<PAGE>   1
 
================================================================================
 
                       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, 1997
 
                                        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
       incorporation or organization)                       Identification No.)
 
              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. [ ]
 
     The aggregate market value of the voting stock held by nonaffiliates of the
Registrant was approximately $85,760,580 as of February 27, 1998. As of February
27, 1998, there were 16,902,383 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 28, 1998.
================================================================================
<PAGE>   2
 
                                     PART I
 
ITEM 1. BUSINESS
 
     Unless the context requires otherwise, references to the Company include
its two wholly-owned subsidiaries, the Institute for Academic Excellence, Inc.
(the "Institute") and IPS Publishing, Inc. ("IPS").
 
                                    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.
 
     The Company's flagship product, the Accelerated Reader,* is software for
motivating and monitoring increased literature-based reading practice. As of
December 31, 1997, the Accelerated Reader had been sold to approximately 33,000,
or 26%, of the K-12 schools in the United States and Canada. The Company
believes that the Accelerated Reader has achieved this 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 the Standardized Test for Assessment of
Reading (S.T.A.R.),* a computer-adaptive reading test and database, and the
Reading Renaissance* program through which the Company provides professional
development training for educators.
 
     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,
1997, the Company had developed quizzes on approximately 13,500 book titles. In
1994, the Company began offering Reading Renaissance training seminars through
the Institute to provide educators with professional development training to
most effectively use the Accelerated Reader and the information it generates. As
of December 31, 1997, approximately 60,000 educators have attended Reading
Renaissance training seminars. In 1996, the Company released STAR which enables
educators to quickly obtain student reading scores statistically correlated to
national norms. The results from STAR 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. The Company began marketing STAR in the spring of 1996, and by the
end of 1997, had sold STAR to approximately 8,100 schools. To expand its
learning information system product offerings into additional academic areas, in
August 1996 the Company acquired IPS, a provider of algorithm-based software for
assessment and skills practice in math and science.
 
     The Company was founded in 1986 and is incorporated under the laws of the
State of Wisconsin. The Company's common stock, par value $0.01 per share (the
"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).
 
                              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. President Clinton's emphasis
on education in his recent State of the Union address, the Department of
Education's Goals 2000 program, the Learning to Read, Reading to Learn campaign,
an increase in Title I funding, and the activities
 
---------------
 
     * The Accelerated Reader(R), Reading Renaissance(R) and Standardized Test
for Assessment of Reading (S.T.A.R)(R) are registered trademarks of the Company.
STAR(TM) is a common law trademark of the Company.
<PAGE>   3
 
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 1996 data from Quality Education Data, Inc. ("QED"), the K-12
marketplace in the United States consists of approximately 107,500 public and
private schools. According to the National Center for Education Statistics, the
number of students enrolled in these schools was approximately 51.7 million in
1996 and is expected to increase to 54.6 million by the year 2006. According to
QED, K-12 public schools in the United States invested $4.1 billion on
educational technologies in 1996. Of this amount, industry sources estimate that
approximately $630 million was invested in educational software, which amount is
expected to increase to $1.1 billion by the year 2000, representing a 15%
compound annual increase. Moreover, according to data obtained from the Software
Publishers Association, the installed base of computers in K-12 schools in the
United States will grow from approximately 5.5 million units in 1995 to 10.0
million units by the year 2000, a 13% compound annual increase.
 
     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
which improve student academic performance by intensifying literature-based
reading practice and increasing the quality, quantity and timeliness of
information available to educators. Until recently, the Company's products have
focused exclusively on improving reading because reading is fundamental to a
student's overall academic performance. The Company's flagship product, the
Accelerated Reader, administers computer-based multiple choice quizzes on
approximately 13,500 books popular among students in grades K-12. Each quiz
verifies that the student has read and comprehended a book. For each book read,
the Accelerated Reader tracks the amount of reading practice by calculating
points based on the length and difficulty of the book and the student's
performance on the quiz, and makes these data available to educators through a
variety of reports. STAR, the Company's computer-adaptive reading test and
database, supplies educators with norm-referenced reading scores for each of
their students typically in 10 minutes or less by selecting test questions based
on a student's pattern of previous responses. Because STAR can be administered
several times per year, it provides educators with a database of reading level
information that enables tracking of students' progress through the school
 
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<PAGE>   4
 
year. The Company's Reading Renaissance professional development training
combines the Company's learning information systems technology and classroom
techniques to improve reading performance by increasing in-school accountable
reading practice.
 
     The Company believes the combination of the Accelerated Reader, STAR and
Reading Renaissance offers 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 Accelerated Reader,
coupled with the techniques taught in the Reading Renaissance training program,
improves student academic performance by providing educators with an effective
system to motivate students to practice reading and encourage students to select
longer, more challenging books. 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 Institute
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 Accelerated Reader and STAR 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 Accelerated Reader and STAR
are easy to use by both students and educators and are capable of running on
substantially all of the computers and hardware platforms currently found in
K-12 schools. Even schools with a limited number of computers can use the
Company's products since these products emphasize literature reading by the
student and do not require extensive individual time on the computer. In
addition, the Accelerated Reader is used in conjunction with books already
commonly found in most K-12 school libraries.
 
     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 reading ability, and ultimately in other 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, 1997,
the Accelerated Reader has been sold to approximately 33,000 K-12 schools, which
represents approximately 26% of the total number of schools in the United States
and Canada and an approximately 27% increase in the number of schools using the
Accelerated Reader over the prior year. In addition, as of December 31, 1997,
STAR has been sold to approximately 8,100 K-12 schools. 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 Accelerated Reader has been sold to approximately 26% of
the K-12 schools in the United States and Canada, most schools begin using the
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<PAGE>   5
 
product 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 has been that increased use of the Accelerated Reader
leads to increased sales of supplemental title disks, STAR and Reading
Renaissance professional development training. To increase the use of its
products, the Company continuously develops quizzes on new book titles,
publishes newsletters, catalogs and research relating to the effectiveness of
its products, sponsors seminars and maintains communication with customers
through its telephone sales force. The Company expects to develop quizzes on at
least 6,000 additional book titles in 1998.
 
     Offer New Products in Other Curriculum Areas. The Company intends to
develop groups of products similar to its reading products for other areas of
the K-12 curriculum. Based on technology acquired in its purchase of IPS and on
additional internal development efforts, the Company is developing math products
similar to the Accelerated Reader and STAR.
 
     Expand International Marketing and Sales. The Company intends to expand its
international marketing and sales. To date, the Company has marketed and sold
the Accelerated Reader in Canada and to several schools in the United Kingdom,
which have begun using it on a pilot basis. In addition, IPS markets and sells
Spanish bilingual versions of its math products in the United States and
neighboring Spanish-speaking countries. 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. In addition, the Company intends to seek strategic alliances
with other firms with an interest in education and literacy.
 
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<PAGE>   6
 
                                    PRODUCTS
 
     OVERVIEW
 
     As of March 1, 1998, the Company offered three core products for use in the
K-12 marketplace: the Accelerated Reader, STAR and Reading Renaissance.
Together, these learning information system products improve student academic
performance by intensifying literature-based reading practice and increasing the
quality, quantity and timeliness of information available to educators. The
Company's products historically have concentrated on reading. The Company is
expanding its product offerings into math based on technology acquired in its
August 1996 acquisition of IPS.
 
     The following table summarizes the Company's primary product offerings as
of March 1, 1998:
 
<TABLE>
<CAPTION>
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                   PRODUCT                                                  DESCRIPTION
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<S>                                                <C>
 Accelerated Reader                                Reading practice management software; available in Starter
                                                   Kits (150-200 book titles), Economy Kits (includes 850-1,000
                                                   book titles, Enhanced Support Plan for the Accelerated Reader
                                                   and a voucher to attend a one-day Reading Renaissance training
                                                   seminar) or Super Kits (includes the Accelerated Reader
                                                   Economy Kit, STAR schoolwide kit and Enhanced Support Plan for
                                                   STAR)
-----------------------------------------------------------------------------------------------------------------
 Accelerated Reader supplemental quiz disks        Computer disks containing supplemental quizzes on additional
                                                   book titles to expand Starter, Economy or Super Kits
                                                   (approximately 50 book titles per disk); currently quizzes on
                                                   13,500 book titles available
-----------------------------------------------------------------------------------------------------------------
 AR BookGuide                                      Database listing of all books covered by Accelerated Reader
                                                   quizzes
-----------------------------------------------------------------------------------------------------------------
 STAR                                              Computer-adaptive reading test and database
-----------------------------------------------------------------------------------------------------------------
 Enhanced Support Plans ("ESP")                    Two-year contracts for telephone support of software
                                                   (available for the Accelerated Reader and STAR)
-----------------------------------------------------------------------------------------------------------------
 Reading Renaissance                               Professional development training for educators; delivered
                                                   through scheduled seminars and school sponsored events
-----------------------------------------------------------------------------------------------------------------
 Math and Science Products                         Off-the-shelf and custom math and science quiz and worksheet
                                                   generators, and student objective and achievement databases
-----------------------------------------------------------------------------------------------------------------
 Other Related Products                            Video and printed training materials, graphics and
                                                   motivational items
-----------------------------------------------------------------------------------------------------------------
</TABLE>
 
     THE ACCELERATED READER
 
     The Accelerated Reader is a learning information system for motivating and
monitoring increased literature-based reading practice. As of December 31, 1997,
the Accelerated Reader has been sold to approximately 33,000 K-12 schools in the
United States and Canada. The Accelerated Reader and supplemental Accelerated
Reader quiz disks accounted for approximately 51.5%, 69.4% and 89.8% of the
Company's net sales in 1997, 1996 and 1995, respectively.
 
     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 the 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
 
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<PAGE>   7
 
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 13,500 book titles. The Company
developed quizzes on approximately 3,500 book titles in 1997 and expects to
develop quizzes on at least 6,000 additional book titles in 1998. Titles on disk
are organized by reading level and subject matter. Continued usage of the
Accelerated Reader creates demand for additional quizzes, STAR, Reading
Renaissance training and related products.
 
     During 1997, the Company successfully developed several new 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.
 
     STANDARDIZED TEST FOR ASSESSMENT OF READING (S.T.A.R.)
 
     STAR is a computer-adaptive reading test which the Company believes is the
first software to provide reading scores statistically correlated to national
norms in ten minutes or less at the computer. STAR administers a series of
multiple choice questions for which students choose the best word to complete
each sentence. STAR 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 is
easy to use and can be administered several times per year. The Company
announced STAR in the spring of 1996 and started shipping it to customers in the
fall of 1996. As of December 31, 1997, STAR has been sold to approximately 8,100
schools. Revenues from sales of STAR contributed significantly to the Company's
net sales in 1997 and to a lesser extent in 1996.
 
     ENHANCED SUPPORT PLANS
 
     The Company offers Enhanced Support Plans which provide users of the
Accelerated Reader and STAR access to telephone support and other benefits such
as free or reduced-cost upgrades. Packaged with some 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.
 
     READING RENAISSANCE
 
     The Reading Renaissance program provides educators with professional
development training to most effectively use the Accelerated Reader, STAR and
the learning information they generate. This training combines technology and
classroom techniques to increase in-school accountable reading practice. Through
the Institute, 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 Institute's training staff
visit an individual school, school district or region to conduct a seminar or
workshop. As of March 1, 1998, the Institute's training staff consisted of 46
presenters, most of whom are K-12 educators who use the Reading Renaissance
techniques in their own classrooms. Since its inception in late 1993, the
Institute has trained approximately 60,000 educators, of whom approximately
35,000 were trained in 1997.
 
     To encourage educators who have completed Reading Renaissance training to
implement the methodology fully, the Institute 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
 
---------------
 
     *AR BookGuide(TM) and AR TitleFinder(TM) are common law trademarks of the
Company.
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<PAGE>   8
 
variables. As of March 1, 1998, the program has received approximately 4,850
applications and certified 1,872 "Model Classroom" teachers, and 60 "Model
Schools" in which the majority of classrooms have "Model Classroom" teachers.
 
     The Company also produces videotapes and manuals to be used in conjunction
with its training programs, and in 1997, began publishing Advantage, a magazine
distributed to over 200,000 educators. Further, through the Institute, 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. Revenues from Reading Renaissance training
services accounted for approximately 16.0%, 13.1% and 6.1% of the Company's net
sales in 1997, 1996 and 1995, respectively.
 
     MATH AND SCIENCE PRODUCTS
 
     Through its subsidiary, IPS, the Company develops algorithm-based software
for assessment and skills practice in math and science. As of March 1, 1998, IPS
had a proprietary library of more than 40,000 algorithms, each capable of
generating virtually unlimited variations of specific math and science problems.
These algorithms are incorporated into off-the-shelf software for sale to
educators and custom software developed primarily for educational textbook
publishers and school districts. Current products include Objective Tracker* and
MathCheck.* Objective Tracker is a quiz and worksheet generator which allows
educators, schools and school districts to specify precise academic objectives
and track the attainment of those objectives for each student. Objective Tracker
is available in both off-the-shelf and custom forms. The Company is currently
using IPS products as a basis for developing math products similar to the
Accelerated Reader and STAR.
 
     OTHER RELATED PRODUCTS
 
     The Company sells other products to support its primary products, including
video and printed training materials, graphics and motivational items.
 
                              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, 1997, 1996 and 1995, the Company
expended approximately $3.4 million, $1.9 million and $919,000, respectively, on
product development (including amounts capitalized).
 
     As of March 1, 1998, the Company employed 62 persons dedicated to product
development and software design, including 4 Mexican quiz writers who were added
in 1997 to develop quizzes for the Spanish/English version of the Accelerated
Reader and 5 software engineers from India who were added in 1997 to give the
Company a local presence in that country. 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 product concepts which 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 product
development group and reviewed by management to determine which should be
developed into prototypes. The product development and software design groups
collaborate to create the prototypes, which are then
 
---------------
 
*Objective Tracker(TM) and MathCheck(TM) are common law trademarks of the
Company.
                                        7
<PAGE>   9
 
tested in customer schools. From this market testing, the Company creates
product specifications. However, 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 Company also continuously
expands its library of book titles by creating supplemental Accelerated Reader
quizzes and creates new algorithms and algorithm libraries for MathCheck and
Objective Tracker.
 
     The Reading Renaissance professional development training program was
originally developed, and is continually refined, through field experience with
the Accelerated Reader and research by the Institute staff. Through the
Institute, 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.
 
                       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, as of March 1, 1998, the Company had resale arrangements with
five U.S. and three Canadian book distributors which are authorized to sell the
Accelerated Reader to their customers. Sales to Perma-Bound, a division of
Hertzberg-New Method, Inc. ("Perma-Bound"), accounted for 14.4%, 15.2% and 12.5%
of the Company's net sales in 1997, 1996 and 1995, respectively. The Company
believes this growth represented maturation of Perma-Bound's field sales efforts
and anticipates that, as a percentage of net sales, sales to schools through
Perma-Bound will not significantly increase. 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 11 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 formed by IPS 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. The Company's full-time computer programming
staff support the telephone service representatives by helping to answer
customer questions by recreating the customer's problem in the Company's
simulation laboratory.
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                                   PRODUCTION
 
     Currently, all of the Company's software products are distributed on
diskettes, except for AR BookGuide and AR TitleFinder which are distributed on
CD-ROM. The Accelerated Reader and STAR disks are duplicated and packaged at
Company headquarters, with the exception of Apple II disks which are produced by
a third-party contractor. CD-ROM disks for AR BookGuide and AR TitleFinder are
also produced by a third-party contractor. Other related products, including
videotapes, books, graphics and motivational items, are purchased from
third-party vendors. IPS's math and science custom software products are
produced at its offices in Vancouver, Washington and provided to customers in
master form which allows the customer to duplicate the software. IPS's
off-the-shelf products such as MathCheck are also produced by in-house staff,
but duplicated by a third-party contractor.
 
                                  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., Broderbund Software, Inc., and The Learning
Company, Inc. The Company also competes with certain other companies, including
The Electronic Bookshelf Inc. and Booksharp, which offer software products which
are more directly competitive with the products offered by the Company. 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 by IPS 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.
 
                                        9
<PAGE>   11
 
                                   EMPLOYEES
 
     As of March 1, 1998, the Company had 343 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
 
     Because ALS generally ships products as orders are received, it has
historically operated with very little or no backlog. The Institute and IPS,
however, operate in the normal course of business with backlogs. As of December
31, 1997 and 1996, the Institute had backlogs which aggregated approximately
$658,000 and $320,000, respectively, and IPS had backlogs which aggregated
approximately $74,000 and $285,000, respectively. With respect to the Institute,
all of the backlog existing at December 31, 1997 is expected to be eliminated by
the end of 1998 and with respect to IPS, all of the backlog existing at December
31, 1997 is expected to be eliminated by the end of 1998.
 
                           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, 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 51.5%, 69.4% and 89.8% of the Company's net sales in
1997, 1996 and 1995, respectively. In addition, revenues from the Accelerated
Reader family of products, including STAR and AR BookGuide, constituted
substantially all of the Company's product sales in 1997, 1996 and 1995. See
Item 7, Management's Discussion and Analysis of Financial Condition and Results
of Operations. Sales of the Company's products through one book distributor
accounted for 14.4%, 15.2% and 12.5% of net sales in 1997, 1996 and 1995,
respectively. An overall decline in sales of the Accelerated Reader,
supplemental quiz disks, STAR 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.
 
                                       10
<PAGE>   12
 
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 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, Georgia,
California and North Carolina, which accounted for approximately $7,620,000,
$2,470,000, $2,148,000, $1,650,000 and $1,608,000, respectively, of the
Company's net sales in 1997. 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. 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. 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
                                       11
<PAGE>   13
 
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.
Furthermore, the Company has key person life insurance on Mr. Paul. 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. Further, because products are
generally shipped as orders are received, the Company has historically operated
with virtually no backlog. Thus, revenues in any quarter are substantially
dependent on the quantity of product orders received in that quarter. Seasonal
variations in demand may 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 by IPS 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 February 27, 1998, 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 74.8% 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
 
                                       12
<PAGE>   14
 
securities markets. 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 13,679,449 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 1,500,000 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.
 
     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.
 
ITEM 2. PROPERTIES
 
     The Company's headquarters are in Wisconsin Rapids, Wisconsin. The Company
owns its headquarters, consisting of a 125,000 square foot building which was
completed in December 1996. Approximately two-thirds of the headquarters
building is currently occupied. The Company leases its former office facility in
Wisconsin Rapids, Wisconsin under a two year lease which expires in June 1999
and which provides the tenant with an option to purchase the property.
 
     The Institute leases approximately 16,400 square feet of office space in
Madison, Wisconsin under various operating leases, which leases expire at
various dates through April 2000. The Company believes that additional office
space in Madison will be required in the next twelve months. The Company is in
the process of negotiating a joint venture agreement with an unaffiliated party
to purchase and develop a 4.6 acre parcel of real estate in Madison, Wisconsin.
The agreement would provide for the construction of an approximately 74,000
square foot building to be completed by December 1998. Once the building is
constructed, the Institute would lease a portion of the building; the remainder
of the building would be leased by an affiliate of the Company's joint venture
partner.
 
     IPS leases 4,800 square feet of office space in Vancouver, Washington,
which lease expires in January 2000. The Company believes this office space is
adequate for IPS' current and expected operations.
 
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 1997 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 51                           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 101 Ways to Motivate Students to Read
                                   (1995) 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 51                           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 supplies. Mr. Paul is the author of
                                   several publications, including How to Create World-Champion
                                   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 50                           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 42                           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 45                           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. 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, 1997
  Third Quarter (September 25 to September 30)..............  $25.25   $22.125
  Fourth Quarter............................................   28.25     20.00
</TABLE>
 
     Information on the price range for shares of the Company's Common Stock for
the first half of 1997 and all of 1996 is omitted since the Common Stock did not
become publicly traded until September 25, 1997.
 
HOLDERS
 
     As of February 27, 1998, there were approximately 78 record holders of the
Common Stock.
 
HISTORICAL DIVIDENDS
 
     For the years ended December 31, 1997 and 1996, the Company declared S
corporation distributions to its shareholders of $18.1 million and $3.5 million,
respectively. 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. 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
 
     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 319,948 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 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 2.8 million shares offered by the Company, in
 
                                       16
<PAGE>   18
 
addition to the 420,000 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, 1997, 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 of
         which related to the construction of the Company's new headquarters
         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 million was used to pay distributions of S
         corporation retained profits to S corporation shareholders.
 
                                       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,
                                                   ---------------------------------------------
                                                    1997      1996      1995      1994     1993
                                                    ----      ----      ----      ----     ----
<S>                                                <C>       <C>       <C>       <C>      <C>
INCOME STATEMENT DATA:
Net sales:
  Products.......................................  $29,060   $18,930   $11,602   $8,088   $5,288
  Services.......................................    6,964     3,451     1,003      163       --
                                                   -------   -------   -------   ------   ------
       Total net sales...........................   36,024    22,381    12,605    8,251    5,288
Cost of sales:
  Products.......................................    3,438     2,329     1,468      937      570
  Services.......................................    3,013     1,898       595      166       --
                                                   -------   -------   -------   ------   ------
          Total cost of sales....................    6,451     4,227     2,063    1,103      570
                                                   -------   -------   -------   ------   ------
          Gross profit...........................   29,573    18,154    10,542    7,148    4,718
Operating expenses:
  Product development............................    3,427     1,555       802      358      465
  Selling and marketing..........................    9,682     6,639     4,201    2,551    1,595
  General and administrative.....................    5,750     3,547     2,090    1,240      611
  Purchased research and development.............       --     3,400        --       --       --
  Phantom stock plan termination.................    1,617        --        --       --       --
                                                   -------   -------   -------   ------   ------
          Total operating expenses...............   20,476    15,141     7,093    4,149    2,671
Operating income.................................    9,097     3,013     3,449    2,999    2,047
Other income (expense), net......................      (71)     (155)       13       23       23
                                                   -------   -------   -------   ------   ------
Income before taxes..............................    9,026     2,858     3,462    3,022    2,070
Income tax benefit (provision)...................      673     1,602        --       --       --
                                                   -------   -------   -------   ------   ------
Net income.......................................  $ 9,699   $ 4,460   $ 3,462   $3,022   $2,070
                                                   =======   =======   =======   ======   ======
Basic and diluted earnings per share.............    $0.67     $0.33     $0.26    $0.22    $0.15
                                                   =======   =======   =======   ======   ======
BALANCE SHEET DATA:
Working capital..................................  $28,674   $   566   $ 1,105   $2,213   $2,098
Total assets.....................................   50,883    19,855     4,761    4,070    3,063
Notes payable and long-term debt, including
  current portion................................       --    10,450        --       --       --
Shareholders' equity.............................   42,835     3,773     2,613    3,065    2,782
</TABLE>
 
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 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
motivating and monitoring increased literature-based reading practice. The
Company's learning information system products also include the Standardized
Test for Assessment of Reading (S.T.A.R.), a computer-adaptive reading test and
database, and the Reading Renaissance program, through which the Company
provides professional development training for educators.
 
                                       18
<PAGE>   20
 
     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. Because software products are generally
shipped as orders are received, the Company has historically operated with
virtually no backlog. 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. The Company records the
estimated cost of returns at the time of sale. 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 software support agreements is reflected as deferred
revenue and is amortized ratably over the 24 month term of the maintenance
period. The Company's deferred revenue represents payments received from
customers for services still to be rendered.
 
     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, (iii) amortization of capitalized software
development costs and (iv) an allocation of facilities costs. The Company
recognizes significantly higher gross margins on its product sales than on its
service sales. As a result, as service sales have increased significantly over
the last several years as a percentage of total sales, the Company's total gross
margin has generally declined. In 1997, however, total gross profit margin
increased slightly due to a substantial decrease in costs associated with
training sessions. Management expects that the general trend of lower total
gross profit margins will continue as service sales increase 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 two years.
 
     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 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.
 
                                       19
<PAGE>   21
 
                             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 costs of sales and gross profit are shown as a percentage of their
corresponding component of net sales:
 
<TABLE>
<CAPTION>
                                                             YEAR ENDED DECEMBER 31,
                                                             -----------------------
                                                             1997     1996     1995
                                                             ----     ----     ----
<S>                                                          <C>      <C>      <C>
Net sales:
  Products...............................................     80.7%    84.6%    92.0%
  Services...............................................     19.3     15.4      8.0
                                                             -----    -----    -----
       Total net sales...................................    100.0%   100.0%   100.0%
                                                             =====    =====    =====
Cost of sales:
  Products...............................................     11.8%    12.3%    12.6%
  Services...............................................     43.3     55.0     59.3
       Total cost of sales...............................     17.9     18.9     16.4
Gross profit:
  Products...............................................     88.2     87.7     87.4
  Services...............................................     56.7     45.0     40.7
       Total gross profit................................     82.1     81.1     83.6
Operating expenses:
  Product development....................................      9.5      6.9      6.4
  Selling and marketing..................................     26.9     29.7     33.3
  General and administrative.............................     16.0     15.8     16.5
  Purchased research and development.....................       --     15.2       --
  Phantom stock plan termination.........................      4.5       --       --
                                                             -----    -----    -----
Operating income.........................................     25.2     13.5     27.4
Other income (expense), net..............................     (0.2)    (0.7)     0.1
                                                             -----    -----    -----
Income before taxes......................................     25.0     12.8     27.5
Income tax benefit (provision)...........................      1.9      7.1       --
                                                             -----    -----    -----
Net income...............................................     26.9%    19.9%    27.5%
                                                             =====    =====    =====
</TABLE>
 
                     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 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 3,500
new book titles on Accelerated Reader title disks since December 31, 1996, (iii)
the sale of the Accelerated Reader to approximately 7,100 new customer schools,
and (iv) inclusion of IPS sales commencing August 1, 1996. Sales of Accelerated
Reader software and supplemental Accelerated Reader title disks accounted for
approximately 51.5% and 69.4% of net sales in 1997 and 1996, respectively.
 
     Service revenue, which consists of revenue from sales of training seminars
and programs 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 somewhat to
 
                                       20
<PAGE>   22
 
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. The
Company anticipates that the total dollar amount of product development costs
will increase as the Company extends its product offerings into other areas of
the K-12 curriculum.
 
     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. Management anticipates incurring increased selling and marketing expenses
during the second half of 1998 due primarily to the expected introduction of new
products.
 
     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 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. The Company anticipates that general and
administrative expenses will generally decline as a percentage of sales in
future periods, excluding the effects of non-recurring charges.
 
     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 1997 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, and phantom stock
plan termination expense, 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.
 
     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
 
                                       21
<PAGE>   23
 
the closing of the Offering and consequently provided for current and deferred
income taxes from September 30, 1997 to December 31, 1997. The Company expects
that the effective rate of tax on its income will be 39.5% to 40.5% during 1998.
See Note 7 of Notes to the Company's Financial Statements.
 
                     YEARS ENDED DECEMBER 31, 1996 AND 1995
 
     Net Sales. The Company's net sales increased by $9.8 million, or 77.6%, to
$22.4 million in 1996 from $12.6 million in 1995. Product sales increased by
$7.3 million, or 63.2%, to $18.9 million in 1996 from $11.6 million in 1995. The
increase in product sales is primarily attributable to (i) the sale of the
Accelerated Reader to approximately 6,500 new customer schools, (ii) increased
sales of Accelerated Reader title disks to Accelerated Reader schools, including
the introduction of Accelerated Reader title disks covering approximately 2,500
new book titles, and (iii) the introduction of STAR, which was announced in
April 1996 and which the Company began shipping in September 1996. Sales of
Accelerated Reader software and supplemental Accelerated Reader title disks
accounted for approximately 69.4% and 89.8% of net sales in 1996 and 1995,
respectively. Sales of the Company's products through one book distributor
contributed significantly to product sales growth in 1996. Sales through this
book distributor, as a percentage of net sales, increased to 15.2% in 1996 from
12.5% in 1995. The Company believes this growth represented the maturation of
this book distributor's field sales efforts. The Company does not anticipate
that sales to schools through this book distributor will significantly increase
as a percentage of net sales.
 
     Service revenue increased by $2.5 million, or 244.0%, to $3.5 million in
1996 from $1.0 million in 1995. 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 $862,000, or
58.7%, to $2.3 million in 1996 from $1.5 million in 1995. As a percentage of
product sales, the cost of sales of products remained relatively constant at
12.3% in 1996 compared to 12.6% in 1995. The cost of sales of services increased
by $1.3 million, or 219.0%, to $1.9 million in 1996 from $595,000 in 1995. As a
percentage of sales of services, however, the cost of sales of services
decreased to 55.0% in 1996 from 59.3% in 1995, primarily as a result of greater
efficiencies in conducting seminars. The Company's overall gross profit margin
declined to 81.1% in 1996 from 83.6% in 1995 due primarily to increased sales of
services, particularly sales of Reading Renaissance training sessions, which
have a lower gross margin than the Company's products.
 
     Product Development. Product development expenses increased by $753,000, or
93.9%, to $1.6 million in 1996 from $802,000 in 1995. These expenses increased
primarily due to the increased development staff and consulting costs associated
with new products. As a percentage of net sales, product development costs
increased to 6.9% in 1996 from 6.4% in 1995. The Company anticipates that
product development costs will increase significantly as the Company expands its
product offerings into other areas of the K-12 curriculum.
 
     Selling and Marketing. Selling and marketing expenses increased by $2.4
million, or 58.0%, to $6.6 million in 1996 from $4.2 million in 1995. These
expenses increased due to an increase in the number of marketing personnel,
participation in more trade shows, the publication of additional catalogs and
the introduction of the "Model Classroom" program. However, as a percentage of
net sales, selling and marketing expenses decreased to 29.7% in 1996 from 33.3%
in 1995. This decrease is due primarily to economies of scale associated with
significantly increased product sales.
 
     General and Administrative. General and administrative expenses increased
by $1.4 million, or 69.6%, to $3.5 million in 1996 from $2.1 million in 1995.
The higher expenses from 1996 are largely due to increased costs associated with
the hiring of additional personnel, including wages and related benefits, and
the write-down of the net book value of the Company's former headquarters. As a
percentage of net sales, however, general and administrative expenses decreased
to 15.8% in 1996 from 16.5% in 1995. This decline is primarily due to economies
of scale associated with significantly increased product sales.
 
     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.
                                       22
<PAGE>   24
 
     Operating Income. Operating income decreased by $436,000, or 12.6%, to $3.0
million in 1996 from $3.4 million in 1995, primarily due to the $3.4 million of
purchased research and development expense resulting from the acquisition of
IPS. As a percentage of net sales, operating income decreased to 13.5% in 1996
from 27.4% in 1995. Excluding the purchased research and development expense,
operating income would have increased by $3.0 million, or 86.0%, to $6.4 million
in 1996, or 28.7% of net sales compared to 27.4% of net sales in 1995.
 
     Interest Expense. In 1996, interest expense of $206,000 was incurred
primarily in connection with loans to finance the acquisition of IPS.
 
     Income Tax Benefit. A tax benefit of $1.6 million was recorded in 1996
relating primarily to the expensing of $3.4 million of purchased research and
development. See Note 7 of Notes to the Company's Financial Statements.
 
YEAR 2000
 
     Substantially all of the Company's products are Year 2000 compliant and,
therefore, the Company does not expect Year 2000 issues to have a material
financial impact on the Company.
 
                        LIQUIDITY AND CAPITAL RESOURCES
 
     As of December 31, 1997, the Company's cash and cash equivalents increased
to $22.3 million from the December 31, 1996 total of $1.8 million. The Company's
operating activities provided net cash of approximately $10.4 million and $9.2
million in 1997 and 1996, respectively. The increase is due primarily to
increased operating income offset by relatively modest increased working capital
demands. Cash flows used by investing activities were $8.8 million in 1997
compared with $14.9 million in 1996. The decrease is due to the purchase of IPS
and the Company's new corporate headquarters building in 1996 offset by an
increase in short term investments in 1997. Cash flows provided by financing
activities were $19.0 million in 1997 compared with $7.2 million in 1996. The
increase is due primarily to proceeds from the Offering offset by lower
borrowings of long-term obligations in 1997 and higher distributions to
shareholders in 1997.
 
     On September 30, 1997, the Company completed the Offering of 2,800,000
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 420,000 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 $6,249,600 in connection with the exercise of this
over-allotment option.
 
     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.
 
          (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 new headquarters 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 million was used to pay distributions of S
     corporation retained profits to S corporation shareholders.
 
     The Company has broad discretion with respect to the use of the remaining
proceeds.
 
                                       23
<PAGE>   25
 
     In December 1997, the Company obtained a $7.5 million unsecured revolving
line of credit with a bank which matures on December 31, 1998. The line of
credit bears interest at either a floating rate based on the prime rate
established by the bank 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, 1997, the line of credit
had not been used.
 
     The Company is in the process of negotiating with an unaffiliated party to
jointly develop an office facility in the Madison, Wisconsin area. This facility
would be used for the Company's Madison operations and the other party would
also utilize part of the facility. The estimated total cost of the project is
$6.5 million. The allocation of costs between the parties and the amount and
source of financing for such development has not been finalized at this time.
The Company believes that its existing sources of liquidity and anticipated
funds from operations will satisfy the Company's projected working capital and
capital expenditure requirements for the foreseeable future.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
 
     Not applicable.
 
                                       24
<PAGE>   26
 
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 and combined balance sheets
of Advantage Learning Systems, Inc. (a Wisconsin corporation) and subsidiaries,
referred to as the "Companies" (see Note 1), as of December 31, 1997 and 1996,
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, 1997. These
financial statements are the responsibility of the company's management. Our
responsibility is to express an opinion of 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, 1997 and
1996, and the results of their operations and their cash flows for each of the
three years in the period ended December 31, 1997 in conformity with generally
accepted accounting principles.
 
                                          /s/ Arthur Andersen LLP
 
                                          ARTHUR ANDERSEN LLP
 
Milwaukee, Wisconsin
February 6, 1998
 
                                       25
<PAGE>   27
 
FINANCIAL STATEMENTS
 
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                    CONSOLIDATED AND COMBINED BALANCE SHEETS
                        AS OF DECEMBER 31, 1997 AND 1996
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,   DECEMBER 31,
                                                                  1997           1996
                                                              ------------   ------------
<S>                                                           <C>            <C>
                           ASSETS
Current assets:
  Cash and cash equivalents.................................  $22,319,975    $ 1,755,866
  Short-term investments....................................    6,864,734             --
  Accounts receivable, less allowance of $638,000 in 1997
     and $161,000 in 1996...................................    3,316,523      2,523,388
  Inventories...............................................      345,451        543,902
  Prepaid expenses..........................................      745,923        265,026
  Deferred tax asset........................................    1,831,000             --
                                                              -----------    -----------
          Total current assets..............................   35,423,606      5,088,182
                                                              -----------    -----------
Property, plant and equipment, net..........................   11,315,305     10,577,709
Building held for sale......................................      727,470        747,392
Deferred tax asset..........................................    1,661,000      1,601,708
Intangibles, net............................................    1,598,842      1,445,798
Capitalized software, net...................................      156,972        393,956
                                                              -----------    -----------
          Total assets......................................  $50,883,195    $19,854,745
                                                              ===========    ===========
            LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable..........................................  $   982,095    $   332,689
  Deferred revenue..........................................    2,854,318      1,442,356
  Payroll and employee benefits.............................      657,223        577,613
  Retainage and amounts due under construction contract.....       16,525      1,151,157
  Other current liabilities.................................    1,684,078        668,421
  Due to former owner of IPS................................           --        350,000
  Distribution payable to shareholders......................      555,000             --
                                                              -----------    -----------
          Total current liabilities.........................    6,749,239      4,522,236
                                                              -----------    -----------
  Long-term debt............................................           --      5,750,000
  Notes payable to shareholders.............................           --      4,700,000
  Deferred revenue..........................................    1,299,056      1,109,519
                                                              -----------    -----------
          Total liabilities.................................    8,048,295     16,081,755
                                                              -----------    -----------
  Shareholders' equity:
     Common stock, $.01 par;
       shares authorized: 50,000,000
       issued and outstanding: 16,902,383 - 1997
                                13,651,133 - 1996...........      169,024        136,511
     Additional paid in capital.............................   40,756,611        216,927
     Retained earnings......................................    1,909,265      3,419,552
                                                              -----------    -----------
       Total shareholders' equity...........................   42,834,900      3,772,990
                                                              -----------    -----------
          Total liabilities and shareholders' equity........  $50,883,195    $19,854,745
                                                              ===========    ===========
</TABLE>
 
The accompanying notes to the financial statements are an integral part of these
                                balance sheets.
 
                                       26
<PAGE>   28
 
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                 CONSOLIDATED AND COMBINED STATEMENTS OF INCOME
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
 
<TABLE>
<CAPTION>
                                                                     TWELVE MONTHS
                                                        ---------------------------------------
                                                           1997          1996          1995
                                                           ----          ----          ----
<S>                                                     <C>           <C>           <C>
Net sales:
  Products............................................  $29,059,537   $18,930,334   $11,601,971
  Services............................................    6,964,124     3,450,758     1,003,417
                                                        -----------   -----------   -----------
       Total net sales................................   36,023,661    22,381,092    12,605,388
Cost of sales:
  Products............................................    3,438,325     2,329,171     1,467,559
  Services............................................    3,012,734     1,898,175       595,362
                                                        -----------   -----------   -----------
       Total cost of sales............................    6,451,059     4,227,346     2,062,921
                                                        -----------   -----------   -----------
       Gross profit...................................   29,572,602    18,153,746    10,542,467
Operating expenses:
  Product development.................................    3,427,276     1,555,411       802,331
  Selling and marketing...............................    9,681,967     6,638,822     4,200,701
  General and administrative..........................    5,749,674     3,546,144     2,090,560
  Purchased research and development..................           --     3,400,000            --
  Phantom stock plan termination......................    1,617,106            --            --
                                                        -----------   -----------   -----------
       Total operating expenses.......................   20,476,023    15,140,377     7,093,592
                                                        -----------   -----------   -----------
       Operating income...............................    9,096,579     3,013,369     3,448,875
Other income (expense):
  Interest income.....................................      483,222        34,752        17,068
  Interest expense....................................     (645,302)     (205,755)           --
  Other, net..........................................       91,627        15,898        (3,728)
                                                        -----------   -----------   -----------
Income before taxes...................................    9,026,126     2,858,264     3,462,215
                                                        -----------   -----------   -----------
Income tax benefit....................................      672,540     1,601,708            --
                                                        -----------   -----------   -----------
Net income............................................  $ 9,698,666   $ 4,459,972   $ 3,462,215
                                                        ===========   ===========   ===========
Basic and diluted earnings per share..................  $      0.67   $      0.33   $      0.26
                                                        ===========   ===========   ===========
</TABLE>
 
The accompanying notes to the financial statements are an integral part of these
                                  statements.
 
                                       27
<PAGE>   29
 
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                 STATEMENTS OF CONSOLIDATED AND COMBINED EQUITY
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
 
<TABLE>
<CAPTION>
                                                              PREFERRED
                                     COMMON STOCK(1)          STOCK(2)        ADDITIONAL
                                  ---------------------   -----------------     PAID IN       RETAINED        TOTAL
                                    SHARES      AMOUNT    SHARES    AMOUNT      CAPITAL       EARNINGS        EQUITY
                                    ------      ------    ------    ------    ----------      --------        ------
<S>                               <C>          <C>        <C>       <C>       <C>           <C>            <C>
Balance, December 31, 1994......          --   $     --        --   $    --   $        --   $         --   $  3,065,133
  Net income....................          --         --        --        --            --             --      3,462,215
  Distributions to
    shareholders................          --         --        --        --            --             --     (3,914,330)
                                  ----------   --------   -------   -------   -----------   ------------   ------------
Balance, December 31, 1995......          --         --        --        --            --             --      2,613,018
  Net income....................          --         --        --        --            --             --      4,459,972
  Distributions to
    shareholders................          --         --        --        --            --             --     (3,500,000)
  Contribution from
    shareholders................          --         --        --        --            --             --        200,000
                                  ----------   --------   -------   -------   -----------   ------------   ------------
Balance, December 31, 1996......          --         --        --        --            --             --      3,772,990
  Net income....................          --         --        --        --            --      9,698,666      9,698,666
  Recapitalization..............  13,651,133    136,511        --        --    (6,683,120)    10,319,599             --
  Distributions to
    shareholders................          --         --        --        --            --    (18,109,000)   (18,109,000)
  Public offering...............   3,220,000     32,200        --        --    46,940,044             --     46,972,244
  Settlement of IPS
    Purchase(3).................      31,250        313        --        --       499,687             --        500,000
                                  ----------   --------   -------   -------   -----------   ------------   ------------
Balance, December 31, 1997......  16,902,383   $169,024        --   $    --   $40,756,611   $  1,909,265   $ 42,834,900
                                  ==========   ========   =======   =======   ===========   ============   ============
</TABLE>
 
-------------------------
(1) Common Stock, $0.01 par value, 50,000,000 shares authorized.
 
(2) Preferred Stock, $0.01 par value, 5,000,000 shares authorized.
 
(3) See Note 3 of Notes to Financial Statements.
 
The accompanying notes to the financial statements are an integral part of these
                                  statements.
 
                                       28
<PAGE>   30
 
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
               CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
 
<TABLE>
<CAPTION>
                                                                       TWELVE MONTHS
                                                        -------------------------------------------
                                                            1997            1996           1995
                                                            ----            ----           ----
<S>                                                     <C>             <C>             <C>
Reconciliation of net income to net cash provided by
  operating activities:
  Net income........................................    $  9,698,666    $  4,459,972    $ 3,462,215
  Noncash (income) expenses included in net income
     --
     Depreciation and amortization..................       1,477,936         711,135        325,817
     (Gain) loss on disposal of assets..............             600            (239)        24,925
     Loss on building held for sale.................              --         200,000             --
     Purchased research and development.............              --       3,400,000             --
     Deferred income taxes..........................      (1,890,292)     (1,601,708)            --
  Change in assets and liabilities --
     Accounts receivable............................        (793,135)       (755,765)      (476,453)
     Inventory......................................         198,451        (311,054)      (161,052)
     Prepaid expenses...............................        (480,897)         60,486       (204,779)
     Accounts payable and other current
       liabilities..................................       1,744,673         858,332        352,780
     Retainage and amounts due under construction
       contract.....................................      (1,134,632)      1,151,157             --
     Deferred revenue...............................       1,601,499       1,030,783        790,517
                                                        ------------    ------------    -----------
       Net cash provided by operating activities....      10,422,869       9,203,099      4,113,970
                                                        ------------    ------------    -----------
Cash flows from investing activities:
  Purchase of property, plant and equipment.........      (1,693,306)     (9,897,551)    (1,224,844)
  Short-term investments............................      (6,864,734)             --             --
  Capitalized software development costs............          (3,787)       (365,444)      (117,432)
  Purchase of IPS...................................        (265,177)     (4,610,000)            --
                                                        ------------    ------------    -----------
       Net cash used in investing activities........      (8,827,004)    (14,872,995)    (1,342,276)
                                                        ------------    ------------    -----------
Cash flows from financing activities:
  Proceeds from issuance of stock...................      46,972,244         200,000             --
  Proceeds from long-term debt and notes payable to
     shareholders...................................              --      10,600,000             --
  Payments on debt..................................     (10,450,000)       (150,000)            --
  Distributions to shareholders.....................     (17,554,000)     (3,500,000)    (3,914,330)
                                                        ------------    ------------    -----------
       Net cash provided by (used in) financing
          activities................................      18,968,244       7,150,000     (3,914,330)
                                                        ------------    ------------    -----------
Net increase (decrease) in cash.....................      20,564,109       1,480,104     (1,142,636)
Cash and cash equivalents, beginning of period......       1,755,866         275,762      1,418,398
                                                        ------------    ------------    -----------
Cash and cash equivalents, end of period............    $ 22,319,975    $  1,755,866    $   275,672
                                                        ============    ============    ===========
</TABLE>
 
The accompanying notes to the financial statements are an integral part of these
                                  statements.
 
                                       29
<PAGE>   31
 
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                         NOTES TO FINANCIAL STATEMENTS
 
(1) CONSOLIDATION
 
     The consolidated and combined financial statements include the financial
results of Advantage Learning Systems, Inc. ("ALS"), the Institute for Academic
Excellence, Inc. ("Institute") and, since its date of acquisition (see Note 3),
IPS Publishing, Inc. ("IPS"), collectively the "Companies." The Companies are
all under common ownership. The Companies conduct their business within one
industry segment. Combined equity represents the combination of the common
stock, paid-in capital and retained earnings of each of the Companies. 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, a
computer-adaptive reading test and database which provides reading scores
correlated to national norms in ten minutes or less at the computer.
 
     The Institute develops and conducts the Reading Renaissance program, which
provides educators with professional development training to most effectively
use the Accelerated Reader, STAR and the learning information they generate.
 
     IPS provides algorithm-based software for assessment and skills practice in
math and science, including MathCheck and Objective Tracker.
 
(3) ACQUISITION
 
     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 (the
"Offering") (see Note 5). The net purchase price was allocated based on fair
values as follows:
 
<TABLE>
<CAPTION>
                                                              (IN THOUSANDS)
                                                              --------------
<S>                                                           <C>
Current assets..............................................      $  101
Plant and equipment.........................................          26
Intangibles.................................................       5,363
Current liabilities.........................................        (115)
                                                                  ------
  Purchase price............................................      $5,375
                                                                  ======
</TABLE>
 
     The purchase price included the acquisition of certain in-process research
and development included in intangibles above, which resulted in a charge to
income of $3,400,000 for the year ended December 31, 1996. The amount allocated
to the in-process research and development was determined by appraisal. The
projects in process require resolution of high-risk development and testing
issues in order to reach technological feasibility. At the date of acquisition,
the purchased technology had no alternative uses.
 
                                       30
<PAGE>   32
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
     Unaudited pro forma results of operations assuming the acquisition of IPS
as of January l, 1995 and the $3,400,000 write-off of purchased research and
development in 1996 would be as follows:
 
<TABLE>
<CAPTION>
                                                              1996      1995
                                                              ----      ----
                                                              (IN THOUSANDS)
<S>                                                          <C>       <C>
Net sales..................................................  $23,062   $13,733
Net income.................................................    4,199     2,972
</TABLE>
 
(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
 
     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 insignificant 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, 1997
and 1996 is $49,000 and $37,000, 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 also include separate maintenance fees whereby ALS
provides ongoing customer support and product upgrades. Such contracts are
reflected as deferred revenue and are amortized ratably over the 24 month term
of the maintenance period which begins after the expiration of any free support
period included with the purchase of the software.
 
     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 Company does not expect that the adoption of SOP
97-2 will materially affect its results in future years or the comparability of
results in future periods with results from prior financial periods.
 
(c) Cash and cash equivalents
 
     The Companies consider 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
 
                                       31
<PAGE>   33
               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>
                                                               1997      1996
                                                               ----      ----
                                                               (IN THOUSANDS)
<S>                                                           <C>       <C>
Cash and time deposits......................................  $ 6,395   $1,756
Commercial paper............................................   15,925       --
                                                              -------   ------
                                                              $22,320   $1,756
                                                              =======   ======
</TABLE>
 
(d) Supplemental disclosure of cash flow information
 
<TABLE>
<CAPTION>
                                                        1997          1996        1995
                                                        ----          ----        ----
                                                                 (IN THOUSANDS)
<S>                                                    <C>       <C>              <C>
Cash paid for:
  Interest...........................................  $   696       $   94       --
  Income taxes.......................................    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, 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, 1997 and 1996, capitalized catalog costs of
approximately $43,000 and $29,000, respectively, are included in prepaid
expenses. All other advertising costs are expensed the first time the
advertising takes place. Advertising expenses for 1997, 1996 and 1995 were
approximately $4,377,000, $2,999,000 and $1,854,000, 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 $955,000, $401,000 and $206,000 for 1997,
1996 and 1995, respectively.
 
                                       32
<PAGE>   34
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
     The estimated useful lives for property, plant and equipment are as
follows:
 
<TABLE>
<S>                                                           <C>
Building....................................................  25 to 40 years
Furniture, fixtures and office equipment....................    5 to 8 years
Computer and production equipment...........................    3 to 5 years
Vehicles....................................................         5 years
</TABLE>
 
     Net property, plant and equipment consisted of the following at December
31:
 
<TABLE>
<CAPTION>
                                                              1997      1996
                                                              ----      ----
                                                              (IN THOUSANDS)
<S>                                                          <C>       <C>
Land and improvements......................................  $   746   $   745
Buildings..................................................    8,064     7,978
Furniture, fixtures and office equipment...................    1,536     1,071
Computer and production equipment..........................    2,265     1,531
Vehicles...................................................       19        --
Construction in progress...................................      385        --
                                                             -------   -------
     Total property, plant and equipment...................   13,015    11,325
Less -- accumulated depreciation...........................   (1,700)     (747)
                                                             -------   -------
Property, plant and equipment, net.........................  $11,315   $10,578
                                                             =======   =======
</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 Companies capitalize 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 $4,000, $365,000 and $117,000 in 1997, 1996 and 1995,
respectively. Amortization expense of approximately $241,000, $208,000 and
$120,000 for 1997, 1996 and 1995, respectively, is included in cost of
sales-products in the statements of income. At December 31, 1997 and 1996,
accumulated amortization of capitalized software development costs was $570,000
and $329,000, respectively.
 
(j) Sales and concentration of credit risks
 
     For the years ended December 31, 1997, 1996 and 1995, one customer (a book
distributor) contributed 14.4%, 15.2% and 12.5% of total revenues, respectively.
No other customer represented more than 10% of total revenues. On December 31,
1997 and 1996, this customer had a receivable balance of 10.3% and 12.9% of
total trade receivables, respectively.
 
     The Companies grant credit to customers in the ordinary course of business.
The majority of the Companies' 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.
 
                                       33
<PAGE>   35
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
(k) Stock-based compensation
 
     The Companies have 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.
 
(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 Companies in 1997. SFAS 128 supersedes
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.
 
     A reconciliation of numerators and denominators of the basic and diluted
earnings per share computations are as follows:
 
<TABLE>
<CAPTION>
                                                                                1997
                                                              -----------------------------------------
                                                              NET INCOME        SHARES        PER SHARE
                                                              (NUMERATOR)    (DENOMINATOR)     AMOUNT
                                                              -----------    -------------    ---------
                                                                (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                           <C>            <C>              <C>
Basic EPS:
  Income available to common shareholders.................      $9,699          14,477          $0.67
Effect of dilutive securities:
  Stock options...........................................          --              47             --
                                                                ------          ------          -----
Diluted EPS:
  Income available to common shareholders and assumed
     conversions..........................................      $9,699          14,524          $0.67
                                                                ======          ======          =====
</TABLE>
 
     During 1996 and 1995 there were no stock options or other dilutive
instruments outstanding. The weighted average shares outstanding during 1996 and
1995 was 13,651,133 and 13,491,067, respectively.
 
(m) 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 and the interim
reporting requirements are not effective until the second year of application.
The adoption of SFAS 131 will not have any impact on financial results of the
Companies.
 
                                       34
<PAGE>   36
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
The Company anticipates that adoption of SFAS 131 will require additional
disclosures to be made concerning financial results of its segments.
 
(5) INTANGIBLE ASSETS
 
     Intangible assets are amortized on the straight-line basis over their
estimated useful lives. Intangibles with a total cost basis 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 the cost basis of goodwill to increase by $415,177 ($500,000 in stock
less $84,823 in interest related to the escrow funds).
 
     Intangible assets consisted of the following at December 31:
 
<TABLE>
<CAPTION>
                                                         1997      1996     USEFUL LIFE
                                                         ----      ----     -----------
                                                                (IN THOUSANDS)
<S>                                                     <C>       <C>       <C>
Algorithms..........................................    $  510    $  510      5 years
Tradename...........................................       210       210     10 years
Assembled workforce.................................        90        90      7 years
Goodwill............................................     1,153       738      7 years
                                                        ------    ------
                                                         1,963     1,548
Accumulated amortization............................      (364)     (102)
                                                        ------    ------
Net intangibles.....................................    $1,599    $1,446
                                                        ======    ======
</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) BUILDING HELD FOR SALE
 
     In December, 1996, ALS completed construction of its new headquarters
facility in Wisconsin Rapids, Wisconsin. The building previously occupied by ALS
is being offered for sale. In 1996, an impairment loss of $200,000 was recorded
as a charge to general and administrative expense in the combined statements of
income to reflect the writedown of the net book value of the building to its
estimated fair value.
 
(7) 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 Companies became subject to federal and state
income taxes as C corporations. Consequently, the Companies are now required to
account for income taxes in accordance with Statement of Financial Accounting
Standards No. 109 ("SFAS 109") "Accounting for Income Taxes."
 
                                       35
<PAGE>   37
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
In connection with this change in the Companies' tax status, SFAS 109 requires
the Companies 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
related effect of recording the basis differences is charged or credited to
current earnings. The change in tax status resulted in recognition of a deferred
tax asset and corresponding benefit of $3.5 million.
 
     The provision (benefit) for income taxes consisted of:
 
<TABLE>
<CAPTION>
                                                               1997          1996          1995
                                                               ----          ----          ----
                                                                        (IN THOUSANDS)
<S>                                                           <C>           <C>           <C>
Current tax provision:
  U.S. federal..............................................  $ 1,026       $    --       $    --
  State and local...........................................      191            --            --
                                                              -------       -------       -------
Total current tax provision.................................    1,217            --            --
                                                              -------       -------       -------
Deferred tax (benefit):
  U.S. federal..............................................   (1,618)       (1,602)           --
  State and local...........................................     (272)           --            --
                                                              -------       -------       -------
Total deferred tax (benefit)................................   (1,890)       (1,602)           --
                                                              -------       -------       -------
Provision for income taxes..................................  $  (673)      $(1,602)      $    --
                                                              =======       =======       =======
</TABLE>
 
     Effective rate reconciliation:
 
<TABLE>
<CAPTION>
                                                               1997          1996          1995
                                                               ----          ----          ----
                                                                        (IN THOUSANDS)
<S>                                                           <C>           <C>           <C>
U.S. statutory rate.........................................       35%           35%           35%
                                                              -------       -------       -------
Income tax provision at statutory tax rate..................  $ 3,159       $ 1,000       $ 1,212
State and local taxes, net of federal tax benefit...........      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)       (1,212)
Deferred tax reinstatement related to termination of S
  corporation elections.....................................   (3,549)           --            --
                                                              -------       -------       -------
Provision (benefit) for income taxes........................  $  (673)      $(1,602)      $    --
                                                              =======       =======       =======
</TABLE>
 
                                       36
<PAGE>   38
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
     Deferred tax assets (liabilities) consisted of the following at December
31:
 
<TABLE>
<CAPTION>
                                                               1997          1996
                                                               ----          ----
                                                                 (IN THOUSANDS)
<S>                                                           <C>           <C>
Current deferred tax assets (liabilities):
  Deferred revenue..........................................  $ 1,234       $    --
  Expenses not currently deductible.........................      597            --
                                                              -------       -------
Net current deferred tax assets.............................    1,831            --
                                                              -------       -------
Noncurrent deferred tax assets (liabilities):
  Operating losses..........................................      150           237
  Deferred revenue..........................................      523            --
  Depreciation and amortization.............................     (144)           --
  Intangibles...............................................    1,153         1,363
  Other.....................................................      (21)            2
                                                              -------       -------
Net noncurrent deferred tax assets..........................    1,661         1,602
                                                              -------       -------
Total deferred tax assets...................................  $ 3,492       $ 1,602
                                                              =======       =======
</TABLE>
 
     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.
 
(8) LINE OF CREDIT
 
     In December 1997, the Companies obtained a $7.5 million unsecured revolving
line of credit with a bank which matures in December 1998. The line of credit
bears interest at either: a floating rate based on the prime rate established by
the bank 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, 1997, the line of credit had not been
utilized.
 
(9) NOTES PAYABLE TO SHAREHOLDERS
 
     Notes payable to shareholders consist of notes payable that financed the
acquisition of IPS in 1996. These notes were subsequently paid in October 1997
with proceeds from the Offering. The notes accrued interest at an annual rate of
6.5%. Related interest expense for 1997 and 1996 was $235,000 and $127,000,
respectively.
 
(10) LONG-TERM DEBT
 
     Long term debt consisted of the following at December 31:
 
<TABLE>
<CAPTION>
                                                              1997     1996
                                                              ----     ----
                                                              (IN THOUSANDS)
<S>                                                           <C>     <C>
Note payable to Woodlands Business Center, due December 31,
  1998, noninterest bearing.................................   $--    $   50
Note payable to bank, payable in annual installments of
  $700,000 beginning March 1, 1998 through March 1, 2002 at
  which time the note is due in full, interest at the 30-day
  LIBOR rate (5.53% at December 31, 1996) plus 1.25%, with a
  maximum interest rate of 8.5%, payable monthly............   --      5,700
                                                               --     ------
Total.......................................................   --      5,750
Less -- Current maturities..................................   --         --
                                                               --     ------
Long-term debt..............................................   $--    $5,750
                                                               ==     ======
</TABLE>
 
                                       37
<PAGE>   39
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
     In 1997, all long-term debt was paid from proceeds of the Offering (See
Note 16).
 
(11) LEASE COMMITMENTS
 
     The Institute and IPS lease their offices under various operating leases.
Additionally, the Companies are party to various operating leases for equipment.
Rent expense for 1997, 1996 and 1995 was approximately $203,000, $159,000 and
$116,000, respectively, for the Companies.
 
     Future approximate minimum rental payments (including estimated operating
costs) required under the operating leases as of December 31, 1997 are as
follows:
 
<TABLE>
<S>                                                         <C>
1998......................................................  $328,000
1999......................................................   328,000
2000......................................................   143,000
2001......................................................    54,000
2002......................................................     9,000
</TABLE>
 
(12) DEFINED CONTRIBUTION BENEFIT PLAN
 
     The Companies have 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 1997, 1996
or 1995. Expense under the plan totaled approximately $297,000 in 1997, $192,000
in 1996 and $93,000 in 1995.
 
(13) 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 in 1996 and $6,000 in 1995 were incurred with respect to
the plan.
 
(14) STOCK OPTION PLAN
 
     The Company has established the 1997 Stock Incentive Plan (the "Plan") for
its officers, key employees, non-employee directors and consultants. A combined
maximum of 1,500,000 options, SARs and share awards may be granted under the
Plan. In addition, not more than 750,000 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. 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 Companies' 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,
 
                                       38
<PAGE>   40
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
the Companies' net income and earnings per share would have been reduced to the
pro forma amounts indicated below:
 
<TABLE>
<CAPTION>
                                                                  1997
                                                                  ----
                                                          (IN THOUSANDS, EXCEPT
                                                           PER SHARE AMOUNTS)
<S>                                                       <C>
Net income:
  As reported.........................................           $9,699
  Pro forma...........................................            9,441
Net income per common share:
  As reported.........................................            $0.67
  Pro forma...........................................             0.65
The weighted average fair value of
  options granted under the Plan during the year
  is:.................................................           $11.20
</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: dividend yield of 0%, expected volatility of 48.14%, risk-free
interest rates of 6.31% and expected lives of 10 years for the options.
 
     As of December 31, 1997, no SARs or share awards have been granted under
the Plan. A summary of stock options granted under the Plan for 1997 is as
follows:
 
<TABLE>
<CAPTION>
                                                                  WEIGHTED AVERAGE
                                                        SHARES     EXERCISE PRICE
                                                        ------    ----------------
<S>                                                     <C>       <C>
Outstanding at beginning of year......................       --        $   --
Granted...............................................  245,268         16.42
Exercised.............................................       --            --
Canceled..............................................   (5,313)        16.00
                                                        -------        ------
Outstanding at end of year............................  239,955        $16.43
                                                        -------        ------
Options exercisable at end of year....................       --        $   --
                                                        =======        ======
</TABLE>
 
(15) 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. 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,
320,133 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. Activity from prior
periods in the Statement of Consolidated and Combined Equity was not
retroactively restated.
 
     The Company issued a total of 3,220,000 common shares during 1997 in the
Offering (see Note 16). Additionally, 31,250 common shares were issued in
settlement of the purchase of IPS (see Note 3). As of December 31, 1997,
1,500,000 common shares were reserved for issuance under the 1997 Stock
Incentive Plan (see Note 14).
 
(16) OFFERING OF COMMON STOCK
 
     On September 30, 1997, the Company completed the Offering of 2,800,000
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
                                       39
<PAGE>   41
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
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 420,000
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.
 
     In 1997, 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 new headquarters 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 million was used to pay distributions of S corporation
       retained profits to S corporation shareholders.
 
(17) QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
 
     The following table sets forth unaudited consolidated and combined income
statement data for each quarter of the Companies' 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>
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 benefit (provision)....................   (1,602)       --        3,505        (1,231)
  Net income........................................      541     2,609        4,639         1,909
  Basic and diluted earnings per share..............     0.04      0.19         0.34          0.11
  Common stock price per share:
     High...........................................       --        --       25.250        28.250
     Low............................................       --        --       22.125        20.000
1996:
  Net sales.........................................   $4,425    $5,050       $5,952        $6,954
  Gross profit......................................    3,624     4,252        4,835         5,443
  Operating income..................................    1,192     1,747       (1,424)        1,498
  Income tax benefit (provision)....................       --        --        1,467           135
  Net income........................................    1,201     1,756          (23)        1,526
  Basic and diluted earnings per share..............     0.09      0.13           --          0.11
</TABLE>
 
     1. The Company acquired IPS in August 1996 (see Note 3).
 
                                       40
<PAGE>   42
               ADVANTAGE LEARNING SYSTEMS, INC. AND SUBSIDIARIES
 
                  NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
 
     2. 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 (see Note 3).
 
     3. Income tax benefits recorded in 1996 relate to IPS net operating losses
        while IPS was a C corporation. Effective January 1, 1997, IPS elected S
        corporation status and wrote off the deferred tax asset associated with
        the IPS net operating losses (see Note 7).
 
     4. The Companies' 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 13).
 
     5. The Companies' S corporation elections were terminated in connection
        with completion of the Offering of its Common Stock. The Companies were
        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 7).
 
                                       41
<PAGE>   43
 
                                    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 28, 1998 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 28, 1998 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 28, 1998
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 28, 1998
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
 
     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 28, 1998
under the caption "Transactions Between Management and the Company," which
information is incorporated by reference herein.
 
                                       42
<PAGE>   44
 
                                    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 Sheet as of December 31, 1997 and Combined Balance
        Sheet as of December 31, 1996
 
        Consolidated Statement of Income for the year ended December 31, 1997,
        and Combined Statements of Income for the years ended December 31, 1996
        and 1995
 
        Statement of Consolidated Shareholders' Equity for the year ended
        December 31, 1997, and Statements of Combined Equity for the years ended
        December 31, 1996 and 1995
 
        Consolidated Statement of Cash Flows for the year ended December 31,
        1997, and Combined Statements of Cash Flows for the years ended December
        31, 1996 and 1995
 
        Notes to Financial Statements
 
(A)(2) FINANCIAL STATEMENT SCHEDULES.
 
     All schedules are omitted because they are not required, not applicable or
the required information is contained elsewhere.
 
(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, 1997.
 
(C) EXHIBITS.
 
     See the Exhibit Index, which is incorporated by reference herein.
 
(D) FINANCIAL STATEMENTS EXCLUDED FROM ANNUAL REPORT TO SHAREHOLDERS.
 
     Not applicable.
 
                                       43
<PAGE>   45
 
                                   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 17, 1998
 
     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>
                       SIGNATURE                                         TITLE                 DATE
                       ---------                                         -----                 ----
<C>                                                            <S>                        <C>
                  /s/ MICHAEL H. BAUM                          Chief Executive Officer
--------------------------------------------------------       and a Director (Principal
                    Michael H. Baum                            Executive Officer)         March 17, 1998
 
                  /s/ TIMOTHY SHERLOCK                         Secretary, Vice President
--------------------------------------------------------       and Chief Financial
                    Timothy Sherlock                           Officer (Principal         March 17, 1998
                                                               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 17, 1998
       -----------------------------------------------
                       Michael H. Baum
                      Attorney-In-Fact*
</TABLE>
 
-------------------------
*Pursuant to authority granted by powers of attorney, copies of which are filed
herewith.
 
                                       44
<PAGE>   46
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
    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.
    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)
    21.1      Subsidiaries of Advantage Learning Systems, Inc.(1)
    23.1      Consent of Arthur Andersen LLP.
    24.1      Directors' Powers of Attorney.
    27.1      Financial Data Schedule.
</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).
 
 *  Management contracts or compensatory plans or arrangements.