1. Nature of Business and Significant Accounting Policies

Principles of Consolidation   The consolidated financial statements include the accounts of the Company and its foreign and domestic subsidiaries. All significant intercompany accounts and transactions have been eliminated. Inventories Inventories are valued at the lower of cost or market. Product cost is determined using standard costs, which approximate the first-in, first-out basis. Other inventory cost is determined using the first-in, first-out basis.

Property, Plant and Equipment   Property, plant and equipment are stated on the cost basis. Depreciation and amortization, which includes the amortization of assets recorded under capital leases, are computed using the straight-line or accelerated method over the useful life of the related assets. Deferred Costs The costs of brochures, design fees for product labels and organization costs are capitalized and amortized on a straight-line basis over the respective assets' useful lives, typically three to five years.

Revenue Recognition   The Company generally receives its sales price in cash accompanying orders from independent distributors and makes related commission payments in the following month. The net sales price is the suggested retail price less the distributor discount of 25 percent to 45 percent of such suggested retail price. Sales revenue and commission expense are recorded when the merchandise is shipped. Unearned income represents prepaid orders for which the Company has not shipped the merchandise.

Foreign Currency Translation   Each foreign subsidiary's assets and liability accounts, which are originally recorded in the appropriate local currencies, are translated into United States dollar amounts at the year-end exchange rates. Revenue and expense accounts are translated at the average rates for the year. Transaction gains and losses, the amounts of which are immaterial, are included in selling, general and administrative expenses. Foreign exchange translation adjustments are accumulated in a separate component of stockholders' equity.

The foreign exchange translation adjustment for 1995 reflects the consolidated effect on the Company resulting from the decline in the value of the Mexican peso relative to the U.S. dollar of approximately 36 percent in 1995. In 1996, the Mexican peso remained relatively stable, while the Australian and New Zealand dollars improved from their 1995 levels. In 1997, the Australian and New Zealand dollars declined substantially in the latter half of the year. The magnitude of the effect on the foreign exchange translation adjustment is mitigated by the fact that the U.S. dollar denominated intercompany financing of the Mexican subsidiary is considered of a long-term investment nature. Accordingly, the effect of exchange rate fluctuations on the intercompany financing is accumulated as a separate component of stockholders' equity.

Income Taxes   The provision for income taxes is computed using the liability method. The primary difference between financial statement and taxable income results from financial statement accruals and reserves.

Stock-Based Compensation   The Company accounts for stock options in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees." Since the Company grants stock options at an exercise price not less than the fair value of the shares at the date of grant, no compensation expense is recognized. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting and Disclosure of Stock-Based Compensation," effective for years beginning after December 1995. The Company has elected to disclose the effects of this pronouncement in a footnote to these financial statements (see Note 8).

Basic and Diluted Earnings per Share   In 1997, the Financial Accounting Standards Board issued Statement No. 128, Earnings per Share. Statement 128 replaced the calculation of primary and fully diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to the Statement 128 requirements.

Basic earnings per common share is computed using the weighted average number of common shares outstanding during the year. Diluted earnings per common share using the weighted average number of common shares and potential dilutive common shares that were outstanding during the period. Potential dilutive common shares consist of outstanding stock options and warrants. See Note 7 for additional information regarding earnings per share. On January 31, 1997, the Company declared a 10 percent stock dividend on the Company's common stock which was distributed on February 28, 1997 to shareholders of record on February 14, 1997. The dividend was transferred from retained earnings to common stock in the amount of $5,848,000, which was based on the closing price of $6.50 per share on the declaration date. Average shares outstanding and all per share amounts included in the accompanying consolidated financial statements and notes are based on the increased number of shares giving retroactive recognition to the stock dividend.

Advertising   Costs of sales aids and promotional materials are capitalized as inventories. All other advertising and promotional costs are expensed when incurred.

Cash Equivalents   The Company's policy is to consider demand deposits and short-term investments with a maturity of three months or less when purchased as cash equivalents.

Use of Estimates   The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Long-Lived Assets   In March 1995, the FASB issued SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," which requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount. SFAS 121 also addresses the accounting for long-lived assets that are expected to be disposed of. The Company adopted SFAS 121 effective January 1, 1996 and determined that no impairment exists. Reclassifications Certain reclassifications have been made to prior years' financial statements to conform to the current presentation.

2. Subsequent Event

3. Research and Development Expenses

4. Accounts Payable and Accrued Expenses

5. Short-Term Borrowings

6. Long-Term Debt

Principal maturities of long-term debt at December 31, 1997 are as follows:

7. Earnings per Share

8. Stock Options, Warrants, Treasury Stock and Repurchase Agreements

In May 1995, the Company adopted a stock option plan which provides for the grant of incentive stock options and nonqualified stock options for employees (including officers) and other consultants and advisors to the Company. A maximum of 1,100,000 shares can be purchased at an option price not less than the fair market value of the stock at the time the options are granted. As the result of the Company's 10% stock dividend in February 1997, all outstanding options and warrants were adjusted to reflect for the stock dividend.

The Company has elected to follow APB Opinion No. 25, "Accounting for Stock Issued to Employees," (APB 25) and related interpretations in accounting for its employee and nonemployee director stock options because, as discussed below, the alternative fair value accounting provided for under SFAS 123, "Accounting for Stock-Based Compensation," requires the 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 employee and nonemployee director 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 income and earnings per share is required by SFAS 123 and has been determined as if the Company had accounted for its employee stock options under the fair value method of the statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions: risk-free interest rates ranging from 5.15% to 5.30% for 1995, 5.15% to 6.10% for 1996, and 5.70% to 5.97% for 1997; dividend yield of .50%; volatility factor of the expected price of the Company's stock of .658 for 1995 and 1996, .624 for 1997; and a weighted average expected life of the options of 3.54 years.

The Black-Scholes 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 and nonemployee director 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 and nonemployee director stock options.

For purposes of pro forma disclosures, the estimated fair value of the options and warrants is amortized to expense over the options' vesting period. The effects of applying the pro forma disclosure provisions of SFAS 123 are not likely to be representative of the effects on reported net income for future years. The Company's pro forma information follows:

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

As of December 31, 1997:

(1) Shares issued were less than options exercised due to cashless exercise provision.

Warrants   In 1995, the Company, as part of a consulting agreement, issued warrants to purchase 3,364 shares of common stock. The exercise prices of these warrants ranged from $.045 per share to $1.932 per share and had a term of two years. In 1996, as part of this same agreement, the Company issued warrants to purchase 38,035 shares with the same range of exercise prices and terms of the warrants issued in the previous year. In 1997, as a renewal of this agreement, the Company issued warrants to purchase 9,600 shares at an exercise price of $6.25 per share with a term of two years.

In July 1996, as part of another consulting agreement, the Company issued a warrant to purchase 101,948 shares of common stock at an exercise price of $4.182 per share. This warrant has a term of three years.

A summary of the Company's warrant activity and related information for the years ended December 31 follows:

(1) Shares issued were less than options exercised due to cashless exercise provision.

Treasury Stock and Repurchase Agreements   In October 1992, the Company entered into a stock repurchase agreement with a former officer/director of the Company. Under the agreement, which was retroactive to July 1992, the Company was obligated to purchase 259,686 of the individual's shares of Company common stock. The mandatory purchase occurred in six quarterly installments of 43,281 shares beginning in July 1992 and concluding in December 1993. As of December 31, 1993, the Company had redeemed all 259,686 shares required by the agreement for $657,683.

Under the same agreement, the Company also had the option to purchase an additional 432,814 of the individual's shares on the basis of 43,281 shares each quarter beginning in January 1995 and concluding in April 1996. Through December 31, 1996, the Company had exercised all options under the agreement and redeemed an additional 432,814 shares for $870,218. As of December 31, 1997, all treasury shares had been retired.

In May 1997, a former officer/director filed a demand for arbitration with respect to the stock purchase agreement and consulting agreement entered into in October 1992. The demand claims damages resulting from alleged misrepresentations made by the Company regarding these agreements. The Company believes the claim is without merit and intends to vigorously defend itself. At this time, the outcome of this matter is uncertain and a range of loss cannot be reasonably estimated. However, management believes that the final outcome will not have a material adverse effect on the financial position of the Company.

9. Leases

Machinery, office and computer equipment at December 31, 1997 and 1996, include approximately $246,333 and $410,662 of equipment under leases that have been capitalized. Accumulated depreciation and amortization for such equipment approximated $154,978 and $344,539 at December 31, 1997 and 1996, respectively. Rent expense for all operating leases was $311,554, $289,979 and $167,985 for the years ended December 31, 1997, 1996 and 1995, respectively.

10. License Agreement

11. Income Taxes

The components of the provision for income taxes are as follows:

The provision for income taxes is different from the amounts computed by applying the United States federal statutory income tax rate of 34 percent. The reasons for these differences are as follows:

Effective December 31, 1995, the Company hybridized its Canadian subsidiary for federal income tax purposes. During 1995, the Company recognized an income tax benefit in excess of the foreign loss recognized for financial statement purposes as a result of this hybridization.

The components of the deferred tax asset and the related tax effects of each temporary difference at December 31, 1997 and 1996, are as follows:

Federal income taxes have not been provided on the undistributed earnings of the Company's Australian and New Zealand subsidiaries since the Company has foreign tax credits available to offset any related federal income taxes.

The Internal Revenue Service (IRS) examinations of the Company's U.S. federal income tax returns for fiscal years 1992 through 1994 resulted in a proposed assessment against the Company. In early 1998, this examination was resolved with no material adverse effect on the Company's financial position or results of operation.

12. Employee Benefit Plans

13. Incentive Compensation Plans

14. Employment Agreements

Effective January 1, 1994, the Company entered into employment agreements with three officers/directors and in June 1997, entered into new employment agreements with two of these officers/directors. The employment agreements provide for base salary rates established annually by the Board of Directors. The Company paid base salaries of $960,000, $960,000 and $768,750 in 1997, 1996 and 1995, respectively, under the terms of the agreements.

15. Related Party Transactions

Accounts and notes receivable include accounts receivable from officers/directors of $4,633, $4,633 and $219,082 at December 31, 1997, 1996 and 1995, respectively.

During 1996, the Company paid $121,000 for goods and services to a company wholly owned by three officers/directors and one director of the company in connection with promotional activities.

16. Consulting Agreements

In conjunction with an acquisition, the Company entered into a consulting agreement with a partnership consisting of three individuals. Under the agreement, which commenced in March 1992 and expires in February 2002, the Company will pay annual consulting fees to the partnership equal to 2 percent of the new company's retail sales (defined as "the gross sales amount of all products sold by the Company in Australia and New Zealand determined by the suggested retail price") up to approximately $A10,000,000 in 1992 and $A12,000,000 in all subsequent years during the term and 3 percent of retail sales that exceed those figures. Total expense under this agreement approximated $96,000, $133,000 and $185,000 in 1997, 1996 and 1995, respectively.

17. Segment Information

Segment data provided is for the 1997 and 1996 fiscal years only, as the Company began contract manufacturing in late 1995 and the results for 1995 were not material.

Operating profit is total revenue less operating expenses, excluding interest, corporate expenses and income tax expense. Identifiable assets by business segment include both assets directly identified with those operations and an allocable share of jointly used assets. Corporate assets consist primarily of cash and non-operating accounts receivable.

18. Geographic Segment Data

(1) The Canadian subsidiary's 1997 loss from operations of $166,750 is offset by a United States federal tax benefit of approximately $57,000 related to the Canadian subsidiary's losses.

(2) The Mexican subsidiary's 1996 loss from operations of $130,483 is offset by a United States federal tax benefit of approximately $44,000 related to the Mexican subsidiary's losses.

(3) The Canadian subsidiary's 1996 loss from operations of $249,066 is offset by a United States federal tax benefit of approximately $85,000 related to the Canadian subsidiary's losses.

(4) The Mexican subsidiary's 1996 loss from operations of $226,441 is offset by a United States federal tax benefit of approximately $77,000 related to the Mexican subsidiary's losses.

(5) The Canadian subsidiary's 1995 loss from operations of $101,185 is offset by a United States federal tax benefit of approximately $101,000 related to the Canadian subsidiary's losses.

(6) The Mexican subsidiary's 1995 loss from operations of $198,943 is offset by a United States federal tax benefit of approximately $68,000 related to the Mexican subsidiary's losses.

19. Quarterly Financial Data (Unaudited)

(1) Per share data reflects the pro forma effect of the Company's 10 percent stock dividend declared on January 31, 1997 and distributed on February 28, 1997.