<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

                                        
                                  FORM 10-K/A
                                 AMENDMENT #1


                                 ANNUAL REPORT
                       PURSUANT TO SECTION 13 OR 15 (d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934


   FOR THE FISCAL YEAR ENDED                 COMMISSION FILE NUMBER
         AUGUST 2, 1998                             0-21943

                     - - - - - - - - - - - - - - - - - - -


                              FOUR MEDIA COMPANY
            (Exact Name of Registrant as Specified in its Charter)


           DELAWARE                               95-4599440
 (State or other jurisdiction                  (I.R.S. Employer
 of incorporation or organization)            Identification No.)

    2813 West Alameda Avenue
      Burbank, California                             91505
 (Address of principal executive offices)          (Zip code)

        Registrant's telephone number including area code: 818-840-7000
                                        
       SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: None

          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

                    Common Stock, par value $.01 per share
                     - - - - - - - - - - - - - - - - - - -
     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

                      Yes   X          No 
                          -----            -----   

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.

                      Yes   X          No  
                          -----            -----   

     The aggregate market value of the voting stock held by non-affiliates of
the Registrant as of October 9, 1998 was $22,516,672.

     As of October 9, 1998, 10,363,256 shares of the Registrant's Common Stock,
$.01 par value, were outstanding.


                      DOCUMENTS INCORPORATED BY REFERENCE


          Part III incorporates information by reference from the definitive
proxy statement for the 1998 Annual Meeting of Stockholders to be held on
January 14, 1999.

                     - - - - - - - - - - - - - - - - - - -

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                                     PART I

          The following should be read in conjunction with the Consolidated
Financial Statements and Notes thereto appearing elsewhere in this Form 10-K.
When used in the following discussion, the words "believes," "anticipates,"
"intends," "expects" and similar expressions are intended to identify forward-
looking statements.  Such statements are subject to certain risks and
uncertainties which could cause actual results to differ materially from those
projected.  Readers are cautioned not to place undue reliance on forward-looking
statements, which speak only as of the date hereof.

Item 1.  Business

Overview

          The Company is a leading provider of technical and creative services
to owners, producers and distributors of television programming, television
commercials, feature films and other entertainment content in the United States
and Asia.  The name Four Media Company is derived from the Company's core
competencies in film, video, sound and data.  The Company's services integrate
and apply a variety of systems and processes to enhance the creation and
distribution of entertainment content.  The Company seeks to capitalize on
growth in domestic and international demand for original entertainment content
and for existing television and film libraries without taking production or
ownership risk with respect to any specific television program, feature film or
other content.

          Since its formation in 1993 through fiscal 1998, the Company has
invested extensively in new digital systems and equipment.  In addition, the
Company has successfully identified and either acquired or started and then
integrated eleven complementary businesses.  The latest of these acquisitions
occurred in September 1998 when the Company acquired the operations of Encore
Video ("Encore").  As a result of its investments and acquisitions, the Company
is one of the largest and most diversified independent (not affiliated with or
related to a content owner) providers of technical and creative services to the
entertainment industry, and therefore is able to offer its customers a single
source for such services.

          The Company has ten wholly-owned operating subsidiaries: 4MC-Burbank,
Inc. ("4MC Burbank"), Digital Magic Company ("DMC"), Anderson Video Company
("Anderson"), Four Media Company Asia Pte. Ltd. ("4MC Asia"), 4MC-Company 3,
Inc. ("Co3"), Visualize, d.b.a. Pacific Ocean Post ("POP"), VSDD Acquisition
Corporation ("VSI"), MSCL, Inc., FilmCore Editorial San Francisco, LLC, and
FilmCore Editorial Los Angeles, LLC (collectively "Encore").  Also, the Company
has one majority-owned subsidiary, POP Animation, and one minority-owned
investee, Cinram POP DVD Center, LLC.  The Company continues to be acquisition-
oriented and is continually evaluating acquisition opportunities to enhance its
operations and profitability.

          The Company has organized its activities into four divisions, each of
which offers services that are integral to the creation, enhancement and/or
distribution of entertainment content.

          Manufacturing and Distribution.  The manufacturing and distribution
division (formerly the studio division) provides owners of television and film
libraries with all of the facilities and services necessary to manage, format
and distribute content worldwide.  These services include restoring and
preserving damaged content, archiving original elements and working masters,
creating working masters from original elements, duplicating masters for
professional applications and formatting masters to meet specific end-user
standards and requirements.  The manufacturing and distribution division offers
customers lower operating costs, improved response time and reliability, access
to new technology, and adherence to quality standards that are recognized
throughout the technical community.  The division's customer base includes the
major domestic studios (and their international divisions) as well as
independent owners of television and film libraries.  Manufacturing and
distribution operations are conducted in Burbank, California.

          Broadcast and Syndication.  The broadcast and syndication division
(formerly broadcast services) provides domestic and international programmers
with the facilities and services necessary to assemble and distribute
programming via satellite to viewers in the United States, Canada and Asia.
These services include assembling programming provided by the customer into a
24-hour "network" format; creating interstitial and promotional graphics and
other material that support the brand identity of the programming;  providing
language translation and subtitling; providing production support and facilities
for the timely creation of original programming such as host and news segments,
and live shows; and providing automated playback systems and satellite uplink
facilities.  In 

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addition, the broadcast and syndication division provides facilities and
services for the delivery of syndicated television programming in the United
States and Canada and also transmits special events, sports or news segments for
insertion in third party networks. The division's customer base includes major
entertainment companies offering worldwide network programming, independent
content owners offering niche market programming, and pay-per-view services
marketing movies and special events to cable and direct-to-home viewers.
Broadcast and syndication operations are conducted in Burbank and the Republic
of Singapore.

          Television.  The television division (formerly television services)
provides producers of original television programming and television commercials
with certain technical and creative services that are necessary to conform
original film or video principal photography into a final product suitable for
airing on network, syndicated, cable or foreign television.  These services
include developing negative in the Company's film laboratory; converting
developed negative to videotape and/or digital formats; creating music and sound
effects; mixing sound elements for inclusion with the final program master;
creating visual effects; integrating visual effects into the final program
master; correcting color; removing artifacts and scratches from the program
master; formatting for commercial integration; and delivering (via tape or
satellite) the program master for broadcast.  The division's customer base
includes most of the major domestic studios and broadcast networks that are
engaged in the production of original programming as well as a large number of
independent production companies.  Television operations are conducted in
Burbank and Santa Monica.

          Film and animation.  The film and animation division (formerly the
visual effects division) provides creators of special visual effects with
certain services required to digitally create or manipulate images in high
resolution formats for integration in feature films and television commercials.
These services include developing negative and correcting color in the Company's
film laboratory; digitally scanning film; digitally compositing multiple layers
of effects; digitally creating computer generated animated sequences and
recording the results on film and creating computer generated animated
sequences.  The division's customer base includes most of the major domestic
studios as well as independent film production companies.  Film and animation
operations are conducted in Burbank and Santa Monica.

Markets

          The entertainment industry creates motion pictures, television
programming, and interactive multimedia content for distribution through
theatrical exhibition, home video, pay and basic cable television, direct-to-
home, private cable, broadcast television, on-line services and video games.
Content is released into a "first-run" distribution channel, and later into one
or more additional channels or media.  In addition to newly-produced content,
film and television libraries may be released repeatedly into distribution.
Entertainment content produced in the United States is exported and is in
increasingly high demand internationally.  The Company believes that several
trends in the entertainment industry have and will continue to have a positive
impact on the Company's business.  These trends include growth in worldwide
demand for original entertainment content, the development of new markets for
existing content libraries, increased demand for innovation and creative quality
in domestic and foreign markets, and wider application of digital technologies
to content manipulation and distribution, including the emergence of new
distribution channels.

          Motion Picture Industry.  The domestic motion picture industry
encompasses the production, distribution and exhibition of feature-length motion
pictures, including their distribution in home video, broadcast and cable
television and other ancillary markets.  While the domestic motion picture
industry is dominated by the major studios, including Paramount Pictures, Sony
Pictures Corporation, Twentieth Century Fox, Universal Pictures, The Walt Disney
Company and Warner Bros., independent production companies also play an
important role in the production of motion pictures for domestic and
international feature film markets.  In 1997, the number of releases soared to
507, topping the 500 mark for the first time in the 1990's.  The major studios
released 231 feature films, while domestic independent producers and
distributors accounted for an additional 276 films.  The Company's film and
animation division create and integrate digital visual effects and animation
sequences into newly released feature films.  The Company's film and animation
division provide services that create and integrate digital visual effects and
animation sequences in to newly released feature films.

          In 1997, the worldwide revenue of filmed entertainment totaled $33.9
billion, an increase of 4.2% over 1996.  Recent growth in international revenue
has far exceeded growth in North American (United States and Canada) revenues,
with international revenue now accounting for nearly half of total revenue.
According to an August 1996 industry forecast, it is expected that by the year
2000, international revenue from motion pictures produced in the United States
will surpass North American revenue.  The Company's manufacturing and

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distribution division provides services that support the preparation and
delivery of feature films for distribution in domestic and international home
video, television and other ancillary markets.

          Television Production Industry.  The North American television
production and distribution industry serves the largest broadcast market in the
world, with a population of approximately 300 million and more than 97 million
television households.  In North America, programming is delivered to television
households via conventional broadcast networks, cable channels, individual
television stations and satellite delivery systems.  Broadcast television
networks in the United States includes two relatively new networks, the United
Paramount Network and the Warner Bros. Network, as well as the established
networks, ABC, NBC, CBS and Fox.  These networks penetrate nearly 100% of
domestic television households and provide access to a broad-based mass audience
for television advertisers.  Spending for television advertising, which drives
the production of new programming and the sale of existing content libraries,
was $34.7 billion in 1997, a 6.1% annual growth rate since 1992.  Projected
spending for 2002 is estimated at $46.6 million.  While the networks have seen
an erosion of their penetration and reduced advertising revenues, the basic
cable networks have increased penetration, programming and advertising revenues.

          The demand for entertainment content has increased significantly as a
result of the introduction of new broadcast networks, cable channels, direct
broadcast satellite systems, pay television, increased cable penetration and the
growth of home video.  The new broadcast and cable television networks have
created the need for more hours of original programming and competition for
viewers has increased the demand for innovation and creative quality resulting
in higher levels of production and related spending.  In 1997, United States
television broadcasters (including cable) spent approximately $12.4 billion for
programming, compared to $8.9 billion in 1995.  The Company's television
division supports the creation of television programming and advertising for
domestic distribution and the Company's broadcast and syndication division
supports the delivery of programming through various channels of distribution
including cable, independent television stations and satellite delivery systems.

          In the last decade, the privatization of broadcasting systems outside
the United States, the proliferation of broadcast licenses, and the introduction
of sophisticated delivery technologies, such as cable and satellite transmission
systems, have led to significant growth of broadcasting and cable television
markets outside North America.  European television is the most visible example
of the growth in programming outlets.  Over the last 15 years, European
governments have encouraged a major expansion of the public and private
broadcasting sectors.  For example, Germany and France each have added six
broadcast networks and the United Kingdom has added four.  The introduction of
new television broadcast systems is just beginning in Asia and Eastern Europe.
Most foreign broadcasters require both indigenous programming to satisfy the
local content requirements of their broadcast licenses and popular international
programming, largely produced in the United States.  The substantial growth of
broadcast markets outside North America has also increased the demand for
entertainment content produced in the United States.  The Company's television
division supports the creation of programming for international distribution,
the Company's manufacturing and distribution division supports the preparation
of content to be viewed in international markets, and the Company's broadcast
and syndication division supports the distribution of cable channels in Asia.

          Multimedia Industry.  The interactive multimedia industry encompasses
video games, "edutainment" and on-line interactive services.  While certain
segments of the industry such as video games are well established, the
multimedia industry is still emerging and represents with significant growth
potential.  Revenues derived from the sale of video game software alone was
approximately $3.6 billion in 1997.  This is expected to grow to $4.7 billion by
2002.  Improvements in technology, the availability of communication bandwidth
including cable modems and direct satellite access, the proliferation of
distribution channels for entertainment products and services, and the
involvement of large entertainment companies, provide the critical mass to
support continued growth.  Advertisers spent an estimated $1.0 billion for
online advertising in 1997.  Online advertising spending in 2002 is expected to
exceed $8.0 billion reflecting anticipated increases in online penetration of
worldwide households and advances in online commerce.  The content currently
being created for online access integrates various forms of media including live
action video, animation, graphics and audio.  Although the Company's current
revenues from these emerging market segments represent only a small portion of
consolidated results, the Company expects the rapid growth of the multimedia
industry will positively impact the Company specifically in the areas of video
compression, digitization, 2D and 3D graphics, and authoring particularly for
the more complex platforms and applications such as digital versatile disk
("DVD") and server-based content on-demand services.

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Products and Services

          The Company has defined its operating divisions in terms of the
entertainment industry market segments that each serves.  Each sector is driven
by related but diverse economic factors, and as a result, the Company is not
solely dependent upon any single market segment within the entertainment
industry.  The Company intends to maintain and expand the diversity of its
revenue sources and views such diversity as a significant competitive operating
and financial advantage.  For each of its operating divisions, the Company has
defined a set of services which support the entire technical and creative
process of its customers.  As such, the Company seeks to provide complete
outsourcing solutions utilizing the full range of its services in each division.

          Manufacturing and Distribution Services

          The manufacturing and distribution division offers a broad range of
facilities and technical services to owners of television and film libraries.
The division provides all of the services necessary to manage, format and
distribute content on an international scale.  These services include archiving
original elements and working masters, restoring and preserving damaged content,
creating working masters from original elements, duplicating masters for
professional applications, and formatting masters to meet specific end-user
standards and requirements.  As an outsourcing solution, the Company offers the
customer lower operating costs, improved response time and reliability, access
to new technology, and standards of quality that are recognized by the
international technical community.

          Archive.  The storage and handling of videotape and film elements
require specialized security and environmental control procedures.  Throughout
the entertainment industry, content representing millions of dollars of future
revenue is stored in physically small units that are subject to the risk of loss
resulting from physical deterioration, natural disaster, unauthorized
duplication or theft.  The Company's archive is designed to store approximately
500,000 master videotapes and film elements in an environment protected from
temperature and humidity variation, seismic disturbance, fire, theft and other
external events.  In addition to the physical security of the archive, content
owners require frequent and regular access to their libraries.  Speed and
accuracy of access is a critical value added factor.  The Company believes that
its archive is the largest among independent service providers and among the
most advanced with respect to security, environmental control and access
features.

          Restoration.  Substantially all film elements originating prior to
1983 have faded, degraded or have been damaged.  Damaged film negative must be
restored because submasters produced from damaged film will generally not meet
the minimum quality standards required in domestic and foreign broadcast
markets.  The Company's technicians restore damaged film negative to original
and sometimes enhanced quality through the use of proprietary optical and
electronic equipment and techniques.  The Company believes it is well recognized
for its ability to complete technically challenging restoration assignments.

          Preservation.  In order to protect their film assets from degradation,
older film is frequently converted to new archival film stock.  Modern film
stock is the preferred archival medium because it has the highest image
resolution of any image storage medium and a shelf life that exceeds 100 years.
Using a proprietary process, the Company takes the original (or restored) film
negative and creates an archival answer print and interpositive (i.e., a new
negative).  The Company believes that, due to technical and operational advances
in its proprietary preservation process, it is a market leader in the
preservation of existing film content.

          Transfer.  Substantially all film content ultimately is distributed to
the home video, broadcast, cable or pay-per-view television markets, requiring
that film images be transferred to a video format.  Each frame must be color
corrected and adapted to the size and aspect ratio of a television screen in
order to ensure the highest level of conformity to the original film version.
Because certain film formats require transfers with special characteristics, it
is not unusual for a motion picture to be mastered in many different versions.
For example, anamorphic (e.g. Cinemascope(R)) formats require mastering in at
least two aspect ratios (pan/scan and letter box) and certain international
broadcasters have other requirements.  The Company transfers film to videotape
using URSA Diamond(R) and Spirit(R) telecine equipment and DaVinci(R) digital
color correction systems.  Technological developments, such as the domestic
introduction of television sets with a 16 x 9 aspect ratio and the
implementation of advanced and high definition digital television systems for
terrestrial and satellite broadcasting, should contribute to the growth of the
Company's film transfer business.

          Transform.  Production companies may choose to originate their work on
videotape even though the ultimate market is a theatrical release on film.  The
Company developed a proprietary process called Transform(R) to convert videotape
to film.  Transform(R) uses an electron beam recorder and a patented color
imaging system to 

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transform video pictures from all current broadcast standards to 16mm or 35mm
film. The process involves transferring red, blue and green video images
sequentially to a 16mm fine grain intermediate film stock using an electron beam
modulated with the video image. These fine grain separations are then
sequentially step-printed onto color negative film stock. The Transform(R)
process is applicable to advertising commercials and interstitial programming
material (less than 90 seconds in length) as well as theatrical length
presentations including feature films, concerts and special events. The Company
currently Transforms(R) numerous short segments and special events, as well as
six to ten feature films per year.

          Audio Layback.  Audio layback is the process of creating duplicate
videotape masters with sound tracks that are different from the original
recorded master sound track.  Content owners selling their assets in foreign
markets require the replacement of dialog with voices speaking local languages.
In some cases, all of the audio elements, including dialog, sound effects, music
and laughs, must be recreated, remixed and synchronized with the original
videotape.  Audio sources are premixed foreign language tracks or tracks that
contain music and effects only.  The latter is used to make a final videotape
product that will be sent to a foreign country to permit addition of a foreign
dialogue track to the existing music and effects track.  The Company attracts
audio layback business by offering optimum sound quality and synchronization of
audio to picture within a half frame accuracy.

          Standards Conversion.  Standards conversion is the process of changing
the frame rate of a video signal from one video standard (such as the United
States standard) to another (such as a European standard).  Through the
utilization of Digital Electronic Film Transfer(R) and Phase Correlation(R)
technologies, the Company provides the highest quality conversion services
available.  The Company's competitive advantages include its state-of-the-art
systems and its detailed knowledge of the international markets with respect to
quality-control requirements and technical specifications.

          Professional Duplication.  Professional duplication is the process of
creating submasters for distribution to professional end users.  Master tapes
are used to make submasters in up to 7 domestic and international broadcast
standards (i.e. NTSC/525 and PAL/625) as well as up to 22 different tape formats
(ie. D1, D2, Digital Beta).  In addition, videotape content is copied for use in
intermediate processes, such as editing, on-air backup and screening, and for
final delivery to cable and pay-per-view programmers, broadcast networks,
television stations, airlines, home video duplicators and foreign distributors.
The Company believes that its professional duplication facility is technically
advanced and has unique characteristics that significantly increase equipment
capacity utilization while reducing error rates and labor cost.

          Broadcast and Syndication

          The broadcast and syndication division offers a broad range of
facilities and technical and creative services to domestic and international
programmers.  The Company services the basic and premium cable, broadcast
syndication, Canadian network first run and direct-to-home market segments by
providing substantially all of the facilities and services necessary to assemble
and distribute programming via satellite to viewers in the United States, Canada
and Asia.  These services include assembling programming provided by the
customer into a 24-hour "network" format, creating interstitial and promotional
graphics and other material that support the brand identity of the programming,
providing production support and facilities for the timely creation of original
programming such as host and news segments and live shows, and providing
automated playback systems to deliver the programming to air via an uplink
facility.  In addition, the Company provides facilities and services for the
delivery of syndicated television programming in the United States and Canada.
The Company also transmits and receives special events, sports or news programs
for insertion in third-party networks.  The Company's customer base consists of
the major studios and independent distributors offering network programming,
world-wide independent content owners offering niche market programming, and
pay-per-view services marketing movies and special events to the cable industry
and direct-to-home viewers.  Broadcast and syndication operations are conducted
in Burbank and the Republic of Singapore.

          Production.  Timely broadcast programming, such as live shows and
news, requires immediate and precise coordination of on-camera talent, the
script, pre-recorded videotape and graphics materials, and the broadcast
schedule.  The Company operates a state-of-the-art production studio in
Singapore with three cameras, production and audio control rooms, videotape
playback and record, multi-language prompter, computerized lighting, and
dressing and makeup rooms.  The studio is configured for practical set and
chroma key segments.  A one-camera field crew is also available for electronic
field production recording, and the Company offers live-to-satellite interview
and teleconference services.

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     On-Air Promotion.  On-screen marketing and broadcast continuity depend on
on-air promotional material to support the channel's brand identity and
programming.  The Company, working in conjunction with the client's writers and
producers, offers a complete on-air promotion service, including graphics,
editing, voice-over record, sound effects editing, sound mixing and music
composition.

     Language.  Programming designed for distribution in markets other than
those for which it was originally produced is prepared for export through
language translation and either subtitling or voice dubbing.  The Company
provides dubbed language versioning with an audio layback and conform service
that supports various audio and videotape formats to create an international
language-specific master videotape.  The Company's Burbank facility also creates
music and effects tracks from programming shot before an audience to prepare
television sitcoms for dialog record and international distribution.  The
Company's Singapore facility supports translation, and a complete on-screen and
closed-caption subtitling facility.

     Assembly.  Prior to broadcast, all material is quality control checked and
may be pre-compiled into final broadcast form prior to on-air playback.
Interstitial pre-compilation is performed in Company editing facilities, often
using proprietary systems and software which permit the efficient assembly of
high production value visual effects.  Syndicated programming is also prepared
for distribution with commercials and similar elements inserted prior to
distribution.  Control procedures are used to ensure on-air reliability.  The
Company provides programming to most United States broadcast television stations
through daily satellite feeds and tape shipments.  A variety of movie and show
formatting and time compression services are available to prepare programming
for distribution.  Commercial, promotional, billboard, warning, logo and other
integration, as well as closed captioning for the hearing impaired and source
identification encoding, is performed.  The Company also provides traffic
support to programmers; affiliate relations and station coordination; library
storage of broadcast master tapes; and a syndication program library and
recycled videotape inventory.

     Origination and Distribution.  The Company provides videotape playback and
origination to cable, pay-per-view and direct-to-home networks.  The Company
accepts daily program schedules, programs, promos and advertising, and delivers
24 hours of seamless daily programming to cable affiliates and home satellite
subscribers.  The Company uses automated systems for broadcast playback, which
includes proprietary systems and software.  The Company also operates industry-
standard encryption and/or compression systems as needed for customer satellite
distribution.  The Company uses a customized approach to satisfy each customer's
timeliness, flexibility and reliability requirements.  Playback systems are
videotape, robotics and video server-based, and subtitling and "local avail"
(head end commercial insertion) are supported.  Quality control, tape storage
and trafficking services are also offered by the Company.  Currently, the
Company supports over twenty 24-hour channels from its Burbank facility, and
three 24-hour channels originate from the Singapore facility.

     Uplink and Satellite Transponder.  The Company's Burbank facility operates
a C-band video-oriented satellite earth station facility with eight
transmit/receive antennas and over 30 transmit chains.  The Company is licensed
by the FCC and operates as a common carrier.  Facilities are staffed 24 hours a
day and are also used for downlink and turnaround services.  The Company
currently utilizes a transponder on the Loral Skynet Telstar 4(R) satellite in
support of the Company's syndication and Canadian distribution businesses.  The
Company accesses various "satellite neighborhoods," including basic and premium
cable, broadcast syndication and direct-to-home markets.  The Company resells
transponder capacity for ad hoc and other occasional use and bundles its
transponder capacity with other broadcast and syndication services to provide a
complete broadcast package at a fixed price.

     Television

     The television division provides a broad range of facilities and technical
and creative services directed to producers of original television programming.
The Company provides all of the technical and creative services that are
necessary to conform original film or video principal photography to a final
product suitable for network, syndicated, cable or foreign television
distribution.  These services include developing negative in the Company's film
laboratory, converting developed negative to video tape and/or digital formats,
creating music and sound effects, mixing all sound elements for laydown to the
final program master, creating visual effects in the final program master, color
correction, dirt and scratch removal, formatting for commercial integrating and
delivery of the program master via tape or satellite.  The Company's customer
base includes most of the major studios and broadcast networks that produce
original programming as well as a large number of independent production
companies.  Television operations are conducted in Burbank, Universal City and
Santa Monica.

     Negative Developing.  Because of the creative freedom, high resolution
image quality and flexibility attained by working with film, the majority of
prime time network and first run syndicated television programming 

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originates on film. "Dailies" (camera original negative shot during each
production day) for a one-hour drama, situation comedy or movie-of-the-week are
delivered to the Company's film laboratory for overnight development. The
Company's film laboratory specializes in negative developing for television
applications and has increased its television related activities in each year
since the Company's inception.

     Transfer and Digitization.  The Company accepts developed negative from a
laboratory and transfers the film to videotape.  The transfer process enables
the customer to view a video tape of the previous day's work and begin the
creative process of editing.  The transfer process is technically challenging,
and is used to integrate various forms of audio and encode with feet and frame
numbers from the original film.  The Company utilizes state-of-the-art URSA
Diamond(R) , Quadra(R) and Spirit(R) telecine equipment adapted for television
specifications.  The Company believes it produces the highest quality results
attainable in the industry today in part because it uses leading technology for
its transfer services.

     Off-Line Editing.  The Company delivers low resolution digitized images to
the customer for processing by various non-linear editing work stations, such as
the Avid(R), Media Composer(R).  Using these or similar systems, the customer
determines a program's content and creates an edit decision list, which will
eventually be used to assemble the source material into a final product suitable
for broadcast.  The Company provides and fully supports non-linear off-line
editing with personnel and equipment for use by the customer within the
Company's facilities or at a location designated by the customer.  In addition,
the Company is currently constructing communications infrastructure to provide
digitized images directly from the film-to-tape transfer process to a work
station via dedicated phone lines.

     Audio.  Through its facilities in Burbank and Santa Monica, the Company
edits and creates sound effects, assists in replacing dialog and re-records all
the audio elements for integration with film and video elements.  The Company
designs sound effects to give life to the visual images with a proprietary
library of over 30,000 digital sound effects.  Dialog replacement is sometimes
required to improve quality, replace lost dialog or eliminate extraneous noise
from the original recording.  Re-recording combines sound effects, dialog, music
and laughter or applause to complete the final product.  In addition, the re-
recording process allows the enhancement of the listening experience by adding
specialized sound treatments, such as stereo, Dolby(R) SR(R) and
Surroundsound(R).  The Company's Burbank facility has four studios devoted to
situation comedies and one-hour dramas as well as two theater-sized re-recording
stages targeted at the feature film and made-for-television movie markets.  The
Company's Santa Monica facility has eleven studios which primarily serve the
sound needs of commercial advertising, music videos and certain home video
applications.  The Company employs an award winning staff and is well respected
for its technical and creative contribution.

     Visual Effects.  Visual effects are used to enhance the entertainment
experience of the viewing audience by supplementing images obtained in principal
photography with computer generated imagery.  The visual effects is typically
used to create images that cannot be created by any other cost effective means.
Digital Magic and POP, both located in Santa Monica, specialize in creating
visual effects for television.  The Company's compositing suites are configured
for nine layers of color correction and eight layers of compositing with
powerful wipe generators.  These devices are used to generate bends, warps,
morphs, 3D shapes and transformations in real time.  The Company also offers an
array of graphics and animation workstations using a variety of software to
accomplish unique effects, including 3D animation.  The Company is a leader in
providing visual effects for the television industry as evidenced by its
involvement in numerous award winning series, including the X Files(R), Star
Trek(R)--Deep Space Nine(R) and Star Trek(R)--Voyager(R).

     Assembly, Formatting and Duplication.  Once client-directed creative
decisions are complete, including the integration of sound and visual effects,
the Company utilizes the edit decision list to assemble the source material into
its final form.  This assembly is accomplished by using a combination of digital
linear assembly systems and full-resolution non-linear assembly systems.  The
Company believes that its assembly systems, which became operational in 1996,
are among the most technologically advanced in the industry.  In addition, the
Company utilizes sophisticated computer graphics equipment to generate titles
and character imagery and to format the program to meet specific network
requirements (including time compression and commercial breaks).  Finally, the
Company creates multiple master videotapes for delivery to the network for
broadcast, archival and other purposes designated by the customer.

     Film and Animation

     The film and animation division offers a broad range of facilities and
technical and creative services to creators of special visual effects and
animation sequences for feature films.  The Company provides services 

                                       8
<PAGE>
 
necessary to digitally create or manipulate images in high resolution formats
for integration into feature films. These services include negative developing
and color correction utilizing the Company's film laboratory facilities, film
scanning and recording, digital compositing, and computer generated animation.
The Company bundles its film and animation to lower the effective cost of
certain visual effects, improve response time and consistency of results, and to
provide customers access to new technology. The Company's customer base includes
most of the major studios as well as independent visual effects supervisors
contracted by producers of feature films. Film operations are conducted in
Burbank and Santa Monica.

     Pre-Production and Principal Photography Consulting.  Using a script
provided by the production company, the Company provides a written outline for
implementing the effects, a time frame and a preliminary effects budget.  The
Company makes recommendations on how best to realize each visual effect, taking
into consideration the complexity of the desired effect, the production schedule
and budget.  Even projects that would not normally be considered a special
effect feature will make use of digital techniques to create sets, backgrounds,
lighting, crowds and similar imagery.  The Company creates a story board as the
basis of understanding as to which elements will be shot and by whom prior to
principal photography.  Upon request, the Company will provide a visual effects
supervisor to assist in principal photography that will later be incorporated in
a digital effect.  The Company will also assemble a film crew to shoot elements
that are necessary to properly integrate a visual effect into a particular
scene.

     Effect Design and Creation.  In order to reduce costs and meet shorter
release schedules, studios are limiting the amount of time available for the
Effect Creation Process from twelve to four months.  This acceleration is often
at odds with the responsibility of the visual effects supervisor to evaluate
different alternatives before making a final selection.  In order to minimize
costs, the Company first designs effects in low (i.e., video) resolution.  Once
the design is approved, the Company creates visual effects in high (i.e., film)
resolution using powerful computers, provided by Quantel and Silicon Graphics.
Quantel products are used for high speed digital image creation, animation,
compositing, retouching, rotoscoping, and motion and color correction.  Silicon
Graphics computers are deployed to utilize a variety of software packages,
including Inferno(R) by Discrete Logic(R), which is capable of creating
elaborate digital multi-plane matte paintings and live action effect composites.
The Company also employs other Silicon Graphics(R) work stations to run
specialized software, including Alias(R), Soft Image(R) and various other
packages for 3D animation applications.

     Film Scanning and Recording.  Scanning is the process of digitizing
principal photography so that images can be created or manipulated in a digital
work station.  The Company digitizes film on a film scanner and transfers the
digital information to a central file server where it can be accessed by any of
the Company's work stations.  Once the effect is completed and approved by the
visual effects supervisor, the Company downloads the digital information to a
digital film recorder, which records the digital information on film.  The
completed conversion can then be assembled with the film negative.

     Color Correction, Negative Developing and Printing.  The Company's film
laboratory is utilized to process and print the visual effects segments for
viewing in film resolution.  In preparing the final cut, it is often difficult
to integrate the effect seamlessly with the principal photography on a timely or
cost efficient basis.  The Company's film laboratory offers a proprietary color
correction process designed to give the visual effects supervisor more control
over the integration of the digitally created images with the principal
photography.  The Company believes that it has the only visual effects operation
incorporating this film laboratory quality control feature.

Customers

     The Company's customer base includes the major studios, independent owners
of television and film libraries, programmers, producers of original television
programming, producers of television commercials, and creators of visual
effects.  As of August 2, 1998, the Company's customer base included
approximately 2,500 customer accounts.  The Company is committed to building and
retaining a loyal customer base by providing a broad range of service offerings,
state-of-the-art equipment and technology, and superior customer service at
competitive prices.

     The Company's ten largest customers accounted for 52.0% and 44.7% of total
revenues in fiscal 1997 and 1998, respectively.  In addition, 38.8% and 27.7% of
the Company's revenues were generated by the six major domestic studios (Disney,
Universal, Sony Pictures, Viacom/Paramount, Warner Bros./Turner and Twentieth
Century Fox) in fiscal 1997 and 1998, respectively.  MTV Asia accounted for 13%
and 8% of the Company's revenues in fiscal 1997 and 1998, respectively.  No
other customer accounted for 10% or more of the Company's 

                                       9
<PAGE>
 
revenues. Except for MTV Asia, TVN and a limited number of other customers, none
of the Company's customers has a long-term contractual relationship with the
Company whereby the customer is obligated to purchase any specified level of
services from the Company. The Company's standard credit term for customers is
"Net 30 Days," although, in the Company's experience, the prevailing practice
among major studios and certain other customers is to pay outstanding accounts
within approximately 60 to 90 days. The Company reviews a customer's credit
history and establishes an allowance for doubtful accounts based upon factors
surrounding the credit risk of specific customers, historical trends, and other
information.

     In the Company's television division, customer relationships can also be
measured by the number and types of projects completed by the Company during the
production season.  For example, the number of episodic television programs that
the Company provided one or more services to has increased from 67 in 1996 to 84
in 1997 to 114 in 1998.  The Company believes that the increase in its
television customer base is the result of an increased volume of television
production, the construction of a new television facility in Burbank (which was
completed in the fourth quarter of fiscal 1997), various acquisitions, and
significantly improved coordination between the Company's television facilities.

Technology

     The Company purchases hardware and software developed and manufactured by
others and integrates various systems and technologies in a proprietary manner
to accomplish the objectives of its customers.  The integration of hardware and
software often requires the development of new proprietary systems and
infrastructure by the Company.  From time to time, the Company forms strategic
alliances with hardware and software manufacturers to jointly develop a specific
application.  Examples of informal strategic alliances involving joint
development projects include: (i) BTS(R) and NVision(R) component digital
routing systems; (ii) Snell & Wilcox Alchemist(R) Phase Correlation(R) standards
conversion equipment; (iii) Cintel, Inc. URSA Diamond(R) and C-Reality(R)
technology for television and feature mastering applications; (iv) SeaChange
file server-based broadcast systems; (v) Quantel, Inc.(R) Edit Box(R) and Clip
Box(R) file server and non-linear editing technology for episodic television
assembly; and (vi) Phillips Spirit(R) and Datacine(R) film transfer equipment.

     The Company believes that its infrastructure is state-of-the-art and sets
the industry standard for performance, efficiency and reliability.  (This
statement is based on the Company's belief and is not supported by any
independent verification).  The Company intends to upgrade its broadcast and
syndication operation in Burbank to accommodate new digital technologies and
convert the remaining analog portions of the Company's television business to
support digital applications and formats as it becomes technically and
operationally feasible. The time frames for the upgrade of the Company's
broadcast and syndication operations in Burbank and the remaining analog
portions of the Company's television operations are as follows:

     Broadcast and Syndication: The Company intends to complete the upgrade of
its broadcast and syndication operations in Burbank by the end of the first
quarter of fiscal 2000.  Upgrades will expand the Company's ability to broadcast
digitally compressed audio and video signals to satellite transponders.

     Television:  Digital upgrades to the television division are conducted on
an ongoing basis.  The Company experiences customer demand for services that
require analog infrastructure and, as a result, the Company will continue to
maintain analog infrastructure as necessary to satisfy such demand.
Approximately eighty percent of the digital upgrades for the Company's
television division are complete. The timing of the remaining digital upgrades
will depend upon each facility's respective workload.  Facilities are upgraded
during the time when the business disruption will be minimal.  The Company
anticipates that the remaining upgrades will be performed between late May 1999
and the end of the second quarter of fiscal year 2000.

See "Management's Discussion and Analysis of Financial Condition and Results of
Operations."

Competition

  Los Angeles is the center of domestic television and feature film production
and the exploitation of content libraries.  It is also the largest and most
competitive market in the world in terms of total revenue potential for the
Company's manufacturing and distribution, film and animation, and television
divisions.  The entertainment services industry in Los Angeles is highly
fragmented, and no single industry participant, including the Company, 

                                       10
<PAGE>
 
has a dominant market share in any service offering. The Company believes that
it is unique, however, among industry competitors in terms of the breadth of its
operating divisions and the depth of service offerings within each business
segment. The Company entered the international broadcast market with the
completion of its Singapore facility in 1995, and seeks to provide services to
domestic and foreign programmers in regional television markets in Asia and
abroad. The Company competes with local service providers that may have
competitive advantages resulting from their experience in the region, including
in Singapore and elsewhere in Asia, who have well established customer
relationships and business operations.

  The Company experiences intense competition in each of its business segments.
Although the Company believes no one competitor offers a comparable range of
services, some of the Company's current and potential competitors, particularly
those who perform services in-house, have substantially greater financial,
technical, creative, marketing and other resources than the Company.  The
Company's competitors may devote substantially greater resources to the
development and marketing of new competitive services.  The Company expects that
competition will increase substantially as a result of industry consolidations
and alliances, as well as the emergence of new competitors.  The Company also
actively competes with industry participants operating niche or specialty
businesses.  In addition, certain of the Company's current and prospective
customers conduct in-house operations that the Company considers competitive.
The Company believes that all of its service offerings are competitive with in-
house operations and with independent service providers.

Employees

  The Company employs creative, technical, engineering, administrative and
managerial staff in each operating division.  In addition, the Company has
centralized certain financial and administrative functions, including
accounting, credit, billing, payroll and human resources.  As of August 2, 1998,
the Company had a total of 1,063 full time employees, of which 598 were located
in Burbank (including 97 in Universal City), 380 in Santa Monica and 85 in
Singapore.

  As of August 2, 1998, the Company had entered into employment agreements with
approximately 52 members of its creative and managerial staff to secure their
services for terms ranging from one to seven years.  These employment agreements
are in the ordinary course of the Company's business and are consistent with the
practices of other companies in the post production industry.  In addition, the
Company has employment agreements with the executives named under the Executive
Compensation section of the Proxy Statement for the Company's January 14, 1999
annual meeting.

     The Company believes that it provides compensation and benefits that are
competitive with the market for persons with the skills required by the Company.
The Company has experienced no work stoppages since its formation in 1993.  As
more fully described in Item 3 below, the Company is involved in a proceeding
with the NLRB and IATSE regarding the potential imposition of successor
liability for backpay owed to former employees of Compact Video.  Pursuant to an
NLRB order, enforced by the Ninth Circuit Court of Appeals, the Company has
commenced bargaining with IATSE.  Of the Company's 1,063 employees, 34 are
members of a collective bargaining unit.  All of these employees are employed by
Meridian Sound Corp., a subsidiary of 4MC-Burbank, Inc.

Government Regulation

  The Communications Act prohibits the operation of satellite earth station
facilities such as those operated by the Company, except under licenses issued
by the FCC.  The Company holds three satellite earth station licenses and other
authorizations required for the operation of the Company's business.  The
license for these stations are granted for a period of ten years and are
routinely renewed.  The Company's licenses expire in 2001, 2004, and 2007.
While the FCC generally renews licenses for satellite earth stations routinely,
there can be no assurance that the Company's licenses will be renewed at their
expiration dates, which could have a material adverse effect on the Company.

  No FCC authorization is required for reception of transmission from domestic
satellites from points within the United States.  The Company relies on third
party licenses or authorizations when it transmits domestic satellite traffic
through earth stations operated by third parties.  The FCC establishes technical
standards for satellite transmission equipment which change from time to time,
and also requires coordination of earth stations with land-based microwave
systems at certain frequencies to assure non-interference.  Transmission
equipment must also be 

                                       11
<PAGE>
 
installed and operated in a manner that avoids exposing humans to harmful levels
of radio-frequency radiation. The placement of earth stations or other antennae
is typically subject to regulation under local zoning ordinances.

Item 2.  Properties

  At August 2, 1998, the Company's operations were located in Burbank,
California, Santa Monica, California, and the Republic of Singapore.  In
Burbank, the Company leases six facilities, which in the aggregate consists of
approximately 118,000 square feet, under agreements with terms expiring between
February 1999 and August 2009.  These facilities, which include five properties
in the Burbank Media District and one property located in Universal City, are
used to house the Company's executive offices, its domestic broadcast and
syndication operations, equipment rental operations and parts of its television
and manufacturing and distribution operations.  The Company also owns two other
buildings located in Burbank.  One is an 18,000 square foot facility used for
the Company's film laboratory and the other is a 90,000 square foot facility of
which the Company's archive occupies 45,000 square feet.  The remainder of this
facility is leased to a third party.  The Company is currently negotiating to
lease an additional 45,000 square feet that is expected to be available soon in
one of the properties that is currently leased by the Company.  The new leases
would expire in February 2003 and January 2004.  Additionally, the Company is
negotiating the purchase of two facilities, aggregating 44,000 square feet,
which the Company is currently leasing.  In Santa Monica, the Company's film and
animation division and part of its television division are located in five
leased facilities, which in the aggregate consists of approximately 90,000
square feet under agreements with terms expiring between October 1999 and
February 2003.  The Company also owns a parcel of land that is being held for
future development to consolidate certain of its Santa Monica operations.  The
Company leases 22,000 square feet in Singapore to house its Singapore broadcast
operations.  The leases expire in September 2000.

  Subsequent to August 2, 1998, in conjunction with its acquisition of Encore
the Company expanded its operations and properties into Hollywood, California
and San Francisco, California.  As part of the Encore acquisition, the Company
purchased five facilities aggregating 62,000 square feet.  One of these
properties, approximately 13,000 square feet, is located in Santa Monica and is
dedicated to the television.  The other four properties are in Hollywood and
house executive offices and other television operations.  The Company leased two
facilities in which the Company obtained and will exercise its options to
purchase these facilities.  Both facilities also house television operations.
The first property is 3,000 square feet and is located in Hollywood.  The second
property is approximately 7,000 square feet and is located in Santa Monica.
Also, the Company is leasing two other facilities in San Francisco which
aggregate 7,000 square feet.  These leases expire in September 1999 and June
2002.

  Most of the Company's leased properties have renewal options generally for one
or two five-year option periods.

Item 3.  Legal Proceedings

  In ATS Acquisition Corp., Inc. v. National Labor Relations Board ("NLRB") Case
No. 31-CA-20089, the NLRB, joined by the International Alliance of Theatrical
Stage Employees ("IATSE") argued that the Company should have bargained with it
as a labor law "successor" following the sale of Compact's assets to the Company
in August 1993.  The Company refused to bargain with IATSE, contending that only
a broad, company-wide bargaining unit was appropriate.  In a decision issued in
July 1996, the NLRB ordered the Company to bargain with IATSE on a prospective
basis with regard to certain of the Compact bargaining unit employees.  Since
the NLRB's orders are not self-executing, the NLRB sought enforcement of its
order in the United States Court of Appeals.  On October 27, 1997 the Ninth
Circuit Court of Appeals (the "Ninth Circuit") enforced the NLRB's order and the
Company has commenced bargaining with IATSE.  However, the National Labor
Relations Act does not require the Company to compromise its position in
collective bargaining.  Moreover, the Ninth Circuit and the NLRB confirmed the
Company's position that it lawfully implemented its own wages, benefits and
working conditions when it acquired the assets owned by Compact in 1993 and
denied the union's request for back pay.  The NLRB's bargaining order,
therefore, provides for no backpay liability to the Company.

  In Compact Video Services v. National Labor Relations Board, Case No. 31-CA-
20104, the NLRB and IATSE argued that Compact should have timely bargained with
IATSE over the effects of the sale of Compact's assets to the Company.  Compact
lost the original case, which was ultimately enforced by the Ninth Circuit, and
owes certain former Compact employees backpay.  The amount of backpay varies
depending upon numerous legal arguments.  While not named in the underlying
proceeding, the Company has been named in the compliance phase 

                                       12
<PAGE>
 
as a "labor law" successor to Compact. The NLRB and IATSE contend that the
Company purchased Compact with knowledge of Compact's failure to bargain with
IATSE over the effects of the 1993 asset sale, and, therefore, the Company
should be jointly and severally liable with Compact for the backpay. The Company
has substantial legal and factual defenses in its favor regarding the issue of
successor liability and has asserted those defenses. The Company intends to
vigorously defend itself against the imposition of any successor liability
associated with an award of damages assessed against Compact in the underlying
proceedings.

        In addition, the Company is subject from time to time to litigation
arising in the ordinary course of its business, and the Company believes that
there is no litigation pending (including the NLRB/IATSE matters referred to
above) that would have a material adverse effect on the Company's results of
operations or financial condition.

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

        No matter was submitted to a vote of security holders of the Company
during the fourth quarter of the fiscal year ended August 2, 1998.

                                    PART II

Item 5. Market for Registrant's Common Stock and Related Stockholder Matters

        Four Media Company's Common Stock has been traded under the Nasdaq Stock
Market(SM) under the symbol "FOUR" since February 7, 1997. The following table
sets forth the high and low closing prices of the Company's Common Stock for the
periods indicated and are as reported on The Nasdaq Stock Market(SM).

<TABLE>
<CAPTION>

                                                               High                                  Low
                                                               ____                                  ___
<S>                                                            <C>                                    <C> 
Year Ended August 3, 1997
Third Quarter (from February 7, 1997)                          10 1/2                                 5 1/4
Fourth Quarter                                                  8 5/8                                 5 7/8

Year Ended August 2, 1998
First Quarter                                                  10 1/8                                 6 3/8
Second Quarter                                                  9 3/8                                 7 5/16
Third Quarter                                                  10 1/2                                 7 1/8
Fourth Quarter                                                 10 1/2                                 7 1/8
 </TABLE>
 
        As of October 30, 1998, there were 16 stockholders of record of the
Company's Common Stock and an estimated 1,200 beneficial owners of its Common
Stock. The Company has never paid cash dividends on its stock, and anticipates
that it will continue to retain its earnings, if any, to finance the growth of
its business. In addition, the Company's bank line of credit prohibits the
payment of cash dividends on capital stock without the bank's prior written
consent
 
        The market price of the Company's Common Stock is highly volatile and is
subject to wide fluctuations in response to a wide variety of factors including
quarterly variations in operating results, announcements of technological
innovations or new services by the Company or its competitors, conditions
affecting the entertainment industry, changes in financial estimates by
securities analysts, or other events or factors. For example, during the 12
month period ended October 30, 1998, the Company's Common Stock closed as low as
$3.31 and as high as $10.50 per share. In addition, the stock market has
experienced significant price and volume fluctuations that have particularly
affected the market prices of equity securities of many small capitalization and
technology companies and that often have been unrelated to the operating
performance of such companies. These broad market fluctuations may adversely
affect the market price of the Company's Common Stock. In the past, following
periods of volatility in the market price of a company's securities, securities
class action litigation has often been instituted against such a company. If
brought against the Company, such litigation could result in substantial costs
and a diversion of management's attention and resources, which would have a
material adverse effect on the Company's business, results of operations and
financial conditions.

                                       13
<PAGE>
 
Item 6.  Selected Consolidated Financial Data
 
  The following selected financial data as of and for the five years ended
August 2, 1998 are derived from the consolidated financial statements of the
Company. The selected consolidated financial data should be read in conjunction
with the Company's Consolidated Financial Statements and related notes thereto
and "Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this document.
                                        
<TABLE>
<CAPTION>
                                                                               Fiscal Years Ended
                                                             July 31,     July 30,     August 4,     August 3,     August 2,
                                                               1994         1995         1996          1997          1998
                                                             --------     --------     ---------     ---------     ---------
                                                                     (dollars in thousands, except per share data)
<S>                                                           <C>         <C>          <C>           <C>           <C>
Statement of Operations Data:
Revenues:
 Manufacturing and distribution...........................   $15,746      $20,677       $23,468       $26,658      $ 35,633
 Broadcast and syndication................................    10,876       16,163        20,901        23,694        22,701
 Television...............................................    15,639       22,712        23,343        30,768        60,405
 Film.....................................................         -        1,452         2,316         3,407        10,429
                                                             -------      -------       -------       -------      --------
     Total revenues.......................................    42,261       61,004        70,028        84,527       129,168
                                                             -------      -------       -------       -------      --------
Cost of services:
 Personnel................................................    17,096       22,795        25,344        31,804        50,431
 Material.................................................     4,240        6,424         7,354         7,315        10,243
 Facilities...............................................     3,774        3,917         4,692         5,128         6,512
 Other....................................................     3,752        5,560         6,021         8,937        13,958
                                                             -------      -------       -------       -------      --------
   Total cost of services.................................    28,862       38,696        43,411        53,184        81,144
                                                             -------      -------       -------       -------      --------
     Gross profit.........................................    13,399       22,308        26,617        31,343        48,024
                                                             -------      -------       -------       -------      --------
Operating expenses:
 Sales, general and administrative........................     7,627       10,918        11,116        12,899        18,504
 Depreciation and amortization............................     3,284        6,241        10,165        13,175        18,191
                                                             -------      -------       -------       -------      --------
   Total operating expenses...............................    10,911       17,159        21,281        26,074        36,695
                                                             -------      -------       -------       -------      --------
     Income from operations...............................     2,488        5,149         5,336         5,269        11,329
Interest expense, net.....................................     1,253        2,917         3,906         3,887         8,139
                                                             -------      -------       -------       -------      --------
     Income before income tax benefits and
        extraordinary item................................     1,235        2,232         1,430         1,382         3,190
Income tax benefits.......................................         -          988           994             -             -
                                                             -------      -------       -------       -------      --------
     Income before extraordinary..........................     1,235        3,220         2,424         1,382         3,190
Extraordinary loss on early extinguishment of debt........         -            -             -             -        (2,449)
                                                             -------      -------       -------       -------      --------
    Net income............................................   $ 1,235      $ 3,220       $ 2,424       $ 1,382      $    741
                                                             =======      =======       =======       =======      ========
Earnings per common share  Basic: (1)
 Income before extraordinary item.........................   $  0.19      $  0.50       $  0.37       $  0.17      $   0.33
 Extraordinary item.......................................         -            -             -             -         (0.25)
                                                             -------      -------       -------       -------      --------
 Net income...............................................   $  0.19      $  0.50       $  0.37       $  0.17      $   0.08
                                                             =======      =======       =======       =======      ========
Earnings per common share  Diluted: (1)
 Income before extraordinary item.........................   $  0.19      $  0.50       $  0.37       $  0.16      $   0.29
 Extraordinary item.......................................         -            -             -             -         (0.22)
                                                             -------      -------       -------       -------      --------
 Net income...............................................   $  0.19      $  0.50       $  0.37       $  0.16      $   0.07
                                                             =======      =======       =======       =======      ========
Weighted average number of common shares outstanding: (1)
   Basic..................................................     6,475        6,475         6,475         7,971         9,634
   Diluted................................................     6,475        6,475         6,475         8,563        10,898

Other Data:
EBITDA(2).................................................   $ 5,772      $11,390       $15,501       $18,444      $ 29,520
Net cash provided by operations...........................     3,047        4,588         9,387         7,908         1,856
Net cash used in investing activities.....................     7,877       30,902        10,318        40,142        54,905
Net cash provided by (used in) financing activities.......     8,972       28,102          (410)       33,164        50,759
</TABLE>
                                       14
<PAGE>


<TABLE>
<CAPTION>
                                                                 As of
                                   July 31,       July 30,      August 4,     August 3,     August 2,
                                     1994           1995          1996          1997          1998
                                     ----           ----          ----          ----          ----
                                                        (in thousands)
<S>                                <C>            <C>            <C>           <C>           <C> 
Balance Sheet Data:
Cash, including restricted cash..  $  4,691       $  7,368       $  6,021      $  6,769      $  3,301
Working capital..................     4,674          5,665          1,642         1,829        17,285 
Total assets.....................    32,982         71,780         81,827       132,237       216,344
Long-term debt...................    20,924         38,472         42,978        54,633       124,671
Total debt(3)....................    21,556         41,942         49,131        65,192       130,855
Total stockholders' equity.......     6,245         19,617         22,143        49,738        67,113
</TABLE>

(1)  The earnings per share amounts prior to 1998 have been restated as required
     to comply with Statement of Financial Accounting Standards No. 128,
     "Earnings per Share".  In addition, weighted average number of common
     shares outstanding has been presented to reflect retroactively the
     Company's reorganization and related stock exchange with and stock dividend
     to its sole stockholder in October and November 1996.  See notes to the
     financial statements.

(2)  EBITDA does not take into account normal capital expenditures and does not
     represent cash generated from operating activities in accordance with GAAP,
     is not to be considered as an alternative to net income or any other GAAP
     measurements as a measure of operating performance and is not indicative of
     cash available to fund all cash needs.  The Company's definition of EBITDA
     may not be identical to similarly titled measures of other companies.  The
     Company believes that in addition to cash flows and net income, EBITDA is a
     useful financial performance measurement for assessing the operating
     performance of the Company because, together with net income and cash
     flows, EBITDA widely is used to provide investors with an additional basis
     to evaluate the ability of the Company to incur and service debt and to
     fund acquisitions or invest in new technologies.  To evaluate EBITDA and
     the trends it depicts, the components of EBITDA, such as net revenues, cost
     of services, and sales, general and administrative expenses, should be
     considered.  See "Management's Discussion and Analysis of Financial
     Condition and Results of Operations."  A reconciliation of net income to
     EBITDA is as follows:

<TABLE>
<CAPTION>
                                                              Fiscal Years Ended
                                             July 31,   July 30,   August 4,   August 3,   August 2,
                                              1994       1995       1996        1997        1998
                                              ----       ----       ----        ----        ----
                                                                (in thousands)
<S>                                           <C>        <C>        <C>         <C>         <C> 
 Net income before extraordinary item.....    $1,235     $ 3,220    $ 2,424     $ 1,382     $ 3,190
 Add (deduct):
 Interest expense, net....................     1,253       2,917      3,906       3,887       8,139
 Income tax benefits......................       ---        (988)      (994)        ---         ---
 Depreciation and amortization............     3,284       6,241     10,165      13,175      18,191
                                              ------     -------    -------     -------     -------
 EBITDA...................................    $5,772     $11,390    $15,501     $18,444     $29,520
                                              ======     =======    =======     =======     =======
</TABLE> 

(3)  Includes current and long-term portions of (i) term loan facilities and a
     revolving line of credit; (ii) equipment notes payable; (iii) capital lease
     obligations; and (iv) a subordinated note due to a Company stockholder,
     TSP.

Item 7.  Management's Discussion and Analysis of Financial Condition and Results
         of Operations

Forward Looking Statements

          When used in the preceding and following discussion, the words
"believes," "expects," "anticipates," "intends," and similar expressions are
intended to identify forward looking statements.  Such statements are subject to
a number of known risks and uncertainties.  Actual results in the future could
differ materially from these described in the forward looking statements.  Such
risks and uncertainties include, but are not limited to, industry-wide market
factors such as the timing of, and spending on, feature film and television
programming production, foreign and domestic television advertising, and foreign
and domestic spending by broadcasters, cable companies and syndicators on first
run and existing content libraries.  In addition, the failure of the Company to
maintain 

                                       15
<PAGE>
 
relationships with key customers and certain key personnel, more rapid than
expected technological obsolescence, failure to integrate acquired operations as
well as regulatory developments affecting the Company's operations and
acquisitions could also cause actual results to differ materially from those
described in forward looking statements.

Overview

     The Company is a leading provider of technical and creative services to
owners, producers and distributors of television programming, feature films and
other entertainment content.  The Company's services integrate and apply a
variety of systems and processes to enhance the creation and distribution of
entertainment content.  The Company seeks to capitalize on domestic and
international growth in demand for original entertainment content as well as
from the exploitation of existing television and film libraries without taking
production or ownership risk with respect to any specific television program,
feature film or other content.

     The Company's business is divided into manufacturing and distribution,
broadcast and syndication, television and film and animation.  In each of its
four business divisions, the Company offers most of the systems and technical
solutions that constitute the processes that are integral to the creation,
enhancement and distribution of entertainment content.  The manufacturing and
distribution services division, located in Burbank, California manages, formats
and distributes existing content libraries to end users in the United States and
internationally.  The broadcast and syndication division, located in Burbank and
the Republic of Singapore, assembles and distributes cable television channels
and programming via satellite to viewers in the United States, Canada and Asia.
The television division, located in Burbank and Santa Monica, California
assembles film or video principal photography into a form suitable for domestic
network, syndicated, cable or foreign television.  The film and animation
division, located in Santa Monica, digitally creates and manipulates images in
high resolution formats and creates computer animated sequences for use in
feature films.  The following table sets forth revenues by business division and
the related percentage of consolidated revenues for the periods indicated.


<TABLE>
<CAPTION>
                                                                  Fiscal Years Ended
                                           August 4, 1996           August 3, 1997            August 2, 1998 
                                         ----------------------   ---------------------    ------------------------ 
                                                     Percentage              Percentage                 Percentage
                                         Amount       of Total    Amount      of Total     Amount       of Total
                                         -------     ----------   ------     ----------    -------      ----------
                                                                    (dollars in thousands)
<S>                                      <C>         <C>          <C>        <C>           <C>          <C> 
Revenues by  division:
     Manufacturing and distribution  ....$23,468      33.5%       $26,658     31.5%        $ 35,633      27.5%
     Broadcast and syndication............20,901      29.9         23,694     28.0           22,701      17.6
     Television...........................23,343      33.3         30,768     36.4           60,405      46.8
     Film and animation....................2,316       3.3          3,407      4.1           10,429       8.1
                                         -------     ------       -------    ------        ---------    ------
          Total revenues.................$70,028     100.0%       $84,527    100.0%        $129,168     100.0%
                                         =======     ======       =======    ======        =========    ======
 
</TABLE>

  Revenues increased from $70.0 million in fiscal 1996 to $129.2 million in
fiscal 1998.  The Company attributes this growth to several factors including:
(i) an increase in demand for the Company's services resulting from the growth
in worldwide demand for entertainment content; (ii) an expansion of capacity
resulting from its extensive investment in new digital infrastructure; (iii)
acquisitions and international expansion; (iv) the diversification of its
service offerings; and (v) the increasing acceptance of its bundled service
outsourcing solutions.

  EBITDA increased from $15.5 million in fiscal 1996 to $29.5 million in fiscal
1998.  The Company attributes this growth to several factors including: (i)
growth in revenues from fiscal 1996 to fiscal 1998; and (ii) decrease in the
ratio of overhead and fixed costs to revenues, as the Company has generally
increased capacity utilization and decreased the cost of adding new capacity.
See the financial statements and the related notes thereto included elsewhere in
this Annual Report.

  The Company believes that EBITDA is an important measure of its financial
performance.  "EBITDA" is defined as earnings before interest, taxes,
depreciation and amortization, excluding gains and losses on asset sales and
nonrecurring charges.  The Company's investments in new infrastructure, machine
capacity and technology have produced a relatively high depreciation expense and
will remain a significant non-cash charge to earnings.  It is the Company's
policy to depreciate equipment and other capitalized items over a period of
three to seven years.  EBITDA is calculated before depreciation and amortization
charges and, in businesses with significant non-cash expenses, widely is used as
a measure of cash flow available to pay interest, repay debt, make acquisitions
or invest in capital equipment and new technologies.  As a result, the Company
intends to report EBITDA as a measure of financial performance.  EBITDA does not
represent cash generated from operating activities in accordance with 

                                       16
<PAGE>
 
generally accepted accounting principles ("GAAP") and should not be considered
in isolation or as a substitute for other measures of performance prepared in
accordance with GAAP. EBITDA does not reflect that portion of the Company's
capital expenditures which may be required to maintain the Company's market
share, revenues and leadership position in its industry. Moreover, not all
EBITDA will be available to pay interest or repay debt. The Company's
presentation of EBITDA may not be comparable to similarly titled measures
reported by other companies. See footnote 2 of "Selected Financial Data".

Results of Operations

  The following table sets forth the percentage of revenues represented by
certain items in the Company's statement of operations and EBITDA.

<TABLE>
<CAPTION>
                                                             Fiscal Years Ended
                                                             ------------------
                                          August 4, 1996      August 3, 1997      August 2, 1998
                                          --------------      --------------      --------------
<S>                                            <C>                 <C>               <C>    
Revenues............................           100.0%              100.0%            100.0%
Cost of services:
 Personnel..........................            36.2                37.6              39.0
 Material  .........................            10.5                 8.6               7.9
 Facilities                                      6.7                 6.1               5.0
 Other..............................             8.6                10.6              10.9
                                               -----               -----             ----- 
   Total cost of services...........            62.0                62.9              62.8  
                                               -----               -----             -----                            
     Gross profit...................            38.0                37.1              37.2
                                               -----               -----             -----
Operating expenses:
  Sales, general and administrative.            15.9                15.3              14.3
  Depreciation and amortization.....            14.5                15.6              14.1 
                                               -----               -----             -----
    Total operating expenses........            30.4                30.9              28.4 
                                               -----               -----             -----
     Income from operations.........             7.6                 6.2               8.8
Interest expense, net...............             5.5                 4.6               6.3
                                               -----               -----             -----
     Income before income tax
      benefits and extraordinary                    
      item..........................             2.1                 1.6               2.5
 Income tax benefits................             1.4                  --                --
                                               -----               -----             -----
     Income before extraordinary
      item...........................            3.5                 1.6               2.5
                                               -----               -----             -----
Extraordinary loss on early 
 extinguishment of debt.............              --                  --              (1.9)   
                                               -----               -----             -----
   Net income.......................             3.5%                1.6%              0.6%
                                               =====               =====             =====
EBITDA..............................            22.1%               21.8%             22.9%
                                                 
</TABLE>

Fiscal Year Ended August 2, 1998 Compared to Fiscal Year Ended August 3, 1997

  Revenues.  Total revenues for fiscal 1998 increased 52.8% to $129.2 million
compared to $84.5 million in fiscal 1997.  The revenue increase was attributable
primarily to the factors set forth below.

  Manufacturing and distribution revenues for fiscal 1998 increased 33.7% to
$35.6 million compared to $26.7 million in fiscal 1997.  The major components of
this increase include increased professional duplication revenues ($5.2
million), laboratory revenues ($0.7 million), telecine revenues ($2.1 million)
and quality control revenues ($0.7 million).  Of those increases, approximately
$4.2 million relates to Anderson which was acquired in March 1997.

  Broadcast and syndication revenues for fiscal 1998 decreased 4.2% to $22.7
million compared to $23.7 million in fiscal 1997. Revenues from the Company's
Singapore operations decreased 23.8% in fiscal 1998 compared to fiscal 1997 as a
result of the completion in 1997 of a one year contract with MGM Gold ($1.8
million) and translation losses caused by a devaluation of the Singapore dollar
($1.4 million).  The decrease in revenues from the Singapore operations was
offset by (i) a 17.1% increase in revenues from the Company's domestic broadcast
and syndication operations, due primarily to expanded service relationships with
TVN Entertainment, Inc., and (ii) a 36.2% increase in syndication revenue,
driven by capacity expansion to meet enhanced demand from studio relationships.

  Television revenues for fiscal 1998 increased 96.3% to $60.4 million compared
to $30.8 million in fiscal 1997.  The major components of this increase include
increased sound revenues ($4.8 million), telecine revenues ($11.0 million),
editorial revenues ($6.7 million), graphics revenues ($4.2 million), and
duplication revenues ($3.0 

                                       17
<PAGE>
 
million). These revenue increases are primarily attributable to completion of
the Company's new digital television facility in Burbank ($5.0 million),
Anderson ($3.4 million), the fiscal 1998 start-up of the Company's commercial
operation, Co3 ($8.8 million), POP acquired in February 1998 ($11.7 million),
and VSI acquired in May 1998 ($0.7 million).

  Film and animation revenues for fiscal 1998 increased 206.1% to $10.4 million
compared to $3.4 million in fiscal 1997.  This increase is attributable to
several new film projects obtained during the period, of which $5.7 million was
contributed by POP.

  Gross Profit.  Gross profit for fiscal 1998 increased 53.2% to $48.0 million
compared to $31.3 million in fiscal 1997.  As a percentage of revenues, gross
profit remained relatively constant at 37.2% in fiscal 1998 compared to 37.1% in
fiscal 1997.

  Sales, General and Administrative Expenses.  Sales, general and administrative
expenses for fiscal 1998 increased 43.5% to $18.5 million compared to $12.9
million in fiscal 1997.  As a percentage of revenues, such expenses decreased
1.0% to 14.3% in fiscal 1998 compared to 15.3% in fiscal 1997.  The dollar
increase is primarily attributed to the acquisitions of Anderson, POP and VSI.
The improvement of 1.0% as a percentage of revenues is a result of the Company's
continued ability to leverage its existing corporate overhead to manage its
expanded domestic and international operations.

  Depreciation and Amortization Expenses.  Depreciation and amortization
expenses for fiscal 1998 increased 38.1% to $18.2 million compared to $13.2
million in fiscal 1997.  The increase was primarily the result of $52.4 million
in capital expenditures during fiscal 1998, the acquisition of the equipment of
Anderson in March 1997, the acquisition of the equipment of POP and VSI in
February 1998 and May 1998, respectively, and amortization of goodwill recorded
from the Anderson, POP, and VSI acquisitions.

  Interest Expense. Interest expense for fiscal 1998 increased 109.4% to $8.1
million compared to $3.9 million in fiscal 1997.  The increase is attributable
to additional long term borrowings incurred by the Company to fund the POP
acquisition (including transaction costs) ($1.0 million), pay loan fees and
other costs associated with the Company's debt refinancing ($0.2 million), and
to fund capital expenditures in fiscal 1997 and fiscal 1998 ($3.0 million).

     Earnings Before Interest, Taxes, Depreciation and Amortization.  EBITDA for
fiscal 1998 increased 60.0% to $29.5 million as compared to $18.4 million in
fiscal 1997.  The increase in EBITDA results from an increase in revenues and
gross profit coupled with a decrease in sales, general and administrative
expenses as a percentage of revenues.  The increase in EBITDA includes EBITDA
contributed by Co3 ($4.2 million), POP ($4.1 million), and VSI ($0.4 million).

  Extraordinary Loss.  To effect its growth and acquisition plans, the Company
entered into a new $200.0 million credit facility (see "Liquidity and Capital
Resources").  Part of the facility was used to retire approximately $80.0
million of existing debt.  The new facility has significantly more favorable
interest rates and amortization requirements than the replaced debt.  However,
the Company incurred prepayment penalties from the early retirement of debt
resulting in an extraordinary loss of $2.4 million.

Fiscal Year Ended August 3, 1997 Compared to Fiscal Year Ended August 4, 1996

  Revenues.  Total revenues for fiscal 1997 increased 20.7% to $84.5 million
compared to $70.0 million in fiscal 1996.  The revenue increase was attributable
primarily to the factors set forth below.

  Manufacturing and distribution revenues for fiscal 1997 increased 13.6% to
$26.7 million compared to $23.5 million in fiscal 1996.  The revenue increase
was primarily attributable to an increase in film to tape conversion revenues
(25.6%) and professional duplication revenues (20.0%).  These revenue increases
were partially offset by a 9.1% decline in film laboratory revenue, resulting
from a temporary decline in the backlog of restoration and preservation work
provided by the major studios.  In addition, the Company substantially increased
the number of master videotape and film elements stored in its archive facility
during fiscal 1997.  The archive provides capacity to store, manage and
distribute up to 400,000 master videotapes and film elements.  The Company
estimates that approximately 85.0% of this capacity was utilized as of the end
of fiscal 1997 compared to 50% at the end of fiscal 1996.  The Company will
continue to develop infrastructure and add machine capacity in response to
market demand and opportunities to fill unused archive capacity.

                                       18
<PAGE>
 
  Broadcast and syndication revenues for fiscal 1997 increased 13.4% to $23.7
million compared to $20.9 million in fiscal 1996.  The revenue increase was
attributable to an increase in revenues generated by the Company's Singapore
operations (25.0%) resulting from increased utilization by MTV Asia, a short
term contract associated with the launch of MGM Gold in Asia and the successful
marketing of the Company's Singapore facilities to various clients during the
year.  The Company's domestic broadcast and syndication revenues did not
increase in fiscal 1997 due to the lack of cable channel capacity to support the
introduction of new cable channels.  The Company believes that the introduction
of compression technology, deployment of digital set top boxes to cable
households and the transition from analog to digital delivery of cable
programming to cable head-ends will increase demand for the Company's domestic
broadcast and syndication services.

  Television revenues for fiscal 1997 increased 32.2% to $30.8 million compared
to $23.3 million in fiscal 1996.  The revenue increase is primarily attributable
to the increasing market acceptance of the Company's outsourcing solutions and
the successful introduction of expanded capacity and service offerings.  The
Company's new Burbank facilities became operational during the fourth quarter
and successfully introduced server based non-linear broadcast quality editing
capabilities.

  Film and animation revenues for fiscal 1997 increased 47.8% to $3.4 million
compared to $2.3 million in fiscal 1996.  Substantially all of the revenue
increase is attributable to increased computer generated imaging capacity for
three-dimensional animation ("3D") and the improved marketability of the
Company's digital compositing capacity when combined with new 3D capabilities.

  Gross Profit.  Gross profit for fiscal 1997 increased 17.7% to $31.3 million
(37.1% of revenues) compared to $26.6 million (38.0% of revenues) in fiscal
1996.  The decline of 0.9% in the Company's gross profit percentage was the
result of increased staffing levels in the Company's television division  in
advance of the commencement of the 1997-1998 television season and increased
space segment costs in anticipation of increased demand for the Company's
syndication services provided by the broadcast and syndication division and
offset by material costs which declined 1.9% as a percentage of revenue.

     Sales, General and Administrative Expenses.  Sales, general and
administrative expenses for fiscal 1997 increased 16.2% to $12.9 million (15.3%
of revenues) compared to $11.1 million (15.9% of revenues) in fiscal 1996.  The
improvement of 0.6% in sales, general and administrative expenses as a
percentage of revenues is a result of the Company's ability to leverage its
existing corporate overhead to manage expanded domestic and international
operations.  The improvement in sales, general and administrative expenses as a
percentage of revenues would have been greater except that 1996 expenses
reflected an offset of $900,000 of insurance proceeds received.

  Depreciation and Amortization Expenses.  Depreciation and amortization
expenses for fiscal 1997 increased 29.4% to $13.2 million compared to $10.2
million in fiscal 1996.  The increase was primarily the result of $27.7 million
in capital expenditures for equipment made during fiscal 1997, and the
acquisition of the equipment of Anderson Film Industries, Inc. for $8.6 million.

  Interest Expense.  Interest expense remained constant at $3.9 million in both
1997 and 1996.  Increased interest expenses associated with new borrowings
required to fund working capital and capital expenditures was offset by the
retirement of debt from the proceeds of the Company's initial public offering.

  Income Tax Benefits.  The Company did not recognize, for financial accounting
purposes, any tax benefit in fiscal 1997 compared to the recognition of a $1.0
million tax benefit in fiscal 1996.  Recognition of tax benefits in fiscal 1996
resulted from the Company's profitability in its domestic operations which made
recognition of future tax deductions (arising from, among other things, net
operating loss carryforwards) more certain.  In fiscal 1997, the Company
generated a domestic tax basis loss and as a result, no recognition of tax
benefit was reflected in 1997.

  Earnings Before Interest, Taxes, Depreciation and Amortization.  EBITDA for
fiscal 1997 increased 18.7% to $18.4 million compared to $15.5 million in fiscal
1996.  The increase in EBITDA was a result of an increase in revenues and gross
profit and a reduction in sales, general and administrative expenses as a
percentage of revenues.  See "Liquidity and Capital Resources" for a discussion
of net cash provided by operating activities for the period.  See footnote 2 to
"Selected Financial Data" for a discussion of EBITDA generally.

                                       19
<PAGE>
 
Liquidity and Capital Resources

  Net Cash Provided by Operating Activities.  The Company's net cash provided by
operating activities was $9.4 million, $7.9 million, and $1.9 million in fiscal
1996, 1997 and 1998, respectively.  The reduction in net cash provided by
operations in fiscal 1998 was primarily attributable to the growth of accounts
receivable ($8.8 million), reductions in accounts payable and accrued
liabilities ($9.5 million), including $5.4 million related to the reduction of
liabilities acquired from POP, offset by increased income before depreciation
and amortization and extraordinary item.

  Net Cash Provided by Financing Activities.  The Company's net cash provided by
(used in) financing activities was ($0.4 million), $33.2 million and $50.8
million in fiscal 1996, 1997 and 1998, respectively.  The increase in cash
provided by financing activities in 1998 is attributed to amounts borrowed on
the Company's new credit facility and funding received from the Company's
preferred equity private placement.  In February 1998, the Company entered into
a $200.0 million credit facility.  As of August 2, 1998, the Company had
borrowed $112.0 million under this agreement.  In addition, in February 1998,
the Company received $14.8 million, net of expenses, from the private placement
of 150,000 shares of Series A Convertible Preferred Stock.  The funds from the
credit facility and preferred equity investment were used to repay approximately
$80.0 million of the Company's outstanding debt, fund the POP acquisition
(including the repayment of most of POP's outstanding debt), repay the VSI debt,
pay loan fees and other transaction costs, and for working capital purposes.

  Capital Expenditures.  Since its inception in 1993 the Company has made
substantial investments to convert its infrastructure from analog to digital,
develop management information systems, consolidate various operations, expand
into the Asian market and acquire and create new businesses.  The Company
expects to continue to make substantial capital investments particularly with
respect to new digital infrastructure for recently acquired operations,
incremental capacity investments to support the anticipated growth in demand for
the Company's services and certain projects associated with new long term
contracts primarily in the Company's broadcast and syndication division.  The
following table sets forth capital expenditures in each business division as
well as capital expenditures associated with new management information systems,
real estate purchases, and businesses acquired by amount and percentage of total
capital expenditures for the periods indicated.


<TABLE>
<CAPTION>
                                                               Fiscal Years Ended
                                          August 4, 1996         August 3, 1997           August 2, 1998
                                          --------------         --------------           --------------
                                                 Percentage               Percentage               Percentage
                                       Amount     of Total     Amount      of Total     Amount      Of Total
                                       ------     --------     ------      --------     ------      --------
                                                             (dollars in thousands)
<S>                                    <C>        <C>          <C>         <C>          <C>         <C>
Capital expenditures (1), (2):
  Manufacturing and distribution..... $ 3,175       16.8%     $ 7,812       16.2%      $ 5,025         9.6%
  Broadcast and syndication..........   2,411       12.7        2,215        4.6         1,814         3.5
  Television.........................  11,853       62.6       24,745       51.4        28,690        54.7
  Film and animation.................     413        2.2          774        1.6         4,627         8.8
  Management information systems.....   1,084        5.7          822        1.7           681         1.3
  Land and building..................    --          --        11,811       24.5        11,563        22.1
                                      -------      -----      -------      -----       -------      ------
    Total capital expenditures....... $18,936      100.0%     $48,179      100.0%      $52,400       100.0%
                                      =======      =====      =======      =====       =======      ======
</TABLE>
------------------------

(1)  Does not include the net assets written off pertaining to the January 1994
     earthquake of $567,000 for the fiscal year ended August 4, 1996.
(2)  Includes assets acquired from the acquisition of Anderson Video ($5.6
     million), POP ($11.7 million), and VSI ($2.0 million).

                                       20
<PAGE>
 
          Credit Agreements and Other Indebtedness.  On February 27, 1998, the
Company entered into a financing agreement representing $200.0 million in credit
facilities from a group of banks, including Canadian Imperial Bank of Commerce
("CIBC").  The facilities include two $75.0 million term loans ("Term A" and
"Term B") and a $50.0 million revolver ("Revolver").  Both Term A and the
Revolver mature on January 31, 2004 and are reduced by quarterly amounts
beginning April 30, 2000, as specified in the financing agreement.  Term A and
the Revolver bear interest at Libor (5.70% at August 2, 1998) plus a margin
ranging from 1.5% to 2.5%, based upon the Company's leverage ratios.  In
addition, the Company must pay a commitment fee of 0.50% on the unused portions
of the Term A and Revolver commitments.  At August 2, 1998, $30.0 million and
$7.0 million were outstanding on Term A and the Revolver, respectively.  Term B
matures July 31, 2004 and is reduced quarterly by amounts specified in the
financing agreement beginning April 30, 1998.  Term B bears interest at Libor
plus a margin ranging from 1.75% to 2.75% based upon the Company's leverage
ratios.  At August 2, 1998, $74.6 million was outstanding on Term B.

          Subsequent to August 2, 1998, the Company borrowed the remaining $45
million available under Term A and $20 million under the Revolver to effect the
acquisition of Encore.  Additionally, the Company has borrowed $9 million under
the Revolver for capital expenditures and other working capital requirements.
At October 15, 1998 total borrowings under the credit facilities were
approximately $186 million.

          In connection with the POP acquisition, the Company issued non-
interest bearing promissory notes to the POP shareholders totaling $1,140,00.
These notes are payable in equal monthly installments through February 1, 2001.
As of August 2, 1998, the balance outstanding on these notes was $953,000.  In
addition, the Company has an outstanding note payable to a former shareholder of
POP, which bears interest at 10%.  Principal and interest is paid on a monthly
basis through March 1999.  As of August 2, 1998, the balance outstanding on this
note was $168,000.

          The Company has entered into various capital leases and equipment
notes related to the purchase of equipment.  As of August 3, 1997 and August 2,
1998, the Company's total obligations under capital leases and outstanding
equipment notes were $25.0 million and $9.8 million, respectively.  These notes
are due at various times through 2004 and bear interest at rates of 8.3% to
13.0%.  The capital lease and equipment notes are collateralized by the assets
acquired under such leases and notes.

          In December 1996, the Company purchased a 90,000 square foot building
in Burbank.  Prior to the purchase, the Company subleased 45,000 square feet for
use as its archive facility.  The additional 45,000 square feet is subleased by
an outside tenant through 1999.  The purchase price was $11.3 million, of which
$8.4 million was borrowed under a term loan agreement with the Tokai Bank of
California and the balance was paid from cash.  The term loan provides for
monthly principal payments over a period of 84 months and a final payment at
maturity in December 2003.  The term loan is collateralized by the building and
any improvements thereon and is guaranteed by 4MC Burbank and DMC.  The term
loan bears interest at the lender's prime rate plus 1% or LIBOR plus 2.25%, at
the Company's option.

          The Company believes that the cash flow from operations combined with
amounts available under the credit facilities, and other borrowing capabilities
of the Company, will be sufficient to meet its anticipated working capital and
capital expenditure requirements through the end of 1999.  The Company would
have to obtain other financing, either debt or equity, if it were to acquire
additional businesses for cash.  Given recent capital market volatility, the
Company believes it may not be possible to increase its current bank facilities,
obtain financing through equipment notes and leases, private equity financing or
high yield debt financing at acceptable prices until markets become more
stabilized and receptive.

Year 2000 Compliance Issue

     State of Readiness.  The Company is currently working to resolve the
potential impact of the Year 2000 problem on its computer systems and
computerized equipment.  The Year 2000 problem is a result of computer programs
having been written using two rather than four digits to identify an applicable
year.  Any information technology systems that have time-sensitive software may
recognize a date using "00" as the year 1900 rather than the year 2000.  The
problem also extends to non-information technology systems that rely on embedded
chip systems.

     The Company has divided the Year 2000 readiness task by the following
functional areas:  IT infrastructure, business systems, operational systems,
facilities, and business partners.  IT infrastructure includes the Company's
wide area networks, local area networks, servers, desktop computers, and
telephone systems.  Business systems include mainframe and midrange computer
hardware and applications.  Operational systems include 

                                       21
<PAGE>
 
equipment used for the Company's day-to-day operations in the post-production
business including telecine machines, satellite broadcasting systems, editing
and graphics equipment. Facilities include fire, life, and safety equipment,
elevators, alarm systems, and environmental monitoring equipment. Business
partners include suppliers and vendors, financial institutions, benefit
providers, payroll services, and customers. The Company has appointed a task
force chaired by its chief technology officer and coordinated by its information
systems manager. Representatives of each of the Company's divisions are included
on the task force, as well as an attorney from its legal department.

     The Company has developed a four phase approach to resolving the Year 2000
issues that are reasonably within its control.  The program is being addressed
separately by each of the five functional Year 2000 areas of the Company.  The
four phases of the program include inventory, assessment, remediation and
testing, and implementation.  The inventory phase consists of a company wide
inventory of computer hardware, software, business applications, and operational
and facilities equipment.  The inventory is then used to generate a master
assessment list and identify equipment vendors.  The assessment phase consists
of identifying at-risk systems and products and ranking the products by
criticality to the business.  Each product is then assigned to a task force
member to determine whether the product is in compliance and, if not, whether
the system should be upgraded or replaced.  The remediation and testing phase
consists of developing a project plan, defining and implementing steps required
to bring the systems or products into compliance, defining a test plan to verify
compliance, and documenting the test results.  The final phase is implementing
remediation on systems and products company wide.

     The Company has been in the process of analyzing and upgrading its
information technology ("IT") systems (i.e., its IT infrastructure and business
systems) since early 1998, including upgrading all of its PC hardware, operating
systems, and office automation software.  With respect to the remaining IT
systems, the Company has completed its inventory phase and anticipates
completion of its assessment and testing phases by February 28, 1999.  With
respect to non-IT systems, including operational systems and facilities systems,
the Company has completed its inventory phase and anticipates completion of the
assessment phase by February 28, 1999.  The Company anticipates completion of
all phases of its compliance program in both IT and non-IT systems by September
1999.

     Third Parties.  Like every other business, the Company is at risk from
potential Year 2000 failures on the part of its major business counterparts,
including suppliers, vendors, financial institutions, benefit providers, payroll
services, and clients, as well as potential failures in public and private
infrastructure services, including electricity, water, transportation, and
communications.  The Company has initiated communications with significant third
party businesses to assess their efforts in addressing Year 2000 issues and is
in the process of determining the Company's vulnerability if these third parties
fail to remediate their Year 2000 problems.  There can be no guarantee that the
systems of third parties will be timely remediated, or that such parties'
failure to remediate Year 2000 issues would not have a material adverse effect
on the Company.

     Costs.  Costs incurred to date in addressing the Year 2000 issue have not
been material and are being funded through operating cash flows.  The Company
anticipates that it may incur significant costs associated with replacing non-
compliant systems and equipment. In addition, the Company anticipates that it
will incur additional costs in the form of redeployment of internal resources
from other activities.  The Company does not expect these redeployments to have
a material adverse effect on other ongoing business operations of the Company.
Based upon the information currently available to the Company, costs associated
with addressing the Year 2000 issue are expected to be between $250,000 to
$500,000.

     Risks.  System failures resulting from the Year 2000 problem could
potentially affect operations and financial results in all aspects of the
Company's business.  For example, failures could affect all aspects of the
Company's television, film and animation, manufacturing and distribution, and
broadcast and syndication operations, as well as inventory records, payroll
operations, security, billing, and collections.  At this time the Company
believes that its most likely worst case scenario involves potential disruption
in areas in which the Company's operations must rely on third parties whose
systems may not work properly after January 1, 2000.  As a result of Year 2000
related failures of the Company's or third parties' systems, the Company could
suffer a reduction in its operations.  Such a reduction may result in a
fluctuation in the price of the Company's common stock.

     Contingency Plan.  The Company does not currently have a comprehensive
contingency plan with respect to the Year 2000 problem.  However, the Company
has created a task force comprised of accounting, legal, and technical employees
that is prepared to address any Year 2000 issues as they arise.  The Company
will continue to develop its contingency plan during 1999 as part of its ongoing
Year 2000 compliance effort.

                                       22
<PAGE>
 
Recently Issued Accounting Standards

          In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income".  This statement will be effective for the Company beginning with the
first fiscal quarter of 1999.  The standard establishes guidelines for the
reporting and display of comprehensive income and its components in financial
statements.  Comprehensive income generally represents all changes in
stockholders' equity, except those resulting from investments by or
distributions to stockholders.  The Company believes that comprehensive income
in future periods will fluctuate as a result of changes in the cumulative
translation account, which is a component of comprehensive income.

     In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of
an Enterprise and Related Information".  SFAS No. 131 requires publicly-held
companies to report financial and descriptive information about its operating
segments in financial statements issued to stockholders for interim and annual
periods.  The statement also requires additional disclosure with respect to
products and services, geographic areas of operation, and major customers.  This
statement will be effective for the Company beginning with the fiscal year end
1999.  Management is currently evaluating the impact, if any, of SFAS No. 131.

          In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities".  This Statement requires that all
derivative instruments be recorded on the balance sheet at their fair value.
Changes in the fair value of derivatives will be recorded each period in current
earnings or other comprehensive income, depending on whether a derivative is
designated as part of a hedge transaction and, if it is, the type of hedge
transaction.  The new rules will be effective the first quarter of 2000.  The
Company is in the process of determining the impact of this new standard and
anticipates that it will not have a material impact on the Company's financial
results when effective.

Item 7A.  Quantitative and Qualitative Disclosures About Market Risk

Foreign Exchange

          Substantially all of 4MC Asia's transactions are denominated in
Singapore dollars, including its liabilities.  Although 4MC Asia is not subject
to foreign exchange transaction gains or losses, its financial statements are
translated into United States dollars as part of the Company's consolidated
financial reporting.  Fluctuations in the exchange rate therefore will affect
the Company's consolidated balance sheets and statements of operations.  Until
the recent Asian economic difficulties the Singapore dollar had been stable
relative to the United States dollar.  However, during fiscal 1998 the Singapore
dollar lost approximately 20% of its value relative to the U.S. dollar.

Quarterly Fluctuations

          The Company has experienced significant quarterly fluctuations in
operating results and anticipates that these fluctuations will continue.  These
fluctuations have been caused by a number of factors, including: (i) with
respect to the Company's manufacturing and distribution division, seasonal and
sometimes fluctuating demand for programming by international broadcasters and
other content buyers, increased labor costs and uneven capacity utilization due
to delays caused by factors outside the Company's control (for example, changes
in customers' production schedules), and unanticipated production downtime due
to equipment failure, work stoppages or the absence of key personnel; (ii) with
respect to the Company's broadcast and syndication division, the expiration of
month-to-month service contracts, the unpredictable use of the Company's
facilities for the broadcast of news stories and special events, and the
inability of the Company to remarket its unused transponder capacity
consistently; (iii) with respect to the Company's television division, the
unpredictability of television production schedules; and (iv) with respect to
the Company's film and animation division, the absorption by the Company of cost
overruns in fixed price contracts and delays in meeting completion deadlines
(for reasons other than the fault of the Company). The Company therefore
believes that quarter-to-quarter comparisons of its results of operations are
not necessarily meaningful and should not be relied upon as indications of
future performance.

                                       23
<PAGE>
 
Item 8.  Financial Statements and Supplementary Data

          The Financial Statements required to be filed hereunder are set forth
on pages 26 to 47 of this report.

Item 9.  Changes in and Disagreements on Accounting and Financial Disclosure

          None


                                   PART III
                                        

Items 10, 11 and 12

          The information required by Items 10, 11 and 12 is hereby incorporated
by reference from the Registrant's definitive proxy statement for the Annual
Meeting of Stockholders to be held on January 14, 1999 which relates to the
election of directors and which will be filed with the Commission within 120
days after the close of the Company's fiscal year.

Item 13.  Certain Relationships and Related Transactions

          None


                                    PART IV

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

          The following documents are filed as a part of this Report:

          (a) The Financial Statements required to be filed hereunder are listed
              in the index to the Financial Statements and Supplementary Data on
              page 25 of this report.

          (b) The Exhibits required to be filed hereunder are listed in the
              exhibit index included herein at page 48.

          (c) The reports on Form 8-K during the last quarter of its fiscal year
              ended August 2, 1998 required to be filed hereunder are listed in
              the exhibit index included herein at page 51.

                                       24
<PAGE>
 
                              Four Media Company
                                        
                  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
                                        
                                        
<TABLE>

<S>                                                                                                                      <C>
   Report of Independent Accountants.................................................................................    26

   Consolidated Balance Sheets at August 3, 1997 and August 2, 1998..................................................    27

   Consolidated Statements of Operations for the fiscal years ended August 4, 1996,
     August 3, 1997 and August 2, 1998...............................................................................    28

   Consolidated Statements of Stockholders' Equity for the fiscal years ended,
     August 4, 1996, August 3, 1997 and August 2, 1998...............................................................    29

   Consolidated Statements of Cash Flows for the fiscal years ended
     August 4, 1996, August 3, 1997 and August 2, 1998...............................................................    30

   Notes to Consolidated Financial Statements........................................................................    31

   Financial Statement Schedule
   Schedule II  Valuation and Qualifying Accounts....................................................................    47
</TABLE>

                                       25
<PAGE>
 
                       REPORT OF INDEPENDENT ACCOUNTANTS

                                        
Board of Directors
Four Media Company
Burbank, California

     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, cash flows and stockholders'
equity present fairly, in all material respects, the financial position of Four
Media Company (the "Company") and its subsidiaries at August 3, 1997 and August
2, 1998, and the results of their operations and their cash flows for each of
the three years in the periods ended August 4, 1996, August 3, 1997, and August
2, 1998, in conformity with generally accepted accounting principles. In
addition, in our opinion, the financial statement schedule listed in the index
presents fairly, in all material respects, the information set forth therein
when read in conjunction with the related consolidated financial statements.
These financial statements and financial statement schedule are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements and financial statement schedule based on
our audits. We conducted our audits of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.



                              PricewaterhouseCoopers LLP


Los Angeles, California
October 21, 1998

                                       26
<PAGE>
 
                               Four Media Company
                          CONSOLIDATED BALANCE SHEETS

                       (In thousands, except share data)

                                        
<TABLE>
<CAPTION>
                                                                                  August 3,        August 2,
                                                                                    1997             1998
                                                                                ---------         ---------
                                ASSETS
<S>                                                                              <C>              <C> 
Current assets:
  Cash..................................................................         $  6,089          $  3,301
  Restricted cash.......................................................              680               --
  Trade accounts receivable, net of allowance for doubtful accounts of 
    $1,873 (1997) and $1,258 (1998).....................................           18,755            31,657
  Inventory.............................................................              952             1,263
  Prepaid expenses and other current assets.............................            3,219             5,624
                                                                                 --------          --------
     Total current assets..............................................            29,695            41,845
Property, plant and equipment, net.....................................            93,672           124,230
Deferred income taxes..................................................             2,000             6,572
Long-term receivable...................................................             4,067             3,276
Goodwill, less accumulated amortization of $529........................               --             37,507
Other assets...........................................................             2,803             2,914
                                                                                 --------          --------
     Total assets......................................................          $132,237          $216,344
                                                                                 ========          ========
                                                                                
                 LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Current maturities of long-term debt and capital lease obligations...          $ 10,559          $  6,184
  Accounts payable.....................................................            11,080            10,781
  Accrued and other liabilities........................................             6,227             5,980
  Deferred income taxes................................................               --              1,615
                                                                                 --------          --------
     Total current liabilities.........................................            27,866            24,560
Long-term debt and capital lease obligations...........................            54,633           124,671
                                                                                 --------          --------
     Total liabilities.................................................            82,499           149,231

Commitments and contingencies (Note 7)

Stockholders' equity:
  Preferred stock, $.01 par value; 5,000,000 shares authorized, 150,000                 
    Series A Convertible shares issued and outstanding; liquidation     
    preference $15,000,000............................................                --                  2
  Common stock, $.01 par value; 50,000,000 shares authorized, 9,552,502                                  
    (1997) and 9,876,770 (1998) shares issued and outstanding.........                96                 99
  Additional paid-in capital...........................................            41,650            59,577
  Foreign currency translation adjustment..............................              (269)           (1,567)
  Retained earnings....................................................             8,261             9,002
                                                                                 --------          --------
     Total stockholders' equity........................................            49,738            67,113
                                                                                 --------          --------
     Total liabilities and stockholders' equity........................          $132,237          $216,344
                                                                                 ========          ========
                                                                                
</TABLE> 


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

                                       27
<PAGE>
 
                               Four Media Company

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     (In thousands, except per share data)

                                        
<TABLE>
<CAPTION>
                                                                                                     Fiscal Year Ended
                                                                                           August 4,     August 3,      August 2,
                                                                                             1996          1997           1998
                                                                                             ----          ----           ----
<S>                                                                                        <C>           <C>            <C>
Revenues:
   Manufacturing and distribution......................................................    $23,468       $26,658        $35,633
   Broadcast and syndication...........................................................     20,901        23,694         22,701
   Television..........................................................................     23,343        30,768         60,405
   Film................................................................................      2,316         3,407         10,429
                                                                                           -------       -------        -------
     Total revenues....................................................................     70,028        84,527        129,168
                                                                                           -------       -------        -------

Cost of services:
   Personnel...........................................................................     25,344        31,804         50,431
   Material............................................................................      7,354         7,315         10,243
   Facilities..........................................................................      4,692         5,128          6,512
   Other...............................................................................      6,021         8,937         13,958
                                                                                           -------       -------        -------
     Total cost of services............................................................     43,411        53,184         81,144
                                                                                           -------       -------        -------
        Gross profit...................................................................     26,617        31,343         48,024
                                                                                           -------       -------        -------
Operating expenses:
   Sales, general and administrative...................................................     11,116        12,899         18,504
   Depreciation and amortization.......................................................     10,165        13,175         18,191
                                                                                            ------        ------         ------
     Total operating expenses..........................................................     21,281        26,074         36,695
                                                                                            ------        ------         ------
       Income from operations..........................................................      5,336         5,269         11,329
Interest expense, net..................................................................      3,906         3,887          8,139
                                                                                            ------        ------         ------
       Income before income tax benefits and extraordinary item........................      1,430         1,382          3,190
Income tax benefits....................................................................        994            --             --
                                                                                            ------        ------         ------
       Income before extraordinary item................................................      2,424         1,382          3,190
Extraordinary loss on early extinguishment of debt.....................................         --            --         (2,449)
                                                                                            ------        ------         ------
       Net income......................................................................     $2,424        $1,382         $  741
                                                                                            ======        ======         ======
Earnings per common share -- Basic:
   Income before extraordinary item....................................................     $ 0.37        $ 0.17         $ 0.33
 Extraordinary item....................................................................         --            --          (0.25)
                                                                                            ------        ------         ------
       Net income per common share.....................................................     $ 0.37        $ 0.17         $ 0.08
                                                                                            ======        ======         ======
Earnings per common share -- Diluted:
   Income before extraordinary item....................................................     $ 0.37        $ 0.16         $ 0.29
   Extraordinary item..................................................................         --            --          (0.22)
                                                                                            ------        ------         ------
       Net income per common share.....................................................     $ 0.37        $ 0.16         $ 0.07
                                                                                            ======        ======         ======
Weighted average number of common shares outstanding:
   Basic...............................................................................      6,475         7,971          9,634
                                                                                            ======        ======         ======
   Diluted.............................................................................      6,475         8,563         10,898
                                                                                            ======        ======         ======
</TABLE>

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

                                       28
<PAGE>
 
                               Four Media Company
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                 (In thousands)


                                        
<TABLE>
<CAPTION>
                                                                                            Foreign
                                                                           Additional      Currency                      Total
                                                                            Paid-In       Translation     Retained    Stockholders'
                                   Preferred Stock      Common Stock        Capital       Adjustment      Earnings       Equity
                                   ---------------     --------------       -------       ----------      --------       ------
                                   Shares   Amount     Shares  Amount
                                   ------   ------     ------  ------
<S>                                <C>      <C>        <C>     <C>        <C>              <C>              <C>          <C>
Balance, July 30, 1995.............   --     $  --         1    $  --       $15,010        $  152           $4,455       $19,617
Foreign currency translation
  adjustments......................                                                           102                            102
Net income.........................                                                                          2,424         2,424
                                    ----      -----    -----     ----       -------        ------           ------       -------
Balance, August 4, 1996............   --        --         1       --        15,010           254            6,879        22,143
Reorganization and stock dividend..                    6,474       65           (65)
Issuance of common stock...........                    3,078       31        26,705                                       26,736
Foreign currency translation
  adjustments......................                                                          (523)                          (523)
Net income.........................                                                                          1,382         1,382
                                    ----      -----    -----     ----       -------        ------           ------       -------
Balance, August 3, 1997............   --        --     9,553       96        41,650          (269)           8,261        49,738
Issuance of preferred stock,
  net of costs.....................  150         2                           14,830                                       14,832
Issuance of common stock...........                      324        3         3,097                                        3,100
Foreign currency translation
  adjustments......................                                                        (1,298)                        (1,298)
Net income.........................                                                                            741           741
                                    ----      -----    -----     ----       -------        ------           ------       -------
Balance, August 2, 1998............  150      $  2     9,877     $ 99       $59,577       $(1,567)          $9,002       $67,113
                                    ====      ====     =====     ====       =======       =======           ======       =======
</TABLE>
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
          
                                      29
<PAGE>
 
                              Four Media Company
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (In thousands)

                                        
<TABLE>
<CAPTION>
                                                                                             Fiscal Year Ended
                                                                                  --------------------------------------
                                                                                  August 4,       August 3,    August 2,
                                                                                    1996            1997         1998
                                                                                    ----            ----         ----
<S>                                                                               <C>            <C>            <C>
Cash flows from operating activities:
  Net income...................................................................   $  2,424       $  1,382       $    741
  Adjustments to reconcile net income to net cash provided by
         operating activities:
    Depreciation and amortization..............................................     10,165         13,175         18,191
    Provision for doubtful accounts............................................        580            871            794
    Extraordinary loss on early extinguishment of debt.........................         --             --          2,449
    Deferred taxes.............................................................     (1,000)            --            438
    Changes in operating assets and liabilities, net of
         acquisitions of businesses:
      Decrease in restricted cash..............................................          8             --            625
      Increase in trade and long-term receivables..............................     (1,469)       (11,305)        (8,836)
      Increase in inventory....................................................       (172)            --           (174)
      Increase in prepaid expenses and other current asset.....................     (1,289)        (1,796)        (2,836)
      Increase (decrease) in accounts payable..................................        792          5,277         (1,263)
      (Decrease) increase in accrued and other liabilities.....................       (652)           304         (8,273)
                                                                                  --------       --------       --------
        Net cash provided by operating activities..............................      9,387          7,908          1,856
Cash flows from investing activities:
  Purchases of property, plant and equipment...................................    (10,318)       (30,720)       (29,561)
  Acquisitions of businesses...................................................         --         (9,422)       (25,344)
                                                                                  --------       --------       --------
        Net cash used in investing activities..................................    (10,318)       (40,142)       (54,905)
Cash flows from financing activities:
  Proceeds from public offering of common stock................................         --         26,736             --
  Proceeds from preferred stock................................................         --             --         14,832
  Proceeds from mortgage loans.................................................         --          8,400          8,100
  Repayments of mortgage loans.................................................         --             --         (8,214)
  Proceeds from term loans.....................................................         --         16,000        105,000
  Repayments of term loans.....................................................         --             --        (16,375)
  Proceeds from revolving credit facilities....................................         --          5,287         13,237
  Repayments of revolving credit facilities....................................         --             --        (11,524)
  Proceeds from equipment notes................................................      3,685          4,583          5,599
  Repayment of equipment notes and capital lease obligations...................     (4,095)       (27,842)       (59,896)
                                                                                  --------       --------       --------
        Net cash provided by (used in) financing activities....................       (410)        33,164         50,759
Effect of exchange rate changes on cash........................................          2           (153)          (498)
                                                                                  --------       --------       --------
Net increase (decrease) in cash................................................     (1,339)           777         (2,788)
Cash at beginning of year......................................................      6,651          5,312          6,089
                                                                                  --------       --------       --------
Cash at end of year............................................................   $  5,312       $  6,089       $  3,301
                                                                                  --------       --------       --------
Supplemental disclosure of cash flow information:
  Cash paid during the fiscal year for:
    Interest...................................................................   $  3,406       $  4,305       $  8,086
    Income taxes...............................................................         --             --            378
  Non cash investing and financing activities:
    Capital lease obligations incurred.........................................   $  7,851       $  9,915       $  9,050
    Notes issued to sellers in connection with POP purchase....................         --             --          1,257
    Stock issued in connection with VSI purchase...............................         --             --          3,100
    Reappraisal of assets in connection with Anderson purchase.................         --             --          3,111
</TABLE>

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

                                      30
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
                                        

1.   Business, Organization and Basis of Presentation

     Four Media Company (the "Company") is a provider of technical and creative
services to owners, producers and distributors of television programming,
television commercials, feature films and other entertainment content.  The
Company's services integrate and apply a variety of systems and processes to
enhance the creation and distribution of entertainment content.

     While the Company believes that it operates in one business segment, which
is providing services to the entertainment industry, the Company has organized
its activities into four divisions: manufacturing and distribution; broadcast
and syndication; television; and film and animation.  The manufacturing and
distribution division located in Burbank, California, manages, formats and
distributes content worldwide.  The broadcast and syndication division, located
in Burbank and the Republic of Singapore, assembles and distributes television
networks and programming via satellite to viewers in the United States, Canada
and Asia.  The television division, located in Burbank, and Santa Monica,
California, assembles film or video principal photography into a form suitable
for network, syndicated, cable or foreign television.  The film and animation
division, located in Santa Monica, digitally creates and manipulates images in
high-resolution formats for use in feature films.

     The Company was incorporated in July 1993 as a wholly owned subsidiary of
Technical Services Partners, L.P. ("TSP"), a limited partnership formed for the
purpose of acquiring certain defined net assets of Compact Video Group, Inc.,
Compact Video Services, Inc., Image Transform, Inc. and Meridian Studios, Inc.
(collectively "Compact").

     On October 17, 1996, the Company completed a reorganization (the
"Reorganization") as of September 29, 1996.  Under the terms of the
Reorganization which was accounted for in a manner similar to a pooling of
interests, the Company issued 5,900,000 shares of its common stock on October
17, 1996 to TSP (defined above) in exchange for 1,000 shares of 4MC-Burbank,
Inc. common stock, representing 100% of the issued and outstanding shares of the
corporation and 4MC-Burbank became a wholly owned subsidiary of the Company.  In
conjunction with the Reorganization, 4MC-Burbank's interests in its wholly owned
subsidiaries, DMC and 4MC Asia were transferred to the Company in the form of a
dividend distribution.  Unless otherwise specified, all references to "the
Company" refer to Four Media Company as of October 17, 1996, and 4MC-Burbank
prior to October 17, 1996.  The purpose of the Reorganization was to facilitate
future financing transactions and acquisitions.

     On February 7, 1997, the Company completed an initial public offering of
5,000,000 shares of Common Stock, of which 3,077,502 shares were sold by the
Company and 1,922,498 shares were sold by TSP, as the selling stockholder.  The
offering generated approximately $26,700,000 of proceeds to the Company, net of
underwriting discount and related expenses.

     On October 26, 1994, 4MC Acquisition Corp., a wholly owned subsidiary of
the Company, acquired substantially all of the assets of Digital Magic and
Transfer Company ("DM&T") for a purchase price of $50,000 in cash.  The
acquisition was accounted for under the purchase method of accounting.  The
purchase price was allocated, to the fair value of the assets and liabilities
acquired as follows: $1,000,000 to current assets, $6,600,000 to, property,
plant, and equipment, $4,050,000 to accrued liabilities, and $3,500,000 to
equipment notes.  Subsequent to the acquisition, 4MC Acquisition Corp. changed
its name to Digital Magic Company ("DMC").

     On February 13, 1995, Four Media Company Asia PTE Ltd. ("4MC Asia"), a
wholly owned subsidiary of the Company registered in the Republic of Singapore,
entered into an agreement with a customer to provide production, post production
and network origination services.  The agreement has a seven year term and
provides for early termination by the customer after five years by paying a fee,
as defined in the agreement, not to exceed $3,500,000.

                                       31
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

1.   Business, Organization and Basis of Presentation, Continued

     On March 10, 1997, AV Acquisition Corp., a wholly owned subsidiary of the
Company, acquired substantially all of the assets of Anderson Film Industries
Corp and Anderson Graphics, LLC.  (collectively, "Anderson").  The total
transaction cost was $10,500,000, comprised of $7,700,000 in payments to secured
and unsecured creditors, $900,000 in assumed capital lease obligations and
$1,900,000 in transaction costs.  The acquisition was accounted for under the
purchase method of accounting.  At the acquisition date, the purchase price was
allocated to the fair value of the assets and liabilities acquired as follows:
$1,800,000 to current assets and $8,700,000 to property, plant and equipment.
Based on subsequent information of fair value obtained by the Company in 1998,
the Company reduced the cost of the fixed assets resulting in $3,100,000 of
goodwill and a net reduction of amortization and depreciation expense of
$458,000 for the quarter ended August 2, 1998.  Subsequent to the acquisition,
AV Acquisition Corp. changed its name to Anderson Video Company.

     On February 2, 1998, the Company acquired all the outstanding shares of
capital stock of Visualize d/b/a Pacific Ocean Post ("POP").  The purchase price
of the transaction was $30,100,000, of which $25,400,000 was paid in cash,
$1,200,000 was represented by promissory notes, and $3,500,000 represented
transaction costs.  The acquisition was accounted for using the purchase method
of accounting.  The purchase price was allocated to the fair value of the assets
and liabilities acquired as follows: $4,700,000 to current assets, $11,700,000
to property, plant and equipment, $31,400,000 to goodwill, $2,900,000 to
deferred taxes, $700,000 to other assets, $5,000,000 to accounts payable and
accrued liabilities, and $16,300,000 to debt and capital lease obligations.
Immediately following the closing, the Company extinguished $8,500,000 of POP's
debt, capital lease obligations, and certain operating lease obligations.

     As part of the POP acquisition, the Company obtained a 49% interest in the
Cinram-POP DVD Center, LLC ("DVD Center").  The DVD Center provides complete
digital versatile disc authoring services to the theatrical and non-theatrical
marketplace.  The Company accounts for the joint venture using the equity method
of accounting.  For fiscal 1998, the Company recorded equity in losses of the
DVD Center of $10,000.  The investment in the DVD Center at August 2, 1998 is
$139,000 and is included in other assets.  In addition, the Company owns 81% of
the outstanding stock of POP Animation, a computer graphics imaging company.
The results of POP Animation are included in the accompanying consolidated
financial statements of the Company as of August 2, 1998.  For fiscal 1998,
operations of POP Animation resulted in losses applicable to the minority
interest.  Such excess of $11,000 is charged against operating losses of the
Company as there is no obligation of the minority interest to make good on such
losses.  Any future losses of POP Animation will continue to be charged against
the operations of the Company, while the Company's majority interest will be
credited for any future earnings to the extent of such losses previously
absorbed.

     On May 4, 1998, the Company through its wholly owned subsidiary VSDD
Acquisition Corp., acquired all of the outstanding ownership interests in
Symphonic Video LLC and Digital Doctors LLC from their parent companies Video
Symphony, Inc. and Digital Doctors, Inc. (collectively "VSI").  In this
transaction, the Company effectively acquired all of the operations of VSI.  The
purchase price of the transaction was approximately $3,300,000, of which
$3,100,000 was paid in the Company's common stock and $200,000 represented
transaction costs.  The acquisition was accounted for using the purchase method
of accounting.  The purchase price was allocated to the fair value of the assets
and liabilities acquired as follows:  $200,000 to current assets, $2,000,000 to
property, plant and equipment, $3,500,000 to goodwill, $400,000 to accounts
payable and accrued liabilities, and $2,000,000 to debt and capital lease
obligations.

2.   Summary of Significant Accounting Policies

     Principles of Consolidation.  The consolidated financial statements include
the accounts of Four Media Company and its wholly owned and majority owned
subsidiaries.  All intercompany accounts and transactions have been eliminated.

                                       32
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

2.   Summary of Significant Accounting Policies, Continued

     Fiscal Year.  The Company's fiscal year is the 52-53 week period ending on
the Sunday closest to July 31.  The fiscal year ended August 4, 1996 consisted
of 53 weeks and the fiscal years ended August 3, 1997 and August 2, 1998 each
consisted of 52 weeks.

     Revenue Recognition.  Revenues are recognized when a product is shipped or
a service is provided.  Revenues from fixed-price contracts are recognized on
the percentage-of-completion method, whereby revenues and gross profits are
recognized ratably throughout the performance period of the contract based on
percentage of actual incurred costs to total estimated final costs.  This method
is used because management considers actual costs incurred to be the best
available measure of progress on these contracts.  The Company performs a
monthly review of uncompleted contracts and adjusts for changes in estimates in
the period of the change.

     Foreign Currency Translation.  All balance sheet accounts of 4MC Asia are
translated at the current exchange rate as of the end of the year.  Statement of
operation items are translated at average currency exchange rates.  The
resulting translation adjustment is recorded as a separate component of
stockholders' equity.  The functional currency in which 4MC Asia transacts
business is the Singapore dollar.  Transaction gains and losses included in
operations were not significant in fiscal 1996, 1997, or 1998.

     Cash and Cash Equivalents.  The Company considers all highly liquid
investments purchased with a maturity of three months or less to be cash
equivalents.  The carrying value of these instruments approximates market value
because of their short maturity.

     Inventory.  Inventories are stated at the lower of cost (first-in, first-
out) or market, and are comprised of raw materials and supplies.

     Property, Plant and Equipment.  Property, plant and equipment acquired from
Compact, DM&T, Anderson, POP and VSI were recorded at their appraised fair
market values at the date of acquisition.  Additions to property, plant and
equipment subsequent to the date of acquisition are recorded at cost.  When
properties are retired or otherwise disposed of, the cost and related
accumulated depreciation are removed from the accounts, and the resulting gain
or loss is credited or charged to operations.  The policy of the Company is to
charge amounts expended for maintenance and repairs to current year expense and
to capitalize expenditures for major replacements and betterments.

     Depreciation and Amortization.  Depreciation of property, plant and
equipment is computed by use of the straight-line method based on the estimated
useful lives of 3 to 7 years of the respective assets, except for leasehold
improvements, which are amortized using the straight-line method over the life
of the improvement or the length of the lease, whichever is shorter.  Interest
costs incurred during construction totaling $142,000, $1,229,000, and $940,000,
were capitalized for the years ended August 4, 1996, August 3, 1997, and August
2, 1998 respectively, and are being amortized over the related assets estimated
useful lives.

     Goodwill.  Goodwill represents the excess of cost over the fair value of
net assets acquired and is amortized using the straight-line method over 30 to
40 years.  Useful lives are determined on a case by case basis for each business
acquired.  The carrying value of goodwill is reviewed if the facts and
circumstances suggest that it may be impaired.  If this review indicates that
goodwill will not be recoverable, as determined based on estimated undiscounted
cash flows of the Company over the remaining amortization period, the Company's
carrying value would be reduced by the estimated shortfall of discounted cash
flows.

                                       33
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 


2.   Summary of Significant Accounting Policies, Continued

     Other Assets.  Other assets include costs incurred by 4MC Asia prior to the
commencement of the service contract and a lease interest associated with the
acquisition of the assets of DM&T. These assets are amortized on the straight-
line method over the contract or lease terms of five to seven years.  Other
assets also include software development costs.  The Company capitalizes
internal software development costs when technological feasibility has been
established.  Capitalization ends when the software is put into service.
Amortization of software development costs is computed by use of the straight-
line method over three years.

     Use of Estimates.  The preparation of financial statements is in accordance
with generally accepted accounting principles and requires management to make
estimates and assumptions for the reporting period and as of the financial
statement date.  These estimates and assumptions affect the reported amounts of
assets and liabilities, the disclosure of contingent assets and liabilities, and
the reported amounts of revenues and expenses.  Actual results could differ from
those estimates.

     Long Lived Assets.  Statement of Financial Accounting Standards ("SFAS")
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of" requires that long-lived assets and certain
identifiable intangibles to be held and used or disposed of by an entity be
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable.  During 1997 the
Company adopted this statement.  The Company has determined that no impairment
loss need be recognized for the fiscal year ended August 2, 1998.

     Stock Based Compensation.  Statement of Financial Accounting Standards No.
123, "Accounting for Stock-Based Compensation" ("SFAS No. 123") encourages, but
does not require companies to record compensation cost for stock-based employee
compensation plans at fair value.  The Company has chosen to continue to account
for stock-based compensation using the intrinsic value method prescribed in
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees," and to adopt the disclosure-only provisions of SFAS No. 123.
Accordingly, compensation cost for stock options is measured as the excess, if
any, of the quoted market price of the Company's stock at the date of the grant
over the amount an employee must pay to acquire the stock.

     Fair Values of Financial Instruments.  SFAS No. 107 "Disclosure About Fair
Value of Financial Instruments" ("SFAS No. 107"), requires disclosure of fair
value information about most financial instruments both on and off the balance
sheet, if it is practicable to estimate.  SFAS No. 107 excludes certain
financial instruments such as certain insurance contracts and all non-financial
instruments from its disclosure requirements.  A financial instrument is defined
as a contractual obligation that ultimately ends with the delivery of cash or an
ownership interest in an entity.  Disclosure regarding the fair value of
financial instruments is derived using external market sources, estimates using
present value or other valuation techniques.  Cash, accounts receivable,
accounts payable, accrued and other liabilities and short-term revolving credit
agreements and variable rate long-term debt instruments approximate their fair
value.

     Earnings Per Share.  During the year ended August 2, 1998, the Company
adopted SFAS No. 128 "Earnings Per Share" ("SFAS No. 128") which established
standards for computing and presenting earnings per share for publicly-held
common stock or potential common stock.  SFAS No. 128 supercedes the standards
for computing earnings per share previously found in APB opinion No. 15
"Earnings per Share" and simplifies the standards for computing earnings per
share.  In addition, SFAS No. 128 replaces the presentation of primary earnings
per share with a presentation of basic earnings per share, requires dual
presentation of basic and diluted earnings per share on the face of the income
statement for all entities with complex capital structures, and requires a
reconciliation of the numerator and denominator on the basic earnings per share
computation to the numerator and denominator of the diluted earnings per share
computation.  All periods presented reflect the adoption of SFAS No. 128.  The
impact on amounts previously reported was not material.

                                       34
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 


2.   Summary of Significant Accounting Policies, Continued

     Advertising.  Advertising costs are expensed as incurred and included in
sales, general and administrative expenses.  Advertising expenses amounted to
$287,000, $225,000, and $365,000 in the years ended August 4, 1996, August 3,
1997, and August 2, 1998, respectively.

     Recently Issued Accounting Standards.  In June 1997, the FASB issued SFAS
No. 130, "Reporting Comprehensive Income".  This statement will be effective for
the Company beginning with the first fiscal quarter of 1999.  The standard
establishes guidelines for the reporting and display of comprehensive income and
its components in financial statements.  Comprehensive income generally
represents all changes in shareholders' equity, except those resulting from
investments by or distributions to shareholders.  The Company believes that
comprehensive income in future periods will fluctuate as a result of changes in
the cumulative translation account, which is a component of comprehensive
income.

     In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of
an Enterprise and Related Information".  SFAS No. 131 requires publicly-held
companies to report financial and descriptive information about its operating
segments in financial statements issued to shareholders for interim and annual
periods.  The statement also requires additional disclosure with respect to
products and services, geographic areas of operation, and major customers.  This
statement will be effective for the Company beginning with the fiscal year end
1999.  Management is currently evaluating the impact, if any, of SFAS No. 131.

     In June 1998, the FASB issued SAFS No. 133, "Accounting for Derivative
Instruments and Hedging Activities".  This Statement requires that all
derivative instruments be recorded on the balance sheet at their fair value.
Changes in the fair value of derivatives will be recorded each period in current
earnings or other comprehensive income, depending on whether a derivative is
designated as part of a hedge transaction and, if it is, the type of hedge
transaction.  The new rules will be effective the first quarter of 2000.  The
Company is in the process of determining the impact of this new standard and
anticipates that it will not have a material impact on the Company's financial
results when effective.

3.   Business and Credit Concentrations

     The Company grants credit to its customers, substantially all of whom are
participants in the entertainment industry.  The Company reviews a customer's
credit history before extending credit.  The Company establishes an allowance
for doubtful accounts based upon factors surrounding the credit risk of specific
customers, historical trends, and other information.  For the fiscal year ended
August 4, 1996 one customer accounted for 10% of the Company's domestic sales
and 12% of net accounts receivable.  For the fiscal years ended August 3, 1997
and August 2, 1998 no single customer accounted for a significant amount of the
Company's domestic sales.  During the fiscal year ended August 4, 1996, the
Company entered into a long term agreement for services with a customer and as a
part of the agreement the Company deferred payment in the amount of $3,300,000.
This amount was payable over three years in monthly installments of principal
and interest at 8%.  In August 1997, based in part upon significant equity
financing obtained by this customer, the Company revised this agreement to cover
all outstanding amounts due from this customer at year end.  This agreement
required payment of $2,300,000 within 30 days plus sixty monthly payments of
$98,972 commencing March 1998.  The Company received the $2,300,000 and all note
payments through July 1998.  The revised obligation for approximately $4,400,000
earns interest at 10% per annum.  The balance at August 2, 1998 is $4,163,000 of
which $887,000 is reflected as a current asset and $3,276,000 as a non-current
asset.  There can be no assurance that this customer ultimately will repay all
outstanding amounts due to the Company.  Principal payments expected beyond 12
months have been reflected as a non-current asset.  The Company has not
recognized any interest income and will recognize interest income as received on
a cash basis only.  No allowance related to this obligation has been recorded by
the Company.

                                       35
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 


3.   Business and Credit Concentrations, Continued

     Approximately 16%, 16%, and 8% of the Company's revenues for the years
ended August 4, 1996, August 3, 1997, and August 2, 1998, respectively, related
to 4MC Asia.  For the year ended August 4, 1996, one customer accounted for 97%
of 4MC Asia revenues, 15% of the Company's consolidated total revenues, and 5%
of the Company's consolidated net accounts receivable at August 4, 1996.  For
the year ended August 3, 1997, this customer accounted for 78% of 4MC Asia
revenues, 13% of the Company's consolidated total revenues, and 3% of the
Company's consolidated net accounts receivable at August 3, 1997.  For the year
ended August 2, 1998, this customer accounted for 90% of 4MC Asia revenues, 7%
of the Company's consolidated total revenues, and less than 1% of the Company's
consolidated net accounts receivable at August 2, 1998.

4.   Property, Plant and Equipment

     The following is a summary of property, plant and equipment (in thousands):


<TABLE>
<CAPTION>
                                                                        August 3,       August 2,
                                                                           1997            1998
                                                                           ----            ----
<S>                                                                     <C>              <C> 
Land..........................................................          $  8,950         $ 17,508
Buildings and building improvements...........................             8,475           11,020
Machinery and equipment.......................................            94,832          126,249
                                                                        --------         --------
                                                                         112,257          154,777
Less, accumulated depreciation and amortization...............            30,889           46,610
                                                                        --------         --------
                                                                          81,368          108,167
Construction in progress......................................            12,304           16,063
                                                                        --------         --------
  Property, plant and equipment, net..........................          $ 93,672         $124,230
                                                                        ========         ========
                                                                                 
Included above is property and equipment under capital leases of:
  Machinery and equipment.....................................          $ 20,559         $ 12,150
  Less, accumulated amortization..............................             4,754            2,334
                                                                        --------         --------
  Machinery and equipment under capital leases, net...........          $ 15,805         $  9,816
                                                                        ========         ========
</TABLE> 
     The reduction in leased equipment reflects the retirement of certain leases
(see Note 6), not the disposal of assets.

     During the fiscal years ended August 4, 1996, August 3, 1997, and August 2,
1998, the Company expensed maintenance, repairs and spare parts in amounts of
$1,795,000, $1,831,000, and $2,878,000, respectively.

     During the year ended August 4, 1996, the Company settled its claim arising
from the January 17, 1994 earthquake for $4,093,000.  Of this amount, $2,333,000
and $1,760,000 was received in 1995 and 1996, respectively.  Insurance proceeds
in excess of the net book value of destroyed assets and repair costs of damaged
assets were approximately $1,098,000.  Of this amount $198,000 and $900,000 was
credited to sales, general and administrative expense as a recovery under the
business interruption coverage of expenses incurred in 1995 and 1996,
respectively.

     The Company leases approximately 40,000 square feet of one of its buildings
to a third party at approximately $55,000 per month through January 2000.

5.   Income Taxes

     Deferred income taxes are determined in accordance with SFAS No. 109,
"Accounting for Income Taxes."  Under this method, deferred income taxes are
recognized for the tax consequences in future years of differences

                                       36
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  


5.   Income Taxes, Continued

between the tax bases of assets and liabilities and their financial reporting
amounts at each year-end based on enacted tax laws and statutory rates
applicable to the periods in which the differences are expected to affect
taxable income.  Valuation allowances are established to reduce deferred tax
assets to the amount expected to be realized.

     The income tax provision (benefit) consisted of the following (in
thousands):

<TABLE>
<CAPTION>
                                       1996      1997      1998
                                      ------    ------    ------
<S>                                   <C>       <C>       <C> 
              Current:
               Federal..............  $   26    $   --    $   --
               State................      11        --        --

              Deferred
               Federal..............    (791)       --        --
               State................    (240)       --        --
                                      ------    ------    ------
                 Total..............  $ (994)   $   --    $   --
                                      ======    ======    ======
</TABLE>

     The significant components of the deferred tax assets and liabilities
consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                       August 3,    August 2,
                                                         1997         1998
                                                       -------      -------
<S>                                                    <C>          <C> 
 Allowance for doubtful accounts..............         $   536      $   377
 Plant, property & equipment..................           1,558        4,679
 Intangible assets............................             113           32
 Accrued vacation.............................             210          496
 Acquisition expenses.........................              36          694
 Net operating loss carryforward..............           2,849        3,800
 Loan origination fees........................              --       (1,268)
 Loss on early extinguishment of debt.........              --         (975)
 Other........................................            (349)        (242)
 Valuation allowance..........................          (2,953)      (2,636)
                                                       -------      ------- 
   Net deferred tax asset.....................         $ 2,000      $ 4,957  
                                                       =======      =======   
</TABLE> 


     At August 3, 1997 and August 2, 1998 the Company had a net deferred tax
asset before valuation allowance of $4,953,000 and $7,593,000, respectively. The
acquisition of POP resulted in an increase in the Company's deferred tax assets
of approximately $2,900,000 which is attributable to a difference between the
book and tax basis of POP's fixed assets.

                                       37
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  


5.   Income Taxes, Continued

     The Company has evaluated its past earnings history and trends, budgeted
revenues and expiration dates of net operating loss carryforwards and has
determined that it is more likely than not that $4,957,000 of deferred tax
assets will be realized.  The remaining valuation allowance of $2,636,000 is
maintained on deferred assets which the Company has not determined to be more
likely than not realizable at August 2, 1998.  The Company will continue to
review this valuation allowance on a quarterly basis and make adjustments, as
appropriate.

<TABLE>
<CAPTION>
                                                               1996         1997         1998                       
                                                               ----         ----         ----                       
<S>                                                            <C>          <C>          <C> 
   Federal tax at statutory rate............................     34%          34%          34%                      
   State income taxes, net of federal tax benefits..........     --           --           --                       
   Permanent differences....................................      1            4           13                       
   Foreign income not subject to taxes......................    (33)         (76)         (22)                      
   Tax net operating loss carryforward......................     --           --           --                       
   Change in valuation allowance............................    (70)          38          (22)                      
   Other....................................................     (2)          --           (3)                      
                                                              -----        -----        -----                       
                                                                (70)%         --%          --%                      
                                                              =====        =====        =====                        
</TABLE>

     As of August 2, 1998, the Company has net operating loss carryforwards of
approximately $16,100,000 and $4,100,000 for Federal and California tax
purposes, respectively, not all of which has been reflected on the Company's
financial statements due to potential annual limitations concerning net
operating loss carryovers under the provisions of Internal Revenue Code Section
382 with respect to change in ownership.  The net operating loss carryforwards
begin to expire in 2009 and 1999 for Federal and California income tax purposes,
respectively.

     In 1995, the government of the Republic of Singapore granted 4MC Asia a
seven-year tax exemption as a "pioneer status" company. The resulting tax
savings reflected in net income amounted to $378,000, $877,000, and $564,000 in
fiscal 1996, 1997, and 1998, respectively.

6.   Long Term Debt

     The following is a summary of long-term debt (in thousands):


<TABLE>
<CAPTION>

                                                                   August 3,            August 2,
                                                                     1997                 1998 
                                                                     ----                 ---- 
<S>                                                                <C>                <C> 
                      CIBC term loans...........................      --              $104,625 
                      CIBC revolving credit facility............      --                 7,000 
                      CIBC letter of credit.....................      --                   117 
                      CIT term loan.............................  $16,000                  --  
                      CIT revolving credit facility.............    5,287                  --  
                      HKSB term loan............................   10,534                  --  
                      Real property loan........................    8,334                8,220 
                      Notes payable.............................    8,832                1,121 
                      Capital lease obligations.................   16,205                9,772 
                                                                  -------              ------- 
                                                                   65,192              130,855 
                      Less, current maturities..................   10,559                6,184 
                                                                  -------              ------- 
                                                                  $54,633              $124,671
                                                                  =======              ======== 
</TABLE>
                                                                                

                                       38
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 


6.   Long Term Debt, Continued


     Aggregate capital lease obligations and loan maturities subsequent to
August 2, 1998 are as follows (in thousands):

<TABLE>
<CAPTION>
                                            Capital Lease          Principal Payments
                                              Payments             on Loans and Notes               Total
                                           ---------------       ----------------------          ----------
<S>                                        <C>                    <C>                            <C>
Fiscal years ending
 1999.....................................    $  5,492                    $  1,415                $  6,907
 2000.....................................       3,447                       8,744                  12,191
 2001.....................................       1,459                      16,054                  17,513
 2002.....................................         585                       8,364                   8,949
 2003.....................................           8                         864                     872
 Thereafter...............................          --                      85,642                  85,642
                                               -------                    --------                --------
     Total................................     $10,991                    $121,083                $132,074
Less: amounts representing interest.......       1,219                          --                   1,219
 interest.................................     -------                    --------                --------
     Total................................     $ 9,772                    $121,083                $130,855
                                               =======                    ========                ========
</TABLE>
     On February 27, 1998, the Company entered into a financing agreement
representing $200,000,000 in credit facilities from a group of banks, including
Canadian Imperial Bank of Commerce ("CIBC").  The facilities include two
$75,000,000 term loans ("Term A" and "Term B") and a $50,000,000 revolver
("Revolver").  At closing, the Company borrowed $104,000,000 (including a
$2,000,000 letter of credit) to refinance most of its then outstanding debt
(including amounts outstanding under the CIT facilities), fund the POP
acquisition (including the refinancing of most of POP's then outstanding debt)
and pay loan fees and other transaction costs.  Both Term A and the Revolver
mature on January 31, 2004 and are reduced by quarterly amounts beginning April
30, 2000, as specified in the financing agreement.  Term A and the Revolver bear
interest at Libor (5.70% at August 2, 1998) plus a margin ranging from 1.5% to
2.5%, based upon the Company's leverage ratios.  In addition, the Company must
pay a commitment fee of 0.50% on the unused portions of the Term A and Revolver
commitments.  At August 2, 1998, $30,000,000 and $7,000,000 were outstanding on
Term A and the Revolver, respectively.  Term B matures July 31, 2004 and is
reduced quarterly by amounts specified in the financing agreement beginning
April 30, 1998.  Term B bears interest at Libor plus a margin ranging from 1.75%
to 2.75% based upon the Company's leverage ratios.  At August 2, 1998,
$74,625,000 was outstanding on Term B.  Borrowings under the agreement are
collateralized by substantially all of the assets held by the Company.  In
addition, the agreement contains certain restrictive covenants and ratios, as
defined, including minimum amounts of operating cash flow, limitations on
capital expenditures, minimum ratios of interest coverage and fixed charge
coverage, and maximum ratios of leverage.

     The Company also entered into an interest rate swap agreement with a bank
that fixed the interest rate on $75,000,000 of the facilities debt at 5.74% plus
the Company's margin (see above). The swap agreement terminates in 2001, but is
subject to extension through 2004 at the bank's option.

     In December 1996, the Company borrowed $8,400,000 under a real property
loan for the purchase of a 90,000 square foot building. The term loan provides
for monthly principal payments over a period of 84 months and a final payment at
maturity in December 2003. The term loan is collateralized by the building and
any improvements thereon and is guaranteed by 4MC Burbank and DMC. The term loan
bears interest at the lender's prime rate plus 1% or LIBOR plus 2.25%, at the
Company's option.

     On February 22, 1995, 4MC Asia entered into a loan agreement with The Hong
Kong and Shanghai Banking Corporation Limited ("HKSB"), providing a term loan
facility of SD$16,898,000 Singapore dollars (approximately $11,495,000 US
dollars at August 3, 1997). This loan was repaid in full in February 1998.

                                       39
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 


6.   Long Term Debt, Continued

     In connection with the POP acquisition, the Company issued non-interest
bearing promissory notes to the POP shareholders totaling $1,140,00.  These
notes are payable in equal monthly installments through February 1, 2001.  As of
August 2, 1998, the balance outstanding on these notes was $953,000.  In
addition, the Company has an outstanding note payable to a former shareholder of
POP, which bears interest at 10%.  Principal and interest is paid on a monthly
basis through March 1999.  As of August 2, 1998, the balance outstanding on this
note was $168,000.

  The Company has entered into various equipment notes and capital lease
agreements related to the purchase of equipment.  These notes and leases
collateralized by the related equipment are due through 2004 and are at interest
rates of 8.3% to 13.0%.

7.   Commitments and Contingencies

     The Company and certain subsidiaries have employment agreements with
certain members of their management and creative staff to retain their services
for up to five years at amounts approximating their current levels of
compensation. At August 2, 1998, the Company's remaining aggregate commitment
under such contracts is approximately $15,011,000.

     The Company leases its production and office facilities under non-
cancelable operating leases with initial terms up to ten years through 2009.
Most leases contain renewal options and require additional payments for property
taxes, utilities, insurance and maintenance costs. Some leases are subject to
periodic escalation charges. Facilities rent expense amounted to $4,392,000,
$3,757,000, and $5,755,000 for the fiscal years ended August 4, 1996, August 3,
1997, and August 2, 1998, respectively. At August 2, 1998 the annual commitment
under these facilities leases is summarized as follows (in thousands):

<TABLE>
<CAPTION>
                        <S>                             <C> 
                    Fiscal years ending in:
                        1999....................        $5,893
                        2000....................         3,733
                        2001....................         3,316
                        2002....................         3,128
                        2003....................         2,244
                        Thereafter..............        10,945
                                                       -------
                           Total................       $29,259
                                                       =======
</TABLE>
                                                                                
  As a result of the POP acquisition, one of the production facilities is leased
through February 2003 from a partnership whose partners include former employees
of POP that are now employees and consultants of the Company.  The future annual
commitments under this lease from August 2, 1998 are $522,000, $548,000,
$576,000, $604,000, and $302,000, respectively.

                                       40
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 


7.   Commitments and Contingencies, Continued

     The Company leases certain office equipment under operating leases which
expire through 2002.  Rent expense related to equipment amounted to $190,200,
$286,000 and $1,329,000 for the fiscal years ended August 4, 1996, August 3,
1997, and August 2, 1998, respectively.  At August 2, 1998 the annual commitment
under various leases is summarized as follows (in thousands):

<TABLE>
<CAPTION>
                        <S>                           <C> 
                        Fiscal years ending in:
                             1999...................  $1,513
                             2000...................     821
                             2001...................     126
                             2002...................       9
                                                      ------
                             Total................    $2,469
                                                      ======
</TABLE>
                                                                                
     The Company is involved in litigation matters arising in the normal course
of business.  Management believes that the disposition of these lawsuits will
not materially affect the financial position or results of operations of the
Company.

8.   Preferred Stock

     On February 27, 1998, the Company completed a $15,000,000 preferred equity
private placement of 150,000 share of Series A Convertible Preferred Stock
("Preferred Stock").  The Preferred Stock is convertible at the option of the
holder into shares of the Company's common stock at a conversion rate equal to
the liquidating value of shares to be converted, plus all declared but unpaid
dividends through the date of conversion, divided by the conversion price.  The
conversion price is subject to adjustment under certain conditions and was $10
per share at August 2, 1998.  While there are no dividend requirements on the
Preferred Stock, the Preferred Stockholders have the right to participate in all
dividends declared on the Company's common stock.  The Company has reserved
shares of its common stock to be issued upon the conversion of the Preferred
Stock.

     The Preferred Stock has liquidation preference over the common stock and
has a liquidation value of $100 per share. Holders of the preferred stock have
equal voting rights with the common stockholders and, as long as one preferred
stockholder owns at least 75,000 shares, the preferred stockholders are
entitled, as a class, to elect one member of the Company's Board of Directors.
The Preferred Stock has a mandatory redemption date of December 31, 2002 and
will be redeemed in cash or shares of common stock at the Company's option. If
redeemed in cash at the mandatory redemption date, the amount shall be equal to
the liquidation value plus all declared but unpaid dividends through the
redemption date. If redeemed for common stock at the mandatory redemption date,
the number of common shares to be issued to the preferred stockholders is
determined based upon the liquidation value of the preferred stock divided by
90% of the market price of the Company's common stock; however, the preferred
stockholders ownership interest cannot exceed 29.9% of the then outstanding
common stock. Any remaining preferred stock will be redeemed for common stock at
any time the preferred shareholders ownership interest in the company's common
stock falls below 29.9%. At the mandatory redemption date, the Company intends
to redeem the outstanding shares of Preferred Stock for shares of the Company's
common stock. Additionally, upon certain sales, consolidations or mergers, the
preferred stockholders have the right, at the holders option, to require the
Company to repurchase all shares for an amount equal to the greater of (a) the
mandatory redemption price or (b) an amount equal to what the holders would have
received on such date had the holders converted the preferred stock into common
stock. If the holders exercise such option, it is within the control of the
Company whether it repurchases such shares for cash or for common stock.

9.   Stock Options

     The Company has two option plans and a series of executive option
agreements (collectively "Plans") 

                                       41
<PAGE>

                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

which reserve shares of common stock for issuance to executives, key employees
and directors. These Plans provide that shares granted come from the Company's
authorized but unissued or reacquired common stock. The price of the options
granted pursuant to these Plans will not be less than 100 percent of the fair
market value of the shares on the date of grant. An option may not be exercised
within one year from the date of grant and no option will be exercisable after
ten years from the date granted. Options vest over a 3 to 6 year period from
date of grant.

  The following table sets forth stock option information relative to all plans:


<TABLE>
<CAPTION>
                                                          
                                        August 4, 1996                   August 3, 1997                  August 2, 1998
                                        --------------                   --------------                  --------------
                                                    Weighted-                       Weighted-                     Weighted-   
                                     Number          Average           Number        Average         Number        Average    
                                   of Options     Exerciser Price    of Options   Exercise Price   of Options     Exercise Price
                                   ----------     ---------------    ----------   --------------   ----------     --------------
<S>                                <C>            <C>                <C>          <C>              <C>            <C> 
Outstanding at beginning of year     615,125           $0.34            615,125        $0.34        1,615,125          $5.70
Granted                                                               1,000,000         9.00          510,000           8.92
Expired or cancelled                                     --                              --                              --
Exercised                               --               --                --            --              --              --
                                     -------           -----          ---------        -----        ---------          -----
Outstanding at end of year           615,125           $0.34          1,615,125        $5.70        2,125,125          $6.47
                                     =======                          =========                     =========
Options exercisable at end of year   308,179                            410,082                       826,035
                                     =======                          =========                     =========
</TABLE>

  The following table summarizes information on fixed stock options outstanding
at August 2, 1998:

<TABLE>
<CAPTION>
                                                                        
                                        Options Outstanding                                   Options Exercisable 
                     ---------------------------------------------------------------    --------------------------------
                                          Weighted-average
   Ranges of            Number       remaining contractual life     Weighted-average      Number        Weighted-average
exercise prices      Outstanding             (in years)              exercise price     exercisable      exercise price
---------------      -----------             ----------              --------------     -----------      --------------
<S>                  <C>                     <C>                     <C>                <C>              <C> 
     $0.34              615,125                  5.0                      $0.34            512,702            $0.34
  $7.00-$10.00        1,510,000                  8.5                       8.97            313,333             8.64
                      ---------                  ---                      -----            -------            -----
                      2,125,125                  7.5                      $6.47            826,035            $3.49
                      =========                                                            =======      
</TABLE>

  As permitted under current accounting standards, no compensation cost was
recognized for the Plans. Had compensation cost for the Company's Plans been
recognized ratably over the options' vesting periods, the Company's pro forma
net income (loss) and net income (loss) per common share would have been
$2,414,000 and $0.37, respectively for 1996, $858,000 and $0.11, respectively
for 1997, and ($1,074,000) and ($0.11), respectively for 1998. Net income (loss)
per share, assuming dilution, would have been $0.37, $0.10 and ($0.11) for 1996,
1997 and 1998, respectively.

  The weighted-average fair value of options granted during 1996, 1997 and 1998
were $.34, $4.77 and $4.08, respectively.  Option grant date fair values were
determined using a Black-Scholes option pricing value.  The underlying
assumptions used were as follows:

<TABLE>
<CAPTION>
                                           August 4, 1996           August 3, 1997            August 2, 1998 
                                           --------------           --------------            --------------
<S>                                        <C>                      <C>                       <C> 
Risk-free interest rate                         4.96%                    6.16%                     5.49% 
Expected stock price volatility                 0.00%                   53.89%                    56.20% 
Expected dividend yield                         0.00%                    0.00%                     0.00%
Expected life (in years)                          7                        5                         4
</TABLE>

10.  Earnings Per Share

  Effective with the interim period ended February 1, 1998, the Company adopted
the earnings per share calculation and disclosure requirements of Financial
Accounting Standards Statement 128.  The tables below demonstrate the earnings
per share calculations for the periods presented.

                                       42
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


10.  Earnings Per Share, Continued
<TABLE>
<CAPTION>
                                                                                (in thousands, except per share data)
                                                        August 4, 1996                          August 3, 1997        
                                            -----------------------------------     ----------------------------------
                                                                            Per                                     Per
                                              Income         Shares        Share      Income           Shares      Share    
                                            (Numerator)    (Denominator)  Amount    (Numerator)    (Denominator)  Amount
<S>                                         <C>            <C>            <C>       <C>            <C>            <C>   
Net income before extraordinary item.....    $2,424                 --               $1,382                --         
Basic EPS................................     2,424              6,475     $0.37      1,382             7,971      $0.17
                                                                           =====                                   =====
Effects of Dilutive Securities:          
Options and convertible preferred stock..        --                 --                   --               592     
                                             ------              -----               ------             -----
Diluted EPS..............................    $2,424              6,475     $0.37     $1,382             8,563      $0.16
                                             ======              =====     =====     ======             =====      =====
Options omitted..........................                           --                                    700
                                                                 =====                                  =====

<CAPTION> 
                                                   August 2, 1998 
                                            --------------------------------------
                                                                           Per 
                                             Income           Shares      Share  
                                            (Numerator)    (Denominator)  Amount      
<S>                                         <C>            <C>            <C> 
Net income before extraordinary item.....    $3,190              --    
Basic EPS................................     3,190           9,634        $0.33 
                                                                           =====
Effects of Dilutive Securities:         
Options and convertible preferred stock..        --           1,264 
                                             ------          ------
Diluted EPS..............................    $3,190          10,898        $0.29 
                                             ======          ======        =====
Options omitted..........................                     1,035 
                                                             ====== 
</TABLE> 
                                           

          The Company incurred an extraordinary loss on early extinguishment of
debt of $2,449,000 for the year ended August 2, 1998 resulting in a net income
for the year of $741,000.  Basic EPS and diluted EPS after the extraordinary
loss was $0.08 and $0.07, respectively, for the year ended August 2, 1998.

          Certain options were omitted in 1997 and 1998 because the exercise
prices exceeded the average traded price during the periods.

11.  Employee Benefit Plans

          The Company's savings and investment plan covers substantially all of
the employees of the Company.  The participants may contribute up to 15% of
their annual compensation (subject to the annual IRS limitation) to the plan and
the Company will match the participant's contribution up to a maximum of 2% of
the participant's compensation.  The Company expensed $211,000, $219,000, and
$265,000 related to the plan for the years ended August 4, 1996, August 3, 1997,
and August 2, 1998, respectively.

          In addition, the Company's POP subsidiary has its own 401(K) defined
contribution plan covering all of its full-time employees.  Employees can
contribute up to 20% of pretax annual compensation (subject to IRS limitations).
The Company contributes on amount equal to 25% of the first 4% of base
compensation that a participant contributes to the plan.  The Company's expense
for the plan totaled $46,000 for the year ended August 2, 1998.

12.  Related Parties

          As of August 4, 1996, TSP was the holder of subordinated promissory
notes from the Company totaling $9,000,000.  During the years ended August 4,
1996, and August 3, 1997 the Company paid $450,000, and $928,000, respectively,
to TSP in interest.  These notes were repaid in full in fiscal 1997.

          The Company paid consulting fees and expenses to a member of the Board
of Directors of the Company of $205,423 for the year ended August 4, 1996.  As
of August 4, 1996, the director was no longer affiliated with the Company.

          The Company paid professional fees to a partnership that a member of
the Board of Directors of the Company is a partner of approximately $27,000 and
$54,000 for fiscal years 1997 and 1998, respectively.

                                       43
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


12.   Related Parties, Continued

          The Company has entered into an agreement with an emerging company
wherein the Company would advance it certain funds.  As of August 4, 1996,
August 3, 1997, and August 2, 1998 the Company has advanced cash for operating
purposes of approximately $238,000, $499,000, and $916,000 respectively.
Beginning January 1, 1997, the Company had the option to purchase a significant
portion of the stock of the emerging company.  Subsequent to August 2, 1998, the
Company exercised its option to acquire all of the stock of this entity for a
total purchase price of approximately $1,000,000, which includes amounts
advanced to the emerging company.

          In connection with the acquisition of Compact in 1993, Mr. Robert T.
Walston, the Company's Chief Executive Officer was granted a profit interest in
TSP for identifying, analyzing and consummating the acquisition.  The profit
interest is equal to 10% of the excess, if any, by which the distributions (in
cash or in kind) from TSP exceed the partners' total investment in TSP plus a
return of 9% per annum.  As a result of his profit interest in TSP, Mr. Walston
beneficially owns approximately 15% of the Company's common stock.  Mr.
Walston's percentage ownership may increase based upon future distributions by
TSP, as determined by Mr. Walston and TSP.

13.   Business Segments

          Information about the Company's operations in different geographic
areas for the years ended August 4, 1996, August 3, 1997, and August 2, 1998 are
as follows (in thousands):

<TABLE>
<CAPTION>
                                            United                                            Consolidated
                                            States           Asia         Corporate              Total
<S>                                         <C>            <C>            <C>                 <C>
Net sales to unaffiliated customers:
  Year ended August 4, 1996                  $ 58,970       $11,058        $    --             $ 70,028
  Year ended August 3, 1997                    70,702        13,825             --               84,527
  Year ended August 2, 1998                   118,635        10,533             --              129,168
 
Income from operations:
  Year ended August 4, 1996                     7,095         2,922         (4,681)               5,336
  Year ended August 3, 1997                     6,824         4,198         (5,753)               5,269
  Year ended August 2, 1998                    14,683         2,543         (5,897)              11,329
 
Identifiable assets:
  Year ended August 4, 1996                    54,741        22,307          4,779               81,827
  Year ended August 3, 1997                    99,342        19,835         13,060              132,237
  Year ended August 2, 1998                   178,093        12,483         25,768              216,344
 
Capital expenditures:
  Year ended August 4, 1996                    14,978         2,208            983               18,169
  Year ended August 3, 1997                    35,335           731         12,113               48,179
  Year ended August 2, 1998                    39,934           222         12,244               52,400
 
Depreciation and amortization expense:
  Year ended August 4, 1996                     6,548         2,722            895               10,165
  Year ended August 3, 1997                     8,984         2,961          1,230               13,175
  Year ended August 2, 1998                    14,155         2,645          1,391               18,191
</TABLE>

                                       44
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

14.  Quarterly Financial Data (Unaudited)

          Summarized unaudited quarterly financial data (in thousands, except
per share data) for fiscal 1997 and 1998 is as follows:

<TABLE>
<CAPTION>
 
                                                              Quarter (1)                  Fiscal
                                            First         Second     Third     Fourth       Year
                                            -----         ------     -----     ------      ------
<S>                                         <C>           <C>        <C>       <C>         <C> 
1997
Revenues.................................  $18,947        $19,078    $23,728   $22,774     $ 84,527
Gross Profit.............................    7,242          6,642      9,532     7,927       31,343
  Net Income (loss)......................      124           (395)     1,226       427        1,382
Earnings per common share (2): 
  Basic..................................     0.02          (0.06)      0.13      0.04         0.17
  Diluted................................     0.02          (0.06)      0.12      0.04         0.16
 
1998
Revenues.................................  $27,267        $28,649    $39,101    $34,151    $129,168
Gross Profit.............................    9,526         10,001     15,207     13,290      48,024
Income before extraordinary item.........      225            693      1,127      1,145       3,190
Extraordinary loss on early 
 extinguishment of debt..................      --             --      (2,449)       --       (2,449)
  Net Income.............................      225            693     (1,322)     1,145         741
  
Earnings per common share - Basic (2):
  Income before extraordinary item.......     0.02           0.07       0.12       0.12        0.33
  Extraordinary item.....................      --             --       (0.26)       --        (0.25)
  Net Income.............................     0.02           0.07      (0.14)      0.12        0.08

Earnings per common share - Diluted (2):
  Income before extraordinary item.......     0.02           0.07       0.10       0.10        0.29
  Extraordinary item.....................      --             --       (0.22)       --        (0.22)
  Net Income.............................     0.02           0.07      (0.12)      0.10        0.07
</TABLE>
------------------------------------------
(1)  Based upon the fiscal year followed by the Company, each quarter presented
     above includes 13 weeks.
(2)  Pursuant to the adoption of SFAS No. 128, basic and diluted earnings per
     share have been presented for all periods.

15.  Subsequent Event

          On September 18, 1998, the Company acquired all the outstanding shares
of capital stock of MSCL, Inc. d.b.a. Encore ("Encore") and the real estate
occupied by Encore, in a transaction valued at approximately $68,600,000,
including estimated transaction costs.  Including in the transaction was
$11,200,000 for the purchase of real estate beneficially owned by the
shareholders of Encore and $2,400,000 for the intended exercise of purchase
options on other real estate occupied by Encore.  The aggregate cash
consideration was $66,100,000.  In addition, 486,486 shares of Four Media
Company common stock valued at $4.38 per share were issued to Encore
shareholders.  The acquisition will be accounted for under the purchase method
of accounting.

                                       45
<PAGE>
 
                              Four Media Company

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


16.  Acquisitions

          The following unaudited pro forma summary combines the consolidated
results of operations of the Company and Anderson, POP, and VSI, as if the
acquisitions had occurred at the beginning of fiscal 1997, after giving effect
to certain adjustments, including adjustments to depreciation, amortization,
interest and taxes.  The pro forma summary does not necessarily reflect the
results of operations as they would have been if the Company and Anderson, POP,
and VSI, had constituted a single entity during such periods (in thousands
except per share data):

<TABLE>
<CAPTION>
 
                                               1997           1998
                                               ----           ----
<S>                                         <C>            <C>
Revenues...............................      $136,166       $150,886
Net income before extraordinary item...         6,751          3,403
Net income.............................         6,751            954
 
 
Earnings per common share - Basic:
   Income before extraordinary item....          0.85           0.35
   Net income..........................          0.85           0.10
 
 
Earnings per common share - Diluted:
   Income before extraordinary item....          0.79           0.31
   Net Income..........................          0.79           0.09
</TABLE>

                                       46
<PAGE>
 
                              FOUR MEDIA COMPANY
                                  SCHEDULE II

                       Valuation and Qualifying Accounts

                            (Amounts in thousands)

<TABLE>
<CAPTION>
                            

                                                            Balance at       Additions Charged to       Additions Charged to      
  Year Ended                   Description               Beginning of year    Costs and Expenses          Other Accounts (1)
  ----------                   ------------              -----------------    ------------------           --------------
<S>                  <C>                                 <C>                  <C>                       <C>  
August 4, 1996       Allowance for doubtful accounts        $   563               $  580                   $      --     
August 3, 1997       Allowance for doubtful accounts            823                  871                         179     
August 2, 1998       Allowance for doubtful accounts          1,873                  794                         218      
                                                                                                    
August 4, 1996       Deferred tax valuation allowance       $ 3,408               $ (961)              
August 3, 1997       Deferred tax valuation allowance         2,447                  506               
August 2, 1998       Deferred tax valuation allowance         2,953                 (317)               
</TABLE>

<TABLE> 
<CAPTION> 
                                                                                      Balance at End
                                                                                      --------------
  Year Ended                   Description                   Deductions  (2)             of Year    
  ----------                   -----------                   ----------                  -------        
<S>                  <C>                                     <C>                      <C>   
August 4, 1996       Allowance for doubtful accounts           $  (320)                  $  823           
August 3, 1997       Allowance for doubtful accounts                --                    1,873         
August 2, 1998       Allowance for doubtful accounts            (1,627)                   1,258         
                                                                                                         
August 4, 1996       Deferred tax valuation allowance                                    $2,447         
August 3, 1997       Deferred tax valuation allowance                                     2,953         
August 2, 1998       Deferred tax valuation allowance                                     2,636          
</TABLE> 


(1)  Amounts assumed in connection with the acquisitions of Anderson, POP, VSI.
(2)  Uncollectable accounts written off.

                                       47
<PAGE>
 
                                 EXHIBIT INDEX
 
Exhibit
-------
Number
------

  3.1     Certificate of Incorporation of the Company. (1)
 
  3.2     By Laws of the Company. (6)
 
  4.1     Specimen Common Stock Certificate. (3)
 
 10.1     Four Media Company 1997 Stock Plan and Stock Option Agreement. (11)*
 
 10.2     Four Media Company 1997 Director Option Plan and Director Stock Plan
          Stock Option Agreement, as amended. (11)*
 
 10.3     Form of Amended and Restated Indemnity Agreement between the Company
          and each of its officers and directors. (6)*
 
 10.4     Agreement dated as of February 13, 1995 between MTV Asia LDC and Four
          Media Company Asia PTE. Ltd. + (2)
 
 10.5     Guaranty by Viacom International, Inc of MTV Asia's of obligations of
          Four Media Company Asia PTE. Ltd. Dated February 13, 1995. (1)
 
 10.6     Guaranty by Four Media Company of obligations of Four Media Company
          Asia PTE. Ltd. Dated February 13, 1995. (1)
 
 10.7     January 18, 1996 Amendment Letter re Agreement dated as of February
          13, 1995 between MTV Asia LDC and Four Media Company Asia PTE. Ltd. +
          (1)
 
 10.8     Uplink-Playback Service Deal Memorandum between TVN Entertainment
          Corporation and Compact Video Services, Inc. dated November 20, 1989,
          as amended. + (1)
 
 10.9     Letter Agreement between Four Media Company and TVN Entertainment
          Corporation dated March 18, 1996. + (1)
 
 10.10    Addendum to Amendment between TVN Entertainment Corporation and Four
          Media Company dated August 19, 1997. (6)
 
 10.11    Satellite Services Agreement re Transponder 7 between Global Access
          Telecommunications Services, Inc. and Four Media Company dated April
          12, 1996. (1)
 
 10.12    Satellite Services Agreement re Transponder 5 between Global Access
          Telecommunications Services, Inc. and Four Media Company dated April
          12, 1996. (1)
 
 10.13    Global Access Telecommunications Services, Inc. Standard Terms and
          Conditions. (1)
 
 10.14    August 28, 1996 Letter Agreement to the Satellite Services Agreement
          re Transponder 5 dated April 12, 1996 and to the Satellite Service
          Agreement re Transponder 7 dated April 12, 1996. (1)

                                       48
<PAGE>
 
Exhibit
-------
Number
------ 
 
 10.15    Financing agreement between the CIT Group/Business Credit, Inc., The
          CIT Group/Equipment Financing, Inc., 4MC-Burbank, Inc. and Digital
          Magic Company dated October 17, 1996. (2)
 
 10.16    Lease between Singapore Telecommunications Limited and Four Media
          Company Asia PTE. Ltd. commencing December 15,1 994. (1)
 
 10.17    Office Building Lease between Ford Motor Credit Company and Four Media
          Company dated August 1, 1994. (1)
 
 10.18    Employment Agreement between the Company and Robert T. Walston dated
          October 1, 1996, as amended. (3)*
 
 10.19    Employment Agreement between the Company and John H. Donlon dated as
          of October 1, 1996. (2)*
 
 10.20    Employment Agreement between the Company and Gavin W. Schutz dated as
          of October 1, 1996 (2)*
 
 10.21    Employment Agreement between the Company and Robert Bailey dated as of
          October 1, 1996 (2)*
 
 10.22    Purchase and Sale Agreement and Escrow Instructions between C.P.
          Private Partners, L.P.I. and Four Media Company dated July 29, 1996.
          (1)
 
 10.23    August 1, 1996 Amendment Letter re Agreement dated as of February 13,
          1995 between MTV Asia and Four Media Company Asia PTE. Ltd. + (2)
 
 10.24    Term Loan Agreement between Tokai Bank of California and Four Media
          Company dated December 5, 1996. (3)
 
 10.25    Letter Agreement dated February 24, 1997 between Anderson Film
          Industries Corp. d/b/a/ Anderson Video and Four Media Company
          (contained in Exhibit No. 10.1). (5)
 
 10.26    Asset Purchase and Sale Agreement between Earle Hagen, Assignee for
          the Benefit of Creditors of Anderson Film Industries Corp. d/b/a/
          Anderson Video and AV Acquisition Corp. dated March 7, 1997 (without
          exhibits or schedules) (contained in Exhibit No. 10.2). (5)
 
 10.27    Agreement dated March 10, 1997 between AV Acquisition Corp. and
          Anderson Graphics, LLC (without exhibits) (contained in Exhibit No.
          10.3). (5)
 
 10.28    Employment Agreement dated March 10, 1997 between Four Media Company
          and Darrell L. Anderson (contained in Exhibit No. 10.4). (5)
 
 10.29    Employment Agreement dated March 10, 1997 between Four Media Company
          and Michael Doggett (contained in Exhibit No. 10.4). (5)
 
 10.30    Consulting Agreement dated March 10, 1997 between Four Media Company
          and Darrell A. Anderson (contained in Exhibit No. 10.4). (5)
 
 10.31    Certificate of Designations of Series A Convertible Preferred Stock
          filed with the Delaware Secretary of State on February 26, 1998.(7)

                                       49
<PAGE>
 
Exhibit
-------
Number
------
 
 10.32    Credit Agreement among Four Media Company, the several lenders from
          time to time parties thereto, Bank of America NT&SA, as Syndication
          Agent, Union Bank of California, N.A., as Documentation Agent, Societe
          Generale, as Co-Agent, and Canadian Imperial Bank of Commerce as
          Administrative Agent, dated as of February 27, 1998.(7)
 
 10.33    Preferred Stock Purchase Agreement dated February 5, 1998 between Four
          Media Company and Fleming US Discovery Fund III, L.P.(7)
 
 10.34    Stockholders' Agreement dated February 27, 1998 among Four Media
          Company, Fleming US Discovery Fund III, L.P., Fleming U.S. Discovery
          Offshore Fund III, L.P., Robert T. Walston, John Donlon, Gavin Schutz
          and Robert Bailey.(7)
 
 10.35    Registration Rights Agreement dated February 27, 1998 among Four Media
          Company, Fleming U.S. Discovery Fund III, L.P. and Fleming U.S.
          Discovery Offshore Fund III, L.P.(7)
 
 10.36    Stock Purchase Agreement between Alan Kozlowski, Sandra Hay, Jerry
          Kramer, Rena Kramer, Andrew Ungerlerdes, Joan Hay and James Fancher
          who are the shareholders of Visualize d/b/a POP and Four Media Company
          dated November 14, 1997 (without exhibits or schedules).(8)
 
 10.37    Amendment to Stock Purchase Agreement dated January 30, 1998 between
          the shareholders of Visualize d/b/a POP and Four Media Company.(8)
 
 10.38    Employment Agreement dated February 2, 1998 between Four Media Company
          and Alan Kozlowski.(8)
 
 10.39    Consulting Agreement dated February 2, 1998 between Four Media Company
          and Jerry Kramer.(8)
 
 10.40    Consulting Agreement dated February 2, 1998 between Four Media Company
          and Sandra Hay.(8)
 
 10.41    Asset Purchase Agreement and Plan of Reorganization By and Among Video
          Symphony, Inc., Digital Doctors, Inc., Four Media Company and VSDD
          Acquisition Corp. dated April 27, 1998 (without exhibits or
          schedules). (9)
 
 10.42    Stock Purchase Agreement by and among 4MC, MSCL, Inc., Charles H.
          Chubak and Patricia A. Chubak, Trustees of the Chubak Family Trust
          dated January 10, 1992, John S. McCoy and Elaine L. McCoy, Trustees of
          the McCoy Family Trust dated November 11, 1991, Larry E. Chernoff and
          Deborah H. Chernoff, Trustees of the Chernoff Family Trust dated
          October 31, 1991, Robert Solomon and Pamela Solomon, Trustees of the
          Solomon Family Trust dated January 23, 1997, Paul Norling and Douglas
          Walker who are the shareholders of MSCL, Inc dated September 15, 1998
          (without exhibits or schedules).(10)
 
 10.43    Agreement of Purchase and Sale and Escrow Instructions between John S.
          McCoy and Elaine L. McCoy Trustees of the McCoy Family Trust dated
          November 11, 1991, Larry E. Chernoff and Deborah H. Chernoff, Trustees
          of the Chernoff Family Trust dated October 31, 1991, Charles H. Chubak
          and Patricia A. Chubak, Trustees of the Chubak Family Trust dated
          January 10, 1992, Robert Solomon and Pamela Solomon, Trustees of the
          Solomon Family Trust dated January 23, 1997, collectively, as Sellers,
          and Four Media Company, a Delaware Corporation, as Purchaser dated
          September 10, 1998.(10)

                                       50
<PAGE>

Exhibit
-------
Number
------ 
 
 10.44    Employment Agreement dated as of September 18, 1998 between Four Media
          Company, a Delaware corporation, and Lawrence Chernoff.(10)
 
 10.45    Employment Agreement dated as of September 18, 1998 between Four Media
          Company, a Delaware corporation, and Robert Solomon.(10)
 
 10.46    Employment Agreement dated as of September 18, 1998 between Four Media
          Company, a Delaware corporation, and Charles Chubak.(10)
 
 10.47    Employment Agreement dated as of September 18, 1998 between Four Media
          Company, a Delaware corporation, and John Stephen McCoy.(10)
 
 21.      List of Subsidiaries. (previously filed)
 
 23.1     Consent of PricewaterhouseCoopers LLP. (previously filed)
 
 27.1     Financial Data Schedule. (previously filed)
 
  +       Portions of exhibits deleted and filed separately with the Securities
          and Exchange Commission pursuant to a request for confidentiality.

 (1)      Incorporated herein by reference to the Company's Registration
          Statement on Form S-1 filed October 8, 1996.
 
 (2)      Incorporated herein by reference to Amendment No. 1 to the Company's
          Registration Statement filed December 27, 1996.

 (3)      Incorporated herein by reference to Amendment No. 2 to the Company's
          Registration Statement filed February 4, 1997.

 (4)      Incorporated herein by reference to Amendment No. 3 to the Company's
          Registration Statement filed February 5, 1997.

 (5)      Incorporated herein by reference to the Company's Current Report on
          Form 8-K filed March 24, 1997.

 (6)      Incorporated herein by reference to the Company's Annual Report on
          Form 10-K filed August 3, 1997 (October 31, 1997).

 (7)      Incorporated herein by reference to the Company's Quarterly Report on
          Form 10-Q filed February 1, 1998 (March 17, 1998).

 (8)      Incorporated herein by reference to the Company's Current Report on
          Form 8-K filed February 2, 1998 (February 17, 1998).

 (9)      Incorporated herein by reference to the Company's Current Report on
          Form 8-K filed May 4, 1998 (May 18, 1998).

(10)      Incorporated herein by reference to the Company's Current Report on
          Form 8-K filed September 18, 1998 (October 5, 1998).

(11)      Incorporated herein by reference to the Company's Registration
          Statement on Form S-8 filed July 28, 1998.

  *       Management contract, compensatory plan or arrangement.

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<PAGE>
 
                                  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 on the 17th day of
February 1999.

                             FOUR MEDIA COMPANY

                   By: /s/ Robert T. Walston
                      ----------------------------------------------------------
                   Robert T. Walston, Chief Executive Officer,
                   Chairman of the Board, and Interim Chief Financial Officer


          Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant, in the capacities indicated on this 17th day of February 1999.

                                       52