TRANS WORLD ENTERTAINMENT CORP - 10-K Annual Report

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DRAFT

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED FEBRUARY 2, 2002

OR

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

FOR THE TRANSITION PERIOD FROM............TO............

COMMISSION FILE NUMBER: 0-14818

TRANS WORLD ENTERTAINMENT CORPORATION
-------------------------------------
(Exact name of registrant as specified in its charter)

NEW YORK 14-1541629
-------- ----------
(State or other jurisdiction (I.R.S. Employer Identification Number)
of incorporation or organization)

38 Corporate Circle
Albany, New York 12203
----------------------
(Address of principal executive offices, including zip code)

(518) 452-1242
--------------
(Registrant's telephone number, including area code)

Indicate by a check mark whether the Registrant (1) has filed all reports
required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for shorter period that the Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes /X/ No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's Knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or an
amendment to this Form 10-K. / /

As of April 26, 2002, 40,732,832 shares of the Registrant's Common Stock,
excluding 13,264,087 shares of stock held in Treasury, were issued and
outstanding. The aggregate market value of such shares held by non-affiliates of
the Registrant, based upon the closing sale price of $8.35 on the NASDAQ
National Market on April 26, 2002, was approximately $213,917,895. Shares of
Common Stock held by the Company's controlling shareholder, who controls
approximately 29.5% of the outstanding Common Stock, have been excluded for
purposes of this computation. Because of such shareholder's control, shares
owned by other officers, directors and 5% shareholders have not been excluded
from the computation.

PART I

ITEM 1. BUSINESS

GENERAL

Trans World Entertainment Corporation (which, together with its consolidated
subsidiaries, is referred to herein as the "Company") was incorporated in New
York in 1972. Trans World Entertainment Corporation owns 100% of the outstanding
common stock of Record Town, Inc., through which the Company's principal retail
operations are conducted, through various subsidiaries.

The Company operates a chain of retail entertainment stores and an e-commerce
site, fye.com, in a single industry segment. The Company is one of the largest
specialty retailers of prerecorded music, videos and related products in the
United States. At February 2, 2002, the Company operated 902 stores totaling
approximately 5.1 million square feet in 46 states, the District of Columbia,
the Commonwealth of Puerto Rico and the U.S. Virgin Islands, with the majority
of the stores concentrated in the eastern half of the United States. The
Company's business is seasonal in nature, with the peak selling period being
the holiday season in the Company's fourth fiscal quarter. Sales were $1.39
billion for its fiscal year ended February 2, 2002 (referred to herein as
"2001").

On October 30, 2000, the Company acquired certain assets and assumed certain
liabilities and operating lease commitments of 112 stores from Wax Works, Inc.
The acquisition was accounted for using the purchase method of accounting. The
Company acquired the assets for $49.8 million, including merchandise inventory,
fixed assets, leasehold interests and other current assets and recognized
approximately $10.2 million in goodwill.

On August 11, 2000, the Company acquired a majority interest in SecondSpin.com
for $4.2 million, net of cash acquired. The acquisition was accounted for under
the purchase method of accounting. SecondSpin.com operates an e-commerce site
and six retail stores for the buying and selling of used CDs, videos and DVDs.

On April 22, 1999, the Company merged with Camelot Music Holdings, Inc.
("Camelot"). The Company exchanged 1.9 shares of its common stock for each share
of Camelot common stock. The Company issued approximately 19.3 million shares of
its common stock in exchange for all outstanding Camelot common stock. The
transaction was accounted for as a pooling-of-interests. Accordingly, prior
period consolidated financial statements have been restated to include combined
results of operations, financial position and cash flows of Camelot as though it
had been a part of the Company since Camelot's adoption of "fresh-start"
accounting on January 31, 1998.

The Company's principal executive offices are located at 38 Corporate Circle,
Albany, New York, 12203, and its telephone number is (518) 452-1242.

STORE CONCEPTS

The Company offers a broad selection of music and video titles at competitive
prices in convenient, attractive stores. It operates four distinct store
concepts, FYE stores, super FYE stores, Saturday Matinee stores and
freestanding stores, designed to take advantage of real estate opportunities
and to satisfy varying consumer demands.

The Company's strategic plan to re-brand its mall-based stores and its
e-commerce site under a single, unified brand, FYE (For Your Entertainment),
was completed during the year. The Company's e-commerce site was re-launched
as fye.com in October 2001. fye.com is the on-line hub for the Company's
retail stores. The site features all of the music CDs and cassettes, video
games, DVD and VHS home videos that are available at its retail stores, and
more. The re-branding initiative was the result of an in-depth analysis of
the changing entertainment marketplace, the technology revolution, as well as
extensive customer research. The unified brand will enable the Company to
leverage its strength as the nation's largest music specialty retailer and
differentiate FYE from the competition. For the first time, our customers
nationwide will enjoy a consistent shopping experience in every mall store,
in every market and across every channel. This enhanced brand experience,
which will include industry-leading product sampling and selection tools, is
designed to cultivate customer loyalty, drive sales and build market share
for the Company.

FYE will create a more relevant shopping experience for consumers, expanding
product selection across the entertainment spectrum. The brand positioning also
enables the Company to broaden its customer base and fully realize the benefits
of a multi-market, multi-channel strategy. The interior and exterior signs have
been changed to reflect the new brand, and a national marketing effort to
support the brand is underway as well. Broadband communication has been
installed in the stores to increase the speed and capacity of information
exchange, including

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the ability to handle digital distribution. Listening and viewing stations
have been installed in select stores and preparation is underway for the
complete rollout by the end of the third quarter of 2002. Also, through the
Company's new relationship with Microsoft Corporation, FYE is creating a
personalized entertainment shopping experience that will drive cross-channel
sales between stores and fye.com. The Company is the premier music retailer
on all of Microsoft's MSN web sites. In addition, during 2002, the Company
will introduce Backstage Pass, a loyalty program that will offer significant
value to consumers. The investment in the branding initiative was $13.0
million in 2001, including operating expenses of $3.1 million, which includes
depreciation.

MALL STORES

FYE (FOR YOUR ENTERTAINMENT). At February 2, 2002, the Company operated 669
mall stores, with the majority operating under the FYE brand, including 16
super FYE stores. An FYE mall store averages 5,800 square feet, and carries
an extensive merchandise assortment.

The super FYE stores carry a broad assortment of music and video merchandise
and an extensive selection of games, portable electronics, accessories and
boutique items. This format makes the traditional superstore experience
available to shopping mall consumers. This format is designed to be a
semi-anchor or destination location in major regional malls. A super FYE
store averages 23,900 square feet.

SATURDAY MATINEE STORES. These stores sell prerecorded video merchandise and
related accessories. They are located in large, regional shopping malls and
average 2,300 square feet in size. There were 17 such locations at February 2,
2002.

FREESTANDING STORES

The Company's freestanding store concept included 216 stores at February 2,
2002, which primarily operate under the names Coconuts, Strawberries Music and
Spec's Music. These stores are designed for freestanding, strip center and
downtown locations and average approximately 5,300 square feet.

The Company also operates "Planet Music," a 31,000 square foot freestanding
superstore in Virginia Beach, VA. The store offers an extensive catalog of
music, video and other related merchandise.

MERCHANDISE

The Company's stores offer a full assortment of compact discs, prerecorded audio
cassettes, prerecorded video, including VHS tapes and DVDs, video games and
related products. Sales by merchandise category as a percent of total sales over
the past three years were as follows:

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MUSIC. The Company's stores offer a full assortment of compact discs and
prerecorded audio cassettes purchased primarily from five major manufacturers.
Music categories include rock, pop, rap, soundtracks, alternative, Latin, urban,
heavy metal, country, dance, vocals, jazz and classical.

VIDEO. The Company offers prerecorded videocassettes and DVDs for sale in all
of its stores. In 2001, DVD sales increased to 61% of the Company's total
video sales from 42% in 2000. Paul Kagan Associates, an entertainment/media
research firm, estimated that more than 35 million households will own a DVD
player by the end of 2002 and as many as 87 million households will own a DVD
player by the end of 2010. The Company plans to continue to capitalize on
this trend by making DVDs increasingly available in its stores.

VIDEO GAMES. The Company offers video game hardware and software in many of its
stores. During 2001, video game sales were positively impacted by new hardware
and software from the Nintendo Company and Microsoft. Management expects the
positive trend in video games to continue and will continue to add video game
hardware and software to the product mix in select stores.

OTHER MERCHANDISE. The Company carries brand name blank audio cassettes,
compact discs and videocassette tapes as well as accessory merchandise for
compact discs, audio cassettes and videocassettes, including maintenance and
cleaning products, storage cases, portable electronics and headphones. The
Company also features consumer electronics and boutique items.

ADVERTISING

The Company makes extensive use of in-store signs and pursues a mass-media
marketing program for its freestanding stores through advertisements in
newspapers, radio, and television. Vendors from whom the Company purchases
merchandise offer advertising allowances to promote their merchandise.

As part of the Company's rollout of the FYE brand, the Company will increase its
regional and national marketing, including TV and radio and concert
sponsorships. In addition, the Company will build recognition around the tag
line "Never Stop Playing."

INDUSTRY AND COMPETITIVE ENVIRONMENT

The retail home entertainment industry is highly competitive. According to the
Recording Industry Association of America, the U.S. retail music market was
approximately $13.7 billion in 2001. The Company's retail stores compete
primarily with other specialty retail music and video chains (e.g. Sam Goody,
Wherehouse Entertainment, Tower Records), as well as mass merchants (e.g.
Wal-Mart, K-Mart, Target), book stores (e.g. Barnes and Noble, Borders) and
consumer electronics stores (e.g. Best Buy, Circuit City), some of which may
have greater financial or other resources than the Company. The Company also
competes with mail order clubs (e.g. BMG Music, Columbia House) and Internet
companies (e.g. Amazon.com, CDnow.com).

CD sales decreased in 2001 for the first time since the format was
introduced. The decrease was attributable to the increased usage of compact
disc recordables ("CD-Rs"). The industry is concerned about the issue of CD
duplication and has begun testing titles with copy protection. It is
anticipated that copy protection will be utilized by the second half of
fiscal 2002.

The cassette and singles formats continue to decline. The Company expects the
declining trend in cassettes to continue and will continue to minimize the
amount of store square footage allocated to cassettes. The singles category
was impacted by a decline in the number of releases offered for sale by the
labels. The Company believes the number of titles to be released in the
future will increase and should have a positive impact on both singles sales
and CD sales.

SEASONALITY

The Company's business is highly seasonal, with the fourth quarter constituting
the Company's peak selling period. In fiscal 2001, the fourth quarter accounted
for approximately 37% of annual sales. In anticipation of increased sales
activity during these months, the Company purchases substantial amounts of
inventory and hires a significant number of temporary employees to supplement
its permanent store sales staff. If for any reason the Company's net sales were
below seasonal norms during the fourth quarter, as a result of merchandise
delivery delays due to receiving or distribution problems, the Company's
operating results, particularly operating and net income, could be adversely

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affected. Quarterly results can be affected by the timing and strength of new
releases, the timing of holidays, new store openings and the sales performance
of existing stores.

DISTRIBUTION AND MERCHANDISE OPERATIONS

The Company's two distribution facilities use automated and computerized systems
designed to manage merchandise receipt, storage and shipment. Store inventories
of regular merchandise are replenished using daily sales information that is
transmitted to the Company's central computer system from each store after the
close of the business day. Shipments from the distribution facilities to the
Company's stores are made at least once a week and currently provide
approximately 75% of all merchandise requirements. The balance of the stores'
requirements is satisfied through direct shipments from manufacturers.

Company-owned trucks service approximately 230 of the Company's stores. The
remaining stores are serviced by several common carriers chosen on the basis of
geography and rate considerations. The Company's sales volume and centralized
merchandise distribution facilities enable them to take advantage of
transportation economies.

The Company believes that its existing distribution centers are adequate to meet
the Company's planned business needs.

SUPPLIERS AND PURCHASING

The Company purchases inventory from approximately 785 suppliers. Approximately
65% of purchases in fiscal 2001 were made from five suppliers: WEA
(Warner/Electra/Atlantic Corp.), Sony Music, Universal Distribution, BMG
(Bertelsmann Music Group) and EMD (EMI Music Distribution). As is typical in
this industry, the Company does not have material long-term purchase contracts
and deals with its suppliers principally on an order-by-order basis. In the
past, the Company has not experienced difficulty in obtaining satisfactory
sources of supply, and management believes that it will retain access to
adequate sources of supply.

The Company produces its own store fixtures for its stores at a facility located
in Johnstown, New York. The Company believes that its costs of production are
lower than purchasing from an outside manufacturer.

TRADE CUSTOMS AND PRACTICES

Under current trade practices with the five largest suppliers, retailers of
compact discs and prerecorded audio cassettes are entitled to return merchandise
they have purchased for other titles carried by the suppliers. This return
practice permits the Company to carry a wider selection of music titles and
reduces the risk of inventory obsolescence. Four of these five suppliers charge
a related merchandise return penalty. Most manufacturers and distributors of
prerecorded video offer return privileges comparable to those of prerecorded
music, but they typically do not charge a return penalty. Merchandise return
policies have not changed significantly during the past five years.
Historically, the Company generally has adapted its purchasing policies to
changes in the policies of its suppliers.

EMPLOYEES

As of February 2, 2002, the Company employed approximately 9,700 associates,
of whom 4,000 were employed on a full-time basis. All other associates were
employed on a part-time or temporary basis. The Company hires seasonal sales
associates during peak seasons to ensure continued levels of customer
service. Store managers, district managers and regional managers are eligible
to receive incentive compensation based on the sales and profitability of
stores for which they are responsible. None of the Company's employees are
covered by collective bargaining agreements, and management believes that the
Company enjoys favorable relations with its employees. Increases in the
minimum wage have had an effect on the Company's compensation expense in
recent years. Management believes future increases in the minimum wage will
not have a material effect on the Company's results of operations and
financial condition.

RETAIL INFORMATION SYSTEMS

The Company's management information systems provide daily information on the
Company's sales, inventory and gross margin by store and by SKU. These
systems process accounting, payroll, telecommunications and operating
information and allow management to compare current performance to historical
performance and Company goals. They include enhanced inventory management
functions such as merchandise receiving and returns. Management believes that
the systems the Company has developed contribute to continued customer
service and operational efficiency, as well as provide the ability to monitor
critical performance indicators. The Company continually assesses its
information system needs to increase efficiency, improve decision-making and
support growth. During the year, the Company installed a broadband
communication network in the stores, facilitating more efficient information
exchange between the stores, corporate offices and field management and
providing streamlined checkout procedures, as well as the ability to handle
digital distribution.

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ITEM 2. PROPERTIES

RETAIL STORES

At February 2, 2002, the Company operated 902 retail locations. All of the
Company's retail stores are under operating leases with various terms and
options. Substantially all of the stores provide for payment of fixed monthly
rentals and operating expenses for maintenance, property taxes, insurance
and utilities. Some also provide for a percentage of gross receipts of the
store in excess of specified sales levels. The following table lists the
number of leases due to expire (assuming no renewal options are exercised) in
each of the fiscal years shown, as of February 2, 2002:

The Company expects that as these leases expire, it will be able either to
obtain renewal leases, if desired, or to obtain leases for other suitable
locations.

CORPORATE OFFICES AND DISTRIBUTION CENTER FACILITIES

The Company leases its Albany, New York, distribution facility and corporate
office space from its largest shareholder and Chief Executive Officer under
three capital leases that extend through the year 2015. All three leases are at
fixed rentals with provisions for biennial increases based upon increases in the
Consumer Price Index. Under such leases, the Company pays all property taxes,
insurance and maintenance. The office portion of the facility is comprised of
approximately 40,300 square feet. The distribution center portion is comprised
of approximately 128,100 square feet. The Company also owns a 236,600 square
foot distribution center and 59,200 square feet of commercial office space in
North Canton, Ohio.

The Company leases an 82,000 square foot facility in Johnstown, New York, where
it manufactures its store fixtures. The operating lease expires in December
2003. The Company also leases 20,700 square feet of commercial office space in
Albany, New York. The operating lease expires in November of 2002.

ITEM 3. LEGAL PROCEEDINGS

On October 16, 2000, the United States District Court for the District of
Delaware issued an opinion in favor of the Internal Revenue Service ("IRS"),
in the case IRS vs. CM Holdings Inc., a wholly-owned subsidiary of the
Company. The case was brought against CM Holdings Inc. by the IRS to
challenge the deduction of interest expense related to corporate-owned life
insurance policies held by Camelot, a subsidiary of CM Holdings Inc., for
certain tax years that ended on or before February 1994. The court ruled that
interest deductions on policy loans should not be allowed and the Company is
responsible for the taxes and related interest and penalties. As a result of
the District Court decision, the Company accrued $11.0 million during 2000,
which is reflected in other (long-term) liabilities in the consolidated
balance sheet as of February 2, 2002 and February 3, 2001. The Company filed
an appeal in response to the decision. On October 30, 2001, the Company's
appeal was heard by the United States Third Circuit Court of Appeals, and a
decision is pending.

On August 8, 2000, 30 Attorneys General served a complaint against the
Company, five major music distributors and two other specialty retailers in
the United States District Court for the Southern District of New York ("AG's
suit"). The complaint has been subsequently amended to add additional states
as plaintiffs and to reflect the transfer of the case to the United States
District Court in Maine pursuant to Multidistrict Litigation Rules. The AG's
suit alleges that the distributors and retailers conspired to violate certain
anti-trust laws and to fix prices by requiring retailers to adhere to minimum
advertised prices in order to receive cooperative advertising funds from the
distributors. The complaint alleges that consumers were damaged in an
unspecified amount and seeks treble damages and civil penalties.

5

Following the service of the AG's suit, these same defendants were named as
defendants in private class action suits ("Class Actions"), each with similar
allegations as in the AG's suit. The Class Actions have been consolidated
along with the AG's suit in the United States District Court in Maine. It is
management's belief that the lawsuits are without merit and the Company will
ultimately prevail in this regard.

The Company is subject to other legal proceedings and claims that have arisen in
the ordinary course of its business and have not been finally adjudicated.
Although there can be no assurance as to the ultimate disposition of these
matters, it is management's opinion, based upon the information available at
this time, that the expected outcome of these matters, individually or in the
aggregate, will not have a material adverse effect on the results of operations
and financial condition of the Company.

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

No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended February 2, 2002.

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PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

MARKET INFORMATION. The Company's Common Stock trades on The NASDAQ Stock
Market under the symbol "TWMC." As of February 2, 2002, there were
approximately 900 shareholders of record. The following table sets forth high
and low last reported sale prices for each fiscal quarter during the period
from February 1, 2000 through April 26, 2002.

On April 26, 2002, the last reported sale price on the Common Stock on the
NASDAQ National Market was $8.35.

Options for the Company's Common Stock trade on the Chicago Board Options
Exchange.

DIVIDEND POLICY: The Company has never declared or paid cash dividends on its
Common Stock. The Company's credit agreement currently allows the Company to pay
a cash dividend once in each calendar year. Such dividends would be restricted
to ten percent of the most recent fiscal year's consolidated net income and
could only be paid if, after any payment of dividends, the Company maintains $25
million in availability under the credit agreement. Any future determination as
to the payment of dividends will depend upon capital requirements and
limitations imposed by the Company's credit agreement and such other factors as
the Board of Directors of the Company may consider.

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following table sets forth selected consolidated financial data and other
operating information of the Company and gives retroactive effect to the
acquisition of Camelot for the periods subsequent to its "fresh-start reporting"
on January 31, 1998, upon its reemergence from bankruptcy. The acquisition was
accounted for using the pooling-of-interests method of accounting. The selected
income statement and balance sheet data for the five fiscal years ended February
2, 2002 set forth below are derived from the audited consolidated financial
statements of the Company. Each fiscal year of the Company consisted of 52
weeks, except the fiscal year ended February 3, 2001, which consisted of 53
weeks. All share and per share amounts have been adjusted for stock splits. The
information is only a summary and should be read in conjunction with the
Company's audited consolidated financial statements and related notes and other
financial information included herein and "Management's Discussion and Analysis
of Financial Condition and Results of Operations."

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(1) THE CAMELOT MERGER-RELATED COSTS INCLUDED THE WRITE-OFF OF THE BOOK VALUE
OF RETIRED ASSETS, PROFESSIONAL FEES ASSOCIATED WITH THE COMPLETION OF THE
MERGER, SEVERANCE COSTS, JOINT PROXY PRINTING AND DISTRIBUTION COSTS, AND
REGULATORY FILING FEES.

(2) THE ASSET IMPAIRMENT CHARGE AND RESTRUCTURING CHARGE (REVERSAL), NET,
DURING THE YEAR ENDED JANUARY 30, 1999, INCLUDED AN ASSET IMPAIRMENT CHARGE
OF $3.7 MILLION TO WRITE DOWN THE CARRYING AMOUNT OF CERTAIN FIXED ASSETS
AT STORES, PRIMARILY LEASEHOLD IMPROVEMENTS, AND THE ONE-TIME REVERSAL OF
THE REMAINING BALANCE OF $2.2 MILLION IN THE STORE CLOSING RESERVE
ORIGINALLY ESTABLISHED DURING THE FISCAL YEAR ENDED FEBRUARY 3, 1996.

(3) A STORE IS INCLUDED IN COMPARABLE STORE SALES CALCULATIONS AT THE BEGINNING
OF ITS 13TH FULL MONTH OF OPERATION.

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following is an analysis of the Company's results of operations, liquidity
and capital resources. To the extent that such analysis contains statements
which are not of a historical nature, such statements are forward-looking
statements, which involve risks and uncertainties. These risks include, but are
not limited to, changes in the competitive environment for the Company's
merchandise, including the entry or exit of non-traditional retailers of the
Company's merchandise to or from its markets; the release by the music industry
of an increased or decreased number of "hit releases"; general economic factors
in markets where the Company's merchandise is sold; and other factors discussed
in the Company's filings with the Securities and Exchange Commission.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements and related disclosures in conformity
with accounting principles generally accepted in the United States requires
that management apply accounting policies and make estimates and assumptions
that affect results of operations and the reported amounts of assets and
liabilities in the financial statements. Management continually evaluates its
estimates and judgments including those related to revenue recognition,
merchandise inventory and return costs, useful lives of fixed assets, the
value of long-lived assets and goodwill, store opening and closing costs, and
provision for income taxes. Management bases its estimates and judgments on
historical experience and other factors that are believed to be reasonable
under the circumstances. Actual results may differ from these estimates under
different assumptions or conditions. Note 1 of the notes to the consolidated
financial statements includes a summary of the significant accounting
policies and methods used by the Company in the preparation of its
consolidated financial statements. We believe that of our significant
accounting policies, the following may involve a higher degree of judgment or
complexity:

REVENUE RECOGNITION: The Company's revenue is primarily from retail sales of
merchandise comprised of prerecorded music (including compact discs and audio
cassettes), video (including DVD and prerecorded videocassettes), video
games and other complementary products (including electronics, accessories,
blank tapes and CD-Rs). Revenue is recognized at the point of sale to the
consumer, at which time payment is tendered. There are no provisions for
uncollectible amounts since payment is received at the time of sale.
Reductions of revenue for returns by customers are generally provided at the
point of return due to infrequency and occurrence within short intervals of
the sale and immateriality to the financial statements.

MERCHANDISE INVENTORY AND RETURN COSTS: Inventory is stated at the lower of cost
or market as determined by the average cost method. The Company is entitled to
return merchandise purchased from major vendors for credit against other
purchases from these vendors. These vendors often reduce the credit with a
merchandise return charge ranging from 0% to 20% of the original merchandise
purchase price depending on the type of merchandise being returned. The Company
records actual and estimated merchandise return charges in cost of sales.

FIXED ASSETS AND DEPRECIATION: Fixed assets are stated at cost. Major
improvements and betterments to existing facilities and equipment are
capitalized. Expenditures for maintenance and repairs that do not extend the
life of the applicable asset are charged to expense as incurred. Buildings are
depreciated over a 30-year term. Fixtures and equipment are depreciated using
the straight-line method over their estimated useful lives, which range from
three to seven years. Leasehold improvements are amortized using the
straight-line method over the shorter of their estimated useful lives or the
related lease term. A majority of the Company's operating leases are ten years
in term. Amortization of capital lease assets is included in depreciation and
amortization expense.

The Company records software developed for internal use in accordance with
Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use". Accordingly, software developed
internally for the use by the Company is capitalized only during the application
development stage and only certain costs are capitalized.

IMPAIRMENT OF LONG-LIVED ASSETS: Fixed assets and other long-lived assets are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to undiscounted future net cash flows expected to be generated by the
asset over its remaining useful life. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which the
carrying amount of the assets exceeds the fair value of the assets. Fair value
is generally measured based on discounted estimated future cash flows.

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GOODWILL: Goodwill represents the adjusted amount of the cost of acquisitions in
excess of fair value of net assets acquired in purchase transactions, and is
being amortized on a straight-line basis over estimated useful lives ranging
from 10 to 20 years. The amortization period is determined by taking into
consideration the following factors: the critical market position and
establishment of brand names; the combined store mass of the companies; the
amortization periods generally used in the retail music business; the highly
competitive nature of the business including emerging forms of competition; and
the overall history of profitability of the acquired businesses. The Company
periodically evaluates the carrying amount of goodwill, as well as the related
amortization periods to determine whether adjustments to these amounts or useful
lives are required based on current events and circumstances. The Company
performs an analysis of the recoverability of goodwill using a cash flow
approach consistent with the analysis of the impairment of long-lived assets.

STORE OPENING AND CLOSING COSTS: Costs associated with opening a store are
expensed as incurred. When it is determined that a store will be closed,
estimated unrecoverable costs are charged to expense. Such costs include the net
book value of abandoned fixtures, equipment, leasehold improvements and a
provision for lease obligations, less estimated sub-rental income. The residual
value of any fixed asset moved to a store as part of a relocation is transferred
to the relocated store.

INCOME TAXES: Income taxes are accounted for under the asset and liability
method. Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases, and tax loss carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.
Deferred tax assets are subject to valuation allowances based upon management's
estimates of realizability.

RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, certain income and
expense items as a percentage of sales:

FISCAL YEAR ENDED FEBRUARY 2, 2002 ("2001")
COMPARED TO FISCAL YEAR ENDED FEBRUARY 3, 2001 ("2000")

SALES. The Company's sales decreased $26.6 million, or 1.9%, from 2000.
Comparisons of 2001 and 2000 are affected by an additional week of results in
the 2000 reporting year. Because the Company's year ends on the Saturday
nearest to January 31, a fifty-third week is added every five or six years.
The decrease was attributable to a decrease in the number of weeks in the
fiscal year, as the fifty-third week in 2000 increased sales by an estimated
$23.7 million. The decrease was also attributable to a comparable store sales
decrease of 2.7% and a decrease of approximately 246,000 square feet of
retail selling space through the closing of 101 stores, which was partially
offset by the opening of 35 stores, 16 of which were relocations of already
existing stores.

For 2001, comparable store sales decreased 3.8% for mall stores and increased
0.9% for freestanding stores. By merchandise category, comparable store sales
decreased 12.7% in music, increased 35.3% in video, increased 75.9%

11

in video games and increased 11.8% in other merchandise categories. The
increase in comparable sales for video was driven by DVD sales and the
increase in comparable sales for other merchandise categories was driven by
electronics sales. The decrease in music sales reflected the impact of an
industrywide decrease in CD sales.

GROSS PROFIT. Gross profit, as a percentage of sales, decreased to 32.6% in 2001
from 35.2% in 2000 primarily as a result of declining sales in the higher margin
music categories, increased sales in the lower margin DVD and video games
categories, and increased promotional pricing.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. SG&A, as a percentage of sales,
increased to 30.5% in 2001 from 29.5% in 2000. The increase can be attributed to
increased spending on strategic initiatives including the unified branding of
mall stores and e-commerce development. Total spending included in SG&A for the
initiatives was $15.9 million. The Company plans to spend an additional $7.4
million in 2002.

INTEREST EXPENSE. Interest expense decreased to $2.5 million in 2001 from $3.1
million in 2000 due to lower interest rates on outstanding borrowings.

OTHER EXPENSES (INCOME), NET. Other income, net decreased to $2.1 million in
2001 from $6.5 million in 2000. The decrease was due to lower interest income
from lower average cash balances during the year and lower interest rates on
invested balances.

INCOME TAX EXPENSE. The effective income tax rate was 43.4% in 2001, as compared
to 52.0% in 2000. Included in income tax expense for 2000 was an $11.0 million
charge, which resulted from a court decision disallowing the deduction of
interest expenses related to corporate-owned life insurance policies held by
Camelot. Excluding the charge, the Company's effective tax rate was 38.9% in
2000. The effective income tax rate for 2001 was impacted by an increase in the
valuation allowance for deferred taxes related to losses on investments and a
decrease in the Company's income before income taxes. See Note 5 of Notes to
Consolidated Financial Statements for a reconciliation of the statutory tax rate
to the Company's effective income tax rate.

NET INCOME. In 2001, the Company's net income decreased to $16.8 million,
compared to a net income of $40.2 million in 2000. The decrease in net income is
attributable to lower gross margins and higher SG&A expenses.

The fifty-third week in 2000 increased operating income by an estimated $4.0
million and net income by an estimated $2.5 million, or $0.05 per share.

FISCAL YEAR ENDED FEBRUARY 3, 2001 ("2000")
COMPARED TO FISCAL YEAR ENDED JANUARY 29, 2000 ("1999")

SALES. The Company's sales increased $56.5 million, or 4.2%, from 1999.
Comparisons of 2000 and 1999 are affected by an additional week of results in
the 2000 reporting year. Because the Company's year ends on the Saturday nearest
to January 31, a fifty-third week is added every five or six years. The increase
was attributable to a increase in the number of weeks in the fiscal year, as the
fifty-third week in 2000 increased sales by an estimated $23.7 million. The
increase was also attributable to a comparable store sales increase of 0.2% and
the addition of approximately 409,000 square feet of retail selling space
through the opening of 12 stores, acquisition of 112 stores (purchase of retail
assets from Wax Works, Inc., a privately-held music and video retailer) and
relocation of 36 stores, which was partially offset by the closing of 107
stores.

For 2000, comparable store sales increased 0.2% for mall stores and 0.3% for
freestanding stores. By merchandise category, comparable store sales decreased
5.4% in music, increased 29.7% in video and 7.7% in other merchandise. The
increase in comparable sales for video was driven by DVD sales.

GROSS PROFIT. Gross profit, as a percentage of sales, decreased to 35.2% in 2000
from 36.8% in 1999 primarily as a result of declining sales in the high margin
singles and audio cassette categories, increased sales in the lower margin DVD
category, and increased promotional pricing.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. SG&A, as a percentage of sales,
increased to 29.5% in 2000 from 27.4% in 1999. The increase can be attributed to
increased spending on strategic initiatives including the unified branding of
mall stores, supply chain enhancement and e-commerce development.

12

INTEREST EXPENSE. Interest expense decreased from $3.5 million in 1999 to $3.1
million in 2000 due to lower average outstanding borrowings.

OTHER EXPENSES (INCOME), NET. Other income, net increased from $4.1 million in
1999 to $6.5 million in 2000. The increase was due to interest income from
higher average cash balances during the year.

INCOME TAX EXPENSE. The effective income tax rate was 52.0% in 2000. Included in
income tax expense was an $11.0 million charge, which resulted from a court
decision disallowing the deduction of interest expenses related to
corporate-owned life insurance policies held by Camelot. Excluding the charge,
the Company's effective tax rate was 38.9% in 2000. See Note 5 of Notes to
Consolidated Financial Statements for a reconciliation of the statutory tax rate
to the Company's effective income tax rate.

NET INCOME. In 2000, the Company's net income decreased to $40.2 million,
compared to a net income of $61.4 million in 1999. The decrease in net income is
attributable to lower gross margins, higher SG&A expenses and the increase in
income tax expense related to the court decision on corporate-owned life
insurance policies.

The fifty-third week in 2000 increased operating income by an estimated $4.0
million and net income by an estimated $2.5 million, or $0.05 per share.

LIQUIDITY AND CAPITAL RESOURCES

LIQUIDITY AND CAPITAL RESOURCES. The Company's primary sources of working
capital are cash flows provided by operations and borrowing capacity under its
revolving credit facility. The Company ended fiscal 2001 with cash balances of
approximately $254.9 million, compared to $265.1 million at the end of 2000.

Cash provided by operating activities decreased $95.4 million to $72.6
million in 2001, compared to $168.0 million in 2000. The decrease was due to
lower net income in 2001 versus 2000 and a reduction in accounts payable of
$51.3 million in 2001 versus an increase in accounts payable of $74.5 million
in 2000. The decrease in accounts payable was due to a decrease in inventory
of $66.7 million. Accounts payable leveraging (the percentage of merchandise
inventory financed by vendor credit terms, e.g., accounts payable divided by
merchandise inventory) increased to 92.6% as of February 2, 2002 compared
with 90.4% as of February 3, 2001.

Cash used in investing activities was $57.8 million in 2001, as compared to
$92.7 million in 2000. In 2001, the primary use of cash was $51.1 million for
the acquisition of fixed assets. In 2000, the primary uses of cash were $56.5
million for acquisitions, primarily relating to the acquired Disc Jockey
stores, and $32.8 million for the acquisition of fixed assets.

Cash used in financing activities was $24.9 million in 2001, as compared to
$90.2 million in 2000. In 2001 and 2000, the primary use of cash was $20.2
million and $85.7 million, respectively, to repurchase outstanding shares of the
Company's common stock under programs authorized by the Board of Directors. As
of February 2, 2002, the Company had purchased approximately 12.8 million shares
of the 15.0 million shares authorized by the Board of Directors under three
separate programs of 5.0 million shares each.

The Company has a three-year $100 million secured revolving credit facility with
Congress Financial Corporation that expires in July 2003 and automatically
renews on a year-to-year basis thereafter at the discretion of both parties.
Interest expense decreased to $2.5 million in 2001 from $3.1 million in 2000. As
of February 2, 2002 and February 3, 2001, the Company did not have any
borrowings outstanding under the facility, and $100 million was available.

The revolving credit facility contains certain restrictive provisions, including
provisions governing cash dividends and acquisitions, is collateralized by
merchandise inventory and has a minimum net worth covenant.

CAPITAL EXPENDITURES. The majority of the Company's capital expenditures are for
new stores and the relocation of existing stores. The Company typically finances
its capital expenditures through cash generated from operations. The Company may
also receive financing from landlords in the form of construction allowances or
rent concessions. Total capital expenditures were approximately $51.1 million in
2001, including $22.3 million for the Company's eWorks and rebranding
initiatives.

13

In fiscal 2002, the Company plans to spend approximately $60.0 million, net of
construction allowances, for additions to fixed assets, including $35.0 million
for the eWorks initiative.

CONTRACTUAL OBLIGATIONS AND COMMITMENTS. The following table summarizes the
Company's contractual obligations at February 2, 2002, and the effect that
such obligations are expected to have on liquidity and cash flows in future
periods (in thousands).

(1) Includes $16.4 million in interest.

SEASONALITY. The Company's business is highly seasonal, with the highest sales
and earnings occurring in the fourth fiscal quarter. See Note 11 of the Notes to
Consolidated Financial Statements for quarterly financial highlights.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS. In July 2001, the FASB issued SFAS
No. 141, "Business Combinations", and SFAS No. 142, "Goodwill and Other
Intangible Assets". SFAS No. 141 requires that the purchase method of accounting
be used for all business combinations initiated after June 30, 2001 as well as
all purchase method business combinations completed after June 30, 2001. SFAS
No. 141 also specifies criteria that intangible assets acquired in a purchase
method business combination must meet to be recognized and reported apart from
goodwill, noting that any purchase price allocable to an assembled workforce may
not be accounted for separately. SFAS No. 142 requires that goodwill and
intangible assets with indefinite useful lives no longer be amortized, but
instead tested for impairment at least annually in accordance with the
provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets
with definite useful lives be amortized over their respective estimated useful
lives to their estimated residual values, and reviewed for impairment in
accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of", and subsequently, SFAS No.
144 after its adoption.

The Company adopted the provisions of SFAS No. 141 as of July 1, 2001, and SFAS
No. 142 is effective February 3, 2002. Furthermore, any goodwill or
intangible asset determined to have an indefinite useful life and acquired in
a purchase business combination completed after June 30, 2001 will not be
amortized, but will continue to be evaluated for impairment in accordance
with the appropriate pre-SFAS No. 142 accounting literature. Goodwill and
intangible assets acquired in business combinations completed before July 1,
2001 will continue to be amortized prior to the adoption of SFAS No. 142.

Upon adoption of SFAS No. 142, the Company is required to evaluate its existing
intangible assets and goodwill that were acquired in purchase business
combinations, and to make any necessary reclassifications in order to conform to
the new criteria in SFAS No. 141 for recognition apart from goodwill. Under SFAS
No. 142, the Company will be required to reassess the useful lives and residual
values of all intangible assets acquired in purchase business combinations, and
make any necessary amortization period adjustments by the end of the second
quarter of 2002. In addition, to the extent an intangible asset is identified as
having an indefinite useful life, the Company will be required to test the
intangible asset for impairment in accordance with the provisions of SFAS No.
142 by the end of the first quarter of 2002. Any impairment loss will be
measured as of the date of adoption and recognized as the cumulative effect of a
change in accounting principle in the first quarter of 2002.

In connection with SFAS No. 142's transitional goodwill impairment evaluation,
the Company will be required to perform an assessment of whether there is an
indication that goodwill is impaired as of the date of adoption. To accomplish
this, the Company must identify its reporting units and determine the carrying
value of each reporting unit by assigning the assets and liabilities, including
existing goodwill and intangible assets, to those reporting units as of February
3, 2002. The Company will then have up to six months from February 3, 2002 to
determine the fair value of each reporting unit and compare it to the carrying
amount of the reporting unit. To the extent the carrying amount of a reporting
unit exceeds the fair value of the reporting unit, an indication exists that the
reporting unit goodwill may be impaired and the Company must perform the second
step of the transitional impairment test. The second step is required to be
completed as soon as possible, but no later than the end of the year of
adoption. In the second step, the Company must compare the implied fair value of
the reporting unit goodwill with the carrying amount of the reporting unit
goodwill, both of which would be measured as of the date of adoption. The
implied fair value of goodwill is determined by allocating the fair value of the
reporting unit to all of the assets (recognized and

14

unrecognized) and liabilities of the reporting unit in a manner similar to a
purchase price allocation, in accordance with SFAS No. 141. The residual fair
value after this allocation is the implied fair value of the reporting unit
goodwill. Any transitional impairment loss will be recognized as the cumulative
effect of a change in accounting principle in the Company's consolidated
statement of operations.

As of the date of adoption of SFAS No. 142, the Company had unamortized
goodwill in the amount of $40.9 million, which will be subject to the
transition provisions of SFAS No. 142. Amortization expense related to
goodwill was $2.9 million and $2.3 million for the years ended February 2,
2002 and February 3, 2001, respectively. Because of the extensive effort
needed to comply with adopting SFAS Nos. 141 and 142, it is not practical to
reasonably estimate the impact of adopting these Statements on the Company's
consolidated financial statements at the date of this report, including
whether the Company will be required to recognize any transitional impairment
losses as the cumulative effect of a change in accounting principle.

In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement
Obligations", which addresses financial accounting and reporting for obligations
associated with the retirement of tangible long-lived assets and the associated
asset retirement costs. SFAS No. 143 requires the Company to record the fair
value of an asset retirement obligation that results from the acquisition,
construction, development and (or) normal use of the assets as a liability in
the period in which it is incurred if a reasonable estimate of fair value can be
made. The standard also requires the Company to record a corresponding asset
which is depreciated over the life of the asset. Subsequent to the initial
measurement of the asset retirement obligation, the obligation will be adjusted
at the end of each period to reflect the passage of time and changes in the
estimated future cash flows underlying the obligation. The Company is required
to adopt SFAS No. 143 for the quarter ending May 3, 2003. The Company is
currently assessing SFAS No. 143 and the impact that adoption will have on the
consolidated financial statements.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets". SFAS No. 144 addresses financial accounting and
reporting for the impairment or disposal of long-lived assets. This Statement
requires that long-lived assets be reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If the carrying amount of an asset exceeds its
estimated future cash flows, an impairment charge is recognized in the amount by
which the carrying amount of the asset exceeds the fair value of the asset. SFAS
No. 144 requires companies to separately report discontinued operations and
extends that reporting to a component of an entity that either has been disposed
of (by sale, abandonment, or in a distribution to owners) or is classified as
held for sale. Assets to be disposed of are reported at the lower of the
carrying amount or fair value less costs to sell. The Company is required to
adopt SFAS No. 144 for the quarter ending May 3, 2002. Management does not
expect the adoption of SFAS No. 144 to have a material impact on the Company's
consolidated financial statements.

DIVIDEND POLICY. The Company has never declared or paid cash dividends on its
Common Stock. The Company's credit agreement currently allows the Company to pay
a cash dividend once in each calendar year. These dividends are restricted to
ten percent of the most recent fiscal year's consolidated net income and can
only be paid if, after any payment of dividends, the Company maintains $25
million of availability under the credit agreement. Any future determination as
to the payment of dividends would depend upon capital requirements and
limitations imposed by the Company's credit agreement and such other factors as
the Board of Directors of the Company may consider.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company does not hold any financial instruments that expose it to
significant market risk and does not engage in hedging activities. Information
about the fair value of financial instruments is included in Note 1 of the Notes
to Consolidated Financial Statements.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The index to the Consolidated Financial Statements of the Company is included in
Item 14, and the consolidated financial statements follow the signature page to
this Annual Report on Form 10-K.

The quarterly results of operations are included herein in Note 11 of the
Consolidated Financial Statements.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

15

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

(a) Identification of Directors

Incorporated herein by reference is the information appearing under the captions
"Election of Directors" and "Board of Directors Meetings and Its Committees" in
the Company's definitive Proxy Statement for the Registrant's 2002 Annual
Meeting of Shareholders to be filed with the Securities and Exchange Commission
within 120 days after February 2, 2002.

(b) Identification of Executive Officers

Incorporated herein by reference is the information appearing under the caption
"Executive Officers and Compensation" in the Company's definitive Proxy
Statement for the Registrant's 2002 Annual Meeting of Shareholders to be filed
with the Securities and Exchange Commission within 120 days after February 2,
2002.

ITEM 11. EXECUTIVE COMPENSATION

Incorporated herein by reference is the information appearing under the caption
"Executive Officers and Compensation" in the Company's definitive Proxy
Statement for the Registrant's 2002 Annual Meeting of Shareholders to be filed
with the Securities and Exchange Commission within 120 days after February 2,
2002.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Incorporated herein by reference is the information appearing under the caption
"Executive Officers and Compensation" in the Company's definitive Proxy
Statement for the Registrant's 2002 Annual Meeting of Shareholders to be filed
with the Securities and Exchange Commission within 120 days after February 2,
2002.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Incorporated herein by reference is the information appearing under the caption
"Executive Officers and Compensation" in the Company's definitive Proxy
Statement for the Registrant's 2002 Annual Meeting of Shareholders to be filed
with the Securities and Exchange Commission within 120 days after February 2,
2002.

16

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

14(a)(1) FINANCIAL STATEMENTS
The consolidated financial statements and notes are listed in the Index to
Financial Statements on page F-1 of this report.

14(a)(2) FINANCIAL STATEMENT SCHEDULES
None of the schedules for which provision is made in the applicable accounting
regulations under the Securities Exchange Act of 1934, as amended, are required.

14(a)(3) EXHIBITS
Exhibits are as set forth in the "Index to Exhibits" which follows the Notes to
the Consolidated Financial Statements and immediately precedes the exhibits
filed.

14(b) REPORTS ON FORM 8-K
Not applicable.

14(c) EXHIBITS
Exhibits are as set forth in the "Index to Exhibits" which follows the Notes to
the Consolidated Financial Statements and immediately precedes the exhibits
filed.

14(d) OTHER FINANCIAL STATEMENTS
Not applicable.

17

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

TRANS WORLD ENTERTAINMENT CORPORATION

Date: May 3, 2002 By: /s/ ROBERT J. HIGGINS
----------------------
Robert J. Higgins, Chairman and Chief
Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.

NAME TITLE DATE
/s/ ROBERT J. HIGGINS Chairman and Chief Executive May 3, 2002
- --------------------- Officer (Principal
(Robert J. Higgins) Executive Officer)

/s/ JOHN J. SULLIVAN Executive Vice President, May 3, 2002
- -------------------- Treasurer and Chief
(John J. Sullivan) Financial Officer (Principal
Financial and Chief
Accounting Officer)

/s/ MICHAEL B. SOLOW Secretary and Director May 3, 2002
- -----------------------
(Michael B. Solow)

/s/ GEORGE W. DOUGAN Director May 3, 2002
- --------------------
(George W. Dougan)

/s/ ISAAC KAUFMAN Director May 3, 2002
- -----------------
(Isaac Kaufman)

/s/ DEAN S. ADLER Director May 3, 2002
- -----------------
(Dean S. Adler)

/s/ DR. JOSEPH G. MORONE Director May 3, 2002
- -----------------------
(Dr. Joseph G. Morone)

/s/ MARTIN E. HANAKA Director May 3, 2002
- --------------------
(Martin E. Hanaka)

18

TRANS WORLD ENTERTAINMENT CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

F-1

REPORT OF KPMG LLP
INDEPENDENT AUDITORS

The Board of Directors and Shareholders
Trans World Entertainment Corporation:

We have audited the accompanying consolidated balance sheets of Trans World
Entertainment Corporation and subsidiaries as of February 2, 2002 and February
3, 2001, and the related consolidated statements of income, shareholders' equity
and cash flows for each of the fiscal years in the three-year period ended
February 2, 2002. These consolidated financial statements are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Trans World
Entertainment Corporation and subsidiaries as of February 2, 2002 and February
3, 2001, and the results of their operations and their cash flows for each of
the fiscal years in the three-year period ended February 2, 2002, in conformity
with accounting principles generally accepted in the United States of America.

/s/ KPMG LLP

Albany, New York
March 14, 2002

F-2

TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)

SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

F-3

TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

F-4

TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(IN THOUSANDS)

SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

F-5

TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

F-6

TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

NATURE OF OPERATIONS: Trans World Entertainment Corporation is one of the
largest specialty retailers of prerecorded music, videos and related products in
the United States. The Company operates a chain of retail entertainment stores
and an e-commerce site, fye.com, in a single industry segment. At February 2,
2002, the Company operated 902 stores totaling approximately 5.1 million square
feet in 46 states, the District of Columbia, Commonwealth of Puerto Rico and the
U.S. Virgin Islands, with a majority of the stores concentrated in the eastern
half of the United States. The Company's business is seasonal in nature, with
the peak selling period being the Christmas holiday season in the Company's
fourth fiscal quarter.

BASIS OF PRESENTATION: The consolidated financial statements consist of Trans
World Entertainment Corporation, its wholly-owned subsidiary, Record Town,
Inc. ("Record Town"), and Record Town's subsidiaries, all of which are
wholly-owned. All significant intercompany accounts and transactions have
been eliminated. Investments in unconsolidated affiliates have been recorded
on the cost basis. The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements, and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates. On April 22, 1999, the Company
merged with Camelot Music Holdings, Inc. ("Camelot"). The transaction was
accounted for as a pooling-of-interests. Accordingly, 1999 consolidated
financial statements have been restated to include combined results of
operations, financial position and cash flows of Camelot as though it had
been a part of the Company since Camelot's adoption of "fresh-start"
accounting on January 31, 1998.

ITEMS AFFECTING COMPARABILITY: The Company's fiscal year is a 52 or 53-week
period ending on the Saturday nearest to January 31. Fiscal 2001, 2000, and 1999
ended February 2, 2002, February 3, 2001, and January 29, 2000, respectively,
and each fiscal year consisted of 52 weeks, except for fiscal year 2000, which
consisted of 53 weeks. The fifty-third week in 2000 increased sales by an
estimated $23.7 million, operating income by an estimated $4.0 million and net
income by an estimated $2.5 million, or $0.05 per share.

REVENUE RECOGNITION: The Company's revenue is primarily from retail sales of
merchandise comprised of prerecorded music (including compact discs and audio
cassettes), video (including DVD and prerecorded videocassettes), video
games and other complementary products (including electronics, accessories,
blank tapes and CD-Rs). Revenue is recognized at the point of sale to the
consumer, at which time payment is tendered. There are no provisions for
uncollectible amounts since payment is received at the time of sale.
Reductions of revenue for returns by customers are generally provided at the
point of return due to infrequency and occurrence within short intervals of
the sale and immateriality to the financial statements.

CASH AND CASH EQUIVALENTS: The Company considers all highly liquid investments
purchased with an original maturity of three months or less to be cash
equivalents.

CONCENTRATION OF CREDIT RISKS: The Company maintains centralized cash management
and investment programs whereby excess cash balances are invested in short-term
funds and money market instruments considered to be cash equivalents. The
Company's investment portfolio is diversified and consists of short-term
investment grade securities consistent with its investment guidelines. These
guidelines include the provision that sufficient liquidity will be maintained to
meet anticipated cash flow needs. The Company maintains cash and cash
equivalents with various financial institutions. At times, such amounts may
exceed the F.D.I.C. limits. The Company limits the amount of credit exposure
with any one financial institution and believes that no significant
concentration of credit risk exists with respect to cash investments.

CONCENTRATION OF BUSINESS RISKS: The Company purchases inventory for its stores
from approximately 785 suppliers, with approximately 65% of purchases being made
from five suppliers. In the past, the Company has not experienced difficulty in
obtaining satisfactory sources of supply, and management believes that it will
retain access to adequate sources of supply. However, a loss of a major supplier
could cause a loss of sales, which would have an adverse effect on operating
results and also result in a decrease in vendor support for the Company's
advertising programs.

MERCHANDISE INVENTORY AND RETURN COSTS: Inventory is stated at the lower of cost
or market as determined by the average cost method. The Company is entitled to
return merchandise purchased from major vendors for credit against other
purchases from these vendors. These vendors often reduce the credit with a
merchandise return charge

F-7

ranging from 0% to 20% of the original merchandise purchase price depending on
the type of merchandise being returned. The Company records actual and estimated
merchandise return charges in cost of sales.

FIXED ASSETS AND DEPRECIATION: Fixed assets are stated at cost. Major
improvements and betterments to existing facilities and equipment are
capitalized. Expenditures for maintenance and repairs that do not extend the
life of the applicable asset are charged to expense as incurred. Buildings are
depreciated over a 30-year term. Fixtures and equipment are depreciated using
the straight-line method over their estimated useful lives, which range from
three to seven years. Leasehold improvements are amortized using the
straight-line method over the shorter of their estimated useful lives or the
related lease term. A majority of the Company's operating leases are ten years
in term. Amortization of capital lease assets is included in depreciation and
amortization expense.

The Company records software developed for internal use in accordance with
Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use". Accordingly, software developed
internally for the use by the Company is capitalized only during the application
development stage and only certain costs are capitalized.

IMPAIRMENT OF LONG-LIVED ASSETS: Fixed assets and other long-lived assets are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to undiscounted future net cash flows expected to be generated by the
asset over its remaining useful life. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which the
carrying amount of the assets exceeds the fair value of the assets. Fair value
is generally measured based on discounted estimated future cash flows. During
fiscal 1999, the Company recorded an impairment loss of $6.7 million as part of
the Camelot merger charge for the write-down of certain fixed assets acquired in
the merger.

GOODWILL: Goodwill represents the adjusted amount of the cost of acquisitions in
excess of fair value of net assets acquired in purchase transactions, and is
being amortized on a straight-line basis over estimated useful lives ranging
from 10 to 20 years. The amortization period is determined by taking into
consideration the following factors: the critical market position and
establishment of brand names; the combined store mass of the companies; the
amortization periods generally used in the retail music business; the highly
competitive nature of the business including emerging forms of competition; and
the overall history of profitability of the acquired businesses. The Company
periodically evaluates the carrying amount of goodwill, as well as the related
amortization periods to determine whether adjustments to these amounts or useful
lives are required based on current events and circumstances. The Company
performs an analysis of the recoverability of goodwill using a cash flow
approach consistent with the analysis of the impairment of long-lived assets.

ADVERTISING COSTS: The costs of advertising are expensed in the first period in
which such advertising takes place. Total advertising expense was $25.6 million,
$22.3 million, and $18.8 million in fiscal 2001, 2000, and 1999, respectively.

STORE OPENING AND CLOSING COSTS: Costs associated with opening a store are
expensed as incurred. When it is determined that a store will be closed,
estimated unrecoverable costs are charged to expense. Such costs include the net
book value of abandoned fixtures, equipment, leasehold improvements and a
provision for lease obligations, less estimated sub-rental income. The residual
value of any fixed asset moved to a store as part of a relocation is transferred
to the relocated store.

GIFT CERTIFICATES: The Company offers gift certificates for sale in the form
of gift cards. A deferred income account, which is included in accrued
expenses and other in the consolidated balance sheet, is established for gift
cards issued. When gift cards are redeemed at the store level, revenue is
recorded.

INCOME TAXES: Income taxes are accounted for under the asset and liability
method. Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases, and tax loss carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the

F-8

years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.
Deferred tax assets are subject to valuation allowances based upon management's
estimates of realizability.

COMPREHENSIVE INCOME: The Company accounts for comprehensive income in
accordance with Statement of Financial Accounting Standards ("SFAS") No. 130,
"Reporting Comprehensive Income". SFAS No. 130 requires only additional
disclosures in the consolidated financial statements; it does not affect the
Company's financial position or results of operations. Comprehensive income
for 2001 and 2000 consists of net income and net unrealized losses on
available for sale securities and is presented in the Consolidated Statements
of Shareholders' Equity. During 1999, the Company did not have other items of
comprehensive income as defined by SFAS No. 130, and accordingly,
comprehensive income is equal to net income.

STOCK-BASED COMPENSATION: The Company applies the intrinsic value-based method
of accounting prescribed by APB Opinion No. 25, "Accounting for Stock Issued to
Employees", and related interpretations including Financial Accounting Standards
Board ("FASB") Interpretation No. 44, "Accounting for Certain Transactions
Involving Stock Compensation - An Interpretation of APB No. 25", in accounting
for its fixed plan stock options. As such, compensation expense would be
recorded on the date of grant only if the current market price of the underlying
stock exceeded the exercise price. SFAS No. 123, "Accounting for Stock-Based
Compensation", established accounting and disclosure requirements using a fair
value-based method of accounting for stock-based employee compensation plans. As
allowed by SFAS No. 123, the Company has elected to continue to apply the
intrinsic value-based method of accounting described above, and has adopted the
disclosure requirements of SFAS No. 123.

INVESTMENT SECURITIES: Certain investments are categorized as available for sale
securities in accordance with SFAS No. 115, "Accounting for Certain Investments
in Debt and Equity Securities", and are recorded at fair value based upon quoted
market prices. Unrealized gains and losses are excluded from earnings and
reflected in shareholders' equity until realized. Realized gains and losses for
available for sale securities are included in earnings and are computed using
the specific identification method for determining the cost of securities sold.
A decline in the market value of any available for sale security below cost that
is deemed other than temporary is charged to earnings, resulting in the
establishment of a new cost basis for the security.

As of February 2, 2002 the amortized cost, gross unrealized loss and fair value
of the Company's available for sale securities was $0. As of February 3, 2001,
the amortized cost, gross unrealized loss and fair value of the Company's
available for sale securities was $2.0 million, ($1.5 million) and $0.5 million,
respectively. Gross realized losses recognized during fiscal 2001, 2000 and 1999
were $2.0 million, $0 and $0, respectively.

EARNINGS PER SHARE: The Company accounts for earnings per share under the
provisions of SFAS No. 128, "Earnings per Share". This standard requires the
Company to disclose basic earnings per share and diluted earnings per share.
Basic earnings per share are calculated by dividing net income by the weighted
average common shares outstanding for the period. Diluted earnings per share is
calculated by dividing net income by the sum of the weighted average shares
outstanding and additional common shares that would have been outstanding if the
dilutive potential common shares had been issued for the Company's common stock
options from the Company's Stock Option Plans (see Note 8). As required by SFAS
No. 128, all outstanding common stock options were included even though their
exercise may be contingent upon vesting. Weighted average shares are calculated
as follows:

Antidilutive stock options outstanding were excluded from the computation of
diluted earnings per share because the exercise price of the options was greater
than the average market price of the common shares during the period.

FAIR VALUE OF FINANCIAL INSTRUMENTS: The carrying amounts reported in the
consolidated balance sheets for cash and cash equivalents, accounts receivable,
accounts payable and other current liabilities approximate fair value because of
the immediate or short-term maturity of these financial instruments.

F-9

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS. In July 2001, the FASB issued SFAS
No. 141, "Business Combinations", and SFAS No. 142, "Goodwill and Other
Intangible Assets". SFAS No. 141 requires that the purchase method of accounting
be used for all business combinations initiated after June 30, 2001 as well as
all purchase method business combinations completed after June 30, 2001. SFAS
No. 141 also specifies criteria that intangible assets acquired in a purchase
method business combination must meet to be recognized and reported apart from
goodwill, noting that any purchase price allocable to an assembled workforce may
not be accounted for separately. SFAS No. 142 requires that goodwill and
intangible assets with indefinite useful lives no longer be amortized, but
instead tested for impairment at least annually in accordance with the
provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets
with definite useful lives be amortized over their respective estimated useful
lives to their estimated residual values, and reviewed for impairment in
accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of", and subsequently, SFAS No.
144 after its adoption.

The Company adopted the provisions of SFAS No. 141 as of July 1, 2001, and
SFAS No. 142 is effective February 3, 2002. Furthermore, any goodwill or
intangible asset determined to have an indefinite useful life and acquired in
a purchase business combination completed after June 30, 2001 will not be
amortized, but will continue to be evaluated for impairment in accordance
with the appropriate pre-SFAS No. 142 accounting literature. Goodwill and
intangible assets acquired in business combinations completed before July 1,
2001 will continue to be amortized prior to the adoption of SFAS No. 142.

Upon adoption of SFAS No. 142, the Company is required to evaluate its existing
intangible assets and goodwill that were acquired in purchase business
combinations, and to make any necessary reclassifications in order to conform to
the new criteria in SFAS No. 141 for recognition apart from goodwill. Under SFAS
No. 142, the Company will be required to reassess the useful lives and residual
values of all intangible assets acquired in purchase business combinations, and
make any necessary amortization period adjustments by the end of the second
quarter of 2002. In addition, to the extent an intangible asset is identified as
having an indefinite useful life, the Company will be required to test the
intangible asset for impairment in accordance with the provisions of SFAS No.
142 by the end of the first quarter of 2002. Any impairment loss will be
measured as of the date of adoption and recognized as the cumulative effect of a
change in accounting principle in the first quarter of 2002.

In connection with SFAS No. 142's transitional goodwill impairment evaluation,
the Company will be required to perform an assessment of whether there is an
indication that goodwill is impaired as of the date of adoption. To accomplish
this, the Company must identify its reporting units and determine the carrying
value of each reporting unit by assigning the assets and liabilities, including
existing goodwill and intangible assets, to those reporting units as of February
3, 2002. The Company will then have up to six months from February 3, 2002 to
determine the fair value of each reporting unit and compare it to the carrying
amount of the reporting unit. To the extent the carrying amount of a reporting
unit exceeds the fair value of the reporting unit, an indication exists that the
reporting unit goodwill may be impaired and the Company must perform the second
step of the transitional impairment test. The second step is required to be
completed as soon as possible, but no later than the end of the year of
adoption. In the second step, the Company must compare the implied fair value of
the reporting unit goodwill with the carrying amount of the reporting unit
goodwill, both of which would be measured as of the date of adoption. The
implied fair value of goodwill is determined by allocating the fair value of the
reporting unit to all of the assets (recognized and unrecognized) and
liabilities of the reporting unit in a manner similar to a purchase price
allocation, in accordance with SFAS No. 141. The residual fair value after this
allocation is the implied fair value of the reporting unit goodwill. Any
transitional impairment loss will be recognized as the cumulative effect of a
change in accounting principle in the Company's consolidated statement of
operations.

As of the date of adoption of SFAS No. 142, the Company had unamortized
goodwill in the amount of $40.9 million, which will be subject to the
transition provisions of SFAS No. 142. Amortization expense related to
goodwill was $2.9 million and $2.3 million for the years ended February 2,
2002 and February 3, 2001, respectively. Because of the extensive effort
needed to comply with adopting SFAS Nos. 141 and 142, it is not practical to
reasonably estimate the impact of adopting these Statements on the Company's
consolidated financial statements at the date of this report, including
whether the Company will be required to recognize any transitional impairment
losses as the cumulative effect of a change in accounting principle.

In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement
Obligations", which addresses financial accounting and reporting for obligations
associated with the retirement of tangible long-lived assets and the associated
asset retirement costs. SFAS No. 143 requires the Company to record the fair
value of an asset retirement obligation that results from the acquisition,
construction, development and (or) normal use of the assets as a liability in
the period in which it is incurred if a reasonable estimate of fair value can be
made. The standard also requires the Company to record a corresponding asset
which is depreciated over the life of the asset. Subsequent to the initial
measurement of the asset retirement obligation, the obligation will be adjusted
at the end of each period to reflect the passage of time and changes in the
estimated future cash flows underlying the obligation. The Company is required

F-10

to adopt SFAS No. 143 for the quarter ending May 3, 2003. The Company is
currently assessing SFAS No. 143 and the impact that adoption will have on the
consolidated financial statements.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets". SFAS No. 144 addresses financial accounting and
reporting for the impairment or disposal of long-lived assets. This Statement
requires that long-lived assets be reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If the carrying amount of an asset exceeds its
estimated future cash flows, an impairment charge is recognized in the amount by
which the carrying amount of the asset exceeds the fair value of the asset. SFAS
No. 144 requires companies to separately report discontinued operations and
extends that reporting to a component of an entity that either has been disposed
of (by sale, abandonment, or in a distribution to owners) or is classified as
held for sale. Assets to be disposed of are reported at the lower of the
carrying amount or fair value less costs to sell. The Company is required to
adopt SFAS No. 144 for the quarter ending May 3, 2002. Management does not
expect the adoption of SFAS No. 144 to have a material impact on the Company's
consolidated financial statements.

NOTE 2. BUSINESS COMBINATIONS

On October 30, 2000, the Company acquired certain assets and assumed certain
liabilities and operating lease commitments of 112 stores from Wax Works,
Inc., a privately-held music and video retailer. The stores are located
primarily in mall locations throughout the Midwest and southern United
States. The acquisition was accounted for using the purchase method of
accounting. The Company paid $49.8 million, net of cash acquired, for the
assets, including merchandise inventory, fixed assets, leasehold interests
and other related current assets. The Company recognized approximately $10.2
million in goodwill related to the acquisition. The goodwill is being
amortized on a straight-line basis over a 15-year period.

On August 11, 2000, the Company acquired a majority interest in SecondSpin.com
for $4.2 million, net of cash acquired. The acquisition was accounted for under
the purchase method of accounting. SecondSpin.com operates on-line and in store
marketplaces for buying and selling of used CDs, videos and DVDs. SecondSpin.com
operates six stores in California and Colorado. In addition, the Company
provided SecondSpin.com $2.5 million in the form of convertible debt to repay
long-term obligations under a recapitalization agreement with the other
shareholders of SecondSpin.com. The Company recognized approximately $4.4
million in goodwill related to the acquisition. The goodwill is being amortized
on a straight-line basis over a 10-year period.

On April 22, 1999, under the Agreement and Plan of Merger dated October 26,
1998, the Company acquired Camelot, a specialty retailer of prerecorded music,
videocassettes and DVDs, and related accessories, in a stock-for-stock
transaction accounted for as a pooling-of-interests. Camelot operated over 480
retail locations in 38 states, the District of Columbia and the Commonwealth of
Puerto Rico. Upon completion of the merger, Camelot became a wholly-owned
subsidiary of the Company. In the merger, each share of Camelot's common stock
was converted into 1.9 shares of the Company's common stock. Each outstanding
option to purchase Camelot common stock immediately prior to the completion of
the merger was converted into 1.9 fully vested and exercisable options to
acquire the Company's common stock. The exercise prices of these options were
adjusted accordingly for the 1.9 to 1 conversion ratio. As a result, the Company
issued approximately 19.3 million shares of its common stock and converted 1.3
million options to acquire its common stock. In connection with the merger, all
of Camelot's outstanding notes payable were repaid.

During 2001, 2000, and 1999, total amortization related to goodwill was $2.9
million, $2.3 million, and $2.4 million, respectively.

F-11

NOTE 3. FIXED ASSETS

Depreciation and amortization expense related to the Company's distribution
center facility and equipment of $1.6 million in fiscal 2001, 2000, and 1999,
respectively, is included in cost of sales. All other depreciation and
amortization of fixed assets is included in selling, general and administrative
expenses. Depreciation and amortization of fixed assets is included in the
condensed consolidated statements of income as follows:

NOTE 4. DEBT

The Company's $100.0 million secured revolving credit facility with Congress
Financial Corporation expires in July 2003, and automatically renews on a
year-to-year basis thereafter at the discretion of both parties. The facility
bears interest at the prime interest rate or the Eurodollar interest rate
plus 1.75% (3.53% at February 2, 2002), and is collateralized by the
Company's inventory allowing the Company to borrow up to 65% of its eligible
merchandise inventory to a maximum of $100.0 million.

During fiscal 2001, 2000, and 1999, the highest aggregate balances outstanding
under the current and previous revolving credit facilities were $12.2 million,
$12.5 million, and $3.3 million, respectively. The weighted average interest
rates during fiscal 2001, 2000, and 1999 based on average daily balances were
6.94%, 9.50%, and 7.44%, respectively. The Company did not have any balances
outstanding under the Company's revolving credit agreements at the end of fiscal
2001, 2000 and 1999.

Interest paid during fiscal 2001, 2000, and 1999 was approximately $2.5 million,
$3.1 million, and $3.6 million, respectively.

F-12

NOTE 5. INCOME TAXES

Income tax expense consists of the following:

A reconciliation of the Company's effective tax rates with the Federal statutory
rate is as follows:

On October 16, 2000, the United States District Court for the District of
Delaware issued an opinion in favor of the Internal Revenue Service ("IRS"),
in the case IRS vs. CM Holdings Inc., a wholly-owned subsidiary of the
Company. The case was brought against CM Holdings Inc. by the IRS to
challenge the deduction of interest expense related to corporate-owned life
insurance policies held by Camelot, a subsidiary of CM Holdings Inc., for
certain tax years that ended on or before February 1994. The court ruled that
interest deductions on policy loans should not be allowed and the Company is
responsible for the taxes and related interest and penalties. As a result of
the District Court decision, the Company accrued $11.0 million during 2000,
which is reflected in other (long-term) liabilities in the consolidated
balance sheet as of February 2, 2002 and February 3, 2001. The Company filed
an appeal in response to the decision. On October 30, 2001, the Company's
appeal was heard by the United States Third Circuit Court of Appeals, and a
decision is pending.

F-13

Significant components of the Company's deferred tax assets and liabilities are
as follows:

At February 2, 2002 and February 3, 2001, the Company had gross deferred tax
assets of $43.0 million and $40.0 million, respectively, and gross deferred tax
liabilities of $9.9 million and $13.6 million, respectively. The Company had a
net operating loss carryforward of $8.1 million for Federal income tax purposes
as of the end of fiscal 2001 and approximately $121.0 million for state income
tax purposes as of the end of fiscal 2001 that expire at various times through
2015 and are subject to certain limitations. The state net operating loss
carryforwards are also subject to various business apportionment factors and
multiple jurisdictional requirements when utilized.

In assessing the propriety of deferred tax assets, management considers whether
it is more likely than not that some portion or all of the deferred tax
assets will not be realized. The ultimate realization of deferred tax assets
is dependent upon the generation of future taxable income. Management
considers the scheduled reversal of deferred tax liabilities, projected
future taxable income and tax planning strategies in making this assessment.
Based upon the level of projected future taxable income over the periods in
which the deferred tax assets are deductible, the valuation allowance was
increased from $1.4 million to $6.3 million, a level where management
believes that it is more likely than not that the tax benefit will be
realized. The valuation allowance was increased to reserve for deferred tax
assets attributable to losses on investments and net operating loss
carryforwards. The amount of the

F-14

deferred tax asset considered realizable could be reduced if estimates of future
taxable income during the carryforward period are reduced.

The Company paid income taxes, net of refunds, of approximately $16.4 million,
$28.8 million, and $39.3 million during fiscal 2001, 2000, and 1999,
respectively.

NOTE 6. COMMITMENTS AND CONTINGENCIES

On October 16, 2000, the United States District Court for the District of
Delaware issued an opinion in favor of the Internal Revenue Service ("IRS"),
in the case IRS vs. CM Holdings Inc., a wholly-owned subsidiary of the
Company. The case was brought against CM Holdings Inc. by the IRS to
challenge the deduction of interest expense related to corporate-owned life
insurance policies held by Camelot, a subsidiary of CM Holdings Inc., for
certain tax years that ended on or before February 1994. The court ruled that
interest deductions on policy loans should not be allowed and the Company is
responsible for the taxes and related interest and penalties. As a result of
the District Court decision, the Company accrued $11.0 million during 2000,
which is reflected in other (long-term) liabilities in the consolidated
balance sheet as of February 2, 2002 and February 3, 2001. The Company filed
an appeal in response to the decision. On October 30, 2001, the Company's
appeal was heard by the United States Third Circuit Court of Appeals, and a
decision is pending.

On August 8, 2000, 30 Attorneys General served a complaint against the Company,
five major music distributors and two other specialty retailers in the United
States District Court for the Southern District of New York ("AG's suit").
The complaint has been subsequently amended to add additional states as
plaintiffs and to reflect the transfer of the case to United States District
Court in Maine pursuant to the Multidistrict Litigation Rules. The AG's suit
alleges that the distributors and retailers conspired to violate certain
anti-trust laws and to fix prices by requiring retailers to adhere to minimum
advertised prices in order to receive cooperative advertising funds from the
distributors. The complaint alleges that consumers were damaged in an
unspecified amount and seeks treble damages and civil penalties. Following
the service of the AG's suit, these same defendants were named as defendants
in private class action suits ("Class Actions"), each with similar
allegations as in the AG's suit. The Class Actions have been consolidated
along with the AG's suit in the United States District Court in Maine. It is
management's belief that the lawsuits are without merit and the Company will
ultimately prevail in this regard.

The Company is subject to other legal proceedings and claims that have arisen in
the ordinary course of its business and have not been finally adjudicated.
Although there can be no assurance as to the ultimate disposition of these
matters, it is management's opinion, based upon the information available at
this time, that the expected outcome of these matters, individually or in the
aggregate, will not have a material adverse effect on the results of operations
and financial condition of the Company.

F-15

NOTE 7. LEASES

As more fully discussed in Note 10, the Company leases its distribution center
and administrative offices under three capital leases with its Chief Executive
Officer and largest shareholder. The Company also has a capital lease for its
point-of-sale system.

Fixed asset amounts for capital leases, which are included in the fixed assets
on the accompanying balance sheets, are as follows:

The Company leases all of its stores under operating leases, many of which
contain renewal options, for periods ranging from five to twenty-five years,
with the majority being ten years. Most leases also provide for payment of
operating expenses and real estate taxes. Some also provide for additional
rent based on a percentage of sales.

Net rental expense was as follows:

Future minimum rental payments required under all leases that have initial or
remaining non-cancelable lease terms in excess of one year at February 2, 2002
are as follows:

F-16

NOTE 8. BENEFIT PLANS

401(k) SAVINGS PLAN

The Company offers a 401(k) Savings Plan to eligible employees meeting
certain age and service requirements. This plan permits participants to
contribute up to 20% of their salary, including bonuses, up to the maximum
allowable by Internal Revenue Service regulations. Participants are
immediately vested in their voluntary contributions plus actual earnings
thereon. Participant vesting of the Company's matching and profit sharing
contribution is based on the years of service completed by the participant.
Participants are fully vested upon the completion of four years of service.
All participant forfeitures of non-vested benefits are used to reduce the
Company's contributions in future years. Total expense related to the Plan
was $921,000, $943,000, and $962,000 in fiscal 2001, 2000, and 1999,
respectively.

STOCK OPTION PLANS

The Company has four employee stock option plans, the 1986 Stock Option Plan,
the 1994 Stock Option Plan, the 1998 Stock Option Plan and the 1999 Stock Option
Plan (the "Plans"). The Compensation Committee of the Board of Directors may
grant options to acquire shares of common stock to employees of the Company and
its subsidiaries at the fair market value of the common stock on the date of
grant. Under the Plans, options generally become exercisable commencing one year
from the date of grant in increments of 25% per year with a maximum term of ten
years. Options authorized for issuance under the Plans totaled 12.3 million. At
February 2, 2002, of the 10.8 million options remaining authorized for issuance
under the Plans, 5.4 million have been granted and are outstanding, 2.7 million
of which were vested and exercisable. Options available for future grants at
February 2, 2002 and February 3, 2001 were 2.0 million and 2.6 million,
respectively.

Under the terms of the Camelot merger agreement, all options issued under the
Camelot 1998 Stock Option Plan (the "Camelot Plan") were converted to Trans
World options. The Camelot Plan provided for the granting of either incentive
stock options or nonqualified stock options to purchase shares of the Company's
common stock. Vesting of the options was originally over a four-year period with
a maximum term of ten years. Based on the terms of the Camelot Plan, vesting was
accelerated based on the market performance of the Company's common stock
whereby 50% of the options vested on March 13, 1998. The remaining 50% vested on
April 22, 1999 in connection with the merger. At February 2, 2002, 77,900
options were outstanding and exercisable. The Company stopped issuing stock
options under the Camelot Stock Option Plan as of April 22, 1999.

The following table summarizes information about the stock options outstanding
under the Plans and the Camelot Plan at February 2, 2002:

The Company also has a stock option plan for non-employee directors (the "1990
Plan"). Options under this plan are granted at an exercise price determined by
the Compensation Committee of the Board of Directors. Under the 1990 Plan,
options generally become exercisable commencing one year from the date of grant
in increments of 25% per year with a maximum term of ten years. As of February
2, 2002, there were 750,000 options authorized for issuance and 268,000 options
have been granted and are outstanding, 226,998 of which were vested and
exercisable. There are 383,645 shares of common stock reserved for possible
future option grants under the 1990 Plan.

F-17

Under the terms of the Camelot merger agreement, all options issued under the
Camelot Outside Director Stock Option Plan (the "Camelot Director Plan") were
converted to Trans World options. As of February 2, 2002, there were 4,750
options outstanding and exercisable under the Camelot Director Plan. The Company
no longer issues options under the Camelot Director Plan.

The following table summarizes information about the stock options outstanding
under the two Director Plans at February 2, 2002:

The following tables summarize activity under the Stock Option Plans:

The per share weighted-average fair value of the stock options granted during
fiscal 2001, 2000, and 1999 was $2.68, $3.57, and $5.01, respectively, using the
Black Scholes option pricing model, with the following weighted-average
assumptions:

2001 - expected dividend yield 0.0%, risk-free interest rate of 4.40%, expected
life of five years and stock volatility of 57%;

2000 - expected dividend yield 0.0%, risk-free interest rate of 5.20%, expected
life of five years and stock volatility of 62%;

1999 - expected dividend yield 0.0%, risk-free interest rate of 6.47%, expected
life of five years and stock volatility of 72%.

The Company applies APB Opinion No. 25, "Accounting for Stock Issued to
Employees", in accounting for its Plans and, accordingly, no compensation cost
has been recognized for its stock options in the financial statements for

F-18

employee stock options, which are issued at the closing stock price on the day
of grant. During fiscal 2001, 2000, and 1999, the Company recognized expenses of
$150,000, $165,000, and $64,000, respectively, for stock options issued to
non-employee directors at an exercise price below the closing stock price on the
date of grant. Had the Company determined compensation cost for employee stock
options based on fair value in accordance with SFAS No. 123, the Company's net
income would have been reduced to the pro forma amounts indicated below:

RESTRICTED STOCK PLAN

Under the 1990 Restricted Stock Plan, the Compensation Committee of the Board of
Directors is authorized to grant awards for up to 900,000 restricted shares of
common stock to executive officers and other key employees of the Company and
its subsidiaries. The shares are issued as restricted stock and are held in the
custody of the Company until all vesting restrictions are satisfied. If
conditions or terms under which an award is granted are not satisfied, the
shares are forfeited. Shares begin to vest under these grants after three years
and are fully vested after five years, with vesting criteria that includes
continuous employment until applicable vesting dates have expired. As of
February 2, 2002, a total of 325,000 shares have been granted, of which 195,000
of these shares had vested and 85,000 shares with an unamortized unearned
compensation balance of $593,000, had been forfeited. Unearned compensation is
recorded at the date of award, based on the market value of the shares, and is
included as a separate component of shareholders' equity and is amortized over
the applicable vesting period. The amount amortized to expense in fiscal 2001,
2000, and 1999, net of the impact of forfeitures, was approximately $128,000,
$7,000, and $66,000, respectively. At February 2, 2002, outstanding awards and
shares available for grant totaled 45,000 and 660,000, respectively.

SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN

The Company maintains a non-qualified Supplemental Executive Retirement Plan
("SERP") for certain executive officers of the Company. The SERP, which is
unfunded, provides eligible executives defined pension benefits that
supplement benefits under other retirement arrangements. The annual benefit
amount is based on salary at the time of retirement and number of years of
service. The Company accounts for the SERP in accordance with the provisions
of SFAS No. 87, "Employers' Accounting for Pensions". For fiscal 2001, 2000,
and 1999, net periodic pension costs recognized under the plan totaled
approximately $488,000, $492,000, and $481,000, respectively. The accumulated
benefit obligation for the SERP, which is included in accrued expenses and
other in the consolidated balance sheet, was approximately $6.0 million and
$3.9 million at February 2, 2002 and February 3, 2001, respectively. The
accumulated benefit obligation and net periodic pension costs are determined
utilizing actuarial assumptions, including a discount rate of 7% and 7.75%
for fiscal 2001 and fiscal 2000, respectively. In addition, an intangible
asset, which is included in other assets in the consolidated balance sheet,
to reflect the excess of the accumulated benefit obligation over the fair
value of plan assets, net of accrued pension costs, of approximately $3.9
million and $2.3 million was recorded at February 2, 2002 and February 3,
2001, respectively.

NOTE 9. SHAREHOLDERS' EQUITY

On January 7, 2000, the Board of Directors approved a stock repurchase plan
authorizing the purchase of up to 5.0 million shares of the Company's common
stock. During fiscal 2000, the Board of Directors approved the repurchase of up
to an additional 10.0 million shares. As of February 2, 2002, the Company had
purchased 12.8 million of the 15.0 million shares authorized by the Board, at a
total cost of $117.4 million. At February 2, 2002 and February 3, 2001, the
Company held 12,884,752 and 10,568,432 shares, respectively, in treasury stock.

F-19

NOTE 10. RELATED PARTY TRANSACTIONS

The Company leases its 168,400 square foot distribution center/office facility
in Albany, New York from Robert J. Higgins, its Chairman, Chief Executive
Officer and largest shareholder, under three capitalized leases that expire in
the year 2015. The original distribution center/office facility was constructed
in 1985. A 77,100 square foot distribution center expansion was completed in
October 1989 on real property adjoining the existing facility. A 19,100 square
foot expansion was completed in September 1998 adjoining the existing facility.

Under the three capitalized leases, dated April 1, 1985, November 1, 1989 and
September 1, 1998 (the "Leases"), the Company paid Mr. Higgins an annual rent of
$1.7 million in fiscal 2001 and 2000 and $1.6 million in fiscal 1999. On January
1, 2002, the aggregate rental payment increased in accordance with the biennial
increase in the Consumer Price Index, pursuant to the provisions of each lease.
Effective January 1, 2004, and every two years thereafter, the rental payment
increases in accordance with the biennial increase in the Consumer Price Index,
pursuant to the provisions of the lease. None of the leases contains any real
property purchase option at the expiration of its term. Under the terms of the
Leases, the Company pays all property taxes, insurance and other operating costs
with respect to the premises. Mr. Higgins' obligation for principal and interest
on his underlying indebtedness relating to the real property is approximately
$1.1 million per year.

The Company leases two of its retail stores from Mr. Higgins under long-term
operating leases. Under the first store lease, annual rent payments were $40,000
in fiscal 2001, 2000, and 1999. Under the second store lease, annual rent
payments were $35,000 in fiscal 2001, 2000, and 1999. Under the terms of the
leases, the Company pays property taxes, maintenance and a contingent rental if
a specified sales level is achieved. Total additional charges for both
locations, including contingent rent, were approximately $11,100, $14,700, and
$17,700 in fiscal 2001, 2000, and 1999, respectively.

The Company regularly utilizes privately chartered aircraft owned or partially
owned by Mr. Higgins. Under an unwritten agreement with Quail Aero Services of
Syracuse, Inc., a corporation in which Mr. Higgins is a one-third shareholder,
the Company paid $70,000, $75,000, and $110,000 for chartered aircraft services
in fiscal 2001, 2000, and 1999, respectively. The Company also charters an
aircraft from Crystal Jet, a corporation wholly-owned by Mr. Higgins. Payments
to Crystal Jet aggregated $91,000, $85,000, and $64,000 in fiscal 2001, 2000,
and 1999, respectively. The Company also charters an aircraft from Richmor
Aviation, an unaffiliated corporation that leases an aircraft owned by Mr.
Higgins. Payments to Richmor Aviation in fiscal 2001, 2000, and 1999 were
$289,000, $217,000, and $325,000, respectively. The Company believes that the
charter rates and terms are as favorable to the Company as those generally
available to it from other commercial charters.

During 2000, the Company made loans aggregating $443,000 and $258,000 to John
J. Sullivan, the Company's Executive Vice President and Chief Financial
Officer, and Bruce J. Eisenberg, the Company's Executive Vice President -
Real Estate, respectively. The loans were in connection with income taxes due
on the vesting of restricted stock. The full principal amount of the loans
was outstanding on February 2, 2002. The loans bear interest at a rate of
5.88% per annum.

Mike Solow, a member of the Company's Board of Directors, is a partner of the
law firm Kaye Scholer L.L.P., which rendered legal services to the Company in
2001 in the amount of $552,000. The Company did not utilize Kaye Scholer's
services prior to 2001.

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NOTE 11. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

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INDEX TO EXHIBITS

DOCUMENT NUMBER AND DESCRIPTION

EXHIBIT NO.
2.1. Agreement and Plan of Merger dated October 26, 1998 by and among Trans
World, CAQ Corporation and Camelot incorporated herein by reference to
Exhibit 2.1 to the Company's Registration Statement on Form S-4, No.
333-75231.

3.1. Restated Certificate of Incorporation -- incorporated herein by reference
to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the fiscal
year ended January 29, 1994. Commission File No. 0-14818.

3.2. Certificate of Amendment to the Certificate of Incorporation --
incorporated herein by reference to Exhibit 3.1 to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended October 29, 1994.
Commission File No. 0-14818.

3.3. Certificate of Amendment to the Certificate of Incorporation --
incorporated herein by reference to Exhibit 3.4 to the Company's Annual
Report on Form 10-K for the year ended January 31, 1998. Commission File
No. 0-14818.

*3.4 Amended By-Laws -- incorporated herein by reference to Exhibit 3.4 to the
Company's Annual Report on Form 10-K for the year ended January 29, 2000.
Commission File No. 0-14818.

3.5. Certificate of Amendment to the Certificate of Incorporation--incorporated
herein by reference to Exhibit 3.5 to the Company's Registration Statement
on Form S-4, No. 333-75231.

3.6. Certificate of Amendment to the Certificate of Incorporation--incorporated
herein by reference to Exhibit 3.6 to the Company's Registration Statement
on Form S-4, No. 333-75231.

3.7. Certificate of Amendment to the Certificate of Incorporation--incorporated
herein by reference to Exhibit 4.2 to the Company's Current Report on Form
8-K filed August 11, 2000. Commission File No. 0-14818.

4.1 Loan and Security Agreement, dated July 9, 1998, between Congress Financial
Corporation and the Company, for the secured revolving credit agreement --
incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly
Report on Form 10-Q for the quarter ended August 2, 1997. Commission File
No. 0-14818.

4.2. Amendment, Dated June 30, 2000, to the Loan and Security Agreement, dated
July 9, 1998, between Congress Financial Corporation and the Company, for
the secured revolving credit agreement -- incorporated herein by reference
to Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q for the
quarter ended July 29, 2000. Commission File No. 0-14818.

10.1 Lease, dated April 1, 1985, between Robert J. Higgins, as Landlord, and
Record Town, Inc. and Trans World Music Corporation, as Tenant and Amendment
thereto dated April 28, 1986 -- incorporated herein by reference to Exhibit
10.3 to the Company's Registration Statement on Form S-1, No. 33-6449.

10.2 Second Addendum, dated as of November 30, 1989, to Lease, dated April 1,
1985, among Robert J. Higgins, and Trans World Music Corporation, and Record
Town, Inc., exercising five year renewal option -- incorporated herein by
reference to Exhibit 10.2 to the Company's Annual Report on Form 10-K for
the fiscal year ended February 3, 1990. Commission File No. 0-14818.

10.3 Lease, dated November 1, 1989, between Robert J. Higgins, as Landlord, and
Record Town, Inc. and Trans World Music Corporation, as Tenant --
incorporated herein by reference to Exhibit 10.3 to the Company's Annual
Report on Form 10-K for the fiscal year ended February 2, 1991. Commission
File No. 0-14818.

10.4 Lease dated September 1, 1998, between Robert J. Higgins, as Landlord, and
Record Town, Inc. and Trans World, as Tenant, for additional office space at
38 Corporate Circle -- incorporated herein by reference to Exhibit 10.1 to
the Company's Quarterly Report on Form 10-Q for the fiscal quarter ended
October 31, 1998. Commission File No. 0-14818.

10.5 Employment Agreement, dated as of May 1, 1998 between the Company and
Robert J. Higgins - incorporated herein by reference to Exhibit 10.4 to the
Company's Quarterly Report of Form 10-Q for the fiscal quarter ended May 2,
1998. Commission File No. 0-14818.

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10.6 Trans World Music Corporation 1986 Incentive and Non-Qualified Stock Option
Plan, as amended and restated, and Amendment No. 3 thereto -- incorporated
herein by reference to Exhibit 10.5 of the Company's Annual Report on Form
10-K for the fiscal year ended February 2, 1991. Commission File No.
0-14818.

10.7 Trans World Music Corporation 1990 Stock Option Plan for Non-Employee
Directors, as amended and restated -- incorporated herein by reference to
Annex A to Trans World's Definitive Proxy Statement on Form 14A filed as of
May 19, 2000. Commission File No. 0-14818.

10.8 Trans World Entertainment Corporation Amended 1990 Restricted Stock Plan --
incorporated herein by reference to Annex B to Trans World's Definitive
Proxy Statement on Form 14A filed as of May 17, 1999. Commission File No.
0-14818.

10.9 Form of Restricted Stock Agreement dated May 1, 1996 between the Company
and John J. Sullivan, Executive Vice President-Finance and Chief Financial
Officer, incorporated herein by reference to Exhibit 10.14 to the Company's
Annual Report on Form 10-K for the fiscal year ended February 1, 1997.
Commission File No. 0-14818.

10.10 Trans World Entertainment Corporation 1994 Stock Option Plan --
incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended July 30, 1994. Commission
File No. 0-14818.

10.11 Trans World Entertainment Corporation 1998 Stock Option Plan --
incorporated herein by reference to Annex B to Trans World's Definitive
Proxy Statement on Form 14A filed as of May 7, 1998. Commission File No.
0-14818.

10.12 Trans World Entertainment Corporation 1999 Stock Option Plan --
incorporated herein by reference to Annex A to Trans World's Definitive
Proxy Statement on Form 14A filed as of May 7, 1998. Commission File No.
0-14818.

10.13 Trans World Entertainment Corporation 1994 Director Retirement Plan --
incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended October 31, 1994.
Commission File No. 0-14818.

10.14 Form of Indemnification Agreement dated May 1, 1995 between the Company
and its officers and directors incorporated herein by reference to Exhibit
10.1 to the Company's Quarterly Report on Form 10-Q for the fiscal quarter
ended April 29, 1995. Commission File No. 0-14818.

10.15 Trans World Entertainment Corporation 1997 Supplemental Executive
Retirement Plan -- incorporated herein by reference to Exhibit 10.1 to the
Company's Quarterly Report on Form 10-Q for the fiscal quarter ended May 3,
1997. Commission File No. 0-14818.

10.16 Trans World Entertainment Corporation Asset Purchase Agreement with Wax
Works, Inc. -- incorporated herein by reference to Exhibit 10.16 to the
Company's Report on 10-K for the fiscal year ended February 3, 2001.
Commission File No. 0-14818.

10.17 Voting Agreement dated October 26, 1998 between Trans World and certain
stockholders named therein -- incorporated herein by reference to Exhibit
10.20 to the Company's Registration Statement on Form S-4, No. 333-75231.

* 21 Significant Subsidiaries of the Registrant.

* 23 Consent of KPMG LLP.

- --------------------------------------------------------------------------------
*Filed herewith.

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