<PAGE>
 
================================================================================


                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
                                        
                                   FORM 10-Q
                                        
[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934

                 For the quarterly period ended March 31, 1998

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

                        Commission file number  0-22558

                          IWERKS ENTERTAINMENT, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
                                        
            Delaware                                    95-4439361
  (STATE OR OTHER JURISDICTION            (I.R.S. EMPLOYER IDENTIFICATION NO.)
 OF INCORPORATION  OR ORGANIZATION)

                           4540 West Valerio Street
                        Burbank, California  91505-1046
             (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES AND ZIP CODE)

                                 (818) 841-7766
              (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
                                        
        Indicate by check mark whether the Registrant (1) has filed all reports
     required to be filed by Section 13 or 15 (d) of the Securities and Exchange
     Act of 1934 during the preceding 12 months (or for such shorter period that
     the Registrant was required to file such reports), and (2) has been subject
     to such filing requirements for the past 90 days.

       Yes  X    No
           ---      ---

     As of May 12, 1998, the Registrant had 12,321,497 shares of Common Stock,
     $.001 par value, issued and outstanding.


================================================================================
<PAGE>
 
                           IWERKS ENTERTAINMENT, INC.

         FORM 10-Q FOR THE QUARTER AND NINE MONTHS ENDED MARCH 31, 1998

                                     INDEX
                                        


<TABLE>
<CAPTION>
                                                                            PAGE
                                                                            ----
<S>                                                                         <C>
PART I - FINANCIAL INFORMATION                                              

ITEM 1 - FINANCIAL STATEMENTS
-----------------------------

Condensed Consolidated Balance Sheets as of March 31, 1998
and June 30, 1997                                                            2

Condensed Consolidated Statements of Operations for the Three and Nine
Months ended March 31, 1998 and 1997                                         4

Condensed Consolidated Statements of Cash Flows for the Nine
Months Ended March 31, 1998 and 1997                                         5

Notes to the Condensed Consolidated Financial Statements                     6


ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF
------------------------------------------------
         FINANCIAL CONDITION AND RESULTS OF OPERATIONS                       9
         ---------------------------------------------

PART II - OTHER INFORMATION

ITEM 1 - LEGAL PROCEEDINGS                                                  17
--------------------------

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                17
------------------------------------------------------------

ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K                                   17
-----------------------------------------

Signatures                                                                  19

</TABLE>

                                       1
<PAGE>
 
                          IWERKS ENTERTAINMENT, INC.
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                                    ASSETS
                                (in thousands)
<TABLE> 
<CAPTION> 
                                                   March 31,          June 30, 
                                                     1998               1997
                                                   ---------          --------
                                                  (unaudited)         (audited)
<S>                                                <C>                <C> 
Current assets:
  
  Cash and cash equivalents                        $ 6,614            $ 3,608

  Short-term investments                             7,558             15,459

  Trade accounts receivable, net of allowance 
   for doubtful accounts                             3,138              5,447

  Costs and estimated earnings in excess of
   billings on uncompleted contracts                 2,829              6,339

  Inventories and other current assets               4,155              4,402
                                                   -------            -------

   Total current assets                             24,294             35,255


Portable simulation theaters at cost, net of
 accumulated depreciation                            3,541              4,018

Property and equipment at cost, net of
 accumulated depreciation                            4,195              2,920

Film inventory at cost, net of amortization          4,914              3,439

Goodwill, net of amortization                       14,898             15,367

Investment in joint ventures and other assets        3,106              3,530
                                                   -------            -------
   
   Total assets                                    $54,948            $64,529
                                                   =======            ======= 

</TABLE> 

                            See accompanying notes.

                                       2
<PAGE>
 
                          IWERKS ENTERTAINMENT, INC.
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                     LIABILITIES AND STOCKHOLDERS' EQUITY
                     (in thousands, except share amounts)

<TABLE>
<CAPTION>
                                                       March 31,    June 30,
                                                        1998         1997
                                                      --------     --------
                                                     (unaudited)   (audited)
<S>                                                   <C>          <C>
Current liabilities:

   Accounts payable                                    $  2,705    $  3,435

   Accrued expenses                                       7,645       8,793

   Notes payable, current portion                          --            81

   Billings in excess of costs and estimated
     earnings on uncompleted contracts                    3,099         990

   Deferred revenue                                         181         278

   Capital leases, current portion                          693         739
                                                       --------    --------

      Total current liabilities                          14,323      14,316


Capital lease obligations, excluding current portion      1,322       1,827

Stockholders' equity:

   Preferred stock, $.001 par value, 1,000,000             --          --
     authorized, none issued and outstanding

   Common stock, $.001 par value, 50,000,000                 57          57
      authorized; issued and outstanding
     12,321,497 and 12,160,102, respectively

   Additional paid-in capital                            78,016      78,016

   Accumulated deficit                                  (38,770)    (29,687)
                                                       --------    --------

Total stockholders' equity                               39,303      48,386
                                                       --------    --------

     Total liabilities and stockholders' equity        $ 54,948    $ 64,529
                                                       ========    ========
</TABLE>

                            See accompanying notes.

                                       3
<PAGE>
 
                           IWERKS ENTERTAINMENT, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (unaudited)
                    (in thousands, except per share amounts)
                                        


<TABLE>
<CAPTION>
                                        For the Three Months Ended              For the Nine Months Ended
                                                 March 31,                               March 31,
                                           1998               1997                  1998                1997
                                     -------------      --------------       --------------      --------------
<S>                                     <C>                <C>                  <C>                 <C>
Revenue                                    $ 4,483             $11,042              $18,524             $30,660
 
Cost of sales                                4,195               7,335               14,152              20,527
                                     -------------      --------------       --------------      --------------
 
  Gross profit                                 288               3,707                4,372              10,133
 
Selling, general, and administrative
 expenses                                    4,637               3,582               12,553              10,285
 
 
Proposed merger expenses (note 6)              888                   -                1,419                   -
                                     -------------      --------------       --------------      --------------
 
  Income (loss) from operations             (5,237)                125               (9,600)               (152)
 
Interest income                                219                 235                  710                 845
Interest expense                                59                  90                  193                 306
                                     -------------      --------------       --------------      --------------
 
  Net income (loss)                        $(5,077)            $   270              $(9,083)            $   387
                                     =============      ==============       ==============      ==============
 
  Basic and diluted income (loss) per
       common share (note 4)                $(0.42)              $0.02               $(0.75)              $0.03
                                     =============      ==============       ==============      ==============
 
Weighted average shares outstanding
 -basic                                     12,199              11,918               12,173              11,756
                                     =============      ==============       ==============      ==============
 
Weighted average shares outstanding -
 diluted                                    12,199              12,174               12,173              12,281
                                     =============      ==============       ==============      ==============
</TABLE>


                            See accompanying notes.
                                        

                                       4
<PAGE>
 
                          IWERKS ENTERTAINMENT, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (unaudited)
                                (in thousands)
<TABLE>
<CAPTION>
                                                         For the nine months ended
                                                                 March 31,
                                                         -------------------------
                                                            1998            1997
                                                         ---------       ---------
<S>                                                      <C>             <C>
Operating Activities
Net income (loss)                                         $ (9,083)      $     387
Depreciation and amortization                                3,558           4,204
Changes in operating assets and liabilities                  6,199          (4,413)
                                                          --------        --------

     Net cash provided by operating activities                 674             178

Investing Activities
Investment in joint ventures                                   125            (897)
Investment in portable simulation theaters                     (46)           (108)
Purchases of property and equipment                         (1,970)           (702)
Additions to film inventory                                 (3,046)         (1,349)
Investment in debt securities                                7,901            (853)
Purchase of Pioneer and acquisition of related patent,
   net of cash acquired and stock issued (Note 7)             --            (1,088)
                                                          --------        --------

     Net cash provided by (used in) investing activities     2,964          (4,997)

Financing Activities
Repayment of notes payable                                     (81)         (1,315)
Payments on capital leases                                    (551)           (526)
Exercise of stock options                                     --               486
                                                          --------        --------
     Net cash used in financing activities                    (632)         (1,355)
                                                          --------        --------

Net increase (decrease) in cash                              3,006          (6,174)

Cash and cash equivalents at beginning of period             3,608          12,674
                                                          --------        --------

Cash and cash equivalents at end of period                $  6,614        $  6,500
                                                          ========        ========

Supplemental disclosures of cash flow information:

   Cash paid during the period for interest               $    188        $    327
                                                          ========        ========

   Cash paid during the period for income taxes           $      8        $   --
                                                          ========        ========
</TABLE>

                            See accompanying notes.

                                       5
<PAGE>
 
                           IWERKS ENTERTAINMENT, INC.
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)
                                        

Note 1 - Introduction
---------------------

     The accompanying condensed consolidated financial statements of Iwerks
Entertainment, Inc. (the "Company") have been prepared without audit pursuant to
the rules and regulations of the Securities and Exchange Commission ("SEC").
Certain information and footnote disclosures normally included in the financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted pursuant to such rules and regulations, although
the Company believes that the disclosures made are adequate to make information
presented not misleading.  In the opinion of management, all adjustments,
including those related to the proposed merger (see note 6) and other normal
recurring adjustments, necessary to present fairly the financial position of the
Company as of March 31, 1998 and the results of its operations for the three and
nine months ended March 31, 1998 and 1997 and the cash flows for the nine months
ended March 31, 1998 and 1997 have been included. The results of operations for
interim periods are not necessarily indicative of the results which may be
realized for the full year.  For further information, refer to the consolidated
financial statements and footnotes thereto included in the Company's latest
Annual Report on Form 10-K.


Note 2 - Income Taxes
---------------------

     At June 30, 1997, the Company had available federal and state tax net
operating loss carryforwards of approximately $20,378,000 and $9,740,000,
respectively expiring through 2012.  As a result of these net operating losses
and current period losses, the Company's effective tax rate was negligible and
consequently no income tax provision or benefit was recorded in the periods
presented.

                                       6
<PAGE>
 
Note 3 - Depreciation and Amortization
--------------------------------------

     Depreciation expense and amortization expense for goodwill and other is
computed using the straight line method over the estimated useful lives of the
assets.  Film costs are amortized using the individual film forecast method.

<TABLE>
<CAPTION>
                                                           Three Months                     Nine Months
                                                              Ended                           Ended
                                                            March 31,                        March 31,
                                                  ---------------------------      ----------------------------
                                                    1998              1997             1998             1997
                                                    ----              -----            ----             ----
<S>                                               <C>              <C>             <C>               <C>
Depreciation  and amortization on fixed assets    $  247,000       $  307,000      $  695,000        $  881,000
Depreciation on touring equipment                    171,000          373,000         523,000         1,113,000
Amortization of film inventory                       586,000          469,000       1,571,000         1,502,000
Amortization of goodwill and other                   295,000          245,000         769,000           708,000
                                                  ----------       ----------      ----------        ----------

Total depreciation and amortization               $1,299,000       $1,394,000      $3,558,000        $4,204,000
                                                  ==========       ==========      ==========        ==========
</TABLE>


Depreciation and amortization included in cost of sales was $766,000 and
$853,000 for the quarter ended March 31, 1998 and 1997, respectively, and
$2,122,000 and $2,653,000 for the nine months ended March 31, 1998 and 1997,
respectively.

 
Note 4 - Net Income (Loss) Per Common Share:
--------------------------------------------

     In February 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, Earnings Per Share, which is effective for annual and interim
financial statements issued for periods ending after December 15, 1997. The
statement requires restatement of prior years' earnings per share ("EPS"). SFAS
No. 128 was issued to simplify the standards for calculating EPS previously
found in APB No. 15, Earnings Per Share. SFAS 128 replaces the presentation of
primary EPS with a presentation of basic EPS. Basic EPS excludes the dilutive
effects of stock options and warrants. Under the provisions of FAS 128, basic
and diluted EPS were the same for the periods reported herein.

Note 5 - Litigation
-------------------
 
     There are no material legal proceedings to which the Company is a defendant
other than ordinary routine litigation in the course of business. In the opinion
of management, resolution of these matters will not have a material adverse
impact on the Company's financial position or results of operations.

Note 6 - Proposed Merger with Showscan Entertainment, Inc.
----------------------------------------------------------

     On August 5, 1997, Iwerks and Showscan Entertainment, Inc. (Showscan)
announced that they signed a definitive agreement to merge which was
subsequently 

                                       7
<PAGE>
 
amended December 29, 1997. The agreement was terminated on March 31, 1998 when
the Iwerks' stockholders failed to approve the merger at it's annual meeting
held on that date. In connection with the proposed merger, the Company incurred
$888,000 and $1.4 million of expenses which include investment banking, legal
(including costs to defend an antitrust lawsuit), accounting, printing,
solicitation, filing fees and other related expenses, in the three and nine
months ended March 31, 1998, respectively. The Company does not expect to incur
any additional costs related to this proposed merger with Showscan.

Note 7 - Acquisition of Pioneer and Related Companies
-----------------------------------------------------

     On March 4, 1997 two newly formed wholly-owned subsidiaries of the Company
acquired the stock of Pioneer Marketing Corporation and a related company
(collectively referred to as "Pioneer") in exchange for 299,101 shares of Iwerks
common stock.  On the same date in a related transaction, the Company purchased
a patent from a partnership related to Pioneer for approximately $1,114,000 in
cash.  These transactions were accounted for as a purchase by Iwerks of Pioneer
resulting in an aggregate purchase price of approximately $2,784,000 including
acquisition costs.  The aggregate purchase price of Pioneer in excess of the
fair value of the identifiable assets of Pioneer at the date of acquisition was
$1,536,000 which has been allocated to goodwill.  The operations of Pioneer have
been consolidated with the operations of the Company from March 4, 1997.

Note 8 - New Accounting Pronouncements
--------------------------------------

     In June 1997, the FASB issued Statement No. 130, Reporting Comprehensive
Income. The Statement establishes standards for the reporting and display of
comprehensive income and its components in a full set of general purpose
financial statements. The Statement applies to all enterprises that provide a
full set of general purpose financial statements. The Statement becomes
effective for all financial statements for fiscal years beginning after December
15, 1997, with earlier application permitted. Further, in June 1997, the FASB
issued Statement No. 131, Disclosures about Segments of an Enterprise and
Related Information. The Statement changes the way public companies report
segment information in annual financial statements and also requires those
companies to report selected segment information in interim financial reports to
shareholders. The Statement becomes effective for all financial statements for
fiscal years beginning after December 15, 1997, with earlier adoption permitted.
The Company has reviewed those Statements and does not believe that they will
have a material impact on its financial statements and related disclosures.

                                       8
<PAGE>
 
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

GENERAL
-------

     The Company is engaged in the business of designing, engineering,
manufacturing, marketing and servicing specialty theatre systems which employ a
variety of projection, show control, ride simulation and software technologies.
The Company is currently in the business of: (a) selling and installing ride
simulation attractions in specialty theatres, (b) selling and installing giant
screen theatres (generally such theatres require projection technology which
utilize film sizes ranging between five perforations per frame by 70 millimeters
(5/70) and fifteen perforations per frame by 70 millimeter (15/70), (c)
licensing and distributing the films in its library to ride simulation theatres
previously sold by the Company, (d) producing films in the 5/70, 8/70 and 15/70
film format for its film library as well as producing films in these formats for
third parties, (e) investing in joint ventures by contributing its ride
simulation technology, design and equipment and participating in the theatre
profits, and (f) operating a fleet of 16 mobile ride simulation attractions.

     During the quarter ended March 31, 1998 the Company had certain management
changes. Charles Goldwater was appointed CEO, Chairman of the Board and
President, replacing Roy Wright. The Company hired two additional officers and
terminated two officers during the quarter. Between January 1, and May 5, 1998
the Company has reduced its full-time workforce by 22%, from 151 to 118
employees resulting in annualized savings of approximately $1.6 million. The
Company is currently in the process of continuing to review its personnel needs.

     The following sections contain forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995. Such forward-
looking statements involve risks and uncertainties such that actual results may
vary materially. Certain factors that may affect the Company's results and
financial condition over the next few quarters are discussed under the caption
"future operating results" below. Other factors that may affect such results and
financial condition are set forth in the Company's Annual Report on Form 10-K as
filed with the Securities and Exchange Commission.

RESULTS OF OPERATIONS
---------------------

     The Company derives its revenues primarily from three sources: sales of
hardware systems, owned and operated (primarily portable simulation theatres),
and licensing of films. To a lesser extent, revenues are also earned from
service to existing theatre owners and production of films for third parties.
The following table presents summary information regarding revenues (amounts in
thousands):

                                       9
<PAGE>
 
<TABLE>
<CAPTION>
                                                                      Periods Ended March 31,
                                                          Three Months                        Nine Months
                                              ------------------------------------   -----------------------------
                                                  1998                 1997             1998            1997
                                                  ----                 ----             ----            ----
<S>                                              <C>                  <C>               <C>             <C>
Hardware Sales & Service                         $1,233               $ 7,831           $ 8,325         $20,189
Owned and Operated                                1,272                 1,277             5,312           5,824
Film Licensing                                    1,785                 1,864             4,544           4,370
Film Production and Other                           193                    70               343             277
                                                 ------               -------           -------         -------
        Total                                    $4,483               $11,042           $18,524         $30,660
                                                 ======               =======           =======         =======
</TABLE>
                                                                                

     Revenues on sales of theatre systems are recognized on the percentage-of-
completion method over the life of the contract.  Accordingly, the timing of
shipment schedules as dictated by the customer can result in variability of
quarterly revenues and earnings.  The gross margin for each contract varies
based upon pricing strategies, competitive conditions and product mix.

     Revenues from owned and operated (O&O) consist of portable ride simulation
theatre revenues (touring) derived primarily from corporate sponsorship or
ticket sales at state fairs, air shows, and similar events, as well as revenues
derived from fixed site joint ventures, which includes Iwerks' contractual share
of the sites' revenues or profits as applicable.  Admission revenues from the
portable ride simulation theatres are subject to variability due to the seasonal
nature of these events and are higher during the summer months.  Sponsorship and
contract revenues for the portable theatres are recognized ratably over the term
of the contract.

     The Company typically licenses its film software under one year film
license agreements.  Revenues and related expenses are recognized at the
beginning of the license period at which time the customer is billed the license
fee and film is delivered to the customer.

COMPARISON OF THE THREE MONTHS ENDED MARCH 31, 1998 TO THREE MONTHS ENDED MARCH
-------------------------------------------------------------------------------
31, 1997
--------

REVENUES

     Hardware sales and service revenue in the three month period ended March
31, 1998 decreased by approximately $6.6 million or 84% as compared to the same
period last year. The Company experienced sharply lower hardware sales in each
of its principal markets during the 1998 quarter when compared to the 1997
quarter. The Company's hardware sales in Asia continue to be negatively impacted
by the economic downturn being experienced in that region. The Company's results
in the 1997 third quarter were benefited by a significant contract with a South
American customer. There were no corresponding revenues realized in that region
in the 1998 third quarter. In addition, the Company experienced a sharp decline
in revenues in North America.

                                       10
<PAGE>
 
     The Company expects that the lower Asia sales trend is likely to continue
into the foreseeable future. The Company signed no new sales contracts in that
region during the third quarter. The Company's current contractual backlog in
the Americas has recently increased, however, and the Company anticipates that
realization on this backlog will contribute to higher revenues from hardware
sales and service in the fourth quarter when compared to the third quarter of
1998, but lower than corresponding revenues recognized in the fourth quarter of
1997. The Company did not realize material revenues in Europe or other
international markets in fiscal 1998 or 1997. The Company is in the process of
searching for a key executive with marketing expertise who will oversee the
sales and marketing operations for the Company. As discussed in greater detail
below under "Future Operating Results," hardware sales can fluctuate
substantially as a result of the timing of theaters system deliveries, contract
signing, the rate of completion of contracts and other factors.

     Film licensing revenue decreased by $79,000 or 4.2% due to one Asian
customer which did not renew its license agreement in the current year.

     Film production and other revenue increased due to the Company actively
renting its cameras in the current quarter as compared to the prior year's
quarter.

COST OF SALES AND GROSS PROFIT MARGIN

     The total gross profit margin percentages for the three months ended March
31, 1998 and 1997 were 6.4% and 33.6%, respectively. The decrease in gross
profit margin in the 1998 third quarter compared to the same quarter in 1997 is
primarily related to the decrease in hardware sales. Included in hardware cost
of sales are certain fixed costs such as facility and certain labor costs which
did not decrease with the decline in hardware sales. The gross profit margin on
the other revenue sources were generally consistent with the prior year's
quarter.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

     Selling, general and administrative expenses include, among other things,
personnel costs, trade shows and other promotional expenses, sales commissions,
travel expenses, public relation costs, outside consulting and professional
fees, depreciation on fixed assets, amortization of goodwill, departmental
administrative costs and research and development costs.

     Selling, general and administrative expenses increased for the three months
ended March 31, 1998 by approximately $1.1 million over the same period in the
prior year.  This increase was primarily due to a $1.5 million charge for
severance costs that were made to fifteen employees including the former CEO and
two other officers whose employment terminated in the third quarter of fiscal
1998.  In addition,  bad debt expense was greater by $0.7 million for the
comparable three month period due to Asia customers and one domestic customer.
These increases were partially offset by a decrease in sales commissions.

                                       11
<PAGE>
 
     As discussed above, between January 1, and May 5, 1998, the Company has
reduced its full time workforce by 22% from 151 to 118 employees resulting in
annualized savings of approximately $1.6 million.  A significant portion of
these cutbacks are in the area of SG&A, but will be partially offset in future
periods as the Company adds additional personnel to complete its management
team.

INTEREST INCOME AND EXPENSE

     Interest income for the three months ended March 31, 1998 and 1997 was
$219,000 and $235,000, respectively, and is derived from the Company's
investments, primarily in U.S. Treasury Notes and short term commercial paper.
The decrease in interest income resulted primarily from the decrease in the
invested balances in the comparable periods.

COMPARISON OF NINE MONTHS ENDED MARCH 31, 1998 TO NINE MONTHS ENDED MARCH 31,
-----------------------------------------------------------------------------
1997
----

REVENUES

     Hardware sales and service revenue in the nine months ended March 31, 1998
decreased by approximately $11.9 million or 58.8% as compared to the same period
last year. The Company experienced sharply lower hardware sales in each of its
principal markets during the 1998 nine months when compared to the 1997 nine
months.  As discussed above, the Company's hardware sales in Asia continue to be
negatively impacted by the economic downturn being experienced in that region.
Sales represented by customers located in Asia declined by about $8 million in
the fiscal 1998 period when compared to the comparable period in 1997.  In
addition, the Company experienced in 1998 declines in revenues in North and
South America when compared with 1997, primarily in the third quarter.  Hardware
sales in the Americas declined by approximately $4.7 million and $4.5 million in
the three month and nine month period, respectively.


     Owned and operated revenue decreased by approximately $512,000 as compared
to the same period last year, primarily due to a reduction in sponsorship
revenue relating to the portable simulation theatres.

     Film licensing revenue increased by approximately 4.0% as a result of the
increasing base of installed theatres that license the Company's film software.

COST OF SALES AND GROSS PROFIT MARGIN

     The total gross profit margin percentages for the nine months ended March
31, 1998 and 1997 were 23.6% and 33.0%, respectively.  The decrease in gross
profit margin was primarily related to the decrease in sales.  Included in
hardware cost of sales are 

                                       12
<PAGE>
 
certain fixed costs such as facility and certain labor costs which did not
decrease with the decline in hardware sales.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

     Selling, general and administrative expenses increased for the nine months
ended March 31, 1998 by approximately $2.3 million over the same period in the
prior year. The increase was mainly due to a $1.5 million charge for severance
costs that were made to fifteen employees including the former CEO and two other
officers whose employment terminated in the third quarter of fiscal 1998.  In
addition, bad debt expense was greater by $1.1 million due to greater
delinquencies of receivables from Asian customers and two domestic customers.
Research and development costs and insurance costs were also higher in the nine
months ended March 31, 1998.  These increases were partially offset by a
decrease in sales commissions.

MERGER RELATED EXPENSES

     On August 5, 1997, the Company and Showscan Entertainment, Inc. announced
an agreement to merge. The merger agreement was subsequently amended on December
29, 1997 (see note 6 of Notes to Condensed Consolidated Financial Statements).
The agreement was terminated on March 31, 1998 when the Iwerks stockholders
failed to approve the merger at its annual meeting held on that date. During the
quarter and nine months ended March 31, 1998, the Company incurred $888,000 and
$1,419,000 of merger related expenses.


IMPACT OF YEAR 2000

     Some of the Company's older computer programs were written using two digits
rather than four to define the applicable year.  As a result, those computer
programs have time-sensitive software that recognize a date using "00" as the
year 1900 rather than the year 2000.  This could cause a system failure or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices, or engage
in similar normal business activities.

     The Company has completed its initial assessment of its existing software
systems and after reviewing various factors, one of which being the year 2000
issue, has determined that modifications or upgrades to or replacements of
certain software and hardware is required. The Company's most critical software
systems are its assembly and financial software systems. The Company has
determined that these systems will require replacement. The Company's initial
estimate of the cost of such replacement is $400,000, which includes
approximately $300,000 for the purchase and implementation of new software and
hardware (which will be capitalized and amortized over their respective useful
lives) and approximately $100,000 of which will be expensed in the period
incurred. The Company has not yet completed the process of selecting its
preferred systems or vendors and consequently the Company's estimates may change
depending upon the 

                                       13
<PAGE>
 
systems but does not believe they will be material. At March 31, 1998, the
Company had incurred approximately $25,000 in connection with this project.

     The Company believes that the required changes to its existing computer
systems will be substantially completed no later than June 30, 1999, which is
prior to any anticipated impact on its operating systems.  The Company believes
that with these changes, the year 2000 issue will not pose significant
operational problems for the Company.

     The costs of the project and the date on which the Company believes it will
complete the conversion are based on management's best estimates, which were
derived utilizing numerous assumptions of future events, including the continued
availability of certain resources and other factors.  However, there can be no
guarantee that these estimates will be achieved and actual results could differ
materially from those anticipated.

FUTURE OPERATING RESULTS

     The market for the Company's products is intensely competitive and is
undergoing significant changes, primarily due to technological developments as
well as changing consumer tastes.  Numerous companies are developing and are
expected to develop new entertainment products or concepts for the out-of-home
entertainment industry.  There is severe competition for financial, creative and
technological resources in the industry and there can be no assurance that
existing products will continue to compete effectively or that products under
development will ever be competitive.

     The Company has experienced a significant decline in revenues in recent
periods.  Historically, a substantial portion of the Company's revenues from new
hardware sales in the ride simulation market have originated in international
markets, particularly in Asia.  The Company began to experience a significant
decline in new hardware contracts during the fourth quarter of fiscal 1997,
which trend has continued through the first nine months of fiscal 1998.  This
trend has been exacerbated by the recent economic crisis experienced in this
region.  While the Company is placing greater focus on other markets,
particularly the United States, Latin America and Europe, the trend of declining
sales in Asia is expected to have a continuing negative impact on the Company's
revenues through the remainder of fiscal 1998 and expected to have a continuing
negative impact in future periods.

     The Company and it principal competitor in the large screen market, Imax
Corporation, are aggressively competing, particularly in the United States
market, for new theater installations.  The Company primarily competes in this
market based upon the price and terms of its projection technology.  Imax, the
dominant competitor in the market, competes primarily on the basis of its brand
identity and its larger film library.  These factors, and Imax's access to
greater financial and other resources, are expected to continue to place the
Company at a competitive disadvantage in this market and could have a negative
impact on the Company's gross margins over time.

                                       14
<PAGE>
 
     In addition to competition in the large-screen market, the Company faces
intense competition in the simulation industry from Showscan Entertainment and a
large number of other competitors. The Company competes in this market based
upon the breadth of its product offerings and the size and quality of its film
library. Few of its competitors in this market have sufficient financial
resources to effectively compete with the Company based on these criteria. The
Company's competitive position in this market segment could be materially
affected if any of its existing competitors or a new entrant were to assemble
the financial, technical and creative resources required to effectively compete
with the Company's range of product offerings and film library.

     Revenues from the Company's owned and operated attractions (primarily
portable simulation theaters) have been declining since the first quarter of
fiscal 1997 when the Company lost its principal sponsorship contract with AT&T.
The Company has been aggressively pursuing and has recently signed other
sponsorship contracts since that time. However, it has not been successful in
fully replacing this revenue source. Because this segment of the Company's
business has a significant level of fixed costs regardless of fluctuations in
revenues, the Company's gross margins will continue to be adversely impacted
unless it is able to secure alternate sources of revenue or disposes of all or a
portion of this business segment or otherwise eliminates a portion of the fixed
costs associated with its operation.

     Iwerks has experienced quarterly fluctuations in operating results and
anticipates that these fluctuations will continue in future periods. Operating
results and cash flow can fluctuate substantially from quarter to quarter and
periodically as a result of the timing of theater system deliveries, contract
signing, sponsorships, the mix of theater systems shipped, the completion of
custom film contracts, the existence of world expos, amount of revenues from
portable simulation theater and film licensing agreements, the timing of sales
of ride simulation attractions, the timing of delivery and installation of such
sales (pursuant to percentage of completion accounting) and any delays therein
caused by permitting or construction delays at the customer's site, the size,
type and configuration of the attractions sold, the timing of film rental
payments from existing attractions and the performance of those attractions that
pay film rental based on a percentage of box office and the timing of sales and
marketing efforts and related expenditures. In particular, fluctuations in
theater system sales and deliveries from quarter to quarter can materially
affect quarterly and periodic operating results, and theater system contract
signing can materially affect quarterly or periodic cash flow. Accordingly,
Iwerks' revenues and earnings in any particular period may not be indicative of
the results for any future period.

     The seasonal fluctuations in earnings also may cause volatility in the
stock price of Iwerks. While a significant portion of Iwerks' expense levels are
relatively fixed, the timing of increases in expense levels is based in large
part on Iwerks' forecasts of future sales. If net sales are below expectations
in any given period, the adverse impact on results of operations may be
magnified by Iwerks' inability to adjust spending quickly enough to compensate
for the sales shortfall. Iwerks may also choose to reduce prices or 

                                       15
<PAGE>
 
increase spending in response to market conditions, which may have a material
adverse effect on Iwerks' results of operations.

     Additionally, the Company plans to continue to evaluate and, when
appropriate, make acquisitions of complementary technologies, products or
businesses. The Company will continue to evaluate the changing value of its
assets, and when necessary, make adjustments thereto. While the Company cannot
predict what effect these various factors may have on its financial results, the
aggregate effect of these and other factors could result in significant
volatility in the Company's future performance and stock price.

LIQUIDITY AND CAPITAL RESOURCES
-------------------------------

     The Company's operating activities for the nine months ended March 31, 1998
generated positive cash flow of $674,000. This was mainly due to the net loss of
$9.1 million offset by non-cash charges of $3.6 million for depreciation and
amortization along with changes in operating assets and liabilities of $6.2
million. Investing activities for the nine months ended March 31, 1998 consisted
primarily of redemptions of investments in debt securities of $7.9 million
partially offset by investments in film inventory of $3.0 million and purchases
of property and equipment of $2.0 million. Cash used in financing activities
consisted primarily of payments for notes payable and capital leases.

     At March 31, 1998, the Company had cash and short-term investments of
approximately $14.2 million compared to $19.1 million at June 30, 1997. In
addition, the Company has maintained a bank line of credit in the amount of $5
million. At March 31, 1998 and 1997, there were no amounts outstanding on the
line of credit. However, at March 31, 1998 the Company was not in compliance
with respect to certain financial covenants relating to the bank line of credit
and the Company is currently renegotiating changes to certain covenants to the
line of credit. There can be no assurance that the Company will be successful in
extending this line into future periods. The Company believes that its cash
balances, short-term investments in debt securities and expected cash flow from
operations will be adequate to meet its cash requirements over at least the next
twelve months. However, the Company expects that its cash balances will continue
to decline during this period. The Company's operations are expected to be cash
flow positive over this twelve month period. This positive cash flow will be
more than offset by the payment of expenses accrued but not yet paid at March
31, 1998 and planned additions to film inventory and other fixed assets. If the
Company's revenues were to be materially less than that forecasted, the
Company's cash balances, short-term investments in debt securities and cash flow
from operations may not be sufficient to meet its expected cash needs. In such a
case, the Company's liquidity may be dependent upon reinstating its current bank
line or arranging for additional equity or debt financing. If unsuccessful, the
Company would be required to defer capital and other expenditures that are not
then committed. Consequently, the Company is exploring available debt financing
resources in the form of bank financing, film financing and equipment financing.
There can be no assurance that such financing will be available to the Company
or, if available, that such financing could be arranged on terms that the
Company would consider attractive.

                                       16
<PAGE>
 
PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS
-------------------------

     The Company is a party to various actions arising in the ordinary course of
business which, in the opinion of management, will not have a material adverse
impact on the Company's financial condition; however, there can be no assurance
that the Company will not become a party to other lawsuits in the future, and
such lawsuits could potentially have a material adverse effect on the Company's
financial condition and results of operations.

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

     On March 31, 1998, the Company held its annual shareholders meeting.  The
following three items were voted on:

     1.   The issuance of shares of Iwerks' Common Stock related to the
          Agreement and Plan of Reorganization, as amended, with Showscan
          Entertainment, Inc. Votes cast for totaled 4,000,470; votes cast
          against totaled 4,729,215; abstentions totaled 14,446; broker non-
          votes totaled 2,972,418.

     2.   Charles Goldwater was elected to the board of directors for a term of
          three years. Votes cast for totaled 10,220,876; votes withheld totaled
          1,495,943. The continuing directors are Dag Tellefsen, Gary Matus and
          Don Iwerks.

     3.   To amend the 1994 Stock Incentive Plan to increase the shares of
          Iwerks Common Stock reserved for issuance thereunder from 1,750,000 to
          2,500,000 and to provide a per employee limit on stock option grant in
          any one year. Votes cast for totaled 3,047,138; votes cast against
          totaled 5,481,750; abstentions totaled 130,862; broker non-votes
          totaled 3,057,069.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K
-----------------------------------------

(a)   Exhibits:
      10.1   Employment agreement dated March 2, 1998 between the Company and
             Dan Griesmer
      11.1   Earnings per share
      27.1   Schedule of financial data


(b)  Reports on Form 8-K filed during the quarter ended March 31, 1998:

                                       17
<PAGE>
 
i)   A Form 8-K was filed on February 2, 1998, Item 5, regarding a press release
     dated January 28, 1998.

ii)  A Form 8-K was filed on February 12, 1998, Item 5, regarding a press
     release  dated February 10, 1998.

iii) A Form 8-K was filed on March 23, 1998, Item 5,  regarding a press
     release dated March 23, 1998.

ii)  A Form 8-K was filed on March 25, 1998, Item 5, regarding a press release
     dated March 24,.

iii) A Form 8-K was filed on March 26, 1998, Item 5, regarding a press release
     dated March 25,.

iv)  A Form 8-K was filed on March 27, 1998, Item 5, regarding a press release
     dated March 26, 1998.

v)   A Form 8-K was filed on March 30, 1998, Item 5, regarding a press release
     dated March 26,.

                                       18
<PAGE>
 
                                  SIGNATURES

     Pursuant to the requirements of Sections 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has caused this report to be signed on its
behalf by the undersigned thereunto duly authorized, in the city of  Burbank,
State of California on the  14 day of May, 1998.



                          IWERKS ENTERTAINMENT, INC.
                                 (Registrant)



                          By:  /s/ Bruce C. Hinckley
                               ---------------------
                               Executive Vice President
                               Chief Financial Officer
                               (Principal Finance Officer)


                          By:  /s/ Jeffrey M. Dahl
                               -------------------
                               Vice President / Controller
                               (Principal Accounting Officer)

                                       19