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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                            ------------------------
 
                                   FORM 10-K
                            ------------------------
 
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
    OF 1934: FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
 
                                        OR
 
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
    ACT OF 1934
 
                          COMMISSION FILE NO. 0-22187
 
                        ADVANTAGE LEARNING SYSTEMS, INC.
             (Exact name of Registrant as specified in its charter)
 
<TABLE>
<S>                                            <C>
                  WISCONSIN                                     39-1559474
       (State or other jurisdiction of             (I.R.S. Employer Identification No.)
       incorporation or organization)
 
              2911 PEACH STREET                                 54495-8036
                P.O. BOX 8036                                   (Zip Code)
         WISCONSIN RAPIDS, WISCONSIN
  (Address of principal executive offices)
</TABLE>
 
              Registrant's telephone number, including area code: (715) 424-3636
 
              Securities registered pursuant to Section 12(b) of the Act: NONE

              Securities registered pursuant to Section 12(g) of the Act:
 
                          COMMON STOCK, $.01 PAR VALUE
                                (Title of class)
 
     Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X]  No [ ]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
 
     The aggregate market value of the voting stock held by nonaffiliates of the
Registrant was approximately $343,153,427 as of March 1, 1999. As of March 1,
1999, there were 33,878,817 of the Registrant's shares of common stock
outstanding.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
     Part III is incorporated by reference from the Proxy Statement for the
Annual Meeting of Shareholders to be held on April 14, 1999.

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ITEM 1. BUSINESS
 
     Unless the context requires otherwise, references to the Company include
its consolidated subsidiaries.
 
                                    OVERVIEW
 
     Advantage Learning Systems, Inc. (the "Company" or "ALS") is a leading
provider of learning information systems to kindergarten through senior high
("K-12") schools in the United States and Canada. The Company's learning
information systems consist of computer software and related training designed
to improve student academic performance by increasing the quality, quantity and
timeliness of performance data available to educators and by facilitating
increased student practice of essential skills. Learning information systems
provide to educators benefits similar to those management information systems
provide to business managers. As of December 31, 1998, the Company has sold its
products to approximately 41,500, or approximately 33%, of the K-12 schools in
the United States and Canada.
 
     The Company's flagship product, the Accelerated Reader,* is software for
motivating and monitoring increased literature-based reading practice. The
Company believes that the Accelerated Reader has achieved a leading market
position as a result of its demonstrated effectiveness in improving student
reading levels and overall academic performance. The Company's other primary
learning information system products include STAR Reading,* Accelerated Math,*
STAR Math* and Perfect Copy*. In addition, the Company provides professional
development training for educators through its Reading Renaissance* and Math
Renaissance* programs.
 
     Originally introduced in 1986, the Accelerated Reader administers
computer-based multiple choice quizzes on books popular among students in grades
K-12 and provides educators with more than 20 reports from which to monitor the
amount and quality of each student's reading practice. Through December 31,
1998, the Company had developed quizzes on approximately 20,500 book titles. In
1994, the Company began offering Reading Renaissance training seminars to
provide educators with professional development training to most effectively use
the Accelerated Reader and the information it generates. As of December 31,
1998, approximately 110,000 educators have attended Reading Renaissance training
seminars. In 1996, the Company released STAR Reading which is a
computer-adaptive reading test and database which enables educators to quickly
obtain student reading scores statistically correlated to national norms. The
results from STAR Reading provide educators with a database of statistically
accurate reading level information on their students from which they can
generate useful reports and adjust instructional strategies accordingly.
 
     In 1998, the Company introduced STAR Math, Accelerated Math and Perfect
Copy. STAR Math is a computer-adaptive math test and database which enables
educators to quickly determine a student's level of math proficiency and monitor
progress throughout the year from third grade through high school. Results from
STAR Math are correlated to major national and state-mandated standardized
tests, and educators are provided with a variety of useful reports. Accelerated
Math is a task-level learning information system that helps teachers ensure
student achievement in math. Accelerated Math uses an algorithm problem
generator to ensure that each student works problems geared to his or her
proficiency level and to learning objectives specified by the teacher.
Accelerated Math handles all scoring and record-keeping chores, minimizing
teacher paperwork. Perfect Copy is the Company's first product targeted to
improving student's writing skills. Perfect Copy allows students to work at the
computer correcting common grammar, punctuation and word usage errors in short
articles and stories. The Company began shipping Perfect Copy in January 1999.
 
     The Company was founded in 1986 and is incorporated under the laws of the
State of Wisconsin. The Company's Common Stock is listed on the Nasdaq National
Market under the symbol "ALSI." The Company's principal executive offices are
located at 2911 Peach Street, P.O. Box 8036, Wisconsin Rapids, Wisconsin
54495-8036 (telephone: 715-424-3636).
 
-------------------------
* The Accelerated Reader(R) and Reading Renaissance(R) are registered trademarks
  of the Company. STAR Reading, Accelerated Math, STAR Math, Math Renaissance
  and Perfect Copy are common law trademarks of the Company.
<PAGE>   3
 
                              INDUSTRY BACKGROUND
 
     Educators, parents and opinion leaders in the United States are
increasingly focusing on improving essential academic skills of students, and,
in particular, their reading and math proficiency. The emphasis on education by
government leaders at all levels, the Department of Education's Goals 2000
program, the Learning to Read, Reading to Learn campaign, the federal
Comprehensive School Reform program, an increase in Title I funding and the
activities of the Education Commission of the States are indicative of this
growing focus. While certain aspects of these initiatives may not endorse, or be
complementary to, the Company's products, this focus and the resulting
initiatives have generally contributed to an increased demand for more effective
methods to improve academic performance. The Company believes that the general
impact of the Goals 2000 program and programs similar to it is to pressure
schools and educators to take action to improve the academic performance of
students. Schools have responded to these demands by investing in computers,
software and other educational technology, testing and other assessment programs
to measure students' progress, and professional development training to help
enhance educators' effectiveness in the classroom.
 
     Based on 1998 data from Quality Education Data, Inc. ("QED"), the K-12
marketplace in the United States consists of approximately 111,000 public and
private schools. According to the U.S. Department of Education, the number of
students enrolled in these schools was approximately 52.7 million in 1998 and is
expected to increase to 54.3 million by 2008. According to industry sources,
U.S. educational technology expenditures were $4.16 billion in 1997 and are
expected to increase to $9.88 billion by 2002. Of this amount, approximately
$770 million was spent on educational software and training, which amount is
expected to increase to $1.39 billion by 2002. Moreover, the installed base of
computers in K-12 schools in the United States was 6.4 million units in 1997 and
is expected to grow to 13.7 million by 2002.
 
     In addition to this increased spending on educational technologies, the
Company believes that there is a growing trend towards requiring better
assessment of student performance and increased accountability of educators and
school systems. The Company also believes there is a growing trend towards
requiring more and better professional development training for educators, as
highlighted in the Department of Education's Goals 2000 program.
 
     The increased public concern over the effectiveness of K-12 schools in
teaching essential academic skills and the rapidly growing role of technology in
the K-12 marketplace have created an increased demand for technology-based
solutions which measure and improve student academic performance and for
professional development training which enables educators to effectively
implement these solutions. However, few providers of educational technology
products have developed tools with demonstrated effectiveness in improving
student academic performance because most products (i) provide inadequate
feedback useful to educators in tailoring instruction to individual students,
(ii) seek to replace educators by attempting to teach skills rather than support
their efforts by encouraging extensive practice on those skills, (iii) compete
with existing curricula and instructional methodologies, (iv) fail to maintain
student interest, and (v) require more advanced technology and/or larger numbers
of computers than are typically available in schools. The Company believes there
is a growing market demand for technology-based learning information systems
that motivate students and achieve measurable results.
 
                    THE ADVANTAGE LEARNING SYSTEMS SOLUTION
 
     The Company develops, markets and supports learning information systems
that improve student academic performance by intensifying skills practice and
increasing the quality, quantity and timeliness of information available to
educators. Originally, the Company's products focused exclusively on improving
reading because reading is fundamental to a student's overall academic
performance. The Company now offers products in reading, math and language arts
and expects to expand its product offering in other curriculum areas. The
Company offers Reading Renaissance and Math Renaissance professional development
training to combine the Company's learning information systems technology and
classroom techniques to improve student performance.
 
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<PAGE>   4
 
     The Company believes its learning information systems offer the following
key benefits:
 
     Improved Student Academic Performance.  The Company is committed to
developing and releasing only those products which have demonstrated
effectiveness in improving student academic performance. The Company's software
products, coupled with the techniques taught in the Renaissance training
programs, improve student academic performance by providing educators with an
effective system to motivate students to spend more time "on-task." Independent
studies on the effectiveness of the Accelerated Reader have demonstrated that
use of the Accelerated Reader improves standardized test performance in reading.
Studies conducted by the Company based on publicly available quantitative data
confirm this result and indicate that use of the Accelerated Reader improves
standardized test performance in other academic subject areas as well, including
math, science, social studies and writing.
 
     Ability to Assess Student Progress.  The Company's software products
provide educators with timely, accurate information to manage the learning
process within their existing curricula. The objective measurement data derived
from the Company's products enable teachers to continually monitor students'
academic progress and easily identify individual students who may require
special attention.
 
     Suitability for K-12 School Environment.  The Company's software products
are easy to use by both students and educators and are capable of running on
computers and hardware platforms commonly found in K-12 schools. Even schools
with a limited number of computers can use most of the Company's products since
these products do not require extensive individual time on the computer. In
addition, the Company's products are used in conjunction with books and
textbooks already commonly found in most K-12 schools.
 
     Supportive of Educators.  Rather than attempting to teach skills, thereby
replacing educators, the Company's products and services provide educators with
tools to encourage increased skills practice and to track student academic
performance. Due to this focus on practice and measurement, the Company's
products complement, rather than compete with, existing curricula and
instructional methodologies. As a result, educators remain in control of the
learning process.
 
     Cost-Effective Solution.  The cost of the Company's products generally
enables schools to purchase such products within their normal budgets. In
addition, schools may purchase the Company's products for use in a single
classroom, and have the flexibility to acquire additional products for more
classrooms as usage increases.
 
                                GROWTH STRATEGY
 
     The Company seeks to establish its products as the de facto standard for
facilitating growth in essential academic skill areas in grades K-12. The key
elements of this strategy are as follows:
 
     Add New Customer Schools.  The Company intends to increase its market
penetration by continuing to add new customer schools. As of December 31, 1998,
the Company's products had been sold to approximately 41,500 K-12 schools, which
represents approximately 33% of the total number of schools in the United States
and Canada. The Company plans to add new customer schools by increasing its
direct marketing efforts and extending its strategic alliances.
 
     Intensify and Expand Use of Products by Existing Customer Schools.  The
Company intends to intensify and expand the use of its products by existing
customers. Although the Company's products have been sold to approximately 33%
of the K-12 schools in the United States and Canada, most schools begin using
the products as a supplementary or voluntary program in a small percentage of
classrooms, thereby creating the opportunity for the Company to intensify usage
in these classrooms and expand usage to other classrooms and other grade levels.
The Company's experience with its reading products has been that increased use
of the Accelerated Reader leads to increased sales of supplemental title disks,
STAR Reading and Reading Renaissance professional development training. The
Company expects similar patterns to occur with its math products. To increase
the use of its products, the Company continuously publishes newsletters,
catalogs and research relating to the effectiveness of its products, sponsors
seminars and maintains communication with customers through its telephone sales
force.
 
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     Offer New Products in Other Curriculum Areas. The Company intends to
develop groups of products similar to its reading and math products for other
areas of the K-12 curriculum. The Company plans to continue to expand the
language arts products and is exploring other areas such as science and social
studies.
 
     Expand International Marketing and Sales. The Company intends to expand its
international marketing and sales. From its Canadian subsidiary near Toronto,
the Company will actively market all its products to current Accelerated Reader
customers and prospects. Additionally, in Australia and the United Kingdom, the
Company has launched reading and math pilot school programs and has begun
establishing operations in each country. As the Company develops new products,
it plans to expand its marketing and sales efforts into other foreign countries.
 
     Expand Market Presence Through Strategic Alliances. In order to penetrate
the K-12 marketplace more rapidly, the Company has established strategic
alliances with educational book distributors and publishers. These firms are
particularly receptive to such alliances because use of the Company's products
in schools encourages, rather than competing with, the sale of books and other
products sold by these firms. The Company believes that such firms are under
increasing pressure from many customers to offer products supported by the
Accelerated Reader.
 
                                    PRODUCTS
 
SOFTWARE AND SUPPORT SERVICES
 
     As of March 1, 1999, the Company offered software products for use in the
K-12 marketplace, as well as support services to the users of its software
products. These software products improve student academic performance by
intensifying skills practice and increasing the quality, quantity and timeliness
of information available to educators. The Company's software and support
services accounted for approximately 86%, 84% and 86% of the Company's net sales
in 1998, 1997 and 1996, respectively.
 
  ACCELERATED READER
 
     The Accelerated Reader is a learning information system for motivating and
monitoring increased literature-based reading practice. The Accelerated Reader
is designed to be very easy to use by students and educators alike. A student
selects a book from a list of books for which the school has an Accelerated
Reader quiz at an appropriate reading level and reads the book. The student then
takes a multiple choice quiz on a computer. The questions contained in the
quizzes are carefully drafted to ensure that a student who has thoroughly read a
book at the appropriate level will pass. For each book read, the Accelerated
Reader tracks amount of reading practice achieved by calculating points based on
the length and difficulty of the book and the student's performance on the quiz.
The information generated from this process -- titles read, percent of
comprehension and amount of reading done -- creates a database of student
reading achievement. From this database, the Accelerated Reader generates more
than 20 different reports from which educators can monitor the amount and
quality of reading practice for each of their students and easily identify
individual students who may require special attention. The Company currently has
a library of computerized book quizzes on more than 20,500 book titles. The
Company developed quizzes on approximately 7,000 book titles in 1998 and expects
to develop quizzes on at least 8,000 additional book titles in 1999. Titles on
disk are organized by reading level and subject matter. Continued usage of the
Accelerated Reader creates demand for additional quizzes, STAR Reading, Reading
Renaissance training and related products.
 
     The Company has successfully developed several products which complement
the Accelerated Reader, including a Spanish/English version of the Accelerated
Reader for bilingual students, AR BookGuide* and AR TitleFinder.* AR BookGuide
is a database listing of all books covered by Accelerated Reader quizzes, in a
format allowing searches by author, reading level, topic and other variables to
facilitate creation of custom book lists for students and for ordering
additional quizzes. AR TitleFinder is a free CD-ROM catalog which the Company
provides to customers to enable them to easily locate and order Accelerated
Reader quizzes.
 
-------------------------
*AR BookGuide(TM) and AR TitleFinder(TM) are common law trademarks of the
Company.
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  STAR READING
 
     STAR Reading is a computer-adaptive reading test which the Company believes
is the first software to provide to classroom teachers reading scores
statistically correlated to national norms in ten minutes or less at the
computer. STAR Reading administers a series of multiple choice questions for
which students choose the best word to complete each sentence. STAR Reading
adapts itself to each student's reading level by applying a proprietary
branching logic which evaluates the pattern of the student's answers to
determine the level of difficulty required for subsequent questions. The results
from this test provide educators with a database of statistically accurate
reading level information on their students from which they can generate useful
reports and adjust instructional strategies accordingly. STAR Reading is easy to
use and can be administered several times per year. Revenues from sales of STAR
Reading contributed significantly to the Company's net sales in 1998 and 1997
and to a lesser extent in 1996.
 
  ACCELERATED MATH
 
     Accelerated Math is a task-level learning information system that helps
every student to meet all math objectives, third grade through calculus. It
employs algorithm technology to automatically align assignments to academic
objectives and tracks mastery of each objective. Like Accelerated Reader,
Accelerated Math encourages and monitors student practice of foundational
skills, while providing immediate feedback on performance to students and
teachers. Accelerated Math also eliminates manual grading of papers and
generates detailed reports that enable teachers to individualize instruction
without increasing their workload.
 
  STAR MATH
 
     STAR Math computer-adaptive math test and database provides the same
benefits as STAR Reading. Quick, accurate and easy to administer STAR Math
provides math scores for third grade through high school in approximately 15
minutes. Like STAR Reading, it can be administered throughout the school year to
track growth.
 
  PERFECT COPY
 
     Perfect Copy is software that helps educators improve students' core
writing skills. It uses in-context editing to cover the rules of grammar,
punctuation and word usage. The Company expects to develop other language arts
products in the future.
 
  EXPERT SUPPORT PLANS
 
     The Company offers Expert Support Plans ("ESPs") which provide users of its
products access to telephone support and other benefits such as free or
reduced-cost upgrades. Packaged with kits and also sold as add-ons, ESPs entitle
educators to expert help resolving questions regarding technical problems with
Company products, networks and other software interacting with Company products.
 
PROFESSIONAL DEVELOPMENT
 
     The Company offers professional development programs and products that
train educators to effectively use the Company's software products. Revenues
from professional development accounted for approximately 14%, 16% and 14% of
the Company's net sales in 1998, 1997 and 1996, respectively.
 
  READING RENAISSANCE
 
     The Reading Renaissance program provides educators with professional
development training to most effectively use the Accelerated Reader, STAR
Reading and the learning information they generate. This training combines
technology and classroom techniques to increase in-school accountable reading
practice. The Company offers a variety of Reading Renaissance seminars and
workshops, including one- and two-day scheduled training programs, which are
conducted throughout the year at various hotel locations in the United States,
and on-site training programs pursuant to which the Company's training staff
visit an individual school,
 
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school district or region to conduct a seminar or workshop. As of March 1, 1999,
the Company's training staff consisted of 94 presenters, both full and
part-time, most of whom are K-12 educators who use the Reading Renaissance
techniques in their own classrooms. Since its inception in late 1993 to December
31, 1998, the Company has trained approximately 110,000 educators, of whom
approximately 50,000 were trained in 1998.
 
     To encourage educators who have completed Reading Renaissance training to
implement the methodology fully, the Company in 1995 initiated the "Model
Classroom" certification program. This program recognizes educators who meet
certain objective implementation standards related to the amount of accountable
reading among students, regular diagnosis and intervention with at-risk
students, and other key variables. As of March 1, 1999, the program has received
approximately 6,850 applications and certified 3,331 "Model Classroom" teachers,
and 106 "Model Schools" in which the majority of classrooms have "Model
Classroom" teachers.
 
  MATH RENAISSANCE
 
     Offered both on-site and at hotel sites throughout the United States, new
one-day Math Renaissance seminars instruct educators in techniques to enhance
their math curriculum and instruction methods. The Company expects Math
Renaissance to grow along with utilization of its STAR Math and Accelerated Math
software.
 
  OTHER PROFESSIONAL DEVELOPMENT
 
     The Company also produces videotapes and manuals to be used in conjunction
with its training programs. Further, the Company conducts research on best
practices, performs field validation of techniques, and gathers information to
guide the development of the Company's learning information systems.
 
                              PRODUCT DEVELOPMENT
 
     The Company believes that continued investment in product development is
required to remain competitive in the K-12 marketplace. The Company invests
continuously in the development of new products, enhancement of existing
products and development of tools to increase the efficiency of product
development. For the years ended December 31, 1998, 1997 and 1996, the Company
expended approximately $5.2 million, $3.4 million and $1.9 million,
respectively, on product development (including amounts capitalized).
 
     As of March 1, 1999, the Company employed 118 persons, both full and
part-time, dedicated to product development and software design. The Company
expects this number to increase in the next year. The Company's product
development staff has a high level of expertise in learning information theory,
quiz writing, interface design, software engineering, quality assurance and
technical writing.
 
     The Company generates new software product concepts that it believes will
help educators improve student academic performance, based on the Company's
understanding of learning information theory and the need for practice of
essential academic skills. These product concepts are then refined based on
feedback from its customers, which the Company continuously solicits and
incorporates throughout the new product development process. Based on the
refined product concepts, product proposals are then formulated by the marketing
and software engineering groups and reviewed by management to determine which
should be developed into prototypes. These prototypes are then tested in
customer schools. Before beginning production, management makes a final
evaluation of each new product to determine that it is both desired by educators
and effective in meeting their needs.
 
     The professional development training programs were originally developed,
and are continually refined, through field experience with the Company's
products and research by the Company's staff. The Company conducts research into
effective education techniques related to the Company's products and services.
This research provides the staff with a standard against which to develop and
refine training programs to help educators accelerate learning.
 
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                       SALES, MARKETING AND DISTRIBUTION
 
     The Company markets its products primarily to individual educators in the
K-12 market, including teachers, school librarians and principals. The Company
is also beginning to market its products to entire schools and school districts.
The Company's sales and marketing strategy consists primarily of direct
marketing to potential and existing customers. The Company uses a variety of
lead generating techniques, including trade shows, advertisements in educational
publications, direct mail, Web sites and referrals. Once product literature has
been forwarded to a current or potential customer, one of the Company's in-house
staff of telephone sales representatives contacts the customer to answer
questions and, ultimately, direct the customer to a purchase. Having an in-house
sales force affords the Company better control over its marketing efforts.
 
     In addition, the Company has resale arrangements with four U.S. and three
Canadian book distributors that are authorized to sell the Company's products to
their customers. Sales to Perma-Bound, a division of Hertzberg-New Method, Inc.
("Perma-Bound"), accounted for 13.9%, 14.4% and 15.2% of the Company's net sales
in 1998, 1997 and 1996, respectively. Under these resale arrangements,
distributors take orders which are then filled by the Company. This control over
product shipment ensures premium customer service and retention of customer
contacts for future marketing and sales opportunities.
 
     In addition to the book distributors which resell the Company's products,
approximately 15 other book distributors and publishers promote the sale of the
Accelerated Reader by publishing special catalogs that advertise book sets
assembled specifically for Accelerated Reader title disks. The Company intends
to seek additional strategic alliances with book distributors and publishers and
to use alliances to expand its base of strategic partners to sell its products.
Furthermore, the Company plans to continue to develop other cross-marketing
arrangements with third-party firms selling non-competing products into the
education market.
 
     The Company believes it maintains a very high level of customer
satisfaction. Historically, the Company has experienced less than a 2% rate of
return for its products.
 
                     CUSTOMER SERVICE AND TECHNICAL SUPPORT
 
     Most of the Company's customers have moderate to low levels of computer
knowledge and do not have any technical support on-site to assist them. The
Company therefore provides a variety of customer and technical support services
to purchasers of its software products. In order to provide the level of
customer service that results in a consistently high level of customer
satisfaction, the Company employs an experienced staff of technical service
representatives who are capable of answering technical questions relating to the
Company's software products, regardless of platform, as well as questions
regarding hardware and networks. In the case of unusually complex problems, the
Company's full-time test services staff support the telephone service
representatives by recreating the customer's problem in the Company's simulation
laboratory.
 
                                   PRODUCTION
 
     Currently, all of the Company's software products are distributed on
diskettes or CD-ROM. The diskettes are duplicated and packaged at Company
headquarters. The CD-ROM disks are produced by a third-party contractor. Other
related products, including videotapes, books, graphics and motivational items,
are produced by third-party vendors.
 
                                  COMPETITION
 
     The K-12 educational technology and professional development markets in
which the Company operates are very competitive. The Company competes primarily
against more traditional methods of education, training and testing, including
pencil and paper testing. In addition, the Company competes with other companies
offering educational software products to schools, including larger companies
with greater resources than the Company, such as International Business Machines
Corporation, Apple Computer, Inc. and Broderbund Software, Inc. The Company's
reading products also compete more directly with products
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<PAGE>   9
 
such as Electronic Bookshelf which was recently purchased by Scholastic Inc.
Many other companies, including Microsoft Corp. and Walt Disney Co., provide
educational software products which the Company believes are not marketed
primarily to schools. While the Company's existing competitors may broaden their
product lines, and potential competitors, including large hardware
manufacturers, software developers and educational publishers, may enter or
increase their focus on the school market, the Company believes it is well
positioned to continue to compete favorably in the markets in which it
participates.
 
                             INTELLECTUAL PROPERTY
 
     The Company regards certain of its technologies as proprietary and relies
primarily on a combination of copyright, trademark and trade secret laws and
employee non-disclosure agreements to establish and protect its proprietary
rights. Although the Company has filed a patent application which covers the
technology developed to automatically generate and format examinations that
include math expressions, the Company does not currently possess any patents or
other registered intellectual property rights with respect to its software.
There can be no assurance that the steps taken by the Company to protect its
rights will be adequate to prevent or deter misappropriation. The Company
believes that factors such as the technological and creative skills of its
personnel and the quality of the content of its products may be more important
in establishing and maintaining a leadership position within the industry than
are the various legal protections of its technology, but that such legal
protections may also be a part of the Company's long-term strategy.
 
     While the Company believes that its products, trademarks and other
proprietary rights do not infringe upon the proprietary rights of third parties,
as the number of software products in the educational technology industry
increases and the functionality of these products begins to overlap, software
developers may become increasingly subject to infringement claims. There can be
no assurance that third parties will not assert infringement claims against the
Company in the future with respect to current or future products, trademarks or
other Company works or that any such assertion may not require the Company to
enter into royalty arrangements or result in costly litigation.
 
     The software market has traditionally experienced widespread unauthorized
reproduction of products in violation of intellectual property rights. Such
activity is difficult to detect and legal proceedings to enforce intellectual
property rights are often burdensome and involve a high degree of uncertainty
and costs. While the Company electronically codes its software products to
protect against unauthorized copying and use, there can be no assurance that the
Company's software products will not experience unauthorized reproduction.
 
                                   EMPLOYEES
 
     As of March 1, 1999, the Company had 518 full and part-time employees. The
Company believes its relations with employees are good. None of the Company's
employees is represented by a union or subject to collective bargaining
agreements.
 
                                    BACKLOG
 
     As of December 31, 1998 and 1997, the Company had backlogs which aggregated
approximately $4.4 million and $1.4 million, respectively. A significant portion
of the backlog at December 31, 1998, was due to the introduction of new products
near year end. All of the backlog is expected to be eliminated during 1999.
 
                           FORWARD-LOOKING STATEMENTS
 
     In accordance with the Private Securities Litigation Reform Act of 1995,
the Company can obtain a "safe-harbor" for forward-looking statements by
identifying those statements and by accompanying those statements with
cautionary statements which identify factors that could cause actual results to
differ materially from those in the forward-looking statements. Accordingly, the
following information contains or may contain forward-looking statements: (1)
information included or incorporated by reference in this Annual Report on Form
10-K, including, without limitation, statements made under Item 1, Business and
Item 7,
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Management's Discussion and Analysis of Financial Condition and Results of
Operations, including, without limitation, statements with respect to growth
plans, projected sales, revenues, earnings and costs, and product development
schedules and plans, (2) information included or incorporated by reference in
future filings by the Company with the Securities and Exchange Commission
including, without limitation, statements with respect to growth plans,
projected sales, revenues, earnings and costs, and product development schedules
and plans and (3) information contained in written material, releases and oral
statements issued by, or on behalf of, the Company including, without
limitation, statements with respect to growth plans, projected sales, revenues,
earnings and costs, and product development schedules and plans. The Company's
actual results may differ materially from those contained in the forward-looking
statements identified above. Factors which may cause such a difference to occur
include, but are not limited to, the following:
 
     Reliance on Single Product Line and Significant Distributor. The Company's
Accelerated Reader software and supplemental Accelerated Reader quiz disks
accounted for approximately 48%, 51% and 69% of the Company's net sales in 1998,
1997 and 1996, respectively. Sales of the Company's products through one book
distributor accounted for 13.9%, 14.4% and 15.2% of net sales in 1998, 1997 and
1996, respectively. An overall decline in sales of the Accelerated Reader,
supplemental quiz disks, STAR Reading and related products, including sales
through book distributors, would have a material adverse effect on the Company's
business, financial condition and results of operations.
 
     Dependence on Continued Product Development. The K-12 educational
technology and professional development markets in which the Company competes
are characterized by evolving industry standards, frequent product introductions
and, to a lesser extent, technological change. The Company's future success will
depend, to a significant extent, on a number of factors, including the Company's
ability to enhance its existing products and develop and successfully introduce
new products, including new products designed for use in other areas of the
curriculum. There can be no assurance that products designed for use in other
areas of the curriculum besides reading will be as well received as the
Company's reading products, particularly since such other products may require
technology and/or resources not generally available in all schools. The Company
attempts to maintain high standards for the demonstrated academic effectiveness
of its products. The Company's adherence to these standards could delay or
inhibit the introduction of new products. Moreover, there can be no assurance
that the Company's products will not be rendered obsolete or that the Company
will have sufficient resources to make the necessary investments or be able to
develop and market the products required to maintain its competitive position.
 
     Management of Growth. The Company has recently experienced rapid growth. If
such growth continues, it may place a strain on the Company's financial,
management and other resources. The Company's ability to manage its growth
effectively will require it to attract, train, motivate, manage and retain key
employees and to improve its operational, financial and management information
systems. If the Company is unable to maintain and manage growth effectively, the
Company's business, financial condition and results of operations would be
adversely affected.
 
     Opposing Educational Philosophies. The Company focuses on developing and
marketing educational products and services that demonstrate effectiveness
through measurable results. This approach, however, is not accepted by all
academics and educators, some of whom formulate opinions about the desirability
of a particular educational product or service based on philosophical or other
concerns rather than the effectiveness of the product. Certain academics and
educators are opposed to the principles and methodologies underlying and
associated with the Company's products, such as the use of objective standards,
standardized testing, computers and motivational techniques, among others. Some
of these philosophical opponents of the Company's products and services have the
capacity to influence the market for the Company's products, and such influence
could have a material adverse impact on demand for the Company's products and,
thus, the Company's business, financial condition and results of operations.
 
     Dependence on Educational Institutions and Government
Funding. Substantially all of the Company's revenue is derived from sales to
educational institutions, individual educators and suppliers thereto. There can
be no assurance that educational institutions and/or individual educators will
continue to invest in technology-based products and professional development for
reading and other curricula or continue to respond favorably
 
                                        9
<PAGE>   11
 
to the Company's marketing. The inability of the Company to increase the number
of products sold or number of schools served would adversely affect the
Company's business, financial condition and results of operations. Because of
the Company's dependence on educational institutions, the funding of which is
largely dependent on government support, a substantial decrease in government
budgets or funding for educational software or technology would have a material
adverse effect on the Company's business, financial condition and results of
operations. In addition, certain aspects of government sponsored education
initiatives may not endorse, or be complementary to, the principles and
methodologies underlying and associated with the Company's products, which could
adversely affect the Company's business, financial condition and results of
operations.
 
     Geographic Concentration of Sales. A substantial portion of the Company's
sales is concentrated in several states, including Texas, Florida, California,
Georgia and Illinois, which accounted for approximately $6.4 million, $3.6
million, $3.2 million, $2.8 million and $2.3 million, respectively, of the
Company's net sales in 1998. If large numbers of schools or a district
controlling a large number of schools in such states were to discontinue
purchasing the Company's products, the Company's business, financial condition
and results of operations would be materially adversely affected.
 
     Highly Competitive Industry. The K-12 educational technology and
professional development markets in which the Company operates are very
competitive. The Company competes primarily against more traditional methods of
education, training and testing, including pencil and paper testing. In
addition, the Company competes with other companies offering educational
software products to schools, including larger companies with greater resources
than the Company, such as International Business Machines Corporation, Apple
Computer, Inc. and Broderbund Software, Inc. The Company's reading products also
compete more directly with products such as Electronic Bookshelf which was
recently purchased by Scholastic Inc. Many other companies, including Microsoft
Corp. and Walt Disney Co., provide educational software products which the
Company believes are not marketed primarily to schools. Existing competitors may
continue to broaden their product lines, and potential competitors, including
large hardware manufacturers, software developers and educational publishers,
may enter or increase their focus on the school market, resulting in greater
competition for the Company. The Company's success in selling its products,
particularly its reading products, may cause competitors to focus on the
Company's products in their marketing efforts thereby increasing direct
competition. There can be no assurance that the Company will continue to be able
to market its products successfully or compete effectively in the educational
products marketplace.
 
     Dependence on Key Personnel. The Company's success depends to a significant
extent upon the continued active participation of certain key members of
management, including Judith Paul and Terrance Paul, the Chairman and Vice
Chairman of the Company, respectively. In addition to serving as Chairman of the
Company, Ms. Paul is a spokesperson for the Company and coordinates the
Company's public relations and customer communications policies. Mr. Paul is
primarily responsible for the Company's long-term strategic planning and new
product development strategy. Mr. Paul also coordinates the research activities
conducted by the Institute. The Company does not have employment agreements with
either of these persons and has no current intention of entering into any such
employment agreements. The loss of services of either of these persons would
have a material adverse effect on the Company's business, financial condition
and results of operations.
 
     Ability to Attract and Retain Qualified Personnel. The Company's future
success will depend, in part, upon its continuing ability to retain the
employees, including senior management personnel, who have assisted in the
development and marketing of the Company's products and to attract and retain
qualified additional employees trained in computer technology, marketing and
finance to enhance the Company's product offerings and broaden its operations.
There can be no assurance that the Company will continue to be able to attract
and retain such personnel. The failure to attract or retain the necessary
personnel would have a material adverse effect on the Company's business,
financial condition and results of operations.
 
     Seasonality; Limited Backlog; Fluctuations in Quarterly Performance. The
Company's business may experience a certain degree of seasonality due to the
budget cycles of the Company's school customers. The Company generally ships
products as orders are received, and, therefore, the Company has historically
operated without significant backlog. Thus, revenues in any quarter are
substantially dependent on the quantity
 
                                       10
<PAGE>   12
 
of product orders received in that quarter. However, it is the Company's
practice to announce new products prior to the time at which such products will
be ready for shipment to allow customers sufficient lead time for budgeting and
curriculum purposes. This practice can result in a significant backlog for
orders of new products. These orders are generally filled within a relatively
short period of time after the product is ready for shipment. The introduction
of products in certain periods could cause those periods to have significantly
higher sales and higher sales growth rates than subsequent periods. Seasonal
variations in demand may also cause significant variations in the Company's
results of operations. The Company's overall gross margins fluctuate based upon
the mix of product sales and service sales. The Company realizes significantly
higher margins on its product sales. Service revenues tend to be more seasonal
than product revenues. Quarterly service revenues are typically highest in the
third quarter. This results in the Company experiencing seasonal variations in
margins. The Company's operating margins also fluctuate based upon a number of
other factors including, but not limited to, the amount of product development
expenditures, the timing of the capitalization of product development
expenditures and the timing of certain marketing activities.
 
     Limited Protection of Intellectual Property and Proprietary Rights. The
Company regards certain of its technologies as proprietary and relies primarily
on a combination of copyright, trademark and trade secret laws and employee
non-disclosure agreements to establish and protect its proprietary rights.
Although the Company has filed a patent application which covers the technology
developed to automatically generate and format examinations that include math
expressions, the Company does not currently possess any patents or other
registered intellectual property rights with respect to its software. There can
be no assurance that the steps taken by the Company to protect its rights will
be adequate to prevent or deter misappropriation. In addition, while the Company
does not believe that its products, trademarks or other proprietary rights
infringe upon the proprietary rights of third parties, there can be no assurance
that a third party will not make a contrary assertion. The cost of responding to
such an assertion may be material, whether or not the assertion is validated.
The software market has traditionally experienced widespread unauthorized
reproduction of products in violation of intellectual property rights. Such
activity is difficult to detect and legal proceedings to enforce intellectual
property rights are often burdensome and involve a high degree of uncertainty
and costs. There can be no assurance that the Company's software products will
not experience unauthorized reproduction, which would have a material adverse
effect on the Company's business, financial condition and results of operations.
 
     Concentration of Share Ownership; Control by Principal
Shareholders/Management. As of March 1, 1999, the principal shareholders of the
Company, Judith Paul and Terrance Paul, who are also the Chairman and Vice
Chairman of the Company, respectively, beneficially owned approximately 73.0% of
the outstanding Common Stock. As a result, such principal shareholders have the
ability to control the Company and direct its business and affairs.
 
     Share Price Volatility. Numerous factors, many of which are beyond the
control of the Company, may cause the market price of the Common Stock to
fluctuate significantly. These factors include announcements of technological
innovations, customer orders of new products by the Company and its competitors,
earnings releases by the Company and its competitors, market conditions in the
industry and the general state of the securities markets. The market price of
the Common Stock may be adversely affected by the Company's failure to meet the
earnings estimates of analysts and others. In addition, the timing of orders by
the Company's customers may cause quarterly fluctuations of the Company's
results of operations which may, in turn, affect the market price of the Common
Stock.
 
     Shares Eligible for Future Sale. Sales of a substantial number of shares of
Common Stock in the public market could adversely affect the market price for
the Common Stock. Approximately 26,800,000 shares are held by "affiliates" of
the Company and may be publicly sold only if registered under the Securities Act
of 1933 or sold in accordance with an applicable exemption from registration,
such as Rule 144. In addition, the Company has filed a registration statement
under the Securities Act to register an aggregate of 3,000,000 shares of Common
Stock reserved for issuance under the Company's 1997 Stock Incentive Plan, which
will, when issued in accordance with such plan, be eligible for immediate sale
in the public market, subject to the Rule 144 resale limitations for affiliates.
 
                                       11
<PAGE>   13
 
     No Payment of Cash Dividends. The Company does not anticipate paying any
cash dividends in the foreseeable future.
 
     Possible Antitakeover Effects of Certain Articles and By-Law Provisions and
Provisions of Wisconsin Law. The Company's Amended and Restated Articles of
Incorporation and Amended and Restated By-Laws, along with Wisconsin statutory
law, contain provisions that could discourage potential acquisition proposals
and might delay or prevent a change in control of the Company. Such provisions
could result in the Company being less attractive to a potential acquiror and
could result in the shareholders receiving less for their Common Stock than
otherwise might be available in the event of a takeover attempt.
 
                                       12
<PAGE>   14
 
ITEM 2. PROPERTIES
 
     The Company owns or leases the following properties:
 
<TABLE>
<CAPTION>
                                                                         APPROXIMATE
LOCATION                                                 USE             SQUARE FEET    TITLE
--------                                                 ---             -----------    -----
<S>                                             <C>                      <C>            <C>
Wisconsin Rapids, Wisconsin...................  Corporate                  125,000      Owned
                                                Headquarters
Madison, Wisconsin............................  Professional Training       74,000      Owned*
                                                Operations
Vancouver, Washington.........................  IPS Operations               9,200      Leased
Ontario, Canada...............................  ALS Canada Operations        8,000      Leased
</TABLE>
 
-------------------------
 
* This property is owned by Athena Holdings LLC. The Company owns 70% of Athena
  Holdings LLC. The Company leases 34,633 square feet of the 74,000-square foot
  property from Athena Holdings LLC.
 
     The Company also owns its former headquarters facility in Wisconsin Rapids,
Wisconsin, which is leased to an unaffiliated tenant.
 
ITEM 3. LEGAL PROCEEDINGS
 
     The Company is not currently involved in any material pending legal
proceedings.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     There was no matter submitted during the fourth quarter of fiscal 1998 to a
vote of the security holders of the Company.
 
                                       13
<PAGE>   15
 
                      EXECUTIVE OFFICERS OF THE REGISTRANT
 
<TABLE>
<CAPTION>
        NAME OF OFFICER                                       OFFICE
        ---------------                                       ------
<S>                                <C>
Judith A. Paul.................    Ms. Paul is the co-founder of the Company and has been
  Age 52                           Chairman of the Board of Directors since 1986. Ms. Paul acts
                                   as the Company spokesperson and coordinates the Company's
                                   public relations and customer communication policies. Ms.
                                   Paul has co-written Great Ways to Motivate Students to Read
                                   (1998) and is the author of The Family Reading Night Kit
                                   (1996) and The Literacy Partnership Kit (1997). Ms. Paul
                                   holds a bachelors degree in elementary education from the
                                   University of Illinois.
Terrance D. Paul...............    Mr. Paul is the co-founder of the Company and has been Vice
  Age 52                           Chairman of the Board of Directors since July 1996. Mr. Paul
                                   is primarily responsible for the Company's long-term
                                   strategic planning and new product development strategy. Mr.
                                   Paul also coordinates the research activities conducted by
                                   the Institute. From November 1995 until July 1996, Mr. Paul
                                   served as the Company's Chief Executive Officer. From
                                   January 1992 until August 1993 and again from September 1994
                                   until November 1995, Mr. Paul served as President of the
                                   Company. For the 12 years prior to 1992, Mr. Paul was
                                   President of Best Power Technology, a manufacturer of
                                   uninterruptible power systems. Mr. Paul is the author of
                                   several publications, including How to Create World-Class
                                   Readers (1993), Patterns of Reading Practice (1996) and The
                                   New Technology of Learning Information Systems (1997). He is
                                   also the general editor of Fundamentals of Reading
                                   Renaissance (1994-1996), the textbook used in seminars on
                                   reading improvement by the Institute. Mr. Paul holds a law
                                   degree from the University of Illinois and an MBA from
                                   Bradley University. Terrance Paul is Judith Paul's husband.
Michael H. Baum................    Mr. Baum has been Chief Executive Officer of the Company
  Age 51                           since July 1996 and a Director since September 1994. Mr.
                                   Baum served as President of the Company between November
                                   1995 and June 1996. From September 1994 until November 1995,
                                   Mr. Baum served as the Managing Director of the Institute
                                   and from June 1994 until September 1994, he served as the
                                   Director of Educational Consulting for the Institute. From
                                   1984 until June 1994, Mr. Baum held a variety of positions
                                   with Francorp, Inc., an international management consulting
                                   firm based in Chicago, his last position being that of
                                   Executive Vice President, which he held from September 1991
                                   until June 1994. Mr. Baum holds a bachelors degree and a
                                   masters degree in teaching from Yale University and an MBA
                                   from Northwestern University.
</TABLE>
 
                                       14
<PAGE>   16
 
<TABLE>
<CAPTION>
        NAME OF OFFICER                                       OFFICE
        ---------------                                       ------
<S>                                <C>
John R. Hickey.................    Mr. Hickey has been President of the Company since July 1996
  Age 43                           and a Director of the Company since October 1996. From
                                   January 1996 until June 1996, Mr. Hickey served as Executive
                                   Vice President of R.F. Technologies, Inc., a manufacturer of
                                   protection devices, and from September 1995 until December
                                   1995, he served as Executive Vice President of Liebert
                                   Corporation (a subsidiary of Emerson Electric), a
                                   manufacturer of uninterruptible power supplies. From January
                                   1989 until June 1995, Mr. Hickey held various senior
                                   management positions with Best Power Technology, including
                                   Executive Vice President of Operations, Senior Vice
                                   President of Sales and Marketing and Vice
                                   President-International. In addition, Mr. Hickey spent
                                   approximately ten years with Briggs and Stratton, a
                                   manufacturer of air-cooled gasoline engines for outdoor
                                   power equipment, headquartered in Milwaukee, Wisconsin.
                                   While at Briggs and Stratton, Mr. Hickey served in various
                                   management positions, eventually rising to the position of
                                   the Director of International Sales and Finance
                                   Administration, a position he held from October 1985 until
                                   January 1989. Mr. Hickey holds a bachelors degree in
                                   international business from the University of Wisconsin.
Timothy Sherlock...............    Mr. Sherlock has been Vice President, Chief Financial
  Age 46                           Officer and Secretary of the Company since January 1998.
                                   From February 1996 until January 1998, Mr. Sherlock served
                                   as the Company's Corporate Controller. From May 1995 until
                                   February 1996, Mr. Sherlock served as the Corporate
                                   Controller of Decisionmark Corporation, an Iowa-based
                                   information software development firm. From May 1987 until
                                   April 1995, Mr. Sherlock served as Finance Manager for the
                                   software division of super computer maker Cray Research,
                                   Inc. Mr. Sherlock holds a bachelors degree in business
                                   administration from the University of St. Thomas, and is a
                                   Certified Public Accountant.
</TABLE>
 
     The term of office of each executive officer is from one annual meeting of
the Board of Directors until the next annual meeting of the Board of Directors
or until a successor for each is selected.
 
     There are no arrangements or understandings between any of the executive
officers of the Company and any other person (not an officer or director of the
Company acting as such) pursuant to which any of the executive officers were
selected as an officer of the Company.
 
                                       15
<PAGE>   17
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
MARKET INFORMATION
 
     The Common Stock is traded under the symbol "ALSI" on the Nasdaq National
Market, and quotations are supplied by the National Association of Securities
Dealers, Inc. The table below sets forth the reported high and low closing sale
prices for shares of the Company's Common Stock on the Nasdaq National Market
during the indicated quarters. Per share data have been restated to reflect a
two-for-one stock split in the form of a dividend effective February 26, 1999.
The prices set forth below reflect prices between dealers of the Company's
Common Stock without retail mark-ups, mark-downs or commissions and may not
necessarily represent actual transactions.
 
<TABLE>
<CAPTION>
                                                              HIGH       LOW
                                                              ----       ---
<S>                                                          <C>       <C>
Fiscal year ended December 31, 1998
  First Quarter............................................  $17.188   $10.719
  Second Quarter...........................................   19.375    12.375
  Third Quarter............................................   20.250    12.000
  Fourth Quarter...........................................   33.188    16.375
Fiscal year ended December 31, 1997
  Third Quarter (September 25 to September 30).............  $12.625   $11.063
  Fourth Quarter...........................................   14.125    10.000
</TABLE>
 
     Information on the price range for shares of the Company's Common Stock for
the first half of 1997 is omitted since the Common Stock did not become publicly
traded until September 25, 1997.
 
HOLDERS
 
     As of March 1, 1999, there were approximately 310 record holders of the
Common Stock.
 
HISTORICAL DIVIDENDS
 
     For the year ended December 31, 1997, the Company declared S corporation
distributions to its shareholders of $18.1 million. The Company's status as an S
corporation for federal tax purposes was terminated in connection with
completion of the Company's initial public offering in September 1997. For the
year ended December 31, 1998, the Company paid distributions of S corporation
retained profits of $302,000 to S corporation shareholders. The Company intends
to retain all of its future earnings to fund growth and the operation of its
business and therefore does not anticipate paying any cash dividends in the
foreseeable future. Future cash dividends, if any, will be at the discretion of
the Company's Board of Directors and will depend upon, among other things, the
Company's future operations and earnings, capital requirements and surplus,
general financial condition, contractual restrictions and such other factors as
the Board of Directors may deem relevant.
 
RECENT SALES OF UNREGISTERED SECURITIES
 
     There were no sales of unregistered securities during the year ended
December 31, 1998. During the year ended December 31, 1997, in addition to any
unregistered sales of the Company's equity securities reported by the Company on
Form 10-Q, the Company sold the following equity securities in a transaction
that was not registered under the Securities Act of 1933:
 
     On January 2, 1997, ALS issued an aggregate of 480 shares of Class A common
stock and 1,920 shares of Class B common stock (representing 640,266 shares of
Common Stock after (i) the filing of the Company's Amended and Restated Articles
of Incorporation which reclassified the Class A and Class B common stock as
Common Stock, and (ii) completion of a 133.31 for 1 stock split in the form of
two separate stock dividends) to Judith and Terrance Paul in exchange for their
shares of IPS and the Institute pursuant to a reorganization which resulted in
IPS and the Institute becoming wholly-owned subsidiaries of the Company. The
shares of
 
                                       16
<PAGE>   18
 
Class A and Class B common stock were issued without registration under the
Securities Act in reliance on Section 3(a)(9) and Section 4(2) thereunder.
 
USE OF PROCEEDS FROM INITIAL PUBLIC OFFERING
 
     The Company's Registration Statement on Form S-1 was declared effective by
the Securities and Exchange Commission on September 24, 1997 (File No.
333-22519), and the initial public offering of the Common Stock began on
September 25, 1997. All of the 5.6 million shares offered by the Company, in
addition to the 840,000 shares subject to an over-allotment option, were sold on
September 30, 1997 and October 2, 1997, respectively.
 
     The net proceeds to the Company from the initial public offering, after
deducting underwriting discounts of $3,606,400 and other expenses of
approximately $941,000, were approximately $46,972,000. From September 24, 1997
through December 31, 1998, the Company used the net proceeds as follows:
 
     (1) Approximately $1.6 million was used to pay compensation expenses
         related to the termination of the Company's phantom stock plan.
 
     (2) Approximately $7.2 million was used to pay the entire principal and
         accrued interest on the mortgage note and an unsecured note, both
         related to the construction of the Company's facility in Wisconsin
         Rapids, Wisconsin.
 
     (3) Approximately $5.1 million was used to pay the entire principal and
         accrued interest on notes from the Company's principal shareholders
         related to the 1996 acquisition of IPS.
 
     (4) Approximately $10.9 million was used to pay distributions of S
         corporation retained profits to S corporation shareholders.
 
     (5) Approximately $6.4 million was used to invest in Athena Holdings LLC, a
         limited liability company formed for the purpose of constructing the
         Company's facility in Madison, Wisconsin.
 
     (6) Approximately $700,000 was used for pilot operations in various markets
         and miscellaneous acquisitions.
 
                                       17
<PAGE>   19
 
ITEM 6. SELECTED FINANCIAL DATA
 
          SELECTED HISTORICAL CONSOLIDATED AND COMBINED FINANCIAL DATA
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                                             YEAR ENDED DECEMBER 31,
                                                  ----------------------------------------------
                                                   1998      1997      1996      1995      1994
                                                   ----      ----      ----      ----      ----
<S>                                               <C>       <C>       <C>       <C>       <C>
CONSOLIDATED AND COMBINED
INCOME STATEMENT DATA:
Net sales:
  Products......................................  $43,680   $29,060   $18,930   $11,602   $8,088
  Services......................................   11,084     6,964     3,451     1,003      163
                                                  -------   -------   -------   -------   ------
       Total net sales..........................   54,764    36,024    22,381    12,605    8,251
Cost of sales:
  Products......................................    4,005     3,438     2,329     1,468      937
  Services......................................    4,496     3,013     1,898       595      166
                                                  -------   -------   -------   -------   ------
          Total cost of sales...................    8,501     6,451     4,227     2,063    1,103
                                                  -------   -------   -------   -------   ------
          Gross profit..........................   46,263    29,573    18,154    10,542    7,148
Operating expenses:
  Product development...........................    4,998     3,427     1,555       802      358
  Selling and marketing.........................   13,614     9,682     6,639     4,201    2,551
  General and administrative....................    7,262     5,750     3,547     2,090    1,240
  Purchased research and development............      475        --     3,400        --       --
  Phantom stock plan termination................       --     1,617        --        --       --
                                                  -------   -------   -------   -------   ------
          Total operating expenses..............   26,349    20,476    15,141     7,093    4,149
Operating income................................   19,914     9,097     3,013     3,449    2,999
Other income (expense), net.....................    1,657       (71)     (155)       13       23
                                                  -------   -------   -------   -------   ------
Income before taxes.............................   21,571     9,026     2,858     3,462    3,022
Income tax provision (benefit)..................    8,844      (673)   (1,602)       --       --
                                                  -------   -------   -------   -------   ------
Net income......................................  $12,727   $ 9,699   $ 4,460   $ 3,462   $3,022
                                                  =======   =======   =======   =======   ======
Basic earnings per share(1).....................  $  0.38   $  0.33   $  0.16   $  0.13   $ 0.11
Diluted earnings per share(1)...................     0.37      0.33      0.16      0.13     0.11
                                                  =======   =======   =======   =======   ======
CONSOLIDATED AND COMBINED
BALANCE SHEET DATA:
Working capital.................................  $34,938   $28,675   $   566   $ 1,105   $2,213
Total assets....................................   67,996    50,883    19,855     4,761    4,070
Notes payable and long-term debt................       --        --    10,450        --       --
Shareholders' equity............................   55,626    42,835     3,773     2,613    3,065
</TABLE>
 
-------------------------
 
(1) Per share data have been restated to reflect a 2-for-1 stock split in the
    form of a dividend effective February 26, 1999.
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
 
                                    OVERVIEW
 
     The Company is a leading provider of learning information systems to
kindergarten through senior high ("K-12") schools in the United States and
Canada. The Company's learning information systems consist of computer software
and related training designed to improve student academic performance by
increasing the quality, quantity, and timeliness of performance data available
to educators and by facilitating increased student practice of essential skills.
The Company's flagship product, the Accelerated Reader, is software for
 
                                       18
<PAGE>   20
 
motivating and monitoring increased literature-based reading practice. The
Company's learning information system products also include STAR Reading, a
computer-adaptive reading test and database, and the Reading Renaissance
program, through which the Company provides professional development training
for educators. In 1998, the Company introduced Accelerated Math and STAR Math,
software products that apply to math the principles that have made the reading
software effective in improving academic performance, Perfect Copy,writing
skills development software, and Math Renaissance, professional development
training in math.
 
     The Company's sales are derived primarily from the sale of software
products, software support agreements, and training seminars and programs. The
Company recognizes revenue from sales of its off-the-shelf software products at
the time of shipment to customers. The Company records the estimated cost of
returns at the time of sale. The Company also develops custom software products
through its subsidiary, IPS. The Company recognizes revenue from the sale of
custom software on the percentage of completion method. Service revenue includes
both revenue relating to the Reading Renaissance professional development
training and revenue from software support agreements for ongoing customer
support and product upgrades. The Company recognizes revenue from sales of its
training seminars and programs primarily at the time the seminar or training
program is conducted. Revenue from separately sold software support agreements
is reflected as deferred revenue and is amortized ratably over the term of the
maintenance period. The Company's deferred revenue represents payments received
from customers for services still to be rendered.
 
     Because software products are generally shipped as orders are received, the
Company has historically operated without significant backlog. However, it is
the Company's practice to announce new products prior to the time at which such
products will be ready for shipment to allow customers sufficient lead time for
budgeting and curriculum purposes. This practice can result in a significant
backlog for orders of new products. These orders are generally filled within a
relatively short period of time after the product is ready for shipment. The
introduction of products in certain periods could cause those periods to have
significantly higher sales and higher sales growth rates than subsequent
periods.
 
     Cost of sales consists of expenses associated with sales of software
products and training seminars and programs. These costs include: (i)
personnel-related costs, (ii) costs associated with the manufacture and assembly
of the Company's products, and (iii) an allocation of facilities costs. The
Company recognizes significantly higher gross margins on its product sales than
on its service sales. Product sales as a percentage of total sales have remained
relatively constant while gross profit margins on products have improved due to
operating leverage associated with increased dollar volume of product sales.
Gross margins on service sales have increased due to decreased costs of
delivering training sessions. Consequently, the Company's total gross profit
margin has increased. Management anticipates that overall gross profit margin
percentage will remain relatively constant as growth in product sales continues,
countered by an increase in service sales as a percentage of total sales.
 
     The Company expenses all product development costs associated with a
product until technological feasibility is established, after which time such
costs are capitalized until the product is available for general release to
customers. Capitalized product development costs are amortized into cost of
sales generally using the straight-line method over 24 months.
 
     In June 1998, the Company acquired 100% of the stock of Logicus
Incorporated ("Logicus"), an Ontario, Canada-based firm specializing in writing
skills development software. The transaction was accounted for using the
purchase method of accounting. Accordingly, the results of operations of Logicus
have been included in the consolidated financial statements since the date of
acquisition. As part of the acquisition, $475,000 of the purchase price was
allocated to purchased research and development which was expensed in the second
quarter of 1998. The acquisition of Logicus had no material effect on the
results of operations of the Company in 1998.
 
     In August 1996, an affiliate of the Company acquired substantially all of
the assets of IPS for $5.0 million plus the assumption of certain liabilities
and the obligation to make certain contingent payments, which obligation was
satisfied in connection with the Company's initial public offering of common
stock in September 1997 (the "Offering"). Effective January 2, 1997, all of the
outstanding capital stock of IPS was contributed to the Company in return for
shares of capital stock of ALS. The acquisition was accounted for
                                       19
<PAGE>   21
 
using the purchase method of accounting. Accordingly, the results of operations
of IPS are included in the combined results of operations of the Company
effective as of August 1, 1996. As part of the acquisition, $3.4 million of the
purchase price was allocated to purchased research and development which was
expensed in August 1996. See Notes 3 and 5 of Notes to the Company's Financial
Statements.
 
                             RESULTS OF OPERATIONS
 
     The following table sets forth certain consolidated and combined income
statement data as a percentage of net sales, except that individual components
of cost of sales and gross profit are shown as a percentage of their
corresponding component of net sales:
 
<TABLE>
<CAPTION>
                                                             YEAR ENDED DECEMBER 31
                                                             -----------------------
                                                             1998     1997     1996
                                                             ----     ----     ----
<S>                                                          <C>      <C>      <C>
Net sales:
  Products...............................................     79.8%    80.7%    84.6%
  Services...............................................     20.2     19.3     15.4
                                                             -----    -----    -----
       Total net sales...................................    100.0%   100.0%   100.0%
                                                             =====    =====    =====
Cost of sales:
  Products...............................................      9.2     11.8     12.3
  Services...............................................     40.6     43.3     55.0
       Total cost of sales...............................     15.5     17.9     18.9
Gross profit:
  Products...............................................     90.8     88.2     87.7
  Services...............................................     59.4     56.7     45.0
       Total gross profit................................     84.5     82.1     81.1
Operating expenses:
  Product development....................................      9.1      9.5      6.9
  Selling and marketing..................................     24.9     26.9     29.7
  General and administrative.............................     13.3     16.0     15.8
  Purchased research and development.....................       .9       --     15.2
  Phantom stock plan termination.........................       --      4.5       --
                                                             -----    -----    -----
Operating income.........................................     36.3     25.2     13.5
Other income (expense), net..............................      3.0     (0.2)    (0.7)
                                                             -----    -----    -----
Income before taxes......................................     39.3     25.0     12.8
Income tax provision (benefit)...........................     16.1     (1.9)    (7.1)
                                                             -----    -----    -----
Net income...............................................     23.2%    26.9%    19.9%
                                                             =====    =====    =====
</TABLE>
 
                     YEARS ENDED DECEMBER 31, 1998 AND 1997
 
     Net Sales. The Company's net sales increased by $18.8 million, or 52.0%, to
$54.8 million in 1998 from $36.0 million in 1997. Product sales increased by
$14.6 million, or 50.3%, to $43.7 million in 1998 from $29.1 million in 1997.
The increase in product sales is primarily attributable to (i) increased sales
of Accelerated Reader title disks to a larger base of Accelerated Reader
schools, including the introduction of approximately 7,000 new book titles on
Accelerated Reader title disks since December 31, 1997 (ii) the addition of
about 7,500 new customer schools in 1998, (iii) the continuation of very strong
STAR Reading sales, and (iv) sales of the Company's new math products which
began shipping in late 1998.
 
     Reading software sales were positively impacted in 1998 by several large
orders: Dade County, Florida, adopted the Company's reading software on a
county-wide basis; a six-district consortium in Washington state received a
federal grant for software and training; and a large number of Idaho schools
received from the Albertson Foundation a grant to purchase software. While the
Company anticipates continued growth over the
 
                                       20
<PAGE>   22
 
long term in the sale of its software products, large scale sales such as those
described above are unlikely to recur in every period. This may cause periods in
which such sales occur to have higher sales and higher sales growth rates than
subsequent periods.
 
     Service revenue, which consists of revenue from sales of training sessions
and software support agreements, increased by $4.1 million, or 59.2%, to $11.1
million in 1998 from $7.0 million in 1997. This increase is primarily
attributable to revenue from software support agreements associated with new
product sales along with renewals of agreements by an expanding base of existing
customers, and to an increased number of Reading Renaissance training sessions.
 
     Cost of Sales. The cost of sales of products increased by $567,000, or
16.5%, to $4.0 million in 1998 from $3.4 million in 1997. As a percentage of
product sales, the cost of sales of products declined to 9.2% in 1998 compared
to 11.8% in 1997 due to operating leverage associated with increased product
sales. The cost of sales of services increased by $1.5 million, or 49.2%, to
$4.5 million in 1998 from $3.0 million in 1997 primarily due to increased costs
of providing technical support relating to software support agreements. As a
percentage of sales of services, the cost of sales of services declined to 40.6%
in 1998 compared to 43.3% in 1997, primarily as a result of decreased costs of
delivering training sessions. The Company's overall gross profit margin improved
2.4% to 84.5% in 1998 from 82.1% in 1997 due to improved gross profit margins on
both products and services.
 
     Product Development. Product development expenses increased by $1.6
million, or 45.8%, to $5.0 million in 1998 from $3.4 million in 1997. These
expenses increased primarily due to increased development staff and consulting
costs associated with the new products and seminars introduced in 1998. As a
percentage of net sales, product development costs decreased to 9.1% in 1998
from 9.5% in 1997. The Company anticipates that the total dollar amount of
product development costs will increase as the Company enhances and extends its
product offerings into other areas of the K-12 curriculum.
 
     Selling and Marketing. Selling and marketing expenses increased by $3.9
million, or 40.6%, to $13.6 million in 1998 from $9.7 million in 1997. These
expenses increased due to (i) the publication of additional catalogs, mailings
to an increased customer and prospect base, and increased advertising in
publications and (ii) salary and recruiting costs associated with the hiring of
additional personnel. As a percentage of net sales, selling and marketing
expenses decreased to 24.9% in 1998 from 26.9% in 1997. This decrease is
primarily due to economies of scale associated with significantly increased
product and service sales. Management anticipates that selling and marketing
expenses will generally continue to rise, while remaining relatively constant as
a percentage of sales, as the Company expands its customer and prospect base and
number of curricular areas its products cover.
 
     General and Administrative. General and administrative expenses increased
by $1.5 million, or 26.3%, to $7.3 million in 1998 from $5.7 million in 1997.
The higher expenses for 1998 are largely due to increased costs associated with
the hiring of additional personnel, including wages and related benefits. As a
percentage of net sales, general and administrative costs decreased to 13.3% in
1998 from 16.0% in 1997. The Company anticipates that general and administrative
expenses will remain relatively constant as a percentage of sales in future
periods.
 
     Purchased Research and Development. In connection with the acquisition of
Logicus, Incorporated, $475,000 of the purchase price was allocated to purchased
research and development which was expensed in June 1998.
 
     Phantom Stock Plan Termination. The Company's phantom stock plan terminated
on September 30, 1997 in connection with the closing of the Offering on that
date. The one-time charge of $1.6 million associated with the plan termination
was expensed in September 1997.
 
     Operating Income. Operating income increased by $10.8 million, or 118.9%,
to $19.9 million in l998 from $9.1 million in 1997. As a percentage of net
sales, operating income increased to 36.3% in 1998 from 25.2% in 1997. Excluding
the effects of the purchased research and development expense in 1998, and the
phantom stock plan termination expense in 1997, operating income would have
increased by $9.7 million, or 90.3%, to $20.4 million in 1998 from $10.7 million
in 1997, or 37.2% of net sales compared to 29.7% of net sales in 1997.
                                       21
<PAGE>   23
 
     Interest Income. Interest income increased $1.2 million to $1.7 million in
1998 from $483,000 in 1997 due to an increase in interest earning short-term
investments purchased with proceeds from the Company's initial public offering
in late 1997.
 
     Interest Expense. Interest expense decreased $637,000 to $8,000 in 1998
from $645,000 in 1997. In late 1997, proceeds from the Company's initial public
offering were used to pay all outstanding indebtedness.
 
     Income Taxes. Income tax expense of $8.8 million was recorded in 1998 at an
effective income tax rate of 41.0%. In January 1997, a deferred tax asset of
$1.6 million was written off when IPS elected S corporation status. In September
1997, a tax benefit of $3.5 million was recorded in connection with the
Company's change in tax status from S corporation to C corporation status. The
Company became subject to corporate level income taxes effective with the
closing of the Offering and consequently provided for current and deferred
income taxes on income subsequent to September 30, 1997. The Company expects
that the effective rate of tax on its income will be approximately 41% during
1999. See Note 6 of Notes to the Company's Financial Statements.
 
                     YEARS ENDED DECEMBER 31, 1997 AND 1996
 
     Net Sales. The Company's net sales increased by $13.6 million, or 61.0%, to
$36.0 million in 1997 from $22.4 million in 1996. Product sales increased by
$10.2 million, or 53.5%, to $29.1 million in 1997 from $18.9 million in 1996.
The increase in product sales is primarily attributable to (i) revenues from
STAR Reading for which shipments and recognition of revenue began in September
1996, (ii) increased sales of Accelerated Reader title disks to a larger base of
Accelerated Reader schools, including the introduction of approximately 3,000
new book titles on Accelerated Reader title disks in 1997 (iii) the sale of the
Accelerated Reader to approximately 7,100 new customer schools in 1997, and (iv)
inclusion of IPS sales commencing August l, 1996.
 
     Service revenue from sales of training seminars and software support
agreements increased by $3.5 million, or 101.8%, to $7.0 million in 1997 from
$3.5 million in 1996. This increase is primarily attributable to an increased
number of Reading Renaissance training sessions, and, to a lesser extent,
additional revenue from software support agreements principally associated with
increased new product sales.
 
     Cost of Sales. The cost of sales of products increased by $1.1 million, or
47.6%, to $3.4 million in 1997 from $2.3 million in 1996. As a percentage of
product sales, the cost of sales of products declined to 11.8% in 1997 compared
to 12.3% in 1996. The cost of sales of services increased by $1.1 million, or
58.7%, to $3.0 million in 1997 from $1.9 million in 1996. As a percentage of
sales of services, the cost of sales of services declined to 43.3% in 1997
compared to 55.0% in 1996, primarily as a result of decreased costs of
delivering training sessions. The Company's overall gross profit margin improved
1.0% to 82.1% in 1997 from 81.1% in 1996 due primarily to improved gross profit
margins on services.
 
     Product Development. Product development expenses increased by $1.8
million, or 120.3%, to $3.4 million in 1997 from $1.6 million in 1996. These
expenses increased primarily due to: (i) increased development staff and
consulting costs associated with new products, and (ii) the inclusion of IPS's
product development commencing August 1, 1996. As a percentage of net sales,
product development costs increased to 9.5% in 1997 from 6.9% in 1996.
 
     Selling and Marketing. Selling and marketing expenses increased by $3.1
million, or 45.8%, to $9.7 million in 1997 from $6.6 million in 1996. These
expenses increased due to an increase in marketing personnel, participation in
more trade shows, the publication of additional catalogs, mailings to an
increased customer and prospect base and increased advertising in publications.
However, as a percentage of net sales, selling and marketing expenses decreased
to 26.9% in 1997 from 29.7% in 1996. This decrease is primarily due to economies
of scale associated with significantly increased product sales and service
sales.
 
     General and Administrative. General and administrative expenses increased
by $2.2 million, or 62.1%, to $5.7 million in 1997 from $3.5 million in 1996.
The higher expenses for 1997 are largely due to increased costs associated with
the hiring of additional personnel, including wages and related benefits, and
increased costs
 
                                       22
<PAGE>   24
 
associated with the Company's new headquarters building. As a percentage of net
sales, general and administrative costs increased somewhat to 16.0% in 1997 from
15.8% in 1996.
 
     Purchased Research and Development. In connection with the acquisition of
IPS, $3.4 million of the purchase price was allocated to purchased research and
development which was expensed in August 1996.
 
     Phantom Stock Plan Termination. The Company's phantom stock plan terminated
on September 30, 1997 in connection with the closing of the Offering on that
date. The one-time charge of $1.6 million associated with the plan termination
was expensed in September 1997.
 
     Operating Income. Operating income increased by $6.1 million, or 201.9%, to
$9.1 million in l997 from $3.0 million in 1996. As a percentage of net sales,
operating income increased to 25.2% in 1997 from 13.5% in 1996. Excluding the
effects of the purchased research and development expense in 1996 and the
phantom stock plan termination expense in 1997, operating income would have
increased by $4.3 million, or 67.2%, to $10.7 million in 1997 from $6.4 million
in 1996, or 29.7% of net sales compared to 28.7% of net sales in 1996.
 
     Interest Income. Interest income increased $448,000 to $483,000 in 1997
from $35,000 in 1996 due to increased levels of funds available for investment
primarily from the Offering proceeds and to a lesser extent cash flow generated
by operations.
 
     Interest Expense. Interest expense increased $439,000 to $645,000 in 1997
from $206,000 in 1996 primarily as a result of interest expense incurred in
connection with loans to finance the acquisition of IPS and the construction of
the Company's new corporate headquarters building in Wisconsin Rapids,
Wisconsin.
 
     Income Tax Benefit. A tax benefit of $3.5 million was recorded in September
1997 in connection with the Company's change in tax status from S corporation
status to C corporation status on September 29, 1997. In August 1996, a deferred
tax asset and corresponding benefit of $1.6 million was recorded in connection
with the operations of IPS which was a C corporation at the time. This benefit
was reversed in January 1997 when IPS elected S corporation status. The Company
became subject to corporate level income taxes effective with the closing of the
Offering and consequently provided for current and deferred income taxes from
September 30, 1997 to December 31, 1997. See Note 6 of Notes to the Company's
Financial Statements.
 
                                   YEAR 2000
 
     The Company has investigated the extent to which its operations are subject
to Year 2000 issues and assessed the measures it believes will be necessary to
avoid any material disruption to its operations relating to Year 2000 issues. On
the basis of this investigation and assessment, the Company has taken steps to
ensure that its systems and products will not be adversely impacted by Year 2000
issues. As of December 31, 1998, substantially all of the Company's systems and
products are Year 2000 compliant. The cost to the Company for such compliance
measures has been approximately $100,000, and management believes that the cost
of additional modifications will be approximately $300,000. The cost of the
Company's internal Year 2000 compliance measures is being funded through
operating cash flows.
 
     In addition to assessing its own readiness for the Year 2000, the Company
has initiated formal communications with all of its significant suppliers to
determine the extent to which the Company is vulnerable to those third parties'
potential failure to remediate their own Year 2000 issues. A significant
percentage of these suppliers have responded in writing to the Company's Year
2000 readiness inquiries. The Company plans to continue assessment of its
third-party business partners, including face-to-face meetings with management
and/or on site visits as deemed appropriate. Despite the Company's diligence,
there can be no guarantee that the systems of other companies, on which the
Company's systems rely, will be timely converted or that a failure to convert by
another company or a conversion that is incompatible with the Company's systems
would not have a material adverse effect on the Company. The cost to the Company
for its third party compliance efforts as of December 31, 1998 has been
approximately $500,000, and management believes that the cost of additional
efforts in this regard will be approximately $300,000. The cost of the Company's
external Year 2000 compliance measures is being funded through operating cash
flows.
 
                                       23
<PAGE>   25
 
     With respect to Year 2000 risks associated with the Company's systems, the
Company believes that the most reasonably likely worst case scenario is that the
Company will experience a number of minor systems malfunctions and errors in the
early part of the Year 2000 that were not detected during its compliance
efforts. The Company believes that these problems will not be overwhelming and
will not have a material effect on the Company's operations or financial
results.
 
     With respect to Year 2000 risks associated with the Company's software
products, the Company cannot be certain that the software will operate error
free, or that the Company will not be subject to litigation, whether the
software operates error free or not. However, the Company believes that based on
its efforts to ensure compliance, it is not reasonably likely that the Company
will be subject to such litigation.
 
     With respect to Year 2000 risks associated with third party suppliers, the
Company believes that the most reasonably likely worst case scenario is that
some of the Company's significant suppliers will not be Year 2000 compliant.
Management also believes that the number of such suppliers will have been
minimized by the Company's program of identifying non-compliant suppliers and
replacing or jointly developing alternative supply or delivery solutions prior
to the Year 2000.
 
     The Company has limited the scope of its risk assessment to those factors
which it can reasonably be expected to have an influence upon. For example, the
Company has made the assumption that government agencies, utility companies and
national telecommunication providers will continue to operate. Obviously, the
lack of such services could have a material effect on the Company's ability to
operate, but the Company has little, if any, ability to influence such an
outcome, or to make alternative arrangements in advance for such services in the
event they are not available.
 
     The Company has not yet established a contingency plan to handle the most
reasonably likely worst case scenarios described above. Nevertheless, the
Company has begun to develop such a plan. If the Company and/or its significant
suppliers are unable to resolve issues related to the Year 2000 on a timely
basis, it could result in a material financial risk to the Company.
 
                        LIQUIDITY AND CAPITAL RESOURCES
 
     As of December 31, 1998, the Company's cash, cash equivalents and
short-term investments increased $3.9 million to $33.1 million from the December
31, 1997 total of $29.2 million. The net increase is due primarily to $13.5
million in net cash provided by operating activities offset by $8.5 million used
in the purchase of property, plant and equipment, including $6.4 million related
to the development of an office and training products development facility in
Madison, Wisconsin. The Company believes cash flow from operations and its
current cash position will be sufficient to meet its working capital
requirements for the foreseeable future.
 
     Effective June 30, 1998, the Company acquired 100% of the stock of Logicus
Incorporated. The acquisition did not have a material impact on 1998 financial
results.
 
     In March 1998, Athena Holdings LLC ("AHL") was formed by the Company and an
unaffiliated party to develop a facility in the Madison, Wisconsin area to house
the offices, marketing and sales functions, training development staff, and
training support staff of the Institute for Academic Excellence. The Company
received a 70% interest in AHL in return for its capital contribution of
$700,000. The other party will also utilize part of the facility. Additionally,
a portion of the property will be leased to third parties. The estimated total
cost of the project is approximately $6.7 million, of which approximately $6.4
million had been incurred in 1998. The Company is providing permanent financing
for the project in the form of a mortgage note with interest at a market rate.
 
     The net proceeds to the Company from its initial public offering in 1997,
after deducting underwriting discounts of $3,606,400 and other expenses of
approximately $941,000 were approximately $46,972,000. The Company has thus far
used the proceeds from the Offering as follows:
 
          (i) Approximately $1.6 million was used to pay compensation expenses
     related to the termination of the Company's phantom stock plan.
                                       24
<PAGE>   26
 
          (ii) Approximately $7.2 million was used to pay the entire principal
     and accrued interest on the mortgage note and an unsecured note, both
     related to the construction of the Company's facility in Wisconsin Rapids,
     Wisconsin.
 
          (iii) Approximately $5.1 million was used to pay the entire principal
     and accrued interest on notes from the Company's principal shareholders
     related to the 1996 acquisition of IPS.
 
          (iv) Approximately $10.9 million was used to pay distributions of S
     corporation retained profits to S corporation shareholders.
 
          (v) Approximately $6.4 million was used to invest in Athena Holdings
     LLC, a limited liability company formed for the purpose of constructing the
     Company's facility in Madison, Wisconsin.
 
          (vi) Approximately $700,000 was used for pilot operations in various
     markets and miscellaneous acquisitions.
 
     The Company has broad discretion with respect to the use of the remaining
proceeds.
 
     At December 31 1998, the Company had a $10.0 million unsecured revolving
line of credit with a bank which is available until March 31, 2000. The line of
credit bears interest at either a floating rate based on the prime rate less
1.0%, or a fixed rate for a period of up to 90 days based on LIBOR plus 1.25%.
The rate is at the option of the Company and is determined at the time of
borrowing. As of December 31, 1998, the line of credit had not been used.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
 
     At December 31, 1998, the Company had no material market risk exposure
(e.g., interest rate risk, foreign currency exchange rate risk or commodity
price risk).
 
                                       25
<PAGE>   27
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
 
TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF
ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES:
 
     We have audited the accompanying consolidated balance sheets of Advantage
Learning Systems, Inc. (a Wisconsin corporation) and subsidiaries as of December
31, 1998 and 1997, and the related consolidated and combined statements of
income, equity and cash flows for each of the three years in the period ended
December 31, 1998. These financial statements are the responsibility of the
company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
 
     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
 
     In our opinion, the consolidated and combined financial statements referred
to above present fairly, in all material respects, the financial position of
Advantage Learning Systems, Inc. and subsidiaries as of December 31, 1998 and
1997, and the results of their operations and their cash flows for each of the
three years in the period ended December 31, 1998 in conformity with generally
accepted accounting principles.
 
                                          /s/ Arthur Andersen LLP
 
                                          ARTHUR ANDERSEN LLP
 
Milwaukee, Wisconsin
February 2, 1999
 
                                       26
<PAGE>   28
 
FINANCIAL STATEMENTS
 
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                          CONSOLIDATED BALANCE SHEETS
                        AS OF DECEMBER 31, 1998 AND 1997
 
<TABLE>
<CAPTION>
                                                               1998      1997
                                                               ----      ----
                                                               (IN THOUSANDS)
<S>                                                           <C>       <C>
                           ASSETS
Current assets:
  Cash and cash equivalents.................................  $14,222   $22,320
  Short term investments....................................   18,869     6,865
  Accounts receivable, less allowance of $1,058,000 in 1998
     and $638,000 in 1997...................................    8,832     3,317
  Inventories...............................................      794       345
  Prepaid expenses..........................................      656       746
  Deferred tax asset........................................    2,242     1,831
                                                              -------   -------
          Total current assets..............................   45,615    35,424
                                                              -------   -------
Property, plant and equipment, net..........................   19,101    12,042
Deferred tax asset..........................................    1,647     1,661
Intangibles, net............................................    1,445     1,599
Capitalized software, net...................................      188       157
                                                              -------   -------
          Total assets......................................  $67,996   $50,883
                                                              =======   =======
            LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable..........................................  $ 1,815   $   982
  Deferred revenue..........................................    3,443     2,854
  Payroll and employee benefits.............................    1,080       657
  Income taxes payable......................................    2,157        --
  Other current liabilities.................................    2,182     1,701
  Distribution payable to shareholders......................       --       555
                                                              -------   -------
          Total current liabilities.........................   10,677     6,749
                                                              -------   -------
  Deferred revenue..........................................    1,398     1,299
                                                              -------   -------
          Total liabilities.................................   12,075     8,048
                                                              -------   -------
  Minority interest.........................................      295        --
  Shareholders' equity:
     Common stock, $.01 par; shares authorized: 50,000,000;
      issued and outstanding:33,835,580 -- 1998
       33,804,766 -- 1997...................................      338       338
     Additional paid in capital.............................   40,674    40,588
     Retained earnings......................................   14,636     1,909
     Accumulated other comprehensive income.................      (22)       --
                                                              -------   -------
       Total shareholders' equity...........................   55,626    42,835
                                                              -------   -------
          Total liabilities and shareholders' equity........  $67,996   $50,883
                                                              =======   =======
</TABLE>
 
The accompanying notes to the financial statements are an integral part of these
                                balance sheets.
 
                                       27
<PAGE>   29
 
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
                 CONSOLIDATED AND COMBINED STATEMENTS OF INCOME
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
 
<TABLE>
<CAPTION>
                                                               1998      1997      1996
                                                               ----      ----      ----
                                                                     (IN THOUSANDS
                                                               EXCEPT PER SHARE AMOUNTS)
<S>                                                           <C>       <C>       <C>
Net Sales:
  Products..................................................  $43,680   $29,060   $18,930
  Services..................................................   11,084     6,964     3,451
                                                              -------   -------   -------
       Total net sales......................................   54,764    36,024    22,381
                                                              -------   -------   -------
Cost of sales:
  Products..................................................    4,005     3,438     2,329
  Services..................................................    4,496     3,013     1,898
                                                              -------   -------   -------
       Total cost of sales..................................    8,501     6,451     4,227
                                                              -------   -------   -------
       Gross profit.........................................   46,263    29,573    18,154
Operating expenses:
  Product development.......................................    4,998     3,427     1,555
  Selling and marketing.....................................   13,614     9,682     6,639
  General and administrative................................    7,262     5,750     3,547
  Purchased research and development........................      475        --     3,400
  Phantom stock plan termination............................       --     1,617        --
                                                              -------   -------   -------
       Total operating expenses.............................   26,349    20,476    15,141
                                                              -------   -------   -------
       Operating income.....................................   19,914     9,097     3,013
Other income (expense):
  Interest income...........................................    1,709       483        35
  Interest expense..........................................       (8)     (645)     (206)
  Other, net................................................      (44)       91        16
                                                              -------   -------   -------
Income before taxes.........................................   21,571     9,026     2,858
Income tax provision (benefit)..............................    8,844      (673)   (1,602)
                                                              -------   -------   -------
Net income..................................................  $12,727   $ 9,699   $ 4,460
                                                              =======   =======   =======
Earnings per share:
  Basic.....................................................  $  0.38   $  0.33   $  0.16
  Diluted...................................................     0.37      0.33      0.16
</TABLE>
 
The accompanying notes to the financial statements are an integral part of these
                                  statements.
 
                                       28
<PAGE>   30
 
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                 STATEMENTS OF CONSOLIDATED AND COMBINED EQUITY
              FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
 
<TABLE>
<CAPTION>
                                                                                             ACCUMULATED
                                                COMMON STOCK (1)    ADDITIONAL                  OTHER
                                                -----------------    PAID IN     RETAINED   COMPREHENSIVE    TOTAL
                                                SHARES     AMOUNT    CAPITAL     EARNINGS      INCOME        EQUITY
                                                ------     ------   ----------   --------   -------------    ------
                                                                           (IN THOUSANDS)
<S>                                             <C>        <C>      <C>          <C>        <C>             <C>
Balance, December 31, 1995....................       --     $ --     $    --     $     --       $ --        $  2,613
  Net income..................................       --       --          --           --         --           4,460
  Distributions to shareholders...............                                                                (3,500)
  Contribution from shareholders..............       --       --          --           --         --             200
                                                -------     ----     -------     --------       ----        --------
Balance, December 31, 1996....................       --       --          --           --         --           3,773
  Net income..................................       --       --          --        9,699         --           9,699
  Recapitalization............................   27,302      273      (6,819)      10,319         --              --
  Distributions to shareholders...............       --       --          --      (18,109)        --         (18,109)
  Public offering.............................    6,440       64      46,908           --         --          46,972
  Settlement of IPS purchase(2)...............       63        1         499           --         --             500
                                                -------     ----     -------     --------       ----        --------
Balance, December 31, 1997....................   33,805      338      40,588        1,909         --          42,835
  Net income..................................       --       --          --       12,727         --          12,727
  Foreign currency translation................                                                   (22)            (22)
                                                                                                            --------
    Comprehensive income......................                                                                12,705
  Distribution to shareholders................       --       --        (302)          --         --            (302)
  Tax benefit on stock options................       --       --         133           --         --             133
  Exercise of stock options...................       31       --         246           --         --             246
  Stock option grants.........................       --       --           9           --         --               9
                                                -------     ----     -------     --------       ----        --------
Balance, December 31, 1998....................   33,836     $338     $40,674     $ 14,636       $(22)       $ 55,626
                                                =======     ====     =======     ========       ====        ========
</TABLE>
 
-------------------------
(1) Common Stock, $0.01 par value, 50,000,000 shares authorized.
 
(2) See Note 3 of Notes to Financial Statements.
 
The accompanying notes to the financial statements are an integral part of these
                                  statements.
 
                                       29
<PAGE>   31
 
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
               CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
 
<TABLE>
<CAPTION>
                                                                  1998        1997        1996
                                                                  ----        ----        ----
                                                                         (IN THOUSANDS)
<S>                                                             <C>         <C>         <C>
Reconciliation of net income to net cash provided by
  operating activities:
  Net income................................................    $ 12,727    $  9,699    $  4,460
  Noncash (income) expenses included in net income --
     Depreciation and amortization..........................       2,087       1,478         711
     Loss on building held for sale.........................          --          --         200
     Purchased research and development.....................         475          --       3,400
     Deferred income taxes..................................        (397)     (1,890)     (1,602)
  Change in assets and liabilities --
     Accounts receivable....................................      (5,459)       (793)       (755)
     Inventory..............................................        (421)        198        (311)
     Prepaid expenses.......................................          89        (481)         60
     Accounts payable and other current liabilities.........       3,758       1,745         858
     Retainage and amounts due under construction
       contract.............................................         (17)     (1,135)      1,151
     Deferred revenue.......................................         688       1,601       1,031
  Other.....................................................         (20)          1          --
                                                                --------    --------    --------
       Net cash provided by operating activities............      13,510      10,423       9,203
                                                                --------    --------    --------
Cash flows from investing activities:
  Purchase of property, plant & equipment...................      (8,465)     (1,693)     (9,898)
  Purchase of short term investments, net...................     (12,004)     (6,865)         --
  Capitalized software development costs....................        (194)         (4)       (365)
  Acquisitions..............................................        (634)       (265)     (4,610)
                                                                --------    --------    --------
       Net cash used in investing activities................     (21,297)     (8,827)    (14,873)
                                                                --------    --------    --------
Cash flows from financing activities:
  Proceeds from issuance of stock...........................          --      46,972         200
  Proceeds from exercise of stock options...................         246          --          --
  Equity contribution from minority partner.................         300          --          --
  Proceeds from long-term debt & notes payable to
     shareholders...........................................          --          --      10,600
  Payments on debt..........................................          --     (10,450)       (150)
  Distributions to shareholders.............................        (857)    (17,554)     (3,500)
                                                                --------    --------    --------
       Net cash provided by (used in) financing
          activities........................................        (311)     18,968       7,150
                                                                --------    --------    --------
Net increase (decrease) in cash.............................      (8,098)     20,564       1,480
Cash and cash equivalents, beginning of period..............      22,320       1,756         276
                                                                --------    --------    --------
Cash and cash equivalents, end of period....................    $ 14,222    $ 22,320    $  1,756
                                                                ========    ========    ========
</TABLE>
 
The accompanying notes to the financial statements are an integral part of these
                                  statements.
 
                                       30
<PAGE>   32
 
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                         NOTES TO FINANCIAL STATEMENTS
 
(1) CONSOLIDATION
 
     The consolidated financial statements include the financial results of
Advantage Learning Systems, Inc. ("ALS") and its subsidiaries, collectively the
"Company". The Company's significant subsidiaries include the Institute for
Academic Excellence, Inc. ("Institute") and IPS Publishing, Inc. ("IPS"). The
Company also owns 70% of Athena Holdings LLC which was formed for the purpose of
constructing a facility in Madison, Wisconsin. Combined equity represents the
combination of the common stock, paid-in capital and retained earnings of ALS,
the Institute, and IPS. Effective January 2, 1997, the Institute and IPS became
wholly owned subsidiaries of ALS. As a result, subsequent periods are presented
on a consolidated basis. All significant intercompany transactions have been
eliminated in the consolidated and combined financial statements.
 
(2) NATURE OF OPERATIONS
 
     ALS is a provider of learning information systems to K-12 schools in the
United States and Canada. ALS's flagship product is the Accelerated Reader, a
learning information system for motivating and monitoring increased
literature-based reading practice. ALS has also developed STAR Reading, a
computer-adaptive reading test and database. In 1998, the Company introduced
Accelerated Math and STAR Math, software products that apply to math the
principles that have made the reading software effective in improving academic
performance, Perfect Copy, writing skills development software, and Math
Renaissance, professional development training in math.
 
     The Institute develops and conducts Renaissance training programs, which
provide educators with professional development training to most effectively use
ALS products and the learning information they generate.
 
     IPS provides customized software to publishers for assessment and skills
practice in math, science, and other subjects. Additionally, IPS develops
content for math products distributed by the Company.
 
(3) ACQUISITIONS
 
     Effective June 30, 1998, the Company acquired 100% of the stock of Logicus
Incorporated ("Logicus"), an Ontario, Canada-based firm specializing in writing
skills development software. The transaction was accounted for using the
purchase method of accounting, and the results of operations of Logicus have
been included in the consolidated financial statements since the date of
acquisition. The purchase price included the acquisition of certain in process
research and development which resulted in a pre-tax charge of $475,000 in the
second quarter of 1998. The acquisition of Logicus had no material effect on the
results of operations of the Company in 1998. Pro forma results for 1998 and
1997 would not be materially different from actual.
 
     Effective August 1, 1996, IPS Acquisition, Inc. ("Acquisition") acquired
substantially all of the assets of IPS. Acquisition was formed by the
shareholders of ALS for the sole purpose of acquiring certain assets of IPS.
Acquisition was capitalized with $200,000 of equity and $4.7 million of loans
from shareholders. Subsequent to the transaction, Acquisition changed its name
to IPS Publishing, Inc.
 
     The acquisition was accounted for under the purchase method of accounting.
The net purchase price was comprised of $4,610,000 cash paid at closing,
$265,177 cash paid in 1997 and $500,000 of ALS common stock given at the closing
date of the Initial Public Offering of the Company's common stock in 1997 (see
Note 5). The purchase price included the acquisition of certain in process
research and development which resulted in a pre-tax charge to income of
$3,400,000 for the year ended December 31, 1996.
 
                                       31
<PAGE>   33
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
(4) SIGNIFICANT ACCOUNTING POLICIES
 
(a) Use of estimates
 
     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amount of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
 
(b) Revenue recognition
 
     In 1997 the Accounting Standards Executive Committee of the AICPA issued
Statement of Position No. 97-2 ("SOP 97-2") "Software Revenue Recognition". This
SOP was issued to provide guidance on applying generally accepted accounting
principles to software transactions and to narrow the range of revenue
recognition practices that were in use before its issuance. SOP 97-2 is
generally effective for transactions entered into in fiscal years beginning
after December 15, 1997. The adoption of SOP 97-2 had no material impact on the
Company's results of operations in 1998.
 
     Revenue from product sales is recognized when the products are shipped, net
of estimated allowances for product returns and exchanges. Allowances for bad
debts and post-contract support obligations, primarily telephone support
provided by ALS, are also accrued for at the time of the sale.
 
     Revenue from IPS's custom products is recognized on the percentage of
completion method. IPS defers revenue for advance payments from customers that
are in excess of revenues earned. Included in receivables at December 31, 1998
and 1997 is $198,000 and $49,000, respectively, of amounts earned on contracts
which are not yet billable.
 
     The Institute generates service revenue both from (i) conducting seminars
and (ii) contracts with schools and school districts to provide training
programs and consulting services. The Institute recognizes revenue from the
seminars at the time the seminar actually takes place. For school and school
district contracts, revenue is generally recognized when the training session is
performed, while certain support services are recognized on a straight-line
basis over the life of the contract. The Institute includes as deferred revenue
(i) prepayments on contract revenues and (ii) payments received for seminars not
yet held.
 
     Service revenues include software support provided as part of the software
product sale and separately sold maintenance fees whereby ALS provides ongoing
customer support and product upgrades. Such separately sold contracts are
reflected as deferred revenue and are amortized ratably over the term of the
maintenance period which begins after the expiration of any support included
with the purchase of the software. Revenue from support agreements included with
the purchase of software is included in service revenue at the time the software
is shipped.
 
(c) Cash and cash equivalents
 
     The Company considers cash amounts on deposit at banks and highly liquid
debt instruments purchased with a maturity date of three months or less to be
cash equivalents. Commercial paper is carried at cost plus
 
                                       32
<PAGE>   34
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
accrued interest, which approximates market value. Cash and cash equivalents
consisted of the following at December 31:
 
<TABLE>
<CAPTION>
                                                              1998      1997
                                                              ----      ----
                                                              (IN THOUSANDS)
<S>                                                          <C>       <C>
Cash and time deposits.....................................  $ 4,756   $ 6,395
Commercial paper...........................................    9,466    15,925
                                                             -------   -------
                                                             $14,222   $22,320
                                                             =======   =======
</TABLE>
 
(d) Supplemental disclosure of cash flow information
 
<TABLE>
<CAPTION>
                                                       1998          1997        1996
                                                       ----          ----        ----
                                                                (IN THOUSANDS)
<S>                                                   <C>       <C>              <C>
Cash paid for:
  Interest..........................................  $     8       $  696       $ 94
  Income taxes......................................    6,606        1,564         --
</TABLE>
 
(e) Short term investments
 
     Short term investments have an original maturity of more than three months
and a remaining maturity of less than one year. As of December 31, 1998 and 1997
short term investments consisted entirely of commercial paper. These securities
are considered to be held to maturity in accordance with Statement of Financial
Accounting Standards No. 115 ("SFAS 115") "Accounting for Certain Investments in
Debt and Equity Securities". Accordingly, these investments are carried at cost
plus accrued interest which approximates market value.
 
(f) Inventories
 
     Inventories are carried at the lower of first-in, first-out (FIFO) cost or
market. Inventories primarily consist of purchased materials which include
manuals, diskettes and motivational items.
 
(g) Catalog and advertising costs
 
     Costs related to direct response advertising, primarily catalogs, are
capitalized over their expected period of future benefits, generally three to
six months. At December 31, 1998 and 1997 capitalized catalog costs of
approximately $113,000 and $43,000, respectively, are included in prepaid
expenses. All other advertising costs are expensed the first time the
advertising takes place. Advertising expenses for 1998, 1997 and 1996 were
approximately $6,202,000, $4,377,000 and $2,999,000, respectively.
 
(h) Property, plant and equipment
 
     Property, plant and equipment are recorded at cost and are depreciated over
the estimated useful lives of the assets using principally the straight-line
method for financial reporting purposes. Maintenance and repair costs are
charged to expense as incurred, and renewals and improvements that extend the
useful life of the assets are added to the plant and equipment accounts.
Depreciation expense was approximately $1,401,000, $975,000 and $401,000 for
1998, 1997 and 1996, respectively.
 
     The estimated useful lives for property, plant and equipment are as
follows: buildings -- 25 to 40 years; furniture, fixtures and office equipment
-- 5 to 8 years; computer and production equipment -- 3 to 5 years; and vehicles
-- 5 years.
 
                                       33
<PAGE>   35
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
     Net property, plant and equipment consisted of the following at December
31:
 
<TABLE>
<CAPTION>
                                                              1998      1997
                                                              ----      ----
                                                              (IN THOUSANDS)
<S>                                                          <C>       <C>
Land and improvements......................................  $ 1,429   $   819
Buildings..................................................   14,469     8,738
Furniture, fixtures and office equipment...................    2,298     1,536
Computer and production equipment..........................    3,600     2,265
Vehicles...................................................       77        19
Construction in progress...................................       10       385
                                                             -------   -------
  Total property, plant and equipment......................   21,883    13,762
Less -- accumulated depreciation...........................   (2,782)   (1,720)
                                                             -------   -------
Property, plant and equipment, net.........................  $19,101   $12,042
                                                             =======   =======
</TABLE>
 
(i) Software development costs
 
     In accordance with Statement of Financial Accounting Standards No. 86
("SFAS 86") "Accounting for the Costs of Computer Software to be Sold, Leased or
Otherwise Marketed," the Company capitalizes certain software development costs
incurred after technological feasibility is achieved. Capitalized costs are
reported at the lower of unamortized cost or net realizable value. Capitalized
software development costs are amortized on a product-by-product basis based on
the greater of the amount computed using (a) the ratio that current gross
revenues for a product bear to the total of current and anticipated future gross
revenues for that product or (b) the straight-line method over the estimated
economic life of the products which is generally estimated to be 24 months.
Amortization begins when the products are available for general release to
customers. All other research and development expenditures are charged to
product development expense in the period incurred. Amounts capitalized were
approximately $194,000, $4,000 and $365,000 in 1998, 1997 and 1996,
respectively. Amortization expense of approximately $163,000, $241,000 and
$208,000 for 1998, 1997 and 1996, respectively, is included in cost of
sales-products in the statements of income. At December 31, 1998 and 1997
accumulated amortization of capitalized software development costs was $733,000
and $570,000, respectively.
 
(j) Sales and concentration of credit risks
 
     For the years ended December 31, 1998, 1997 and 1996, one customer (a book
distributor) contributed 13.9%, 14.4% and 15.2% of total revenues, respectively.
No other customer represented more than 10% of total revenues. On December 31,
1998 and 1997, this customer had a receivable balance of 11.9% and 10.3% of
total trade receivables, respectively.
 
     The Company grants credit to customers in the ordinary course of business.
The majority of the Company's customers are schools. Concentrations of credit
risk with respect to trade receivables are limited due to the significant number
of customers and their geographic dispersion.
 
(k) Stock-based compensation
 
     The Company elected, as permitted by Statement of Accounting Standards No.
123 ("SFAS 123") "Accounting for Stock Based Compensation" to follow the
intrinsic value based method of accounting for stock options consistent with
Accounting Principles Board Opinion No. 25 ("APB 25") "Accounting for Stock
Issued to Employees" and to provide the pro forma disclosures of net income and
earnings per share as if the fair value based method had been applied. Under the
intrinsic method, compensation cost for stock options is measured by the excess,
if any, of the quoted price of the company's stock at the measurement date over
the exercise price. The Black-Scholes option-pricing model was used to compute
the fair value of each option granted for purposes of the pro forma disclosures
required by SFAS 123.
 
                                       34
<PAGE>   36
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
(l) Earnings per common share
 
     In February 1997 the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128 ("SFAS 128") "Earnings Per Share."
This statement established new standards for computing and presenting earnings
per share which was adopted by the Company in 1997. SFAS 128 supercedes
Accounting Principles Board Opinion No. 15 "Earnings Per Share" and purports to
simplify the standards for computing earnings per share and make such
computations comparable with international standards.
 
     Basic earnings per common share ("Basic EPS") has been computed based on
the weighted average number of common shares outstanding. Diluted earnings per
common share ("Diluted EPS") has been computed based on the weighted average
number of common shares outstanding, increased by the number of additional
common shares that would have been outstanding if the dilutive potential common
shares had been issued. All share and per share data has been retroactively
adjusted to reflect a 2-for-1 stock split in the form of a stock dividend
effective February 26, 1999 (see Note 13).
 
     The weighted average shares outstanding for 1998, 1997 and 1996 are as
follows:
 
<TABLE>
<CAPTION>
                                                                1998          1997          1996
                                                                ----          ----          ----
<S>                                                          <C>           <C>           <C>
Basic weighted average shares outstanding................    33,812,062    28,954,466    27,302,266
Dilutive effect of stock options.........................       163,998        93,210            --
                                                             ----------    ----------    ----------
Diluted weighted average shares outstanding..............    33,976,060    29,047,676    27,302,266
                                                             ==========    ==========    ==========
</TABLE>
 
(m) Comprehensive income
 
     During 1997 the Financial Accounting Standards Board adopted Statement of
Financial Accounting Standards No. 130 ("SFAS 130") "Reporting Comprehensive
Income". Effective for periods beginning after December 15, 1997, SFAS 130
establishes new rules for the reporting and display of comprehensive income and
its components. SFAS 130 requires that the total of other comprehensive income
for a period be transferred to a component of equity that is displayed
separately from retained earnings and additional paid-in capital. The Company's
only component of comprehensive income, foreign currency translation
adjustments, is included in accumulated other comprehensive income in the
"Statements of Consolidated and Combined Equity."
 
(n) Reclassifications
 
     Certain previously reported amounts have been reclassified to conform with
the 1998 presentation.
 
(5) INTANGIBLE ASSETS
 
     Intangible assets, including goodwill, are amortized on the straight-line
basis over their estimated useful lives. In connection with the acquisition of
Logicus, intangibles of $344,000 were acquired during 1998. Intangibles of
$1,548,000 were acquired during 1996 in connection with the acquisition of IPS.
Subsequently, in February 1997, the IPS purchase agreement was amended providing
for the release of the $1.5 million held in escrow and the issuance of $500,000
in Common Stock in settlement of the contingent consideration upon closing of
the Offering. This caused goodwill to increase by $415,177 ($500,000 in stock
less $84,823 in interest related to the escrow funds).
 
                                       35
<PAGE>   37
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
     Intangible assets consisted of the following at December 31:
 
<TABLE>
<CAPTION>
                                                        1998      1997     USEFUL LIFE
                                                        ----      ----     -----------
                                                               (IN THOUSANDS)
<S>                                                    <C>       <C>       <C>
Algorithms and software code.......................    $  854    $  510     2-5 years
Tradename..........................................       210       210      10 years
Assembled workforce................................        90        90       7 years
Goodwill...........................................     1,153     1,153       7 years
                                                       ------    ------
Total intangibles..................................     2,307     1,963
Less -- accumulated amortization...................      (862)     (364)
                                                       ------    ------
Net intangibles....................................    $1,445    $1,599
                                                       ======    ======
</TABLE>
 
     Management periodically reviews the carrying value of its intangible
assets, including goodwill, for potential impairment. To date, no impairment of
these assets exists.
 
(6) INCOME TAXES
 
     Prior to September 29, 1997, the shareholders of ALS and the Institute had
elected to have these companies treated as "S corporations" under the Internal
Revenue Code. As an S corporation, a company's taxable income or loss is
included in the individual tax returns of its shareholders for Federal and state
income tax purposes. Accordingly, the financial statements do not include any
provision or liability for current or deferred Federal or state income taxes
related to ALS or the Institute for any periods prior to September 29, 1997.
 
     IPS was taxed as a C corporation under the provisions of the Internal
Revenue Code and similar state tax laws from the time of its acquisition on
August 1, 1996 through December 31, 1996. Therefore, included in the 1996
combined financial statements is an income tax provision and related deferred
income taxes for IPS from the date of its acquisition until the end of 1996.
Subsequently, IPS elected to be taxed as an S corporation effective January 1,
1997. Consequently, the deferred tax asset recognized in 1996 was written off in
1997.
 
     On September 29, 1997 the Company became subject to federal and state
income taxes as a C corporation. Consequently, the Company is now required to
account for income taxes in accordance with Statement of Financial Accounting
Standards No. 109 ("SFAS 109") "Accounting for Income Taxes." In connection with
this change in the Company's tax status, SFAS 109 required the Company to record
deferred taxes on the balance sheet for all book to tax basis differences
existing on the date of change to C corporation status. The financial statement
effect of recording the basis differences resulted in recognition of a deferred
tax asset and corresponding tax benefit of $3.5 million in 1997.
 
                                       36
<PAGE>   38
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
     The provision (benefit) for income taxes consisted of:
 
<TABLE>
<CAPTION>
                                                               1998          1997          1996
                                                               ----          ----          ----
                                                                        (IN THOUSANDS)
<S>                                                           <C>           <C>           <C>
Current tax provision:
  U.S. Federal..............................................  $ 7,428       $ 1,026       $    --
  State and local...........................................    1,813           191            --
                                                              -------       -------       -------
Total current tax provision.................................    9,241         1,217            --
                                                              -------       -------       -------
Deferred tax (benefit):
  U.S. Federal..............................................     (329)       (1,618)       (1,602)
  State and local...........................................      (68)         (272)           --
                                                              -------       -------       -------
Total deferred tax (benefit)................................     (397)       (1,890)       (1,602)
                                                              -------       -------       -------
Provision (benefit) for income taxes........................  $ 8,844       $  (673)      $(1,602)
                                                              =======       =======       =======
</TABLE>
 
     Effective rate reconciliation:
 
<TABLE>
<CAPTION>
                                                               1998          1997          1996
                                                               ----          ----          ----
                                                                        (IN THOUSANDS)
<S>                                                           <C>           <C>           <C>
U.S. statutory rate.........................................       35%           35%           35%
                                                              -------       -------       -------
Income tax provision at statutory tax rate..................  $ 7,550       $ 3,159       $ 1,000
State and local taxes, net of Federal tax benefit...........    1,134           175            --
(Benefit) of IPS losses.....................................       --            --        (1,602)
Deferred taxes written off in connection with IPS S
  corporation election......................................       --         1,602            --
S-corporation income not subject to tax.....................       --        (2,060)       (1,000)
Deferred tax reinstatement related to Termination of S
  corporation elections.....................................       --        (3,549)           --
Other.......................................................      160            --            --
                                                              -------       -------       -------
Provision (benefit) for income taxes........................  $ 8,844       $  (673)      $(1,602)
                                                              =======       =======       =======
</TABLE>
 
     Deferred tax assets (liabilities) consisted of the following at December
31:
 
<TABLE>
<CAPTION>
                                                               1998          1997
                                                               ----          ----
                                                                 (IN THOUSANDS)
<S>                                                           <C>           <C>
Current deferred tax assets (liabilities):
  Deferred revenue..........................................  $ 1,334       $ 1,234
  Expenses not currently deductible.........................      908           597
                                                              -------       -------
Net current deferred tax assets.............................    2,242         1,831
                                                              -------       -------
Noncurrent deferred tax assets (liabilities):
  Operating losses..........................................      155           150
  Deferred revenue..........................................      458           523
  Depreciation and amortization.............................      (43)         (144)
  Intangibles...............................................    1,221         1,153
  Other.....................................................     (144)          (21)
                                                              -------       -------
Net noncurrent deferred tax assets..........................    1,647         1,661
                                                              -------       -------
Total deferred tax assets...................................  $ 3,889       $ 3,492
                                                              =======       =======
</TABLE>
 
                                       37
<PAGE>   39
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
     No valuation allowance has been recorded as the net deferred tax asset
related to the operating losses are assumed to be realizable through the future
profitable operations of IPS. The tax operating loss carryforward expires in
2011.
 
(7) LINE OF CREDIT
 
     The Company has obtained a $10.0 million unsecured revolving line of credit
with a bank which is available until March 31, 2000. The line of credit bears
interest at either a floating rate based on the prime rate less 1.0%, or a fixed
rate for a period of up to 90 days based on LIBOR plus 1.25%. The rate is at the
option of the Company and is determined at the time of borrowing. As of December
31, 1998 the line of credit had not been used.
 
(8) LEASE COMMITMENTS
 
     The Company is party to various operating leases for equipment and for the
IPS office facility. Rent expense for 1998, 1997 and 1996 was approximately
$395,000, $203,000 and $159,000, respectively.
 
     Future approximate minimum rental payments (including estimated operating
costs) required under the operating leases as of December 31, 1998 are as
follows:
 
<TABLE>
                                                         (IN THOUSANDS)
                                                            --------
<S>                                                      <C>
1999...................................................     $160
2000...................................................      135
2001...................................................      137
2002...................................................      140
2003...................................................      143
</TABLE>
 
(9) DEFINED CONTRIBUTION BENEFIT PLAN
 
     The Company has a defined contribution benefit plan covering all of its
full-time employees meeting certain service requirements. The plan provides for
matching employer contributions based on 67% of employees' elective
contributions up to 6% of compensation. The plan allows employee contributions
of up to 15% of compensation. Discretionary employer contributions may also be
made to the plan. There were no discretionary contributions made in 1998, 1997
or 1996. Expense under the plan totaled approximately $370,000 in 1998, $297,000
in 1997 and $192,000 in 1996.
 
(10) PHANTOM STOCK PLAN
 
     As an incentive for certain key employees, ALS had a phantom stock plan. A
total of 585 phantom shares were issued prior to termination of the plan. Under
the terms of the plan, the completion of the Offering triggered a payout and
termination of the plan. Under the plan, each phantom share was paid an amount
equal to .001% of the market capitalization immediately after completion of the
Offering. This resulted in phantom stock plan termination expense of
approximately $1.6 million in the third quarter of 1997. Compensation expense of
approximately $21,000 was incurred in 1996 with respect to the plan.
 
(11) STOCK OPTION PLAN
 
     The Company has established the 1997 Stock Incentive Plan for its officers,
key employees, non-employee directors and consultants. A combined maximum of
3,000,000 options, SARs and share awards may be granted under the Plan. In
addition, not more than 1,500,000 shares may be subject to incentive stock
options. The exercise price of the stock options is market value of the common
stock at the date of grant.
 
                                       38
<PAGE>   40
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
Generally, the options vest and become exercisable ratably over a four-year
period, commencing one year after the grant date. The options expire 10 years
from the grant date.
 
     Had compensation cost been determined for the Company's stock option
portion of the Plan based on the fair value at the grant dates for awards
consistent with the alternative method set forth under SFAS 123, the Company's
net income and earnings per share would have been reduced to the pro forma
amounts indicated below:
 
<TABLE>
<CAPTION>
                                                     1998       1997
                                                     ----       ----
                                                      (IN THOUSANDS
                                                         EXCEPT
                                                        PER SHARE
                                                        AMOUNTS)
<S>                                                 <C>        <C>
Net income:
  As reported...................................    $12,727    $9,699
  Pro forma.....................................     11,772     9,441
Diluted net income per common share:
  As reported...................................    $  0.37    $ 0.33
  Pro forma.....................................       0.35      0.33
The weighted average fair value of options
  granted under the Plan during the year is:....    $ 10.91    $ 5.60
</TABLE>
 
     The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option pricing model with the following weighted average
assumptions for 1998 and 1997, respectively: dividend yield of 0% and 0%,
expected volatility of 58.94% and 48.14%, risk-free interest rates of 5.14% and
6.31%, and expected lives of 10 years for the options.
 
     As of December 31, 1998, no SARs or share awards have been granted under
the plan. A summary of stock option activity under the plan for 1998 and 1997 is
as follows:
 
<TABLE>
<CAPTION>
                                                          1998                         1997
                                                -------------------------    -------------------------
                                                              WEIGHTED                     WEIGHTED
                                                              AVERAGE                      AVERAGE
                                                SHARES     EXERCISE PRICE    SHARES     EXERCISE PRICE
                                                ------     --------------    ------     --------------
<S>                                             <C>        <C>               <C>        <C>
Outstanding at beginning of year............    479,910        $ 8.22             --        $  --
Granted.....................................    422,952         14.88        490,536         8.21
Exercised...................................    (30,814)         8.00             --           --
Cancelled...................................    (92,572)         9.70        (10,626)        8.00
                                                -------        ------        -------        -----
Outstanding at end of year..................    779,476         11.66        479,910         8.22
                                                =======        ======        =======        =====
Options exercisable at end of year..........     95,135          8.24             --           --
                                                =======        ======        =======        =====
</TABLE>
 
(12) EMPLOYEE STOCK PURCHASE PLAN
 
     Effective July 1, 1998, the Company adopted an Employee Stock Purchase Plan
which allows employees to purchase shares of common stock through payroll
deductions, up to 10% of eligible compensation. The purchase price is equal to
85% of the fair market value of the common stock on either the first or last day
of the subscription period, whichever is lower. A total of 500,000 shares are
available for purchase under the plan. The Company has elected to apply
Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to
Employees," in accounting for its stock-based plans. Accordingly, the Company
will not recognize compensation expense for employee stock purchases. In January
1999, approximately 18,800 shares were issued to employees at $11.85 with
respect to the 1998 plan.
 
                                       39
<PAGE>   41
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
(13) SHAREHOLDERS' EQUITY
 
     The Company's amended and restated articles of incorporation includes
authorization to issue up to 50,000,000 shares of common stock with a $.01 par
value and up to 5,000,000 shares of preferred stock with a $.01 par value. No
preferred stock has been issued. On January 18, 1999, the board of directors of
the Company authorized a 2-for-1 split of common stock in the form of a stock
dividend payable on February 26, 1999 to shareholders of record on February 11,
1999. Accordingly, all share and per share data presented herein have been
restated to reflect this split.
 
     In 1997 a 133.31-for-1 stock split was effected in the form of two common
stock dividends which took place on March 28 and August 21, 1997. Also, in 1997,
640,266 common shares were issued in exchange for all of the outstanding shares
of the Institute and IPS. Accordingly, shares issued and outstanding on the face
of the balance sheet and all historical weighted average share and per share
amounts have been restated to reflect the stock split and the common stock
issued in exchange for the shares of the Institute and IPS.
 
     The Company issued a total of 6,440,000 common shares during 1997 in a
public offering (see Note 14). Additionally, 62,500 common shares were issued in
settlement of the purchase of IPS (see Note 3). As of December 31, 1998,
3,000,000 common shares were reserved for issuance under the 1997 Stock
Incentive Plan (see Note 11).
 
(14) OFFERING OF COMMON STOCK
 
     On September 30, 1997, the Company completed the Offering of 5,600,000
shares of common stock. As a result of this Offering, the Company received net
cash proceeds of $41,664,000 on the September 30, 1997 closing date. In
addition, the Company incurred approximately $941,000 in costs associated with
the Offering. This resulted in a net increase to shareholders' equity of
$40,723,000. Subsequently, on October 2, 1997, an additional 840,000 shares of
the Company's common stock were sold pursuant to the exercise of an over-
allotment option granted in connection with the Offering. The Company received
additional net proceeds of $6,249,200 in connection with the exercise of this
over-allotment option all of which was accounted for as an increase to
shareholders' equity.
 
     From September 1997 through December 31, 1998, the proceeds from the
Offering were used as follows:
 
     - Approximately $1.6 million was used to pay compensation expenses related
       to the termination of the Company's phantom stock plan.
 
     - Approximately $7.2 million was used to pay the entire principal and
       accrued interest on the mortgage note and an unsecured note, both related
       to the construction of the Company's facility in Wisconsin Rapids,
       Wisconsin.
 
     - Approximately $5.1 million was used to pay the entire principal and
       accrued interest on notes from the Company's principal shareholders
       related to the 1996 acquisition of IPS.
 
     - Approximately $10.9 million was used to pay distributions of S
       corporation retained profits to S corporation shareholders.
 
     - Approximately $6.4 million was used to invest in Athena Holdings LLC, a
       limited liability company formed for the purpose of constructing the
       Company's facility in Madison, Wisconsin.
 
     - Approximately $700,000 was used for pilot operations in various markets
       and miscellaneous acquisitions.
 
                                       40
<PAGE>   42
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
(15) SEGMENT REPORTING
 
     During 1997 the Financial Accounting Standards Board adopted Statement of
Financial Accounting Standards No. 131 ("SFAS 131") "Disclosures about Segments
of an Enterprise and Related Information." SFAS 131 significantly changes the
disclosures required for the segments of a business but does not change income
measurement principles. The annual reporting requirements of SFAS 131 are
effective for fiscal years beginning after December 15, 1997. The adoption of
SFAS 131 did not have any impact on financial results of the Company.
 
     The Company's reportable segments are strategic business units that offer
different products and services. They are managed separately because each
business requires different technology and marketing strategies. The Company has
two reportable segments: software and training.
 
     The software segment produces learning information system software for the
K-12 school market in the United States and Canada. The software assists
educators in assessing and monitoring student development by increasing the
quantity, quality, and timeliness of student performance data in the areas of
reading, math and writing. Revenue from the software segment includes product
revenue from the sale of software and service revenue from the sale of software
support agreements.
 
     The training segment provides professional development training seminars.
The program trains educators how to accelerate learning in the classroom through
use of the information that the Company's learning information systems provide.
The training program includes a variety of seminars presented in hotels and
schools across the country.
 
     The accounting policies of the reportable segments are the same as those
described in Note 4 of Notes to Financial Statements. The Company evaluates the
performance of its operating segments based on operating income before
nonrecurring items. Intersegment sales and transfers and revenue derived outside
of the United States are not significant.
 
     Summarized financial information concerning the Company's reportable
segments is shown in the following table:
 
<TABLE>
<CAPTION>
                                                                SOFTWARE    TRAINING     TOTAL
                                                                --------    --------     -----
                                                                        (IN THOUSANDS)
<S>                                                             <C>         <C>         <C>
1998
  Revenues..................................................    $46,859      $7,905     $54,764
  Operating income(1).......................................     20,663        (274)     20,389
  Total assets..............................................     56,480      11,516      67,996
  Capital expenditures......................................      1,069       7,396       8,465
  Depreciation and amortization.............................      1,875         212       2,087
1997
  Revenues..................................................    $30,098      $5,926     $36,024
  Operating income(1).......................................     10,609         105      10,714
  Total assets..............................................     49,210       1,673      50,883
  Capital expenditures......................................      1,291         402       1,693
  Depreciation and amortization.............................      1,362         116       1,478
1996
  Revenues..................................................    $19,347      $3,034     $22,381
  Operating income(1).......................................      7,318        (905)      6,413
  Total assets..............................................     18,843       1,012      19,855
  Capital expenditures......................................      9,587         311       9,898
  Depreciation and amortization.............................        655          56         711
</TABLE>
 
                                       41
<PAGE>   43
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
-------------------------
 
(1) Operating income Total differs from Operating income in the Consolidated and
    Combined Statements of Income due to nonrecurring items not included above:
    $475,000 purchased research and development in 1998; $1.6 million phantom
    stock plan termination in 1997; and $3.4 million purchased research and
    development in 1996.
 
     The information about the segments presented above is in compliance with
SFAS 131 reporting requirements. The reported measures are consistent with those
used in measuring amounts in the consolidated financial statements. Such
measurements are generally along legal entity lines as aggregated.
 
     It is management's opinion, however, that because many flows of value
between the reporting entities can not be precisely quantified, this information
provides an incomplete measure of the training segment profit or loss, and may
be subject to misinterpretation. The chief operating officer evaluates the
performance of the training segment based on many factors not captured by the
financial accounting system and often evaluates the company's financial
performance on a total entity basis.
 
(16) QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
 
     The following table sets forth unaudited consolidated and combined income
statement data for each quarter of the Company's last two fiscal years. The
unaudited quarterly financial information has been prepared on the same basis as
the annual information presented in the financial statements and, in
management's opinion, reflects all adjustments (consisting of normal recurring
entries) necessary for a fair presentation of the information provided. The
operating results for any quarter are not necessarily indicative of results for
any future period.
 
<TABLE>
<CAPTION>
                                                                  QUARTER ENDED
                                                                  -------------
                                                MARCH 31    JUNE 30    SEPTEMBER 30    DECEMBER 31
                                                --------    -------    ------------    -----------
                                                     (IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
<S>                                             <C>         <C>        <C>             <C>
1998:
  Net sales.................................    $10,623     $11,721      $15,019         $17,401
  Gross profit..............................      8,857       9,917       12,800          14,688
  Operating income..........................      2,742       3,349        6,221           7,601
  Income tax provision......................      1,347       1,551        2,676           3,269
  Net income................................      1,899       2,274        4,009           4,545
  Basic and diluted earnings per share......       0.06        0.07         0.12            0.13
  Common stock price per share:
     High...................................     17.188      19.375       20.250          33.188
     Low....................................     10.719      12.375       12.000          16.375
1997:
  Net sales.................................    $ 7,813     $ 8,732      $ 9,653         $ 9,826
  Gross profit..............................      6,314       7,250        7,898           8,110
  Operating income..........................      2,310       2,806        1,305           2,675
  Income tax provision (benefit)............      1,602          --       (3,505)          1,231
  Net income................................        541       2,609        4,639           1,909
  Basic and diluted earnings per share......       0.02        0.10         0.17            0.06
  Common stock price per share:
     High...................................         --          --       12.625          14.125
     Low....................................         --          --       11.063          10.000
</TABLE>
 
     1. Per share data have been restated to reflect a 2-for-1 stock split in
        the form of a dividend effective February 26, 1999 (see Note 13).
 
                                       42
<PAGE>   44
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
     2. In connection with the acquisition of Logicus, $475,000 of the purchase
        price was allocated to purchased research and development which was
        expensed in June 1998 (see Note 3).
 
     3. The Company's phantom stock plan terminated in connection with
        completion of the Offering of its common stock, resulting in a $1.6
        million charge to operating income in September 1997 (see Note 10).
 
     4. The Company's S corporation election was terminated in connection with
        completion of the Offering of its common stock. The Company was required
        to adopt SFAS 109 and to record a deferred tax asset and corresponding
        tax benefit for all timing differences existing on the date of the tax
        status change. This resulted in a $3.5 million tax benefit in September
        1997 (see Note 6).
 
     5. Effective January 1, 1997, IPS elected S corporation status and wrote
        off the deferred tax asset associated with its 1996 net operating losses
        (see Note 6).
 
                                       43
<PAGE>   45
 
                                    PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     (a) Executive Officers. Reference is made to "Executive Officers of the
Registrant" in Part I hereof.
 
     (b) Directors. The information required by this Item is set forth in the
Company's Proxy Statement for the Annual Meeting of Shareholders to be held on
April 14, 1999 under the caption "Election of Directors," which information is
incorporated by reference herein.
 
     (c) Section 16 Compliance. The information required by this Item is set
forth in the Company's Proxy Statement for the Annual Meeting of Shareholders to
be held on April 14, 1999 under the caption "Section 16(a) Beneficial Ownership
Reporting Compliance," which information is incorporated by reference herein.
 
ITEM 11. EXECUTIVE COMPENSATION
 
     The information required by this Item is set forth in the Company's Proxy
Statement for the Annual Meeting of Shareholders to be held on April 14, 1999
under the captions "Executive Compensation," "Employment Agreements,"
"Non-Employee Director Compensation," "Compensation Committee Report," and
"Performance Graph," which information is incorporated by reference herein.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     The information required by this Item is set forth in the Company's Proxy
Statement for the Annual Meeting of Shareholders to be held on April 14, 1999
under the caption "Security Ownership of Management and Certain Beneficial
Owners," which information is incorporated by reference herein.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     Not applicable.
 
                                       44
<PAGE>   46
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
(A)(1) FINANCIAL STATEMENTS.
 
     Combined and Consolidated Financial Statements.
 
        Report of Independent Public Accountants
 
        Consolidated Balance Sheets as of December 31, 1998 and 1997
 
        Consolidated and Combined Statements of Income for the years ended
        December 31, 1998, 1997 and 1996
 
        Statements of Consolidated and Combined Equity for the years ended
        December 31, 1998, 1997, and 1996
 
        Consolidated and Combined Statements of Cash Flows for the years ended
        December 31, 1998, 1997 and 1996
 
        Notes to Financial Statements
 
(A)(2) FINANCIAL STATEMENT SCHEDULES.
 
    See the Exhibit Index, which is incorporated by reference herein.
 
(A)(3) EXHIBITS.
 
    See (c) below.
 
(B) REPORTS ON FORM 8-K.
 
     There were no reports on Form 8-K filed for the three months ended December
31, 1998.
 
(C) EXHIBITS.
 
    See the Exhibit Index, which is incorporated by reference herein.
 
(D) FINANCIAL STATEMENTS EXCLUDED FROM ANNUAL REPORT TO SHAREHOLDERS.
 
    Not applicable.
 
                                       45
<PAGE>   47
 
                                   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.
 
                                          ADVANTAGE LEARNING SYSTEMS, INC.
 
                                          By:   /s/ MICHAEL H. BAUM
                                             -----------------------------------
                                                      Michael H. Baum
                                                  Chief Executive Officer
 
                                          Date: March 11, 1999
 
     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 and in the capacities and on the dates indicated:
 
<TABLE>
<CAPTION>
                          NAME                                           TITLE                 DATE
                          ----                                           -----                 ----
<S>                                                            <C>                        <C>
                  /s/ MICHAEL H. BAUM                          Chief Executive Officer
--------------------------------------------------------       and a Director (Principal
                    Michael H. Baum                            Executive Officer)         March 11, 1999
 
                  /s/ TIMOTHY SHERLOCK                         Secretary, Vice President
--------------------------------------------------------       and Chief Financial
                    Timothy Sherlock                           Officer (Principal         March 11, 1999
                                                               Financial and Accounting
                                                               Officer)
 
   Directors: Judith A. Paul, Terrance D. Paul, John R. Hickey, Timothy P. Welch, Perry S. Akins and
              John H. Grunewald
 
By:              /s/ MICHAEL H. BAUM                                                      March 11, 1999
   -----------------------------------------------------
                       Michael H. Baum
                      Attorney-In-Fact*
</TABLE>
 
-------------------------
*Pursuant to authority granted by powers of attorney, copies of which are filed
herewith.
 
                                       46
<PAGE>   48
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER                               EXHIBIT
    -------                              -------
    <C>        <S>
      3.1      Amended and Restated Articles of Incorporation of Advantage
               Learning Systems, Inc.(1)
      3.2      Amended and Restated By-laws of Advantage Learning Systems,
               Inc.(1)
      4.1      Form of Stock Certificate.(2)
     10.1      Asset Purchase Agreement dated as of August 1, 1996 by and
               among IPS Acquisition, Inc., IPS Publishing, Inc. and
               Timothy P. Welch, individually and as sole Trustee of the
               Timothy P. Welch Revocable Trust.(1)
     10.2      Supplement to Asset Purchase Agreement dated as of February
               25, 1997, by and among IPS Publishing, Inc. (f/k/a IPS
               Acquisition, Inc.), Welch Publishing, Inc. (f/k/a IPS
               Publishing, Inc.) and Timothy P. Welch, individually and as
               sole Trustee of the Timothy P. Welch Revocable Trust.(1)
     10.3      Employment Agreement between IPS Publishing, Inc. (f/k/a IPS
               Acquisition, Inc.) and Timothy P. Welch dated as of August
               1, 1996.(1)*
     10.4      1997 Stock Incentive Plan (as amended and restated).(3)*
     10.5      Advantage Learning Systems, Inc. Phantom Stock Plan.(1)*
     10.6      Institute for Academic Excellence, Inc. Phantom Stock
               Plan.(1)*
     10.7      Accelerated Reader Resale Agreement dated May 1, 1994,
               between Advantage Learning Systems, Inc. and Perma-Bound, a
               division of Hertzberg-New Method, Inc.(1)
     10.8      Promissory Note dated August 1, 1996 in the principal amount
               of $2,350,000 from IPS Publishing, Inc. to Judith A.
               Paul.(1)
     10.9      Promissory Note dated August 1, 1996 in the principal amount
               of $2,350,000 from IPS Publishing, Inc. to Terrance D.
               Paul.(1)
     10.10     Credit Agreement dated as of December 31, 1997, by and
               between Norwest Bank Wisconsin, National Association and
               Advantage Learning Systems, Inc.(4)
     10.11     Tax Indemnification Agreement between Terrance Paul, Judith
               Paul, Mark J. Bradley, as Trustee of the Terrance and Judith
               Paul Descendants' Trust, and Advantage Learning Systems,
               Inc.(2)
     10.12     Tax Indemnification Agreement between Terrance Paul, Judith
               Paul, Mark J. Bradley, as Trustee of the Terrance and Judith
               Paul Descendants' Trust, and the Institute for Academic
               Excellence, Inc.(2)
     10.13     Advantage Learning Systems, Inc. Employee Stock Purchase
               Plan(5)*
     10.14     Office Lease dated as of December 17, 1998 by and between
               Athena Holdings LLC and Institute for Academic Excellence,
               Inc.
     10.15     Real Estate Mortgage dated December 17, 1998 between Athena
               Holdings LLC and Advantage Learning Systems, Inc.
     21.1      Subsidiaries of Advantage Learning Systems, Inc.
     23.1      Consent of Arthur Andersen LLP.
     24.1      Directors' Powers of Attorney.
     27.1      Financial Data Schedule.
     99.1      Schedule II -- Valuation and Qualifying Accounts.
</TABLE>
 
-------------------------
(1) Incorporated by reference to the Company's Registration Statement on Form
    S-1 (Registration No. 333-22519).
(2) Incorporated by reference to the Company's Form 10-Q for the quarter ended
    September 30, 1997 (SEC File No. 0-22187).
(3) Incorporated by reference to the Company's Form S-8 filed on October 28,
    1997 (Registration No. 333-38867).
(4) Incorporated by reference to the Company's Form 10-K for the fiscal year
    ended December 31, 1997 (SEC File No. 0-22187).
(5) Incorporated by reference to the Company's Proxy Statement for the 1999
    Annual Meeting of shareholders.
 *  Management contracts or compensatory plans or arrangements.