<PAGE>   1
                     U.S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                             ----------------------

                                  FORM 10 - KSB

                   ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996

(x ) Annual report under section 13 or 15(d) of the Securities Exchange Act
     of 1934

(  ) Transition report pursuant to section 13 or 15(d) of the Securities
     Exchange Act of 1934

     COMMISSION FILE NUMBER 0-23672

                          SMART GAMES INTERACTIVE, INC.
                 (Name of Small Business Issuer in its Charter)

        DELAWARE                                     34-1692323
(State or other jurisdiction
of incorporation or organization)         (IRS Employer Identification Number)
<TABLE>
<S>                                                                             <C>
2075 Case Parkway South
Twinsburg, OH                                                                   44087
(Address of principal executive offices)                                        (Zip Code)

         Issuer's telephone number, including area code:                        (216) 963-0660

         Securities registered under Section 12(b) of the Exchange Act:         None

         Securities registered under Section 12(g) of the Exchange Act:         Common Stock,
                                                                                .0002 par value
                                                                                Common Stock Purchase Warrants
</TABLE>

Check whether the issuer (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 a subject to such filing requirements for the
past 90 days.
Yes x  No   .
   ---   ---
Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B is not contained in this form, and no disclosure will 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-KSB. (__)

Issuer's revenues for year ending December 31, 1996 were $663,406.

The approximate market value of stock held by non-affiliates was $5,073,578
based upon 11,596,749 shares of Common Stock held by such persons and the
average of the bid and asked prices of the Common Stock on March 25, 1997
($.4375). Such quotations reflect interdealer prices, without retail mark-up,
mark-down on commission and may not necessarily represent actual transactions.
As of March 25, 1997, the number of outstanding (i) shares of the Common Stock,
was 12,648,244 and (ii) Common Stock Purchase Warrants was 1,880,160. The
officers and directors of the registrant are considered affiliates only for this
calculation.

Documents incorporated by reference: Portions of the Issuer's definitive proxy
statement for its 1997 Annual Meeting of Shareholders to be held on June 17,
1997, which the Issuer intends to file within 120 days after the close of the
fiscal year ended December 31, 1996, are incorporated by reference into Part
III.

Transitional Small Business Disclosure Format (Check One):
Yes                                 No   X
    ------                             ------

Page 1 of 42 pages.  Exhibit index is located on pages 17 through 18.









<PAGE>   2

                          SMART GAMES INTERACTIVE, INC.
                                   FORM 10-KSB
                          YEAR ENDED DECEMBER 31, 1996

                                      INDEX

<TABLE>
<CAPTION>
ITEM                                 PART I                                           PAGE
----                                                                                  ----

<S>                                                                                    <C>
 1.      Business....................................................................... 3

 2.      Properties.....................................................................12

 3.      Legal Proceedings..............................................................12

 4.      Submission of Matters to a Vote of Security Holders............................13


                                     PART II

 5.      Market for Common Equity and Related Stockholder Matters.......................14

 6.      Management's Discussion and Analysis of Financial Condition
         and Results of Operations......................................................14

 7.      Financial Statements...........................................................15

 8.      Changes In and Disagreements with Accountants on Accounting
         and Financial Disclosures......................................................16

                                    PART III

 9.      Directors and Executive Officers of the Registrant;
         Compliance with Section 16(a) of the Exchange Act..............................17

10.      Executive Compensation.........................................................17

11.      Security Ownership of Certain Beneficial Owners and Management.................17

12.      Certain Relationships and Related Transactions.................................17

13.      Exhibits and Reports on Form 8-K...............................................17
</TABLE>


<PAGE>   3


                                     PART I

ITEM 1.  BUSINESS

GENERAL

         Smart Games Interactive, Inc. (the "Company"), formerly known as
"Sports Sciences, Inc.", creates, designs, develops, and assembles interactive
electronic game simulators that incorporate Company-owned hardware and software
technology. The Company has developed five principal products: The Pro Swing
System(R) ("Pro Swing"), TeeV Golf(R), PC Golf(R), Smart Baseball (TM) and PC
Smart Baseball(TM). Pro Swing is an indoor interactive golf simulator which can
be used as a free standing device or with a personal computer. PC Golf(R) is an
indoor interactive golf simulator used with a personal computer. The Company
licenses the Country Club Golf Game(R) Software for use with Pro Swing and PC
Golf(R). TeeV Golf(R) is an indoor interactive video golf simulator used with
Sega(R) and Nintendo(R) platforms. These game simulators enable the player to
use skills similar to those the player would use if he or she were to play golf
on a golf course. Smart Baseball(TM) is an indoor interactive baseball game
simulator used with platforms produced by Sega(R) and Nintendo(R) which enables
the player to use skills similar to those the player would use if he or she were
to be at bat on a baseball field. PC Smart Baseball(TM) is an interactive
baseball game simulator used with a personal computer and compatible baseball
game software. The Company designs its game simulators to be instructive,
entertaining and capable of use by people of all ages. The Company's suggested
retail prices for these products range from $39 for Smart Baseball(TM) to $229
for Pro Swing. The suggested retail prices of TeeV Golf(R) and PC Golf(R) are
$129 and $169, respectively. The suggested retail price of Smart Baseball(TM)
and PC Smart Baseball(TM) is $39.

         Until mid-1993 the Company primarily marketed its products directly to
consumers by way of direct mail, catalogs and telemarketing. During the third
and fourth quarters of 1993, the Company expanded its marketing efforts by
selling its products through department stores, consumer electronics stores and
other computer and video game retailers. The Company continued to expand its
retail distribution channels in 1994 and early 1995, which included mass
merchandisers Walmart and Sears Roebuck. In late 1995 and during 1996, the
Company was unable to continue distribution of PC Golf(R), TeeV Golf(R), and
Smart Baseball(TM) through retail distribution channels. Although management
believes the retail distribution channel offers the best method to profitably
distribute its consumer products, lack of adequate financing to support
"sell-through" at the retailers has forced the Company in 1997 to market its
products directly to consumers by way of direct mail, catalogs, direct response
television, and sports-related advertising and promotions with strategic
marketing partners. The Company currently markets Pro Swing by way of direct
mail and catalogs. The Company believes that the market for interactive
electronic game simulators is international and, accordingly, in 1993 the
Company began establishing, and continues to develop, relationships with
distributors interested in marketing the Company's products in Australia, Japan,
Southeast Asia and Europe.

         The Company believes that it has created products that are unique for
their entertainment and instructional values. In the six year period since its
inception, the Company believes that it identified its markets, particularly in
the United States and Japan, expanded its product line, refined its sales,
marketing and distribution strategies, and achieved significant production
efficiencies.





                                       3
<PAGE>   4

PRODUCTS

         The Pro Swing System(R). Pro Swing is an indoor interactive golf
simulator which can be used with a personal computer that enables the player to
"play" golf on any one of several international championship golf courses. Pro
Swing consists of hardware that contains a central processing unit, a sound
device, light sensors and LED displays, the Country Club Golf Game(R) Software,
and a 26-inch long golf "club" developed by the Company in conjunction with Dr.
Donald Schuele, the Michelson Professor of Physics at Case Western Reserve
University. The short club is designed to simulate the grip, feel and dynamics
of a fully extended golf club while allowing for safe, indoor play. A player
selects from golf courses such as Pebble Beach, Firestone, Pinehurst, Bay Hill
or Mauna Kea and the image of the golf course selected appears on the display
terminal. The player uses the club to take a full golf swing. A light beam
projected from the club directs the "ball" onto the display terminal "fairway"
or "green." The player can observe the progress of the ball as it hits the
"fairway" or "green" then bounces and rolls toward the hole. Simultaneously, the
base unit displays provide the player with an instant analysis of his or her
swing--club speed, club face angle, impact of club to ball, ball flight path and
distance traveled. One player can use Pro Swing to play a solo round of golf and
to analyze his or her swing, or up to eight players can play a round of golf
together in tournament style play. The Pro Swing Instruction Manual not only
instructs players on how to use Pro Swing but also provides possible reasons
for, and suggestions for correcting, swing flaws.

         TeeV Golf(R). TeeV Golf(R) is a smaller version of Pro Swing that has
been developed for use as an interactive video golf simulator used with video
game systems produced by Sega(R) and Nintendo(R). Unlike Pro Swing, TeeV Golf(R)
does not have digital readouts and indicators that provide feedback as to such
things as club speed and club face angle, but is available to consumers at an
estimated suggested retail price ($129 per unit) which is substantially less
than the suggested retail price of Pro Swing ($229 per unit) and PC Golf ($169
per unit).

         In TeeV Golf(R), the player plugs the base into the connection normally
used for the video game system's hand held control. The player simulates hitting
the ball with the short club and watches the ball's progression on the
television screen. TeeV Golf(R) can be equipped with adapters that permit the
use of TeeV Golf(R) with the video golf games of other companies such as "PGA
Tour(R) Golf", "PGA Tour(R) Golf II" and "PGA Tour(R) Golf III" from Electronic
Arts(R) and "Jack Nicklaus Power Challenge Golf"(TM) from Accolade, Inc. In
Spring 1994, the Company introduced an additional adapter for use with "Pebble
Beach(R) Golf Links" from Sega(R), and in late fall 1994 introduced an
additional adapter for "Links" for "Sega(R) CD" from Virgin Interactive
("Virgin"). In addition, Virgin now includes a game play option in its "Links"
for "Sega(R) CD" specifically for TeeV Golf(R). Adapters are also available
for PGA Tour(R) 96. The Company intends to discontinue sales of TeeV Golf(R)
in 1997 when its current inventory is depleted and, to effect such
discontinuance, will substantially discount the selling price of this product.

         In October 1994, the Company executed a license agreement with
Nintendo(R) whereby the Company acquired a three-year non-exclusive right to
use Nintendo(R)'s trademarks, logos and seal of quality on TeeV Golf(R) and
Batter Up(R). The Company intends to let this agreement, which covers the
Company's 16-bit product line, to expire on its expiration date in October
1997. Management does not believe the expiration of this agreement will have a
material adverse effect on the Company.



                                       4
<PAGE>   5



         PC Golf(R). PC Golf(R), like TeeV Golf(R), is a smaller version of Pro
Swing that has been developed for use as an interactive video golf simulator.
Unlike TeeV Golf(R), which is used with video game systems, PC Golf(R) can only
be used with a personal computer and with Country Club Golf Game(R) software or
"Picture Perfect Golf(TM)" from Enteractive, Inc. PC Golf(R) does not include on
screen feedback's such as club speed and club face angle provided by Pro Swing's
digital readouts and indicators, but is available to consumers at an estimated
suggested retail price ($169 per unit) which is substantially less than the
suggested retail price of Pro Swing ($229 per unit). The Company is seeking to
have PC Golf(R) compatible with software currently being developed by other
software publishers such as Accolade, Inc., Brilliant Interactive and Mindflux.
There can be no assurance that relationships with these or other software
publishers will be consummated, and if consummated, that they will be
successful.

         Smart Baseball(TM). Smart Baseball(TM) is an indoor interactive
baseball simulator for use with video game systems produced by Sega(R) and
Nintendo(R) or with a personal computer. Smart Baseball(TM) uses a special
electronic bat that simulates "hitting" the ball, making Smart BaseballTM the
first video baseball simulation game to give players "full swing" action. All
of the offensive moves of the baseball game are controlled with the foam
covered electronic bat. Players swing the bat to "hit" the ball thrown by the
pitcher on the television screen or computer monitor. The Company has
introduced Smart BaseballTM in standard cabled version that is compatible with
most Sega(R) Genesis and Super Nintendo(R) baseball game cartridges or personal
computer software and is available to consumers at a suggested retail price of
$39.

         Current Product Development. During 1995, the Company began development
of an indoor interactive skateboard simulator. The initial prototype design of
the skateboard simulator was for the Sony Playstation(TM), a next generation
32-bit video game machine. The Company intends to finalize the development of
this product and establish software compatibility with new or published games in
the fourth quarter of 1997 or in 1998.

         The Company held discussions with Sega(R) and Sony(R) to obtain
trademark peripheral licensees from these companies for their next generation
32-bit video game machines, which were introduced worldwide during 1995. The
Company has not yet determined whether such peripheral licenses will be required
for its current and future products. The Company is working with several
software publishers to establish compatibility between its golf and baseball
products and the software being developed for the new video game platforms.
During the first quarter of 1997, the Company began marketing a version of Smart
Baseball(TM) for the Sony Playstation(TM) which will be compatible with most
baseball games available for the Playstation(TM).

         Future Products. The Company's longer-range plans include the
utilization, and further development of its proprietary technology for
interactive boxing, football, hockey or tennis games and for other sports and
leisure interactive video games. The Company has not yet finalized the
adaptation of its technology for these simulation games. There can be no
assurance that these products will be developed by the Company and, if
developed, that they will be successful.

         The Company's current and future product development depends in large
part on the Company's ability to obtain sufficient capital resources to fund
research and development. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations".



                                       5
<PAGE>   6



SALES, MARKETING AND DISTRIBUTION

         From its inception in October 1991 through 1992, the Company focused
its marketing efforts on the instructional benefits of Pro Swing. Accordingly,
the Company entered into numerous domestic and foreign distributor agreements
with representatives who could place Pro Swing in locations where consumers
would be primarily motivated by a desire to analyze, and thereby improve, their
golf swings, such as country clubs and golf pro shops. The Company promoted its
products by limited airing of television "infomercials" and by placing
advertisements in Golf Digest, Golf Magazine and U.S. Air magazine.

         In early 1993, the Company recognized that placement of Pro Swing in
golf pro shops and in country clubs did not result in effective market
penetration and that Pro Swing would have a broader appeal as an entertainment
product rather than merely as an instructional device for golfers. The Company
refocused its domestic sales and marketing strategy to attract a broader base of
consumers who the Company believed would be interested in the interactive
entertainment value of Pro Swing. The Company expanded its sales efforts to
include marketing through direct mail catalogs such as Golfsmith International's
The Golf Store, and telemarketing. The impact of minimizing the use of domestic
distribution relationships has been negligible. The Company continues to use
foreign distributor relationships for sales of Pro Swing abroad but these
relationships are not currently material to the Company's overall sales and
marketing strategy. The Company maintains ongoing discussions with parties
interested in distributing the Company's other products internationally.

         More significantly, the Company began to distribute its products
through department stores, consumer electronics stores, computer and video game
retailers and mass merchandisers. During the third and fourth quarters of 1993,
the Company's sales organization established various relationships within the
United States with companies which distribute, or act as sales agents to
distribute, products to major retail chains throughout the United States. The
Company commissioned independent sales representatives to act as sales agents
for the Company. These sales representatives have specific geographic
territories in which they make sales calls to major retail national accounts to
sell the Company's products. Retail chains place sales orders directly with
the Company and the sales representatives receive a commission on sales
generated by them. The Company has sold its golf products to national retail
chains including Babbage's, Electronics Boutique, Software Etc., Inc., Sears
Roebuck & Co., Circuit City and Best Buy Company, while Batter Up(R) has been
sold to the above outlets, plus Toys "R" Us, Walmart, Dillard's and selected
Kay Bee Toys stores.

         Although management believes the retail distribution channel offers
the best method to profitably distribute its products, lack of adequate
financing to support "sell-through" at the retailers has forced the Company in
1997 to market its products directly to consumers by way of direct mail,
catalogs, direct response television, and sports-related advertising and
promotions with strategic marketing partners.


                                       6
<PAGE>   7


         Early in 1995, the Company finalized the development of a print
advertising campaign with the intention of increasing consumer affordability and
retail sell-through of its products. Advertisements were placed in publications
such as Boys Life, NBA Inside Stuff and McCall's. The Company also reduced the
suggested retail price of Batter Up(R) from $69 to $59 in order to improve
consumer affordability and increase retail sell-through of this product. The
combined print advertising and lower pricing for Batter Up(R) was an initial
success as Batter Up(R) sales at Toys "R" Us and Walmart doubled during the
second quarter of 1995 as compared to the first quarter of 1995. This
advertising campaign had to be terminated prematurely, however, due to the
Company's lack of capital resources.

         In 1995 and 1996 the Company's ability to market its products was
severely hampered by its lack of capital resources. This lack of capital
resources forced the Company to terminate its marketing staff and public
relations firm. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations".

         In September 1996 the Company executed a license agreement with Little
League Baseball, Incorporated ("Little League") where by the Company can utilize
the trademarks of Little League on Smart Baseball(TM). This agreement extends to
September 1997 but can be renewed upon written consent of Little League. The
Company pays Little League a royalty of five (5%) percent quarterly on all sales
of Smart Baseball(TM). Little League selected Smart Baseball as one of a
limited number of products it selected for inclusion in the Little League
Collection Catalog mailed out to over 75,000 potential customers beginning in
December 1996 and continuing through February 1997.

         During 1997 the Company plans on developing relationships with various
Little League sponsors in order to provide Smart Baseball(TM) as a promotional
product. From January 1997 throughout May 1997, Smart Baseball Flyers will be
distributed nationally in 250,000 Hershey's Candy Fund Raising boxes for Little
League organizations.

         The Company will introduce in April 1997 a special edition of its Smart
Baseball game, the Gary Carter Signature Edition, to benefit the Leukemia
Society of America. Additionally, a special offer for Smart Baseball will appear
on several million Lehigh Valley Dairy's milk cartons for several weeks
beginning in April 1997.

         Due to the Company's limited capital resources, during 1997 the Company
has engaged a new marketing plan that will focus on implementing strategic
alliances with logical marketing partners. Management believes these marketing
partnerships will provide an inexpensive way to access target consumers and
increase awareness of the Company's golf and baseball products. However, the
Company's ability to effectively market its products in 1997 and beyond will
depend in large part on its ability to obtain sufficient capital resources.


                                       7
<PAGE>   8


         Consistent with the approach of other consumer electronic computer and
video game manufacturers, the Company only sells its products overseas to
distributors who then resell the products to major retail chains. The Company
continues to develop distribution channels in Australia, Japan, Southeast Asia
and Europe for TeeV Golf(R), PC Golf(R), Batter Up(R) and PC Batter Up(R).
International sales, which the Company classifies as sales in countries other
than the United States, were 13.4% of net sales reported for the period ending
December 31, 1996. The Company believes that the high level of interest in golf,
baseball and interactive electronic games in Japan makes it an attractive
market. Although sales to date have been limited, the Company believes that
Europe will be a lucrative market once distribution channels are identified and
fully developed. There can be no assurance that the Company will establish
distribution channels in Australia, Japan, Southeast Asia and Europe and, if
established, that such channels will be successful.

RESEARCH AND DEVELOPMENT

         The Company believes that enhancement and expansion of its current
product line and the development of new products are necessary for the Company's
growth and success. The Company conducts its research and development activities
through a Research and Development department which manages all aspects of the
Company's product development engineering from the conceptual design to product
manufacturing. The department currently consists of two full-time employees and,
from time to time, the Company retains independent engineering consultants with
specialized expertise.

         From its inception in October 1991 through December 31, 1994, the
Company spent approximately $846,000 on engineering, research and development.
This amount was spent for development of the hardware and software of the Pro
Swing, for the development of TeeV Golf and its related software interface, for
the development of PC Golf and the coin-operated Country Club Golf Game.

         The Company spent approximately $188,000 and $133,216 during 1995 and
1996, respectively, for engineering, research and development activities. In
1995 and 1996, the Company completed development activities for PC Batter Up and
initiated research and engineering activities for new product concepts that
utilize the Companies current or newly developed technology, including a
skateboard/snowboard product.

         The Company's research and development efforts were curtailed in 1996
due to lack of capital resources. The Company's ability to pursue research and
design in 1997 and beyond will depend, in large part, on its efforts to obtain
sufficient capital resources. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations".



                                       8
<PAGE>   9


PRODUCTION

         The Company's current production includes final assembly, testing and
packaging of its products. The Company maintains good relations with many
suppliers and sub-contractors. A substantial majority of its sub-assemblies are
obtained from many contract manufacturers who produce to the Company's
specifications. These relationships assure the Company of many sources for the
supply of its components and can accommodate most surges in demand, most of
which can be planned for (e.g., holiday season demand) and, hence, do not
generally impact gross margins. Unplanned surges in demands may, however,
negatively impact gross margins over a very short period of time (e.g., two to
three weeks).

         The Company owns all of the tooling for all product lines. Production
employees are cross trained to perform each production step and individual
stations can be easily re-configured to respond to changes in product mix. New
product introductions do not materially impact assembly steps and production
efficiency of current products in production.

         Production capacity utilization levels in 1996 were approximately 2%,
compared to 6% in 1995 and 30% in 1994. Management believes that the Company's
properties are adequate to support the Company's current production operations.

COMPETITION

         The consumer electronics industry is highly competitive. The Company
competes directly with national and international manufacturers of electronic
video games. Substantially all of the Company's competitors have greater
financial, marketing and other resources than the Company. Although the Company
believes that the prices for its products are competitive, substantially all of
the Company's competitors have greater financial resources than the Company so
as to permit more aggressive pricing.

         The Company's products compete generally with the wide variety of
electronic video games that are currently available to consumers. These
competitive electronic video games include both sports-related video games that
simulate such sports as shooting and boxing, and non-sports-related video games,
that simulate such activities as aircraft piloting. The material methods of
competition among the Company and its competitors include the entertainment
value perceived by a customer for a product, the realism that is afforded a
customer by a product, and the compatibility of a product among numerous game
software available in the consumer electronics industry today. The Company is
unaware of any current electronic video game that competes directly with the
Company's consumer golf products by permitting the playing of simulated golf
without a full-length club and without a golf ball, or the playing of simulated
baseball without a full-length baseball bat and without a baseball.

         The Company believes that Pro Swing, PC Golf, TeeV Golf(R), Batter
Up(R) and PC Batter Up are unique in the consumer electronics marketplace
because each permits the playing of a simulated game without full-length clubs
or bats and without a golf ball or baseball, thereby permitting play in a small
space, without the need for a net or other containment device to stop a flying
golf ball or baseball. The Company believes that the uniqueness of its products,
coupled with the growing public participation in the game of golf and the
continuing public enjoyment of baseball, will enable the Company to compete
effectively in the consumer electronics industry if it is successful in
obtaining sufficient capital resources to develop, market, and distribute its
products.



                                       9
<PAGE>   10



PATENTS AND TRADEMARKS

         John D. Lipps, the Chairman of the Board, President, and Chief
Executive Officer of the Company, received a United States patent for Pro Swing
in November 1990 and assigned the patent to the Company in December 1991. The
patent extends for 17 years until 2007. A similar patent is pending in Japan
but there can be no assurance that this patent will be granted in Japan and, if
granted, when it will be granted. Another patent application, with John Lipps
and Stephen Szczecinski as co-inventors, was filed in January 1992 for
enhancements and modifications to the original design and the Company has
received a notice of allowance and is currently awaiting formal issuance of
this patent. The rights to this second patent application have been assigned to
the Company. On June 17, 1994, the Company filed a U.S. patent application,
with John Lipps, Stephen Szczecinski and Robert Baskette as co-inventors,
entitled "Sensing Spatial Movement" relating to improvements in its current
technology, including technology for products such as Batter Up(R). The rights
to this patent application have been assigned to the Company. The Company has
received a notice of allowance and is currently awaiting formal issuance of
this patent. On May 18, 1995, the Company filed a patent application, with John
Lipps, Stephen Szczecinski and Gregory Svetina as co-inventors entitled,
"Riding Board Game Controller", which relates to improvements in the Company's
current technology to allow for such products as skateboards, snowboards and
surfboards. The rights to this patent application have been assigned to the
Company. In February 1997, the Company filed a continuation part to this patent
application which provides for enhancements and modifications to the original
design, and is still pending.

         Mr. Lipps and Mr. Szczecinski have each executed an agreement pursuant
to which each is obligated to assign to the Company any rights he may receive
during his employment with the Company for any new products or inventions he
develops which relate to the Company's business. These assignment obligations
expire upon termination of employment. Mr. Lipps has an employment agreement
with the Company that expires on December 31, 1999.

         In July 1995, the Company and Mr. Lipps executed an Agreement with
Respect to Patentable Inventions pursuant to which the Company agreed to make
severance payments to Mr. Lipps with respect to four patents and/or patent
applications owned by Mr. Lipps and assigned to the Company. These severance
payments become payable to Mr. Lipps upon termination of his employment with the
Company for any reason, and are equal in amount to three percent (3%) of annual
gross revenues received by the Company from the sale of products which rely on
any of the four patents (maximum $360,000 per annum; minimum $90,000 per annum),
and are payable only for the life of each of the four patents. The Agreement
also provides that ownership of the four patents reverts to Mr. Lipps upon the
occurrence of (i) the Company's breach of the Agreement if the breach continues
unremedied for more than 60 days after the Company receives notice there of from
Mr. Lipps, (ii) the Company's insolvency or assignment for the benefit of
creditors, (iii) the Company's dissolution or other termination of existence, or
(iv) sale of the Company's assets outside the Company's ordinary course of
business such that the Company ceases as a going concern.

         Ownership, rather than licensing of, the Company's hardware and
software technology incorporated in its products permits the Company to utilize
this technology without payment of costly license fees or royalty payments,
provides maximum flexibility in making modifications to, and improvements on,
such technology and precludes use of the technology by the Company's
competitors.



                                       10
<PAGE>   11


         Trademark registration for TeeV Golf(R), PC Golf(R), Batter Up(R) and
Country Club Golf Game(R) have been granted. The Company has copyright
registration for the original "firmware" for Pro Swing. Unlike software, which
stores programs on a disk and can be altered in that form, firmware stores
programs on a microchip which cannot be altered. The Company has been granted
copyright registration for the current version of this firmware and the firmware
for TeeV Golf(R) and has filed for copyright registration of firmware for PC
Golf(R). The Company has been granted copyright registration for a
communications utility program for use with Pro Swing and PC Golf(R).

         In 1992 the Company applied for trademark registration of "The Pro
Swing System." This application was rejected because the trademark "Pro-Swing"
had been registered by a California company in 1987 for use with products
different from any of the Company's products. The Company successfully initiated
a cancellation proceeding with respect to the California company's registration,
alleging, in part, non-use of the trademark for a period of at least two years.
The Company's trademark registration, "The Pro Swing System", has been allowed.
There can be no assurance that the California company will not oppose the
Company's registration of this trademark.

                  In August 1993, the Company received correspondence from
counsel to a Canadian corporation claiming that Pro Swing infringes that
corporation's patent rights. The Company believes that the claim is without
merit and so advised the Canadian corporation. To date the Company has received
no additional communications from the Canadian corporation or its counsel.

         In March 1994, the Company received correspondence from counsel of a
Texas corporation claiming that TeeV Golf(R) infringes that corporation's patent
rights. The Company's patent counsel has communicated to the Texas corporation
that it believes that the claim is without merit. In November 1995, the Company
received a follow-up request to clarify its position and the Company's patent
counsel has complied. To date, the Company has received no additional
communication from the Texas corporation or its counsel.

         In December 1994, a California corporation claimed, in writing to the
Company, that it had produced a video game identified as "Super Batter Up". The
Company's patent counsel has communicated to the California corporation, and its
legal counsel, that the Company's Batter Up(R) and the California corporation's
video games are wholly different products. There have been no further
communications with, from or to the California corporation or its counsel.

SEASONALITY

         Based upon approximately five years of operations, sales are highest
during the Company's fourth quarter due to holiday season buying.

IMPACT OF INFLATION AND CHANGING PRICES

         At this stage of the Company's development, it is not clear what impact
inflation will have on the financial position or results of operations. While
many of the component parts used in the Company's products are subject to
general inflation, some of the most costly parts are electronic components which
have tended to decrease in price over recent periods. Management does not
believe that the effects of inflation, in the aggregate, will have a material
adverse effect on the Company over the next twelve months.



                                       11
<PAGE>   12



ENVIRONMENTAL IMPACT

         The Company assembles its products at its Twinsburg, Ohio facility
using components and raw materials purchased from third parties. In the assembly
process, the Company does not discharge any reportable materials into the
environment. The Company believes that it is in compliance with applicable
federal, state and local provisions regulating the discharge of materials into
the environment and that such compliance does not have a material effect on the
capital expenditures, earnings or competitive position of the Company.

EMPLOYEES

         As of March 25, 1997, the Company employed 9 full-time employees, five
of whom were management and administrative personnel, two of whom were
engineering personnel, one of whom were sales and marketing personnel and one of
whom were manufacturing personnel. In addition, the Company hires independent
consultants, part time employees and temporary help from time to time.

         The Company believes that it enjoys good relations with all of its
employees. None of the Company's permanent full-time employees are unionized or
subject to collective bargaining agreements. The Company has experienced no work
stoppages or strikes.

         Some of the Company's employees are highly skilled and the Company's
continued success will depend, in part, on its ability to retain these
employees. There can be no assurance, given the Company's financial condition,
that the Company will be able to retain any of these employees.

ITEM 2.  PROPERTIES

         The offices and production facility of the Company are located at 2075
Case Parkway South, Twinsburg, Ohio in a five year old, 12,000 square foot
building. This facility is leased by the Company from Oakleaf II Co. pursuant to
a five year lease expiring May 14, 1997 and providing for monthly rental
installments of $6,200 plus insurance, taxes and maintenance costs. The lease
provides the Company with the opportunity to construct additional space on
adjacent property it leases at any time during the term of the lease. The
Company intends to renew this lease. There will be no significant increase in
rent expense upon renewal.

ITEM 3.  LEGAL PROCEEDINGS

         The Company is subject to potential claims and legal actions arising
in the ordinary course of business.  Pending claims at December 31, 1996 total
approximately $253,000.  In 1996 the Company was named as a defendant in the
matter of Miles Rubber and Packing Co., versus Sports Sciences, Inc. which is
currently pending in the Court of Common Pleas, Summit County, Ohio.  The
lawsuit alleges that the Company failed to pay approximately $98,000 in trade
payable indebtedness and failed to receive and pay for inventory totaling
approximately $99,000.  Management believes that it has defenses of
considerable merit and will litigate all pending disputes and/or seek
settlements favorable to the company, but is not able to predict the ultimate
outcome of these matters at this time.  Accordingly, resolutions unfavorable to
the Company could result in material liabilities and charges which have not
been reflected in the accompanying financial statements.  The Company is not
aware of any contemplated proceeding by a governmental authority with respect
to it or its Property.




                                       12
<PAGE>   13



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

         The Company's Annual Meeting of Shareholders was held on August 21,
1996 and was reconvened on October 9, 1996.

         The following matters were voted upon at the meeting:
<TABLE>
<CAPTION>

                                                    FOR       AGAINST    ABSTAIN        UNVOTED
                                                    ---       -------    -------        -------
           1. Election of Directors
<S>                                              <C>          <C>           <C>            <C>
                (a) Nicholas J. Chuma            3,586,931     52,921       0              0
                (b) John D. Lipps                3,611,031     28,821       0              0
                (c) Donald Miller                3,486,531    153,321       0              0
                (d) Gary Taylor                  3,486,110    153,742       0              0
                (e) Peter Waite                  3,486,431    153,421       0              0

           2. Amendment of Articles
              of Incorporation*                  3,487,114    23,460      30,299        98,979

           3. Adoption of Amendment
              to 1993 Non-Qualified
              and Incentive Stock
              Option Plan**                      3,327,063    118,976     94,844        98,979

           4. Approval of Saltz, Shamis
              & Goldfarb, Inc. as
              Independent Accountants            3,531,051    54,221      54,580           0
</TABLE>



*    To increase the number of authorized shares of Common Stock from 10 million
     to 50 million shares and to change the state of incorporation of the
     Company from Ohio to Delaware by means of a merger of the Company with and
     into a wholly-owned Delaware subsidiary.

**   To increase the number of shares authorized for issuance under the Plan
     from 490,000 shares to 1,000,000 shares.



                                       13
<PAGE>   14



                                     PART II

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

          The following table sets forth for the periods indicated, the range of
high and low closing bid quotations for the Common Stock and Warrants as quoted
on the NASDAQ Over The Counter ("OTC") Market.
<TABLE>
<CAPTION>
  PERIOD                              COMMON STOCK
1995 Quarter                        High         Low
------------                        ----         ---
<S>                             <C>           <C>
First                                7            2
Second                               3            1
Third                               1 7/8         5/8
Fourth                              19/16         1/4


1996 Quarter                        High         Low
------------                        ----         ---
<S>                             <C>           <C>
First                                1           3/8
Second                               1          15/32
Third                               15/32        1/8
Fourth                               1/4         1/16
</TABLE>

         Due to limited trading activity on the Warrants, the data obtained by
the Company, from wire services, report the high and low closing bid quotations
during 1996 were $2.00  and $.001, respectively.

         The above quotations represent inter-dealer bid quotations, without
retail mark-ups, mark-downs or commissions, and do not necessarily represent
actual transactions.

         Substantially all of the holders of Common Stock maintain ownership of
their shares in "street name" accounts and are not stockholders of record. At
March 25, 1997 there were approximately 230 holders of record of Common Stock,
however the Company believes that there are approximately 1,100 beneficial
owners of Common Stock.

         The Company has not paid cash dividends with respect to the Common
Stock in the past and has no pursuant plans to pay dividends on the Common Stock
in the foreseeable future because it intends to retain earnings, if any, in
order to finance the continued growth of the Company.

ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATION.

RESULTS OF OPERATION
--------------------

Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
---------------------------------------------------------------------

          The Company generated net sales of $663,000 for the year ended
December 31, 1996 as compared to net sales of $1,397,000 for the comparable
period in 1995.

         International sales, including Canada, for the year ended December 31,
1996 were $89,000 as compared to $267,000 for the comparable period in 1995.
Provisions for product returns during the year ended December 31, 1996 were
$84,000 as compared to $668,000 for the comparable period in 1995.

         Gross margin percentage for the year ended December 31, 1996 was
approximately 19% as compared to approximately (5)% during the comparable period
in 1995. The increase in gross margin percentage is attributable to a
substantial decrease of $383,000 in fixed manufacturing overhead for the year
ended December 31, 1996, as compared to the same period in 1995. In the year
ended December 31, 1996, the Company's unit production volume decreased 63%,
compared to the same period in 1995.



                                       14
<PAGE>   15

         Total operating expenses for the year ended December 31, 1996 were
$1,622,000 consisting of selling, general and administrative costs of $792,000,
research and development costs of $133,000, a non-recurring charge of $67,000
for inventory write-downs and a non-recurring charge of $630,000 for write-down
of assets to net realizable value, as compared to total operating expense of
$2,384,000 for the year ended December 31, 1995 consisting of selling, general
and administrative costs of $1,793,000, research and development costs of
$188,000 and a non-recurring charge of $403,000 for inventory write-downs. The
decrease in selling, general and administrative expense of $1,001,000 is due to
a decrease in personnel costs of approximately $424,000, a decrease of
approximately $535,000 for advertising and marketing expenditures, and a
decrease in royalty expenses of approximately $40,000.

         Other expense for the year ended December 31, 1996, was $25,000 as
compared to $78,000 during the year ended December 31, 1995. The decrease in
other expense is due primarily to bank charges in 1995 relating to a now expired
line of credit with Comerica Bank.

Financial Condition and Liquidity
---------------------------------

         Cash flow used by operations was $750,677 for the year ended December
31, 1996. In October 1996, the Company received approximately $1,075,000 in net
proceeds from the private placement of Common Stock (6,933,333 shares in the
aggregate) effected under Regulation D of the Securities Act of 1933, as
amended. At December 31, 1996 the Company has used a total of approximately
$593,000 in net proceeds for payment of trade payables, including settlements of
trade payable indebtedness, totaling approximately $205,000, repayment of notes
payable of $160,000, prepayment of and payment for inventory totaling
approximately $98,000 and approximately $130,000 for sales, marketing, and
administrative expenses.

         Management estimates that its minimum cash requirements for 1997 are
approximately $1,000,000. These minimum cash requirements are as follows:
$160,000 for working capital, $710,000 for sales, marketing and administrative
expenses, and $130,000 for research and development costs. Management believes
that cash flow generated from operations during 1997 will not be sufficient to
meet minimum cash requirements. To address the Company's ongoing serious cash
flow problems and to meet its minimum cash requirements, the Company must
obtain at least $500,000 through private placements of equity securities to
meet its minimum cash requirements and to supplement cash on hand at  December
31, 1996 of $482,340.

         The Company is currently discussing the terms of a private placement of
$1,000,000 of equity securities with its investment banker, Taglich Brothers,
D'Amadeo, Wagner & Company, Incorporated, who completed a private placement of
$1,300,000 in equity securities for the Company in 1996. The Company would use
$500,000 to meet its minimum cash requirements described above and the
approximately $375,000 in additional net proceeds to finalize the development
of its skateboard/snowboard product. This product would be developed for the
personal computer and new video game platforms on the market, with revenues
generated from this product beginning in 1998.

         There can be no assurance that the Company will be able to generate or
raise sufficient funds to meet minimum liquidity needs in 1997.

ITEM 7.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         The information required by this Item begins at page 19 hereof.



                                       15
<PAGE>   16

ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURES

         None.



                                       16
<PAGE>   17



                                    PART III

ITEM 9.  DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
         COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT

         The information required by this Item is omitted inasmuch as the
Company intends to file its definitive 1997 Proxy Statement containing such
information with the Securities and Exchange Commission within 120 days after
the close of its fiscal year ended December 31, 1996, and such information is
incorporated herein by reference.

ITEM 10. EXECUTIVE COMPENSATION

         The information required by this Item is incorporated by reference from
the 1997 Proxy Statement.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The information required by this Item is incorporated by reference from
the 1997 Proxy Statement.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The information required by this Item is incorporated by reference from
the 1997 Proxy Statement.

ITEM 13. EXHIBITS AND FINANCIAL REPORTS ON FORM 8-K

         (a)      EXHIBITS

         Exhibits noted with an asterisk are incorporated by reference to the
         Issuer's Registration Statement on Form SB-1 (Registration
         No.33-77480). Exhibits noted with a double asterisk are incorporated
         by reference to the Registration Statement on Form SB-2 (Registration
         No. 33-82706). Exhibits noted with a triple asterisk are incorporated
         by reference to the Registrant's Registration Statement on Form SB-2
         (Registration No. 333-6458)

         Exhibit Number
         (Reference to Item 601 of Regulation S-B)

***      3(i)     Certification of Incorporation of the Company.

***      3(ii)    By-laws of the Company.

***      4        Specimen Common Stock Certificate

*        4.3      Form of  Underwriter's Warrants.





                                       17
<PAGE>   18

*        4.4      Roulston Warrants dated October 19, 1993.

***      4.5      Form of  Common Stock Purchase Warrant dated October 31, 1996.

**       10       Trademark  Licensing  Agreement  dated January 11, 1994
                  between the Company and Sega(R)of America, Inc.

*        10.1     Form of Licensing Agreement between the Company and Access
                  Software, Inc.

*        10.2     Employment Agreement dated January 1, 1993 between the
                  Company and John D. Lipps.

*        10.3     Stock and Warrants  Purchase  Agreement  dated  October
                  19, 1993 between the Company and Roulston Investment Trust
                  Limited Partnership.

*        10.4     1993 Non-Qualified and Incentive Stock Option Plan.

**       10.5     Form of confidential Non-Exclusive License Agreement for
                  Nintendo Product Accessories.

**       10.6     Assignment Agreement dated December 1, 1991 (John D. Lipps).

**       10.7     Assignment Agreement (undated) (John D. Lipps and Stephen J.
                  Szczecinski).

**       10.8     Assignment Agreement (undated) ( John D. Lipps, Stephen J.
                  Szczecinski and Robert W. Baskette).

**       10.9     Form of  Regulation S Subscription Agreement.

**       10.10    From of  $75,000 Cognovit Note in favor of Peter Waite dated
                  June 6, 1995.

**       10.12    Agreement with respect to Patenable Inventions dated
                  July 21, 1995 between the Company and John D. Lipps.

***      10.13    Agreement with Little League Incorporated dated June 25, 1996.

         23.2     Consent of Saltz, Shamis & Goldfarb, Inc.

         b)       REPORTS ON FORM 8-K:

The issuer filed one report on Form 8-K during the Fourth Quarter of the fiscal
year ended December 31,1996:

         **       Current report on Form 8-K dated October 31, 1996.





                                       18
<PAGE>   19
                          SMART GAMES INTERACTIVE, INC.

                              FINANCIAL STATEMENTS

                               FOR THE YEARS ENDED
                           DECEMBER 31, 1996 AND 1995




                                       19
<PAGE>   20



                          SMART GAMES INTERACTIVE, INC.

                                TABLE OF CONTENTS



<TABLE>
<CAPTION>
                                                                                                               Page
                                                                                                               ----


<S>                                                                                                      <C>
INDEPENDENT AUDITORS' REPORT...................................................................................F-1

FINANCIAL STATEMENTS

     Balance Sheets as of December 31, 1996 and 1995....................................................F-2 -- F-3

     Statements of Income for the years ended December 31, 1996 and 1995.......................................F-4

     Statements of Shareholders' Equity for the years ended December 31, 1996 and 1995.........................F-5

     Statements of Cash Flows for the years ended December 31, 1996 and 1995...................................F-6

     Notes to Financial Statements.....................................................................F-7 -- F-20
</TABLE>


                                      20









<PAGE>   21








                          INDEPENDENT AUDITORS' REPORT


To the Board of Directors
Smart Games Interactive, Inc.

We have audited the accompanying balance sheets of Smart Games Interactive,
Inc. (known as Sports Sciences, Inc. prior to merger with and into Smart
Games Interactive, Inc. on October 11, 1996 (see Note A)) as of December 31,
1996 and 1995 and the related statements of income, shareholders' equity and
cash flows for the years then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits 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 1996 and 1995 financial statements referred to above present
fairly, in all material respects, the financial position of Smart Games
Interactive, Inc. as of December 31, 1996 and 1995, and the results of its
operations and its cash flows for the years then ended in conformity with
generally accepted accounting principles.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As more fully described in Note B, the
Company has incurred losses since its start-up and is not currently generating
sufficient cash flows from operations. This situation raises substantial doubt
about the Company's ability to continue as a going concern. Management's plans
are set forth in Note B. The financial statements do not include any adjustments
to reflect the possible future effects on the recoverability and classification
of assets or the amounts and classification of liabilities that may result from
the outcome of this uncertainty.


                                            SALTZ, SHAMIS & GOLDFARB, INC.
Akron, Ohio
March 24, 1997                   F-1



<PAGE>   22
                          SMART GAMES INTERACTIVE, INC.

                                 BALANCE SHEETS

                           DECEMBER 31, 1996 AND 1995



<TABLE>
<CAPTION>


                                     ASSETS
                                     ------

                                                                     1996              1995
                                                                     ----              ----
<S>                                                              <C>               <C>
CURRENT ASSETS
  Cash and cash equivalents                                      $  482,340        $  166,944
  Accounts receivable, less allowances of
     $44,000 and $208,000, respectively                              28,980           301,634
  Prepaid expenses and other current assets                         171,886            68,230
  Inventories:
     Raw materials                                                  301,289           497,157
     Work-in-process                                                166,180           143,835
     Finished goods                                                  91,374           158,722
                                                                 ----------        ----------
        Total inventories                                           558,843           799,714
                                                                 ----------        ----------

     TOTAL CURRENT ASSETS                                         1,242,049         1,336,522

PROPERTY AND EQUIPMENT, net                                         165,061           206,618

OTHER NONCURRENT ASSETS
     Trade credits, net of valuation reserves of $798,000
          and $168,000, respectively                                 42,000           672,000
     Other assets, net                                               84,085            74,218
                                                                 ----------        ----------
                                                                    126,085           746,218
                                                                 ----------        ----------

                                                                 $1,533,195        $2,289,358
                                                                 ==========        ==========
</TABLE>


                See accompanying notes to financial statements.
                                      F-2

<PAGE>   23

                          SMART GAMES INTERACTIVE, INC.

                                 BALANCE SHEETS

                           DECEMBER 31, 1996 AND 1995





                      LIABILITIES AND SHAREHOLDERS' EQUITY
                      ------------------------------------

<TABLE>
<CAPTION>

                                                                 1996                1995
                                                                 ----                ----
<S>                                                          <C>                 <C>
CURRENT LIABILITIES
  Current portion of capital lease obligations               $     5,841         $         -
  Accounts payable                                               591,235           1,423,680
  Accrued compensation and related liabilities                     4,328              41,387
  Other accrued expenses                                         207,700             269,584
                                                             -----------         -----------

     TOTAL CURRENT LIABILITIES                                   809,104           1,734,651

CAPITAL LEASE OBLIGATIONS,
  net of current portion                                          28,797                   -

SHAREHOLDERS' EQUITY
  Preferred stock, at par value ($0.0002),
     5,000,000 shares authorized, 0 shares issued and
     outstanding                                                       -                   -
  Common stock, at par value ($0.0002),
     50,000,000 shares authorized; 12,648,244 issued
     and outstanding at December 31, 1996, 10,000,000 shares
     authorized; 5,176,379 issued and outstanding
     at December 31, 1995                                          2,530               1,035
  Paid in capital                                              6,262,943           4,803,192
  Accumulated deficit                                         (5,570,179)         (4,249,520)
                                                             -----------         -----------
                                                                 695,294             554,707
                                                             -----------         -----------

                                                             $ 1,533,195         $ 2,289,358
                                                             ===========         ===========
</TABLE>

               See accompanying notes to financial statements.
                                      F-3

<PAGE>   24
                          SMART GAMES INTERACTIVE, INC.

                              STATEMENTS OF INCOME

                 FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995



<TABLE>
<CAPTION>
                                                               1996                1995
                                                               ----                ----

<S>                                                        <C>                 <C>
Net sales                                                  $   663,406         $ 1,397,318

Cost of goods sold                                             537,921           1,470,681
                                                           -----------         -----------

Gross margin                                                   125,485             (73,363)

Selling, general and administrative expenses                   791,532           1,793,337
Research and development costs                                 133,216             187,936
Non-recurring charges                                          697,303             402,644
                                                           -----------         -----------
                                                             1,622,051           2,383,917
                                                           -----------         -----------

Loss from operations                                        (1,496,566)         (2,457,280)

Other expenses, primarily interest                              25,243              77,909
                                                           -----------         -----------

Loss before extraordinary items                             (1,521,809)         (2,535,189)

Extraordinary items                                            201,150                   -
                                                           -----------         -----------

Net loss                                                   $(1,320,659)        $(2,535,189)
                                                           ===========         ===========

Net loss per common share before extraordinary items       $     (0.23)        $     (0.74)
                                                           ===========         ===========

Net loss per common share                                  $     (0.20)        $     (0.74)
                                                           ===========         ===========

Shares used in calculation of net loss per share             6,692,154           3,407,425
                                                           ===========         ===========
</TABLE>


               See accompanying notes to financial statements.

                                      F-4

<PAGE>   25
                          SMART GAMES INTERACTIVE, INC.

                       STATEMENTS OF SHAREHOLDERS' EQUITY

                 FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995




<TABLE>
<CAPTION>

                                               Common stock                                                       Total
                                        ------------------------         Paid in          Accumulated         Shareholders'
                                          Shares        Dollars          Capital            Deficit              Equity
                                          ------        -------          -------            -------             ---------
<S>                                     <C>              <C>           <C>                 <C>                 <C>
Balance, January 1, 1995                2,923,979        $  585        $ 3,827,481         ($1,714,331)        $ 2,113,735

Issuance of common stock for
   cash pursuant to private
   placements                           2,252,400           450          1,189,455                   -           1,189,905

Expenditures for private
   placements                                   -             -           (213,744)                  -            (213,744)

Net loss                                        -             -                  -          (2,535,189)         (2,535,189)
                                       ----------        ------        -----------         -----------         -----------

Balance, December 31, 1995              5,176,379         1,035          4,803,192          (4,249,520)            554,707

Issuance of common stock for
   cancellation of indebtedness           538,532           108            385,998                   -             386,106

Issuance of common stock for
   cash pursuant to private
   placements                           6,933,333         1,387          1,298,613                   -           1,300,000

Expenditures for private
   placements                                   -             -           (224,860)                  -            (224,860)

Net loss                                        -             -                  -          (1,320,659)         (1,320,659)
                                       ----------        ------        -----------         -----------         -----------

Balance, December 31, 1996             12,648,244        $2,530        $ 6,262,943         ($5,570,179)        $   695,294
                                       ==========        ======        ===========         ===========         ===========
</TABLE>

                 See accompanying notes to financial statements.

                                       F-5


<PAGE>   26
                          SMART GAMES INTERACTIVE, INC.

                            STATEMENTS OF CASH FLOWS

                 FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995

                           INCREASE (DECREASE) IN CASH

<TABLE>
<CAPTION>

                                                                               1996              1995
                                                                               ----              ----
<S>                                                                        <C>                 <C>
CASH FLOWS FROM OPERATING ACTIVITIES
  Loss before extraordinary item                                           $(1,521,809)        $(2,535,189)
  Extraordinary item                                                           201,150                   -
                                                                           -----------         -----------
  Net loss                                                                  (1,320,659)         (2,535,189)
    Adjustments to reconcile net loss to net cash used by operating
       activities:
       Depreciation and amortization                                            95,933             105,523
       Accounts receivable allowances                                         (164,278)           (146,769)
       Non-recurring charges                                                   697,303             402,644
       Sale of inventory for trade credits, net of allowances                        -            (672,000)
       Cash provided (used) by the change in:
          Accounts receivable                                                  436,932           1,448,116
          Inventories                                                          173,568             501,301
          Prepaid expenses and other assets                                   (124,194)            162,168
          Accounts payable                                                    (446,339)            532,037
          Accrued expenses                                                     (98,943)           (156,405)
                                                                           -----------         -----------
NET CASH USED BY OPERATING ACTIVITIES                                         (750,677)           (358,574)

CASH FLOWS FROM INVESTING ACTIVITIES
  Purchases of property and equipment                                           (5,845)            (26,220)

CASH FLOWS FROM FINANCING ACTIVITIES
  Proceeds from issuance of common stock,
       net of expenses                                                       1,075,140             976,161
  Net repayments on line of credit                                                   -            (469,142)
  Issuance of notes payable                                                    466,396             150,000
  Repayment of notes payable                                                  (466,396)           (150,000)
  Repayment of capital lease obligations                                        (3,222)                  -
                                                                           -----------         -----------
NET CASH PROVIDED BY FINANCING ACTIVITIES                                    1,071,918             507,019
                                                                           -----------         -----------
NET INCREASE IN CASH                                                           315,396             122,225
CASH AND CASH EQUIVALENTS, beginning of year                                   166,944              44,719
                                                                           -----------         -----------
CASH AND CASH EQUIVALENTS, end of year                                     $   482,340         $   166,944
                                                                           ===========         ===========
</TABLE>

                 See accompanying notes to financial statements.

                                       F-6



<PAGE>   27


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995

NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
---------------------------------------------------

Organization and Nature of Operations
-------------------------------------
Smart Games Interactive, Inc. (the Company) is engaged in the consumer
electronics industry. The Company designs, develops and manufactures interactive
electronic game simulations that incorporate the Company-owned hardware and
software technology. The Company's products are sold throughout the United
States and internationally.

On October 11, 1996, Sports Sciences, Inc. ("SSI"), the predecessor to the
Company, reincorporated from the State of Ohio to the State of Delaware by means
of a merger with and into the Company (the "Merger"), then a wholly-owned
subsidiary of SSI. The Company was the surviving corporation in the Merger. In
the Merger, SSI's outstanding common stock was automatically extinguished and
converted into issued and outstanding shares of the Company's common stock.

Concentrations of Credit Risk
-----------------------------
Financial instruments that potentially subject the Company to concentrations of
credit risk consist principally of temporary cash investments and trade accounts
receivables. The Company places its temporary cash investments with financial
institutions and, although at December 31, 1996 they had invested amounts in
excess of federal insurance limits, management does not feel that the Company is
exposed to any substantial credit risk. Trade accounts receivable at December
31, 1996 and 1995 include $63,418 and $293,493 receivable from two and five
customers, respectively. Additionally, sales to one and three customers during
the years ended December 31, 1996 and 1995 represented 68% and 76% of total net
sales, respectively. See Note D regarding sales to one of these customers which
comprised 62% of 1995 net sales.

Cash and Cash Equivalents
-------------------------
The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.

Accounts Receivable
-------------------
The Company performs periodic credit evaluations of its customers' financial
condition and generally does not require collateral. Returns and credit losses
to date have been within management's expectations. Allowances include $24,000
in 1996 and $204,000 in 1995 for returns and $20,000 in 1996 and $4,000 in 1995
for uncollectible accounts.

Inventories
-----------
The Company values its inventories at the lower of cost or market. Cost is
determined utilizing the first-in, first-out (FIFO) method.




                                       F-7

<PAGE>   28


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995


NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
---------------------------------------------------

Property and Equipment
----------------------
Property and equipment is stated at cost. Depreciation is computed on a
straight-line basis over the estimated useful lives of the assets, ranging from
five to seven years. Repairs and maintenance costs are charged to expense as
incurred.

Other Assets, Net
-----------------
Other assets consist primarily of patents and trademarks which are stated at
cost. The Company capitalizes the costs associated with obtaining patents and
trademarks, primarily legal expenses and filing fees. On an ongoing basis, the
Company evaluates the carrying value of its patents and trademarks and adjusts
for any impairment in value. Amortization is computed on a straight-line basis
over the estimated useful life of the patent or trademark, not to exceed 17
years for patents and 40 years for trademarks. Amortization expense for the
years ended December 31, 1996 and 1995 was $10,671 and $5,303, respectively.

Revenue Recognition
-------------------
The Company recognizes revenue when goods are shipped to customers except for
inventory shipped on a consignment basis. Revenue from consignments is
recognized when the consignee sells the product to individual consumers.
Allowances are recorded for estimated product returns and warranties.
International sales, including Canada, amounted to approximately $89,000 and
$267,000 for the years ended December 31, 1996 and 1995, respectively.

Income Taxes
------------
Income taxes are accounted for in accordance with the provisions of Statement of
Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income
Taxes." Under SFAS 109, the asset and liability method is used to account for
income taxes. This method requires the recognition of deferred tax liabilities
and assets for the expected future tax consequences of temporary differences
between the financial reporting basis and tax basis of assets and liabilities.
Valuation allowances are established, if necessary, to reduce the deferred tax
asset to the amount that will more likely than not be realized. Income tax
expense is the current tax payable or refundable for the period plus or minus
the net change in the deferred tax assets and liabilities.

Net Loss Per Common Share
-------------------------
Net loss per common share is computed using the weighted average number of
shares of common stock and common equivalent shares outstanding.

Use of Estimates
----------------
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect certain reported amounts and disclosures. Accordingly, actual results
could differ from those estimates.

                                       F-8

<PAGE>   29


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995



NOTE B - BASIS OF PRESENTATION; LIQUIDITY
-----------------------------------------

As shown in the accompanying financial statements, the Company incurred a net
loss of $1,320,659 during the year ended December 31, 1996. Sales, since
the Company's inception, have not been sufficient to support operations based
on the Company's current capitalization. Accordingly, uncertainty exists
regarding the Company's ability to generate sufficient working capital to
sustain ongoing operations.

The Company's assessment of its operating requirements and plans for 1997
follow.

Management estimates that its minimum cash requirements for 1997 are
approximately $1,000,000. These minimum cash requirements are as follows:
$160,000 for working capital, $710,000 for sales, marketing and administrative
expenses, and $130,000 for research and development costs. Management believes
that cash flow generated from operations during 1997 will not be sufficient to
meet minimum cash requirements. To address the Company's ongoing serious cash
flow problems and to meet its minimum cash requirements, the Company must
obtain at least $500,000 through private placements of equity securities to
meet its minimum cash requirements and to supplement cash on hand at December
31, 1996 of $482,340.

The Company is currently discussing the terms of a private placement of
$1,000,000 of equity securities with its investment banker, Taglich Brothers,
D'Amadeo, Wagner & Company, Incorporated, who completed a private placement of
$1,300,000 in equity securities for the Company in 1996. The Company would use
$500,000 to meet its minimum cash requirements described above and the
approximately $375,000 in additional net proceeds to finalize the development
of its skateboard/snowboard product. This product would be developed for the
personal computer and new video game platforms on the market, with revenues
generated from this product beginning in 1998.



                                       F-9


<PAGE>   30


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995




NOTE B - BASIS OF PRESENTATION; LIQUIDITY
-----------------------------------------

The Company's financial statements have been prepared on a going concern basis
and do not include any adjustments to reflect the possible future effects on the
recoverability and classification of assets or the amounts and classification of
liabilities that may result from the possible inability of the Company to
continue as a going concern.

NOTE C - INVENTORY; NON-RECURRING CHARGES
-----------------------------------------

During the fourth quarters of 1996 and 1995, the Company recognized unusual,
non-recurring charges of $67,303 and $402,644, respectively, related to
reducing inventories to net realizable value. Such value is based on
management's estimate of sales of its 16-bit technology products in the ensuing
years.

The inventory balance of the Company's remaining 16-bit technology products at
December 31, 1996 is approximately $51,000.

NOTE D - BARTER TRANSACTION - TRADE CREDITS; NON-RECURRING CHARGES
------------------------------------------------------------------

During June 1995, the Company entered into an agreement whereby it sold
$1,040,000 of its products at fair market value to SKR Resources, Inc. in
exchange for cash of $200,000 and $840,000 of trade credits to be utilized on a
part cash (cash portion not to exceed 50%), part trade basis for media
advertising, goods and or services. Sales discounts and a reduction of the trade
credits in the amount of $168,000 were recorded to reflect advertising agency
charges which would be incurred in connection with the utilization of these
credits. Amounts included in net sales and cost of sales in 1995 resulting from
bartered transactions are $872,000 and $636,972, respectively.

The initial term of the agreement is for 36 months; however, the Company may
extend the agreement for an additional 12 months. Any trade credits remaining
after expiration of the agreement shall become null and void. As of December 31,
1996 none of these trade credits had been utilized by the Company.

Present circumstances indicate that there is substantial uncertainty as to the
Company's ability to utilize the trade credits during the remaining term of the
agreement as realization of the trade credits is dependent on the Company
generating sufficient future cash flows to meet the cash payments required in
connection with the utilization of the trade credits. During December 1996, the
Company recorded a non-recurring charge of $630,000 as a result of reducing the
trade credits to their net realizable value.

                                      F-10

<PAGE>   31



                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995



NOTE E - PROPERTY AND EQUIPMENT
-------------------------------

Property and equipment consists of the following at December 31, 1996 and 1995:

<TABLE>
<CAPTION>
                                               1996       1995
                                               ----       ----
         <S>                                 <C>        <C>
         Machinery and equipment             $325,471   $320,521
         Computer equipment                    84,983     84,087
         Furniture and fixtures                31,095     31,095
         Leasehold improvements                 3,283      3,283
         Assets held under capital leases      37,860         --
                                             --------   --------
                                              482,692    438,986
         Less accumulated depreciation and
         amortization                         317,631    232,368
                                             --------   --------

         Property and equipment, net         $165,061   $206,618
                                             ========   ========
</TABLE>

Accumulated amortization on the assets held under capital leases was $4,206 at
December 31, 1996. Amortization of assets under capital leases is included in
depreciation expense for 1996.

NOTE F - NONCASH TRANSACTIONS
-----------------------------

In May 1996, the Company issued 538,532 shares of its common stock to several
creditors of the Company, in consideration for their cancellation of trade
payable indebtedness owed by the Company in the aggregate amount of $386,106.

During 1996, the Company also entered into two capital leases for equipment
totaling $37,860.

NOTE G - EXTRAORDINARY ITEMS
----------------------------

During the fourth quarter of 1996, the Company initiated a program whereby it
negotiated settlements of outstanding trade payable indebtedness owed by the
Company. The Company paid cash of approximately $99,000 in order to settle
indebtedness of approximately $326,000. The Company reduced accounts payable and
other accrued expenses on its balance sheet by approximately $326,000 and
recorded an extraordinary after tax gain of approximately $201,000, net of
expenses of approximately $26,000.

The Company has continued this program during the first quarter of 1997 and has
paid cash of approximately $98,000 to settle indebtedness of approximately
$355,000.

                                      F-11

<PAGE>   32


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995



NOTE H - FINANCING ARRANGEMENTS
-------------------------------

During 1994, the Company had a $3,000,000 revolving credit agreement with a
bank. The agreement, which was initially scheduled to expire in November 1995,
required monthly interest payments based on the bank's prime rate plus 2.25%.
The amount which the Company could borrow under the agreement was based on
inventory and accounts receivable levels. The agreement required the Company to
meet minimum net worth levels and certain other borrowing covenants and to repay
the line by May 31, 1995 and maintain a zero balance thereafter for thirty
consecutive days. Substantially all assets of the Company were pledged as
collateral under this agreement.

During 1995, the Company used a portion of the proceeds from private placements
to repay the outstanding balance on the revolving credit agreement, at which
time the bank terminated any further lending obligations under this agreement.
Also see Note O - Related Party Transactions.

During 1996, the Company sold approximately $380,000 of accounts receivable to a
third party and was advanced approximately $306,000 in cash. Pursuant to the
related contract, the Company was responsible for repayment to the third party
factoring company of the amount initially advanced plus a fee equivalent to one
percent (1%) for each ten day period (or portion thereof) the account receivable
remained outstanding. Amounts collected in excess of the amount advanced and
related fees remained with the Company. The accounts receivable were paid within
terms of approximately thirty (30) days.

In August 1996, the Company was advanced $150,000 by Taglich Brothers, D'Amadeo,
Wagner & Company, Incorporated at a zero percent interest rate. The Company
repaid this note payable out of the proceeds of the private placement completed
in October 1996.

Interest expense and cash paid for interest totaled $15,567 in 1996 and $83,120
in 1995.













                                      F-12


<PAGE>   33


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995




NOTE I - LEASES
---------------

The Company leases its office, manufacturing facility and certain office
equipment under noncancellable operating leases. The office and manufacturing
facility lease expires in May 1997 and has a five year renewal option
exercisable by the Company through June 2002. The Company also leases certain
office equipment under noncancellable capital leases. Future minimum rental
payments required under the initial terms of these leases are as follows:

<TABLE>
<CAPTION>
                                                                          Capital               Operating
                  Year ending December 31,                                Leases                  Leases
                  ------------------------                                ------                  ------
                  <S>                                                  <C>                   <C>
                               1997                                    $       9,786         $      26,413
                               1998                                            9,648                 1,613
                               1999                                            9,648                 1,613
                               2000                                            9,648                 1,613
                               2001                                            6,698                   269
                                                                       -------------         -------------
                  Total lease payments                                        45,428         $      31,521
                                                                                             =============

                  Less:  amounts representing interest                        10,790
                                                                       -------------
                  Present value of minimum capital
                    lease payments                                            34,638

                  Less:  current portion                                       5,841
                                                                       -------------
                                                                       $      28,797
                                                                       =============
</TABLE>


Rent expense was $80,532 and $92,803 for the years ended December 31, 1996 and
1995, respectively.


NOTE J - WARRANTY AND RIGHT OF RETURN POLICIES
----------------------------------------------

All of the Company's products carry a minimum 90 day manufacturer's warranty.
The warranty period begins on the date of purchase by the individual consumer.
Consumers, who purchase a product from the Company, have the right to return the
product for either merchandise, credit or refund (within 30 days of purchase)
provided the product is free of damage or abuse not consistent with the normal
use of the product. Provisions for product returns for the years 1996 and 1995
were approximately $84,000 and $668,000, respectively.








                                      F-13


<PAGE>   34


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995


NOTE K - COMMITMENTS
--------------------

Patent Agreement with Company President
---------------------------------------

The President of the Company assigned four patents and/or patent applications to
the Company in connection with his employment. In the event the President's
employment is terminated for any reason, he is entitled to severance payments
equal to three percent of the annual gross revenues received by the Company from
the sale of its products which rely on these patents, and are payable only for
the life of the patents and patent applications. Pursuant to the agreement,
payments will not exceed $360,000 or be less than $90,000 on an annual basis. In
the event the Company does not perform in accordance with the agreement, the
patents and patent applications shall revert to the President.

Purchase Commitments
--------------------
As of December 31, 1996, the Company was committed under contractual purchase
agreements to acquire inventory totalling $187,294. Losses that will be
incurred upon fulfillment of purchase committments for inventory used in the
Company's 16-bit technology products have been recognized in the accompanying
statements of income (see Note C).

Licensing Agreements
--------------------
The Company has licensing agreements with certain major manufacturers of video
games for the limited right to use the manufacturers' trademarks in connection
with several of the Company's products. The agreements call for royalties equal
to five percent of net sales of products licensed under the agreements. The
Company recognized royalty expense of approximately $0 in 1996 and $40,000 in
1995 relating to these agreements. The Company intends to let these agreements,
which cover the Company's 16-bit product line, expire at their respective
expiration dates.

In September 1996, the Company executed a license agreement with Little League
Baseball, Incorporated ("Little League") whereby the Company can utilize the
trademarks of Little League on Smart BaseballTM. This agreement extends to
September 1997 but can be renewed upon written consent of Little League. The
Company pays Little League a royalty of five (5%) percent quarterly on all sales
of Smart BaseballTM. No royalty expense related to this agreement was recorded
during 1996.









                                      F-14

<PAGE>   35


                        SMART GAMES INTERACTIVE, INC.

                        NOTES TO FINANCIAL STATEMENTS

                          DECEMBER 31, 1996 AND 1995



NOTE L - COMMON STOCK
---------------------

On April 18, 1994, the Company completed a public offering of 800,000 units
consisting of one common share and one common share purchase warrant for
proceeds of approximately $4 million ($3.4 million after expenses). The
warrants became separately transferable sixty days after the effective date of
the offering. Under the terms of the warrant agreements, the exercise price of
the warrants and the number of shares purchasable are adjusted whenever common
stock is issued at a share price below the current market value. At December
31, 1996, warrants to purchase 1,061,571 shares of the Company's common stock
exersisable at $4.71 per share and expiring on April 7, 1997 were outstanding.
In 1994, the Company issued 71,785 common stock purchase warrants to the
underwriter of the offering.  At December 31, 1996, warrants to purchase 95,256
shares of the Company's common stock exercisable at $4.71 per share and
expiring on April 8, 1999 were outstanding. Any or all of these warrants are
callable at the option of the Company at a price of $.01 per warrant if the
closing price of the Company's common stock equals or exceeds $4.71 for thirty
consecutive trading days.

In addition, 30,000 warrants, each providing for the purchase of one share of
the Company's common stock at an exercise price of $4 per share, were issued
on October 19, 1993 and expire October 19, 1998.

Also, at completion of the public offering, the Company converted certain
debenture bonds to common stock through the issuance of 323,979 shares of
common stock.

During 1995, the Company's shareholders approved an amendment to the Company's
Articles of Incorporation to increase the number of authorized shares of the
Company's common stock from 5,000,000 to 10,000,000 and to authorize a class of
5,000,000 shares of $.0002 par value preferred stock.

In 1995, the Company issued and sold an aggregate 2,252,400 shares of its common
stock in foreign distributions effected under Regulation S of the Securities
Act of 1933, as amended.

In May 1996, the Company issued 538,532 shares of common stock to certain trade
payable creditors in exchange for the cancellation of $386,106 in trade payable
indebtedness.

During June 1996, the Company's stock was no longer listed on the NASDAQ Small
Cap Market. The Company's stock is currently traded on the over the counter
(OTC) market.

In October 1996, the Company's shareholders approved an amendment to the
Company's Articles of Incorporation to increase the number of authorized shares
of the Company's common stock from 10,000,000 to 50,000,000.

                                      F-15

<PAGE>   36


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995



NOTE L - COMMON STOCK
---------------------

On October 11, 1996, Sports Sciences, Inc. ("SSI"), the predecessor to the
Company, reincorporated from the State of Ohio to the State of Delaware by means
of a merger with and into the Company ("Merger"), then a wholly-owned subsidiary
of SSI. The Company was the surviving corporation in the Merger. In the Merger,
SSI's outstanding common stock was automatically extinguished and converted into
issued and outstanding shares of the Company's common stock.

On October 30, 1996, the Company issued and sold 6,933,333 shares of its common
stock without registration under the 1933 Act in reliance on the exemption
effected under Regulation D of the Securities Act of 1933, as amended. The
securities were offered and sold in a private placement to a limited number of
accredited investors for a total offering price of $1,300,000. The placement
agent for the offering received a commission paid in the form of 520,000 shares
of common stock. In addition, representatives of the placement agent received
warrants to purchase an aggregate 693,333 shares of common stock at a purchase
price of $.20625 per share.

In 1996, the Company has authorized for the issuance of 10,000 shares of common
stock to the Company's manufacturing representative in China for the continued
warehousing of product. Additionally in 1996, the Company has authorized the
issuance of 30,000 shares of common stock as partial settlement of trade payable
indebtedness. As of March 24, 1997, none of these shares of common stock have
been issued.

At December 31, 1996 and 1995, the closing price of the Company's common stock
was $.09 and $.56 per share, respectively.

NOTE M - COMMON STOCK OPTIONS
-----------------------------

On November 15, 1993, the Company's Board of Directors adopted the 1993
Nonqualified Incentive Stock Option Plan. Under the plan, as amended by the
Company's shareholders in April 1995 and in October 1996, options may be granted
to employees to purchase up to 1,000,000 shares of the Company's common stock at
exercise prices not less than market value at the date of grant unless otherwise
authorized by the Board of Directors. The options are exercisable at various
times determined at the date of grant for a period of no more than ten years. No
options have been exercised under this plan.





                                      F-16

<PAGE>   37


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995




NOTE M - COMMON STOCK OPTIONS

The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") and related
interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under
Financial Accounting Standards Board Statement No. 123 ("FASB 123"), "Accounting
for Stock-Based Compensation," requires use of option valuation models that were
not developed for use in valuing employee stock options. Under APB 25, because
the exercise price of the Company's employees stock options equals the market
price of the underlying stock on the date of grant, no compensation expense is
recognized.

Pro forma information regarding net loss and net loss per share is required by
FASB 123, and has been determined as if the Company had accounted for its
employee stock options under the fair value method of that Statement. The fair
value for these options was estimated at the date of grant using a Black-Scholes
option pricing model.

The following assumptions were made in estimating fair value:

<TABLE>
<CAPTION>
         Assumption                                            1996  (1)
                                                        -----------------------
                                                        March          December            1995
                                                        -----          --------            ----
         <S>                                           <C>              <C>              <C>
         Dividend yield                                   0%                0%                0%
         Risk-free interest rate                       5.70%             5.59%             6.43%
         Expected life                                 2 years           2 years           2 years
         Expected volatility                           1.17              1.69              1.12

<FN>
         (1)      Each column represents assumptions based on each option grant
                  date during 1996.
</TABLE>

The Black-Sholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.





                                      F-17

<PAGE>   38


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995



NOTE M - COMMON STOCK OPTIONS
-----------------------------

For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting period. The Company's pro
forma information follows:

<TABLE>
<CAPTION>
                                                                            1996                 1995
                                                                            ----                 ----
         <S>                                                             <C>                 <C>
         Pro forma net loss before extraordinary item                    $(1,456,587)        $(2,753,687)
         Pro forma net loss                                               (1,255,437)         (2,753,687)
         Pro forma net loss per share before
             extraordinary item                                               (.22)              (.81)
         Pro forma net loss per share:                                        (.19)              (.81)
</TABLE>

A summary of the Company's stock option activity, and related information for
the years ended December 31, 1996 and 1995, follows:

<TABLE>
<CAPTION>
                                                           1996                                1995
                                               ------------------------------         -------------------------
                                                               Weighted Avg.                     Weighted Avg.
                                               Options         Exercise Price         Options    Exercise Price
                                               -------         --------------         -------    --------------
<S>                                             <C>           <C>                     <C>        <C>
Options outstanding at January 1                182,250(1)    $          2.14         114,550(3) $       3.85

         Granted                                885,000                   .21         130,000            2.25
         Forfeited                              (51,750)                 1.42         (62,300)           2.25
                                              ---------                               -------

Options outstanding at December 31            1,015,500(2)                .24         182,250            2.14
                                              =========                               =======

Options exercisable at December 31              880,500(2)                .26         132,500            2.10

Weighted-average fair value of
  options granted during the year                                         .14                            1.35

<FN>
(1) Includes 143,000 options that were repriced in March 1996 to the then market
    price of $.50.

(2) Includes 75,000 options granted to directors of the Company outside the Plan
    during 1996.

(3) Includes 102,050 options that were re-priced in April 1995 to the then
    market price of $2.25.
</TABLE>






                                      F-18

<PAGE>   39


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995


NOTE M - COMMON STOCK OPTIONS
-----------------------------

The following is a summary of the options outstanding at December 31, 1996:

<TABLE>
<CAPTION>
                                               Options Outstanding                        Currently Excercisable
                                      -------------------------------------           -------------------------------
                                        Weighted
                                        Average
                                       Remaining                Weighted                                 Weighted
    Exercise                          Contractual                Average                                  Average
   Price Range        Number              Life               Exercise Price            Number          Exercise Price
  ------------       -------          -----------            --------------           -------          --------------
<C>                   <C>              <C>                       <C>                  <C>                   <C>
$0.00-$0.10           635,000          10.0 years                $0.090               525,000               $0.090
$0.11-$0.50           375,500           8.7 years                $0.500               350,500               $0.500
$0.51-$1.00             5,000           7.0 years                $0.625                 5,000               $0.625
</TABLE>

NOTE N - INCOME TAXES
---------------------

Prior to October 20, 1993, the Company was treated as a Subchapter S corporation
under the Internal Revenue Code for income tax purposes. Accordingly,
substantially all of the income and expenses of the Company through October 19,
1993 are included in the federal and state income tax returns of the
shareholders and operating losses generated through such period are not
available to the Company for carryover. Net operating losses since October 19,
1993 of approximately $5,800,000 are available for carryover and expire in
various years through 2011.

Deferred income taxes reflect the net effects of temporary differences between
the carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for income tax purposes.

Significant components of the Company's deferred tax liabilities and assets are
as follows at December 31, 1996 and 1995:

<TABLE>
<CAPTION>
                                                        1996          1995
                                                        ----          ----
<S>                                                  <C>          <C>
Deferred tax liabilities, principally property and
  equipment, patents and return reserves             $   76,000   $   137,000

Deferred tax assets:
  Accrued expenses                                       13,000        63,000
  Start up costs                                         49,000       113,000
  Trade credits                                         239,000            --
  Net operating loss carryforwards                    2,204,000     1,785,000
  Other                                                  38,000       237,000
                                                     ----------   -----------
Total deferred tax assets                             2,543,000     2,198,000
Valuation allowance for deferred tax assets          (2,467,000)    (2,061,000)
                                                     ----------   -----------
Net deferred taxes                                   $       --   $        --
                                                     ==========   ===========
</TABLE>

                                      F-19

<PAGE>   40


                          SMART GAMES INTERACTIVE, INC.

                          NOTES TO FINANCIAL STATEMENTS

                           DECEMBER 31, 1996 AND 1995



NOTE N - INCOME TAXES
---------------------

Management has provided a valuation allowance for its net deferred tax assets as
the Company has incurred losses since inception.

NOTE O - RELATED PARTY TRANSACTIONS
-----------------------------------

During 1995, the Company borrowed a total of $150,000 from two members of the
Board of Directors, which accrued interest at a rate of 10%. These loans,
including interest, were repaid prior to December 31, 1995.

During 1996, the Company borrowed a total of $10,000 from the wife of the
president of the Company, which accrued interest at a rate of 0%. This loan was
repaid out of the net proceeds of the October 1996 private placement.

NOTE P - CONTINGENCIES
----------------------

The Company is subject to potential claims and legal actions arising in the
ordinary course of business. Pending claims at December 31, 1996
total approximately $253,000. Management believes that it has defenses of
considerable merit and will litigate all pending disputes and/or seek
settlements favorable to the Company, but is not able to predict the ultimate
outcome of these matters at this time. Accordingly, resolutions unfavorable to
the Company could result in material liabilities and charges which have not
been reflected in the accompanying financial statements.

NOTE Q - SUBSEQUENT EVENTS
--------------------------

On February 14, 1997, the Company filed a Registration Statement on Form SB-2 in
order to register, (i) 538,532 shares of common stock the Company issued to
certain trade payable creditors in exchange for cancellation of trade payable
indebtedness, (ii) 6,933,333 shares of common stock the Company issued in the
October 1996 private placement, (iii) 693,333 shares of common stock to be
issued by the Company upon the exercise of 693,333 warrants issued to the
placement agent in the October 1996 private placement and (iv) 10,000,000 shares
of common stock to be offered by the Company from time to time.








                                      F-20

<PAGE>   41

                                   SIGNATURES

         In accordance with Section 13 or 15(d) of the Exchange Act, the
Registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

Date: March 25, 1997      SMART GAMES INTERACTIVE,  INC.

                          By:    /S/ John D. Lipps
                             -----------------------------------------------
                             John D. Lipps, Chairman of the Board, President
                             and Chief Executive Officer

                          By:    /S/ Nicholas J. Chuma
                             -----------------------------------------------
                             Nicholas J. Chuma
                             Executive Vice President, Chief Financial Officer

In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the Registrant and in the capacities and on the
dates indicated:
<TABLE>
<CAPTION>

Signature                                   Title                                       Date
---------                                   -----                                       ----
<S>                                       <C>                                          <C>
                                            Director, Chairman of the Board             March 25, 1997
      /S/  John D. Lipps                    President and Chief Executive Officer
-----------------------------------
John D. Lipps

                                            Director, Executive Vice President,
     /S/  Nicholas J. Chuma                 Treasurer, Chief Financial Officer          March 25, 1997
-----------------------------------
Nicholas J. Chuma

     /S/  Donald Miller                     Director                                    March 25, 1997
-----------------------------------
Donald Miller

     /S/  Richard Groberg                   Director                                    March 25, 1997
-----------------------------------
Richard Groberg

     /S/  Peter Waite                       Director                                    March 25, 1997
-----------------------------------
Peter Waite

</TABLE>


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