                      F-45
<PAGE>   93

                                  FANTASMA LLC

                          NOTES TO FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      Financial instruments that potentially subject Fantasma to concentrations
      of credit risk are principally accounts receivable. A significant portion
      of its business activity is with domestic mass merchandisers whose ability
      to meet their financial obligations is dependent on economic conditions
      germane to the retail industry. During recent years, many major retailers
      have experienced significant financial difficulties and some have filed
      for bankruptcy protection; other retailers have begun to consolidate
      within the industry. To reduce credit risk, Fantasma routinely assesses
      the financial strength of its customers.

      Intangible and Other Long-Lived Assets

      In accordance with Statement of Financial Accounting Standards (SFAS) No.
      121, Accounting for Impairment of Long-Lived Assets and For Long-Lived
      Assets To Be Disposed Of, Fantasma reviews its long-lived assets
      (consisting primarily of goodwill) for impairment as events and
      circumstances indicate the carrying amount of an asset may not be
      recoverable. Fantasma evaluates the realizability of its long-lived assets
      based on profitability and cash flow expectations for the related asset.
      Management believes that as of each of the balance sheet dates presented
      none of Fantasma's long-lived assets were impaired. Amortization expense
      was approximately $270,000 for the year ended January 2, 1999.

      Disclosure of Fair Value of Financial Instruments

      Fantasma's financial instruments consist mainly of cash, accounts
      receivable, accounts payable and debt. The carrying amounts of Fantasma's
      financial instruments approximate fair value.

      New Accounting Standards

      In June 1998, the Financial Accounting Standards Board (FASB) issued SFAS
      No. 133, Accounting for Derivative Instruments and Hedging Activities.
      SFAS No. 133 establishes accounting and reporting standards for derivative
      instruments, including certain derivative instruments embedded in other
      contracts, and for hedging activities. It requires that an entity
      recognize all derivatives as either assets or liabilities in the statement
      of financial position and measure those instruments at fair value. SFAS
      No. 133 is effective for all fiscal quarters of fiscal years beginning
      after June 15, 1999. Fantasma does not believe that the adoption of SFAS
      No. 133 will have a material impact on its financial instruments.

      In April 1998, the American Institute of Certified Public Accountants
      issued Statement of Position 98-5, Reporting on the Costs of Start-up
      Activities (SOP 98-5). SOP 98-5 provides guidance on the financial
      reporting of start-up activities and organization costs to be expensed as
      incurred. Fantasma does not believe that the adoption of SOP 98-5 will
      have a material impact on its financial statements.

      Income Taxes

      Fantasma is treated as a partnership for federal and state income tax
      purposes, whereby the membership owners are taxed on their proportionate
      share of Fantasma's income. As a result, Fantasma has not provided for
      federal income taxes. The provision for income taxes reflects New York
      City Unincorporated Business Tax and New York State filing fees. For the
      period from January 1, 1996 to August 31, 1996, Fantasma accounted for
      state income taxes on a separate company basis.

(2)   NOTE PAYABLE


                                      F-46
<PAGE>   94

                                  FANTASMA LLC

                          NOTES TO FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      Fantasma issued a note payable to Overdrive as consideration for the asset
      purchase on September 1, 1996 (see Note 1), under which it could borrow up
      to $5,000,000. At December 31, 1997, approximately $3,764,000 was
      outstanding under this note. The note accrued interest at the prime rate
      (8.5% at December 31, 1997). Total interest charged on this note was
      approximately $107,000, $320,000 and $141,000 in the years ended December
      31, 1996 and 1997 and January 2, 1999, respectively. This note was repaid
      in June 1998 with the proceeds from a note payable issued to
      AAi.FosterGrant.

      On June 13, 1998, the Company entered into a $15,000,000 demand revolving
      promissory note payable with AAi.FosterGrant. Borrowings under the note
      are secured by substantially all of Fantasma's assets and bear interest at
      a rate equal to AAi.FosterGrant's borrowing rate. The note is payable on
      demand with thirty-days notice. Total interest charged on this note was
      approximately $282,000 for the year ended January 2, 1999. At January 2,
      1999, $7,088,000 was outstanding under this note payable.

(3)   OPTIONS

      In connection with AAi.FosterGrant's investment in Fantasma, Fantasma
      issued options to two employees. The options provide that the employees
      may purchase up to 13% of Fantasma at the fair market value on the date of
      grant. Certain of these options contain performance criteria and,
      therefore, will be accounted for as variable options. Based on 1998
      activity, options to purchase 3% of Fantasma expired during the fiscal
      year. As of January 2, 1999 options to purchase 10% of the Company were
      outstanding and the exercise price was equal to or greater than the fair
      market value, therefore no expense was recorded.

      In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-Based
      Compensation. SFAS No. 123 requires the measurement of the fair value of
      stock options granted to employees to be included in the statement of
      operations or disclosed in the notes to financial statements. Fantasma has
      determined that it will account for stock-based compensation for employees
      under Accounting Principles Board Opinion No. 25, Accounting for Stock
      Issued to Employees, and elect the disclosure-only alternative under SFAS
      No. 123.

      Had compensation cost for Fantasma's options been determined based on the
      fair value at the grant dates, as prescribed in SFAS No. 123, Fantasma's
      net loss for the fiscal year ended January 2, 1999 would have been
      $63,000.

      The fair value of each option grant is estimated on the date of grant
      using the Black-Scholes option pricing model with the following
      assumptions used for grants during the applicable period: no dividend;
      yield volatility of 35.53%; risk-free interest rates of 6.00% and a
      weighted average expected option term of 5 years. The weighted average
      grant date fair value for an option to purchase a 1% membership interest
      in Fantasma granted during the year ended January 2, 1999 was
      approximately $14,400.

(4)   RELATED PARTY TRANSACTIONS

      Shared Resources

      As discussed in Note 1, for the period from January 1, 1995 to August 31,
      1996, Fantasma operated as the Fantasma division of Overdrive. During this
      period, and for the period from September 1, 1996 to June 10, 


                                      F-47
<PAGE>   95

                                  FANTASMA LLC

                          NOTES TO FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

      1998, general corporate overhead costs related to corporate headquarters
      and shared administrative support were allocated by Overdrive to Fantasma
      based on a number of factors, including, for example, personnel and space
      utilized. In addition, Fantasma has operated as a division of
      AAi.FosterGrant since June 10, 1998 and has had similar expenses allocated
      to it by AAi.FosterGrant using similar factors. Management believes these
      allocations were reasonable and the costs of the services charged to
      Fantasma were not materially different from the costs that would have been
      incurred had Fantasma performed these functions as a stand-alone entity.

      Overdrive allocated expenses through advances. Interest on advances was
      charged monthly until June 10, 1998, based on the prime rate applied to
      the average outstanding monthly balance. Total interest charged on
      advances payable to Overdrive was $129,000, $160,000, and $27,000 in the
      years ended December 31, 1996 and 1997 and January 2, 1999, respectively.
      Advances from Overdrive were repaid on June 10, 1998. Expenses allocated
      by AAi.FosterGrant are funded through the note payable (see Note 2 for
      further discussion).

(5)   SIGNIFICANT CUSTOMERS

      During the year ended January 2, 1999, three customers accounted for
      approximately 22%, 17% and 10% of net sales, respectively. These
      customers' accounts receivable balances represented approximately 27%, 14%
      and 4% of gross accounts receivable as of January 2, 1999.


                                      F-48
<PAGE>   96

                                  FANTASMA LLC

                          NOTES TO FINANCIAL STATEMENTS
                                 JANUARY 2, 1999

                                   (Continued)

(6)   SEGMENT REPORTING

      The Company has adopted SFAS No. 131, Disclosures About Segments of an
      Enterprise and Related Information, in the 1998 fiscal year. SFAS No. 131
      establishes standards for reporting information regarding operating
      segments in annual financial statements and requires selected information
      for those segments to be presented in interim financial reports issued to
      stockholders. SFAS No. 131 also establishes standards for related
      disclosures about products and services and geographic areas. Operating
      segments are identified as components of an enterprise about which
      separate discrete financial information is available for evaluation by the
      chief operating decision maker, or decision making group, in making
      decisions now to allocate resources and assess performance. To date, the
      Company has viewed its operations and manages its business as principally
      one segment.

(7)   VALUATION AND QUALIFYING ACCOUNTS

<TABLE>
<CAPTION>
                                            ADDITIONS
                           BALANCE AT       CHARGED TO      DEDUCTIONS    
                          BEGINNING OF      COSTS AND          FROM         BALANCE AT 
                             PERIOD          EXPENSES       RESERVES(1)    END OF PERIOD
<S>                          <C>              <C>             <C>            <C>    
Accounts receivable-
   December 31, 1996         $    80          $   171         $    65        $   186
   December 31, 1997             186              360             144            402
   January 2, 1999               402               --              29            373
</TABLE>

(1)   Amounts deemed uncollectible


                                      F-49
<PAGE>   97

              REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULE

To the Shareholders of
AAi.FosterGrant, Inc. and Subsidiaries:

We have audited in accordance with generally accepted auditing standards, the
consolidated financial statements of AAi.FosterGrant, Inc. and Subsidiaries
included in this 10-K and have issued our report thereon dated February 19,
1999. Our audits were made for the purpose of forming an opinion on the basic
consolidated financial statements taken as a whole. This schedule is the
responsibility of the Company's management and is presented for purposes of
complying with the Securities and Exchange Commission's rules and is not part of
the basic financial statements. This schedule has been subjected to the auditing
procedures applied in the audit of the basic consolidated financial statements
and, in our opinion, fairly states in all material respects, the financial data
required to be set forth therein in relation to the basic consolidated financial
statements taken as a whole.


                             /s/ ARTHUR ANDERSEN LLP

Boston, Massachusetts
February 19, 1999


                                      F-50
<PAGE>   98

                                                                     SCHEDULE II

                     AAI. FOSTERGRANT, INC. AND SUBSIDIARIES

                        VALUATION AND QUALIFYING ACCOUNTS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                        ADDITIONS
                                  BALANCE AT            CHARGED TO       DEDUCTIONS
                                 BEGINNING OF           COSTS AND           FROM                              BALANCE AT 
                                    PERIOD               EXPENSES        RESERVES(1)       OTHER (2)        END OF PERIOD

<S>                              <C>                   <C>               <C>              <C>                <C>       
Accounts receivable-
    December 31, 1996            $      728            $   16,265        $   13,721       $    9,810         $   13,082
    December 31, 1997                13,082                27,477            31,130              909             10,338
    January 2, 1999                  10,338                47,048            48,711            1,300              9,975
                                                                                                          
Restructuring reserve-                                                                                    
    December 31, 1996            $       --            $       --        $       --       $       --         $       --
    December 31, 1997                    --                    --                --               --                 --
    January 2, 1999                      --                 2,600             1,947               --                654
</TABLE>

      (1)   Amounts deemed uncollectible

      (2)   Reserves related to accounts receivable acquired in acquisitions


                                      F-51