ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES INC - 10-K Annual Report

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

FORM 10-K

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

COMMISSION FILE NUMBER 1-10367

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

DELAWARE 71-0675758
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

914 NORTH JEFFERSON STREET
SPRINGDALE, ARKANSAS 72764
(Address of principal executive offices) (Zip Code)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(479) 756-7400

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
CLASS A COMMON STOCK, $.01 PAR VALUE

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X]

On June 28, 2002, the last business day of the registrant's most recently
completed second fiscal quarter, the aggregate market value of the voting and
non-voting common equity beneficially held by non-affiliates of the registrant
was $40,813,842 (for the purposes hereof, directors, executive officers and 10%
or greater shareholders have been deemed affiliates).

Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of the latest practicable date.

Number of shares of common stock outstanding at April 11, 2003:
CLASS A -- 28,331,312
CLASS B -- 1,465,530
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PART I

ITEM 1. BUSINESS

SUMMARY

Advanced Environmental Recycling Technologies, Inc. ("AERT") develops,
manufactures and markets composite building materials that are used in place of
traditional wood products for exterior applications in building and remodeling
homes. Our products are made from approximately equal amounts of waste wood
fiber and reclaimed polyethylene plastics, have been extensively tested, and are
sold by leading national companies such as the Weyerhaeuser Company
(Weyerhaeuser), Lowe's Companies, Inc. (Lowe's) and Therma-Tru Corporation. Our
products are marketed under the trade names LifeCycle(R), MoistureShield(R),
Weyerhaeuser ChoiceDek(R) Classic, Weyerhaeuser ChoiceDek(R) Plus and
Weyerhaeuser ChoiceDek(R) Premium.

PRODUCTS

Using the same basic material, we manufacture three product lines:

- Commercial and residential decking planks and accessories such as
balusters and handrails (ChoiceDek),

- Exterior door, window and housing trim components (MoistureShield), and

- Industrial flooring.

The wood fiber content of our products gives them many properties similar
to all-wood products, but we believe the plastic content makes our products for
certain uses superior to either all-wood or all-plastic alternatives because:

- They are less subject to thermal contraction or expansion and have
greater dimensional stability than competing all-plastic products.

- They are engineered for superior moisture-resistance and will not swell
or expand like wood.

- Unlike wood, they do not require preservatives or treatment with toxic
chemicals such as chromated copper arsenic (CCA), nor do they require
yearly water sealing or staining.

- They can be designed and extruded through dies to a desired shape in
accordance with customer specifications, which helps the customer to
minimize waste.

- They are less subject to rotting, cracking, warping, splintering, and
insect infestation and water absorption than conventional wood materials.

- When combined with our unique tie coat primer, the life of exterior paint
can be greatly enhanced, thus creating a low-maintenance non-wood trim
and fascia system designed to enhance and complement fiber cement siding.

Our composites manufacturing process involves proprietary technologies,
certain of which are patented. We also use manufacturing equipment that has been
custom-built or modified to our specifications. Our composite building material
became a patented product in June 1998 under U.S. Patent No. 5,759,680.

MANUFACTURING

We operate the following manufacturing, recycling, and warehouse
facilities:

- Our Junction, Texas facility manufactures ChoiceDek Classic and ChoiceDek
Premium decking components.

- Our door, window and housing trim components (MoistureShield) are
manufactured at our Springdale, Arkansas facility. The Springdale
facility also manufactures the LifeCycle, ChoiceDek Plus, and ChoiceDek
Premium lines of decking product, and all of our heavy industrial
flooring. Springdale has four extruder lines and a plastic recycling
facility. We will install an additional extrusion line at Springdale in
2003.

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- In late 2002 we started up another plastics recycling facility in
Northwest Arkansas. We plan to add plastic recycling capacity to that
Northwest Arkansas facility during the first half of 2003, and build a
truck and rail "reload" facility later in 2003 where we can store
finished goods prior to shipping them to customers.

- We operate a waste plastics receiving, testing, and storage facility in
Springdale, about two miles from the main plant.

- In 2002, we opened two warehouses in Northwest Arkansas, one for finished
goods and one for waste plastics storage. As we grow, we anticipate
adding additional warehouse space.

- During first quarter 2003, we initiated road and bridge infrastructure
work on an adjoining 18.6 acre tract, south of the existing Springdale,
Arkansas facility, adjoining the two properties into a larger complex.

We are constantly upgrading and improving our facilities to expand
capacities and improve efficiencies. Our expansion plans currently are
prioritized around increasing plastic recycling capacity and lowering raw
material costs. These projects will be followed by a second warehouse and
manufacturing facility in Springdale, Arkansas with plans for additional
composite extrusion capacity by early 2004. There is no assurance that funds
will be available on a timely basis to prevent some construction projects from
being delayed (see Liquidity and Capital Resources and Note 4: Bonds Payable).

CURRENT OPERATIONS

As reported on Friday, March 28, 2003, there was an accidental fire at our
Junction, Texas plant, which was caused when a power pole adjacent to the plant
exploded. As of April 8, 2003, our engineers and insurance carries were still
evaluating the full extent of the damage, and the insurance company had not
released control of the site. It appears, however, that the extrusion lines, a
portion of the building they were housed in and its infrastructure, and the
plastic processing area are severely damaged. We are now in the process of
determining the costs to rebuild less severely damaged portions of the plant and
one extrusion line, with the intent of having one line fully operational as soon
as possible. Simultaneously, we are expediting the installation of an additional
extrusion line in the Springdale, Arkansas plant. It should be operational
during the second quarter of 2003. When the Junction rebuilding and Springdale
installations are complete, we will have replaced the capacity lost in the fire.
We expect minimal disruptions of product distribution to our current customers.

The Junction plant is fully insured for fire damage, as well as for
business interruption during the time required to rebuild. There is no assurance
as to the timing of the completion of the rebuilding of the Junction plant, or
if all of the facility will be rebuilt.

MARKETING AND SALES

General Market Strategy. Our products are designed for applications where
we can add the greatest value and address market needs, i.e. for external
applications where wood is prone to rot and/or requires substantial yearly
maintenance in the form of staining or water sealing. We have developed an
extensive customer and end-user base in the national door, window, and decking
markets. We are working to constantly develop and improve strong customer
relationships.

Outdoor Decking Systems. Weyerhaeuser Building Materials distributes our
decking products through its 71 customer service centers across the U.S. and
Canada. Weyerhaeuser also sells our ChoiceDek Premium decking products to Lowe's
Home Improvement Centers. In December 2001, we entered into a contract with
Weyerhaeuser, under which they guarantee to purchase a minimum quantity of
decking products each year. The Weyerhaeuser Contract (the "Contract")
automatically renews each December for the three subsequent years unless
Weyerhaeuser or we specifically act to cancel it. If the Contract is cancelled,
it will remain in effect for the remaining two years of its term. The Contract
automatically renewed in December 2002 to cover 2003 through 2005. The Contract
requires us to produce, and Weyerhaeuser to purchase, a minimum number of
truckloads of ChoiceDek decking and accessories during 2003. Weyerhaeuser has
traditionally sold ChoiceDek through its retail network of over 5,000 primarily
independent lumberyards. These lumberyards service both contractor and retail
accounts as well as large tract homebuilding companies. The Company, through
Weyerhaeuser regional distribution centers, has established a network of around
750 stocking ChoiceDek dealers. In addition, independent lumber dealers can
special order
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ChoiceDek from the Weyerhaeuser distribution network. Additional information is
available on our website at www.choicedek.com. Based on the Contract,
Weyerhaeuser has entered into an agreement with Lowe's whereby Lowe's has the
exclusive right to carry the ChoiceDek Premium product line. Lowe's has agreed
to provide dedicated retail shelf space in all of its 800+ stores and to promote
ChoiceDek Premium through a national print and advertising campaign. We believe
the Contract will strengthen our competitive position in the decking marketplace
and give us the opportunity to develop and sell new products through the same
channel.

We promote our decking products through displays and presentations at
regional and local home, lawn and garden shows, and through in-store displays.
We have an on-going print and cable TV advertising program that targets the
residential decking market. Lowe's is also conducting a national print and
television advertising campaign for ChoiceDek Premium.

Weyerhaeuser purchases and re-sells substantially all of our decking
products, which represented about 80% of our 2002 revenues. If Weyerhaeuser were
to cancel the Contract, we would have to develop an alternative distribution
system for decking products, which could be expensive and time consuming. Though
Weyerhaeuser has purchased most all of our decking production since 1995, there
is no assurance that it will continue to do so past the terms of the contract in
2005 (see Note 2 to the financial statements regarding concentration of risk).

Door and Window Products. We sell our MoistureShield products to door and
window manufacturers for use as component parts of their products. For example,
we manufacture a windowsill that is built into products like Portrait windows by
Carolina Builders or Vetter windows, among others, and we manufacture door rails
built into doors by Therma-Tru Corporation. In marketing, we emphasize the
"value-added" potential of the MoistureShield composite product, which, unlike
competing wood products, can be engineered to incorporate certain desired
end-product characteristics, which saves our customers time and expense.
Customers will also avoid the need for chemical treatments to their final
product, which are often necessary to prevent rot and sustain durability. The
durability of our MoistureShield composite components allow our customers to
extend the lifetime or warranties of their products while reducing or
eliminating warranty claims costs. Information about MoistureShield products is
available on the Internet at www.moistureshield.com.

Therma-Tru and Carolina Builders each purchase a large portion of our
MoistureShield production. The loss of either customer would negatively impact
sales and earnings. We are unable to predict the future size of the markets for
MoistureShield, however, we believe that the national door and window,
commercial and residential trim and residential decking material markets are
significant and will allow us to diversify our customer base over time.

Exterior Trim and Fascia Products. In mid-2002, we began test marketing an
exterior trim and fascia system under the trade name MoistureShield(R)
CornerLoc(TM). Three national homebuilders are now using the product. Our
production capacity has been strained to meet demand for our decking systems, so
we have been forced to limit CornerLoc production. We are planning a limited
product rollout to retail distributors in 2003. We believe this product line has
significant growth potential, and we are striving to increase production
capacity so that we can begin a full production and marketing program, but the
timetable of a full product launch is dependent upon our construction and
financing timetable.

Sales and Customer Service. We provide sales support and customer service
through our own marketing department, through Weyerhaeuser, and through training
programs for our customers and their sales associates. Our in-house sales team
is focused on serving commercial decking contractors and supporting the
Weyerhaeuser and Lowe's sales professionals. Information and customer service
are provided through our web site, www.choicedek.com, and through a national
toll-free telephone number. We also use independent, outside sales
representatives to promote and serve door, window and decking customers.

Cyclical Building Products Industry. Our products are used in home
improvement and new home construction. The home improvement and housing
construction industries are subject to significant fluctuations in activity and
periodic downturns caused by general economic conditions. Increased interest
rates and economic uncertainty, in particular, can lead to reduced homebuilding
and/or home improvement activity. Reductions in such activity could have an
adverse effect on the demand for our products.

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SOURCES AND AVAILABILITY OF RAW MATERIALS

Our products are manufactured primarily from hardwood fiber, cedar fiber
and polyethylene industrial and post-consumer film scrap and ground industrial
and post-consumer high-density polyethylene containers, as well as other sources
of consistent compatible polyethylene waste products.

Wood Fiber. All of our products were originally made with cedar wood fiber
from mills located in or near the Junction, Texas plant. As our operations in
Springdale, Arkansas grew, we began using hardwood waste from the numerous mills
and manufacturers in the local Ozark mountain region. We now have supply
contracts for a variety of cedar and hardwood fiber that provide sources of
materials. As we grow, we are evaluating the addition of in-house processing
capacity in order to meet additional wood fiber requirements and lower raw
material costs.

Recycled Plastics. Our plastics manufacturing processes recycle the
following polyethylene films:

- Low density polyethylene (LDPE) poly coatings or linings from recycled
bleached food-board, which are generated from the hydro-pulping process;

- High density polyethylene (HDPE) and linear low density polyethylene
(LLDPE) mixed plastic grocery bags from supermarket and store collection
programs;

- HDPE ground container material; and

- LLDPE stretch film from warehouses and packing waste.

These materials are highly contaminated with paper and other non-plastic
materials, which lessens their value to other plastic recyclers. Our proprietary
recycling process does not require the purity, extensive cleaning, additional
washing and melt filtration required for conventional plastics manufacturing,
and can be conducted faster and more economically. By using primarily
contaminated plastics, we produce a usable, but lower cost, feedstock for our
composite extrusion lines.

We do not have the capacity to recycle all of the plastic that we need to
meet our production goals. We thus purchase some recycled materials from other
processors and also use virgin resin. We recently initiated a major program
intended to increase the amount of waste plastic we recycle internally. We are
planning on adding plastic recycling equipment at our Springdale, Arkansas
facility, and building a second plastic recycling facility in Northwest
Arkansas. A significant amount of equipment for the Northwest Arkansas facility
has been ordered and/or purchased, and construction is planned to commence in
the second quarter of 2003. To the extent that we rely on outside vendors for
plastic, we are subject to varying prices and quality, both of which can
increase our cost of materials. During the first quarter of 2003, conventional
plastic costs have increased significantly, causing a negative variance on our
raw material costs.

PATENTED AND PROPRIETARY TECHNOLOGY

Our composite manufacturing process and our development efforts in
connection with waste plastics reclamation technologies involve patents and many
trade secrets that we consider to be proprietary. We have also developed certain
methods, processes and equipment designs for which we have sought additional
patent protection. We have taken measures to safeguard our trade secrets by,
among other things, entering into confidentiality and nondisclosure agreements,
and restricting access to our facilities. We also have installed advanced
security systems, including cameras, at all facilities.

We have filed nineteen patent applications and have received issuance from
the United States Patent and Trademark Office for fifteen patents, six of which
relate to our composite materials manufacturing operations and product, and nine
of which relate to waste plastics reclamation technologies. The patents cover
our composite product, extrusion process and apparatus, our continuous
down-stream cooling and forming conveyor system and our plastic reclamation
process and equipment. Should our trade secrets be disclosed notwithstanding
these efforts, our business and prospects could be materially and adversely
affected. The cost of patent protection and, in particular, patent litigation is
extremely high. It can also strain resources and inhibit growth.

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INDUSTRY STANDARDS

Local building codes often require that building materials meet strength
and safety standards developed by the American Society for Testing Materials and
that, in order to qualify, the materials be evaluated by an independent testing
organization. Our decking, handrails and stair applications have a national
evaluation report "NER" code rating under NER-596. The NER rating provides local
building inspectors and code officials with independent testing and installation
information regarding our products. We believe that the NER listing has helped
to increase sales and market acceptance of our decking products.

COMPETITION

Competition for Sales. Our products compete with high-grade western pine
and other woods, aluminum, high-performance plastics, an increasing number of
composites and other construction materials. We believe that our products have
superior physical characteristics that make them a better value for the
consumer. Manufacturers of some competing products however, have
long-established ties to the building and construction industry and have well-
accepted products. Many of our competitors are larger and have research and
development budgets, marketing staffs and financial and other resources, which
far surpass our resources. There can be no assurance that these competitors will
not attempt to develop and introduce composite materials similar to ours.

Sales of non-wood decking products represent a small portion of the decking
market. Pressure treated pine, cedar, redwood and other traditional woods
constitute the vast majority of annual decking sales. We thus view wood decking
as our principal competitor. The wood decking industry is highly segmented with
many small to medium sized manufacturers. Wood decking is principally a
commodity that competes as the low-priced product, whereas the more-expensive
non-wood products must compete on features and performance.

Among manufacturers of alternative decking materials, we view Trex Company,
Crane Plastic's TimberTech, Louisiana-Pacific's WeatherBest and CertainTeed
Corporation's BoardWalk, as our primary competitors.

The market for door, windowsill, and trim products is highly segmented,
with many competitors. We believe that our MoistureShield products have superior
characteristics and are competitively priced. We emphasize durability, which
means that manufacturers and homebuilders using our products should see reduced
warranty callbacks and higher customer satisfaction. Our product competes on
durability and the ability of the customer to order a product that is custom
manufactured to their specifications.

Competition for Raw Materials. As the wood/plastic composites industry
grows, we sometimes compete for raw materials with other plastic recyclers or
plastic resin producers. We believe, however, that our ability to use highly
contaminated polyethylene limits the number of competitors because most
recycling processes require "cleaner" waste plastic sources. Nonetheless, we
expect to encounter new entrants into the composites or plastics reclamation
business. These new entrants may have greater financial and other resources than
we do, and may include beverage bottlers, distributors and retailers, as well as
forestry product producers, petrochemical and other companies. Increased
competition for waste plastics could increase our materials cost and reduce our
profit margins.

EMPLOYEES

On December 31, 2002, we employed 410 people. We had 117 employees at the
Texas facility, of which 4 were executive and/or office personnel and 113 were
full-time factory personnel. The Arkansas facilities employed 293 people, of
which 44 were executives and/or office personnel and 249 were full-time factory
personnel. From time-to-time, we hire part-time employees to supplement our
factory workforce. In 2003, we are focused on streamlining and automating our
manufacturing operations, and we hope to increase output and improve
efficiencies without substantially increasing the number of employees.

ITEM 2. PROPERTIES

We conduct our composite products manufacturing operations from two
separate facilities, including a 49,000 square foot manufacturing and storage
facility on a seven-acre site in Junction, Texas. In accordance with the lease
on the Junction facility, we exercised our right to purchase this property from
Marjorie S. Brooks, a major shareholder, in May 2001. We believe that the
Junction facility is currently suitable for its composite materials
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manufacturing requirements on a regional basis. We upgraded and improved the
Junction facility to provide additional composite capacity and further reduce
operating costs.

Our Springdale, Arkansas manufacturing facility consists of 103,000 square
feet and is located on 10 acres with a rail siding in the Springdale Industrial
District. We have added 30,440 square feet of shed storage space since 1999 and
installed a dual sprinkler system. We lease the facility for $22,000 per month
with an option to purchase it for $1.8 million. We intend to purchase the
facility with a portion of the $16.5 million bond financing (see Liquidity and
Capital Resources and Note 4. Bonds Payable).

In March 1999, we leased an office, storage building and parking lot
adjacent to the Springdale facility. The lease is for $3,500 per month for two
years, renewable yearly. We also lease a parking area for $200 per month. The
office and storage facility is comprised of 10,000 square feet on 2.36 acres and
houses our corporate offices. We have an option to purchase this property for
$360,000, with half of the lease payments applicable to the purchase price. We
own 18.6 acres of land, south of and adjoining the existing manufacturing
facility. This land was acquired for $785,000 and is where the second Springdale
manufacturing facility will be built.

We have also leased a 55,000 square foot second plastic storage warehouse
and laboratory. The lease payment is $7,021 per month for two years with a
renewal option. In the third quarter we entered into an agreement to purchase
land and a building in Northwest Arkansas, on approximately 10 acres, for
$900,000. We intend to expand and retrofit the building to become a plastic
regrinding and blending facility, and serve as a reload area for finished
products.

In 2002, we began leasing two warehouses in Northwest Arkansas. One
warehouse is used to store finished goods, and the other is used to store raw
materials. Lease payments on the two facilities are $10,622 and $5,525 monthly,
respectively.

ITEM 3. LEGAL PROCEEDINGS

We were sued in May 2000, in a federal action in the Western District of
Texas, for breach of contract seeking royalties allegedly owed but unpaid from a
1987 settlement of prior litigation against a predecessor entity and two of our
founders in the United States District Court for the Western District. The
plaintiffs were seeking approximately $1.2 million in past royalties, plus
attorneys' fees, any applicable pre-judgment and post-judgment interest, and a
declaration that the Company pay an ongoing royalty in the amount of $10 per ton
on future sales from the Company's Junction, Texas facility on production
utilizing cedar fiber and recycled plastic. In 2001, the plaintiffs amended the
complaint to include two of our founders as co-defendants. At trial, the
plaintiffs obtained a judgment for past royalties in the amount of approximately
$821,000, plus prejudgment and post-judgment interest and attorneys' fees. We
settled the lawsuit in December 2002 for $1,100,000. The court, in May 2002,
declined to enter a declaratory judgment requested by the plaintiff requiring
the Company to pay a royalty on a monthly basis in the future on the Company's
products, and the release executed in connection with the December 2002
settlement does not release any potential claims for royalties after January 1,
2002. As to the requested declaratory judgment, the court noted that the
plaintiffs had not properly sought a declaratory judgment from a procedural
standpoint and also took note that the changes to the initial process developed
over the years by the Company have brought the Company's manufacturing
operations farther away from the plaintiff's technology.

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

There were no matters submitted to a vote of security holders during the
fourth quarter of the fiscal year ended December 31, 2002.

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PART II

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

The Company's Class A common stock is traded in the small cap market and is
listed on The NASDAQ Stock Market(R) under the symbol AERTA. In order to remain
listed on NASDAQ, the Company is required to meet certain criteria as
maintenance standards established by NASDAQ. One such standard is a minimum bid
price of $1.00 per share. At December 31, 2002, the Company's closing stock
price per share was $1.20 (and $1.25, as of March 12, 2003). There is no
guarantee that the Company will maintain this minimum stock price requirement.

The following table sets forth the ranges of high and low quarterly sales
prices (as reported by NASDAQ) of the Company's Class A common stock for the
years ended December 31, 2001 and 2002. The quotations represent prices between
dealers, do not include retail markup, markdown or commission, and do not
necessarily represent actual transactions.

As of December 31, 2002, there were approximately 1,600 record holders of
Class A common stock and 11 record holders of Class B common stock. The Company
has not previously paid cash dividends on the common stock and there are
currently restrictions under various debt obligations and preferred securities
that would prevent the payment of such dividends for the foreseeable future.

7

ITEM 6. SELECTED FINANCIAL DATA

The following tables set forth selected historical data for the Company for
the years ended December 31, 1998 through 2002, derived from the Company's
audited financial statements for each such year and should be read in
conjunction with such financial statements and the footnotes attached thereto as
well as the discussion contained herein in "Management's Discussion and Analysis
of Financial Condition and Results of Operations". Certain prior period amounts
have been reclassified to conform to the current period presentation.

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(1) The net income (loss) per share of common stock is based on the combined
weighted average number of shares of Class A and Class B common stock
outstanding during the period. See Note 2 to the financial statements for a
reconciliation of basic and diluted weighted average number of shares
outstanding.

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

RESULTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001

Net sales were $41,415,466 for the year ended December 31, 2002, which
represented an increase of $7,992,507 or 24% over sales of $33,422,959 for the
year ended December 31, 2001. Net sales are computed by subtracting from gross
sales early pay discounts, returns, seasonal discounts, and allowances, which
together totaled $795,531 for 2002. The 2002 composite sales consisted of
MoistureShield net sales of $7,418,602 and decking (ChoiceDek Classic, ChoiceDek
Plus and ChoiceDek Premium) net sales of $33,996,864. These figures compare with
2001 MoistureShield net sales of $6,679,085 and ChoiceDek decking net sales of
$26,743,874.

The Texas plant net sales increased to $14,513,658 in 2002, from
$14,012,418, an increase of $501,240 or 4%. The Texas plant primarily produces
the ChoiceDek Classic product line, but also produced ChoiceDek Premium in 2002.
Texas net sales in 2002 for ChoiceDek were $13,929,018 compared to $13,939,495
in 2001, a decrease of $10,477. Net sales of MoistureShield were $584,640
compared to $72,923 in 2001, an increase of $511,717.

The Arkansas plant net sales in 2002 were $26,901,808, an increase of $7.5
million, or 39%, over 2001 sales of $19,410,541. Decking net sales increased
from $12,804,379 in 2001 to $20,067,846 in 2002, an increase of $7.3 million

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or 57%. During 2002, MoistureShield net sales were $6,833,962, which was an
increase of $227,800 or 3% from 2001 MoistureShield net sales of $6,606,162.

Net sales increased primarily due to Weyerhaeuser's new contract to supply
all Lowe's stores with ChoiceDek Premium. Net sales were limited, however, by
our production capacity. During 2002, we added production capacity and expect to
add more capacity during 2003. As a result, we expect 2003 sales to increase
versus 2002.

Cost of goods sold increased $5,591,300 from $24,209,639 in 2001 to
$29,800,939 in 2002. However, as a percent of net sales, cost of goods sold
decreased 0.4% in 2002, from 72.4% in 2001 to 72.0% in 2002. The changes in the
three major cost components of cost of goods sold as a percent of sales were as
follows; raw materials decreased 1.6%, direct labor increased 0.2%, and
manufacturing overhead increased 1.0%. A summary of the cost of goods sold is
presented below.

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* Amounts for "Other" have been reclassified from the prior year's presentation
to compare to the current year presentation for this cost category.

In late 2002, the price of petroleum products increased materially, which
drove up the cost of virgin plastic resin. Because of uncertainties created by
world political tensions, we believe this trend will continue in 2003. As the
price of resin increases, plastic consumers increasingly turn to recycled
plastics. The increased demand in turn raises the price that we must pay.
Because we use both waste plastics and virgin resin, we expect a higher
percentage cost of materials for 2003 versus 2002. To help offset rising
materials costs, and to be assured of a cleaner, more dependable, and consistent
supply of plastic raw material, we are in the process of expanding the plastic
processing capacity at a second Northwest Arkansas facility and seeking new
sources of waste plastic materials. We expect this additional plastic processing
capacity to come on-line in the third quarter of 2003, subject to the
availability of operating cash flow, financing from either the proceeds of our
industrial development bond financing currently held in escrow, or from other
debt or equity financing. There can be no assurance that we will have funds
available to increase plastic processing capacity (see Liquidity and Capital
Resources and Note 4. Bonds Payable).

Selling and administrative expenses were $9.3 million in 2002 compared to
$7.6 million in 2001, a $1.7 million increase. The increase includes a $1.1
million settlement of outstanding litigation (see "Litigation"). Excluding the
litigation settlement, selling and administrative costs were $8.2 million, which
we believe more accurately reflects our on-going obligations in this category.
As a percent of sales, selling and administrative expenses decreased 0.5% from
2001 to 2002. In 2002, an amount of $220,354 was charged as research and
development. Excluding the litigation settlement, the increase in selling and
administrative expenses was principally attributable to additional sales staff
and increased marketing and brand building expenses related to the new
Weyerhaeuser contract with Lowe's.

The operating profit for 2002 was $2.4 million, up from an operating profit
of $1.6 million in 2001, an $800,000 improvement. The increased profit was due
to higher sales. Net interest increased to $1,029,954 in 2002, up $34,570 from
$995,384 in 2001.

The Texas plant recorded a net profit of $202,154 in 2002, an earnings
improvement of $496,779 from the net loss of $294,625 in 2001. The Texas plant
extrusion lines were reduced from 3 to 2 in 2002 and other operating
improvements were made. The result was improved efficiency and reduced
production costs while still achieving a slight increase in sales.

The Springdale, Arkansas plant recorded a net profit of $713,096 in 2002
compared to a net profit of $607,489 in 2001. This is an increase of $105,607.
The earnings improvement resulted from efficiencies implemented in operations
and the increase in sales volume while holding expenses at a slower growth rate
than the sales increase.

9

Net profit for 2002 was $915,250. This compares to a net profit in 2001 of
$312,864, or an increase in earnings of $602,386 or 193% over last year.

We believe that increased production and sales, improved product focus,
increased job training, and increased throughputs have allowed us to attain and
increase profitability. Additional production capacity and increased efficiency
will be required for us to increase sales and profits, of which there is no
assurance.

YEAR ENDED DECEMBER 31, 2001 COMPARED TO YEAR ENDED DECEMBER 31, 2000

Net sales were $33,422,959 for the year ended December 31, 2001, which
represented an increase of $5,715,468 or 21% over sales of $27,707,491 for the
year ended December 31, 2000. Net sales are computed by subtracting from gross
sales early pay discounts, returns, seasonal discounts and allowances, which
together totaled $623,903 for 2001. The 2001 composite sales consisted of
MoistureShield net sales of $6,679,085 and decking (ChoiceDek Classic, ChoiceDek
Plus and ChoiceDek Premium) net sales of $26,743,874. These figures compare with
2000 MoistureShield net sales of $7,917,091 and ChoiceDek decking net sales of
$19,790,400.

The Texas plant net sales increased to $14,012,418 in 2001 from
$12,340,775, an increase of $1,671,243 or 13.5%. The Texas plant primarily
produces the ChoiceDek Classic product line. Texas net sales in 2001 for
ChoiceDek were $13,939,495 compared to $12,102,732 in 2000, an increase of
$1,836,763 or 15%; net sales of MoistureShield were $72,923 compared to $238,043
in 2000, a decrease of $165,120. The change to focus the Texas plant on
ChoiceDek Classic was intended to improve efficiencies.

The Arkansas plant net sales in 2001 increased to $12,804,379 for ChoiceDek
decking and $6,606,162 for MoistureShield, for total net sales of $19,410,541,
an increase of $4,043,825 or 26% over 2000 sales of $15,366,716. Decking net
sales increased from $7,687,668 in 2000 to $12,804,379 in 2001, an increase of
$5,116,711 or 67%. 2001 MoistureShield net sales of $6,606,162 represented a
decrease of $1,072,886 or 14% from 2000 MoistureShield net sales of $7,679,048.

Cost of goods sold increased $1,360,273 from $22,849,366 in 2000 to
$24,209,639 in 2001. However, as a percent of net sales, cost of goods sold
decreased 10.1% in 2001, from 82.5% in 2000 to 72.4% in 2001. All three major
cost components of cost of goods sold decreased as a percent of sales; raw
materials decreased 3.4%, direct labor decreased 2.0%, and manufacturing
overhead decreased 4.7%. In 2001, the Company started the year with a program to
reduce its manufacturing costs and it was successful. The following
manufacturing expenses were reduced by a total of 4.2%, or $720,142, as compared
to 2000: repair and maintenance, tooling, leases/rents, supplies, fuel and oil,
and waste disposal. A summary of the cost of goods sold is presented below.

Significant cost categories are as follows:

- ---------------

* Amounts for "Payroll and payroll taxes" and "Other" have been reclassified
from the prior year's presentation to compare to the current year presentation
for these cost categories.

Selling and administrative expenses, excluding litigation expense of
$882,644, increased $791,000 to $6.75 million in 2001, up from $5.96 million in
2000. Including litigation expense, the increase was $1,673,934 to $7,632,764 in
2001 from $5,958,830 in 2000. As a percent of sales, selling and administrative
expenses increased 1.3% from 2000 to 2001. Excluding the litigation percent
increase, the following expenses increased as a percent of sales: salaries,
commissions, advertising and promotion, and travel and entertainment. The
increase in selling and administrative expenses was directly attributable to
increased decking sales. All of these expenses related to the buildup of the
sales

10

staff and developmental and marketing expenses for the build up of the brand
awareness of ChoiceDek in conjunction with Weyerhaeuser.

The operating profit for 2001 was $1,580,556, up from an operating loss of
$1,100,705 in 2000, a $2.7 million improvement and a significant turnaround over
prior periods. The profit was attained by reducing operating costs, even as
selling and administrative expenses increased. Net interest increased to
$995,384 in 2001 up $179,568 from $815,816 in 2000.

The Texas plant recorded a net loss of $294,624 in 2001, a decrease of
$376,553 from the net loss of $671,177 in 2000. The Texas plant experienced
significant downtime and efficiency reductions associated with capital
improvements, combined with reduced fourth quarter sales of ChoiceDek Classic.
The Texas plant also carried a significant amount of corporate overhead that may
be reduced in future periods as sales continue to increase at other AERT
locations. This reflects improvements made in reducing targeted manufacturing
overhead expenses by $220,730.

The Springdale, Arkansas plant recorded a net profit of $607,488 in 2001 as
compared to a net loss of $1,535,344 in 2000. This is a positive change of
$2,142,832. The earnings improvement resulted from efficiencies implemented in
operations and the increase in sales volume while holding expenses at a slower
growth rate than the sales increase, and, as previously mentioned, the programs
to reduce manufacturing overhead expenses which resulted in a savings of
$499,412 in 2001.

The net profit for 2001, the first profitable year in the history of the
Company, was $312,864. This compares to a net loss in 2000 of $2,206,521, or an
increase in earnings of $2,519,385 over last year.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 2002, the Company had a working capital deficit of
$6,557,943 compared to a working capital deficit of $4,535,600 at December 31,
2001. The Company expended approximately $6 million on capital expansion during
2002, primarily for improving our equipment at both production facilities in the
areas of extrusion, raw material processing and plastic production. The increase
in the working capital deficit is primarily attributable to the Company's payout
for its legal settlement and its decision to finance its ongoing expansion from
cash flow and short-term loans. Of such deficit, involving total current
liabilities of approximately $29.3 million as of December 31, 2002, $16.5
million was for bonds payable, which is currently escrowed and offset by a $16.5
million restricted bond escrow fund, $4.0 million was to the Company's major
shareholder or companies controlled by her, $2.1 million was in short term
bridge loans, $1.7 million was for miscellaneous accrued liabilities, and
approximately $4.7 million was in payables. The $6.5 million working capital
deficit reflects management's decision to enter into short-term debt financing,
while the Company has expanded, built and improved its production and sales
capacities to increase cash flows from operations. The Company's plan was to
issue short-term debt and refinance in the future, rather than enter into what
it felt would have been more expensive and dilutive equity financing at that
time. The Company generated sufficient cash flow to more than cover debt
service. Cash flow available for debt service for the year ended December 31,
2002, was approximately $5.5 million, up from $4.5 million for the year ended
December 31, 2001.

The Company closed a $16.5 million tax-exempt bond financing during the
fourth quarter of 1999, which was intended to refinance existing obligations,
shift construction and expansion related accounts payable into long-term
financing and provide additional financing of capital expenditures. The bonds
were subject to mandatory tender for purchase by the Company in whole on October
13, 2000 (the Reset Date), at which time the bonds were repurchased by the
bondholder and a new reset date of October 13, 2001 was established. Just prior
to that date, the tragedy of September 11, 2001 occurred, and the bond markets
were unsettled. While we were seeking to remarket the bonds, we continued to
invest additional short-term funds into the Company, and used our cash flow to
continue to grow and expand our production capabilities. The bonds are currently
due to reset on April 16, 2003. The terms and covenants of the bonds in regard
to the Company's financing needs are being reexamined and negotiated with
potential buyers. The final reset date for the issuance of the bonds is October
16, 2003. At that time, the bonds will have to be repurchased and retired.
Currently, due to the circumstances in the Industrial Revenue Bond market, the
slowing economy, low interest rates and the uncertainty concerning Iraq and the
Middle Eastern region, it is questionable if the bonds will be rolled over past
October 16, 2003, or if alternative financing at more competitive rates can be
acquired. Therefore, the bonds could be repurchased with its escrowed funds and
retired on October 16, 2003. If the
11

bonds are retired, we will have to take a one-time write-off of approximately
$1.09 million for costs associated with the initial marketing of the bonds and
the rollover attempts to reissue the bonds over the past four years. Because of
our increased productive capacity, strong customer commitments and the ability
to generate sufficient cash flow to cover debt service, we are evaluating
several financing alternatives for $21 million of non-bond resources to continue
our expansion and to refinance some of our short-term debt. This financing could
allow us to complete the projects that are underway in a more timely manner and
commence additional projects.

Cash decreased $251,236 in 2002. Significant components of that decrease
were: (i) cash provided by operating activities of $4,872,146, which consisted
of the net income for the period of $915,250 increased by depreciation and
amortization of $3,097,697 and increased by other sources of cash of $859,199;
(ii) cash used in investing activities of $4,837,311, and (iii) cash used in
financing activities of $286,071. Payments on notes during the period were
$769,302, and proceeds from the issuances of notes amounted to $1,415,000. At
December 31, 2002, the Company had bonds and notes payable in the amount of
$24,783,567, of which $20,715,357 was current bonds and notes payable and the
current portion of long-term debt. Of the current bonds and notes payable,
$3,822,463 or 18% was to Marjorie S. Brooks, a major shareholder, and other
investors closely associated with the Company.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company has no material exposures relating to its long-term debt, due
to all of the Company's long-term debt bearing interest at fixed rates. See Note
4 to the financial statements for a discussion of the Company's debt. The
Company depends on the market for favorable long-term mortgage rates to help
generate sales of its product to its customers for use in the residential
construction industry. Should mortgage rates increase substantially, the Company
could be impacted by a reduction in the residential construction industry.
Important raw materials purchased by the Company are recycled plastic and wood
fiber, which are subject to price fluctuations. The Company attempts to limit
the impact of price increases on these materials by negotiating with each of its
suppliers on a term basis.

FORWARD-LOOKING INFORMATION

An investment in the Company's securities involves a high degree of risk.
Prior to making an investment, prospective investors should carefully consider
the following factors, among others, and seek professional advice in analyzing
this Company. In addition, this Form 10-K contains certain "forward-looking
statements" within the meaning of Section 27A of the Securities Act and Section
21E of the Exchange Act. Such forward-looking statements, which are often
identified by words such as "believes," "anticipates," "expects", "estimates,"
"should," "may," "will" and similar expressions, represent the Company's
expectations or beliefs concerning future events. Numerous assumptions, risks
and uncertainties could cause actual results to differ materially from the
results discussed in the forward-looking statements. Prospective purchasers of
the Company's securities should carefully consider the information contained
herein or in the documents incorporated herein by reference.

The foregoing discussion contains certain estimates, predictions,
projections and other forward-looking statements (within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934) that involve various risks and uncertainties. While these
forward-looking statements, and any assumptions upon which they are based, are
made in good faith and reflect the Company's current judgment regarding the
direction of its business, actual results will almost always vary, sometimes
materially, from any estimates, predictions, projections, or other future
performance suggested herein. Some important factors (but not necessarily all
factors) that could affect the Company's sales volumes, growth strategies,
future profitability and operating results, or that otherwise could cause actual
results to differ materially from those expressed in any forward-looking
statement include the following: market, not breaking the bonds from escrow,
political or other forces affecting the pricing and availability of plastics and
other raw materials; accidents or other unscheduled shutdowns affecting the
Company's, its suppliers' or its customers' plants, machinery, or equipment;
competition from products and services offered by other enterprises; state and
federal environmental, economic, safety and other policies and regulations, any
changes therein, and any legal or regulatory delays or other factors beyond the
Company's control; execution of planned capital projects; weather conditions
affecting the Company's operations or the areas in which the Company's products
are marketed; adverse rulings, judgments, or settlements in litigation or other
legal matters. The Company undertakes no obligation

12

to publicly release the result of any revisions to any such forward-looking
statements that may be made to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The response to this item is submitted in a separate section of this
report.

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

There have been no disagreements on accounting and financial disclosures
with accountants during the quarter ended December 31, 2002. There was a change
in accountants on March 4, 2002. See Forms 8K and 8-K/A filed with the SEC in
March 2002.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The directors and executive officers of the Company are as follows:

The Company's board of directors elected JOE G. BROOKS as its chairman and
the Company's co-chief executive officer in December 1998, and he has served as
president since February 2000. Mr. Brooks has previously served as president and
has been a director since the Company's inception in December 1988. He was also
previously chairman and CEO from inception until August 1993. He was a member of
Clean Texas 2000, appointed by then Governor George W. Bush in 1995.

In December 1998, the Company's board of directors elected SAL MIWA as its
vice-chairman. Mr. Miwa also served as chairman of the board between December
1995 and December 1998. He has been an outside director of the Company since
January 1994. From 2000 to present, Mr. Miwa has been COO and director of
RealRead Inc., an online document service company located in New York, New York.
From 1995 to 2000, he was CEO/President of Seiwa Optical America Corp.,
importer/distributor of electronic and optical components for Semiconductor
industry. For more than 20 years Mr. Miwa has been engaged in various
international businesses and serves on boards of several closely held family
businesses around the world. He received his master's degree in Aerospace
Engineering from the Massachusetts Institute of Technology.

The Company's board of directors elected STEPHEN W. BROOKS as co-chief
executive officer in December 1998. Mr. Brooks has served as its chief executive
officer and has been a director since January 1996. Mr. Brooks was appointed CEO
and chairman of the board of Razorback Farms, Inc. in January 1996. Razorback
Farms is

13

Springdale, Arkansas based firm that specializes in vegetables processing. Mr.
Brooks also serves on the board of the Ozark Food Processors Association.

J. DOUGLAS BROOKS has served as executive vice-president, served on the
Executive Committee since December 1998 and is in charge of raw material
processing, research and development (R&D) and sourcing. Mr. Brooks was
vice-president of Plastics from 1995 through 1998, was previously project
manager for AERT's polyethylene recycling program with The Dow Chemical Company,
and is a joint inventor on several of AERT's process patents for recycling
polyethylene film for composites.

JIM PRECHT has served as executive vice-president of sales and marketing
for the Company since February 2001. Mr. Precht was formerly general manager of
Weyerhaeuser Building Materials' Pittsburgh Customer Service Center with
32-years of industry experience and has a dual reporting relationship to both
AERT and Weyerhaeuser Building Materials.

MARJORIE S. BROOKS has been secretary, treasurer and a director since the
Company's inception in December 1988. Mrs. Brooks has served as secretary and
treasurer of Brooks Investment Co., a holding company for the Brooks' family
investments, for more than thirty years.

EDWARD J. LYSEN joined AERT in April 1999 as chief financial officer. Mr.
Lysen has over 30 years experience in financial management. Prior to entering
the private sector, Mr. Lysen was a consultant in the Management Consulting
Group, KPMG-Peat Marwick from 1966 to 1979. From 1979 to 1992, Mr. Lysen was
senior vice-president, CFO and on the board of Tuesday Morning, Inc., a publicly
traded retailer. From 1993 to 1996, he served as chairman of the board and CFO
of Distribution Data Management Systems, a computer service provider in the
office products industry. In 1996, Mr. Lysen entered the financial planning
industry with AAL, a leading fraternal benefits society. In 1998 to 1999, he was
the CFO of Hairston Roberson, a leading designer and manufacturer of women's
fashion apparel. He has an MBA in Finance from Northwestern University and is a
certified public accountant.

JERRY B. BURKETT was appointed a director to the board of directors of the
Company in May 1993. Mr. Burkett has been a rice and grain farmer since 1979 and
has been a principal in other closely held businesses. He is the past president
of the Arkansas County Farm Bureau. In April 2002, Mr. Burkett was elected to
serve as a director of the Ag Heritage Farm Credit Services board.

MICHAEL M. TULL was appointed a director to the board of directors of the
Company in December 1998. Mr. Tull has served since 1990 as the president and
majority owner of Tull Sales Corporation, a manufacturer's representative
company, which professionally represents eight manufacturing companies and is
responsible for sales and marketing of those companies' window and door related
components in the southeastern Unites States. Mr. Tull serves on boards of
several closely held family businesses and is the chairman and a board of
director member of the National Wild Turkey Federation, which is one of the
largest North American conservation organizations.

SAMUEL L. "TONY" MILBANK was elected to the board of directors in July
2000. From 1997 to the present, Mr. Milbank has been a managing director of
Zanett Securities Corporation, an investment advisory company focusing on small
and microcap companies. From 1992 to 1996, Mr. Milbank was a senior
vice-president and sales manager with Lehman Brothers, Inc. in New York, where
he managed a team that provided interest rate and currency risk management for
central banks and other official institutions. From 1973 to 1992, Mr. Milbank
worked with Salomon Brothers, Inc. as a director and manager of the
international department. Since 1990, Mr. Milbank has served as chairman of
Milbank Memorial Fund, a private operating foundation (established in 1905),
concerned with environmental and public health issues. He has a BS from Columbia
University and a MBA in Finance from The Amos Tuck School of Business
Administration at Dartmouth College.

DELBERT E. "PETE" ALLEN, JR. was elected to the board of directors in July
2001. Currently, Mr. Allen is President of Allen Holding, Inc., an investment,
finance and ranching enterprise. From 1970 to 1999, Mr. Allen was President and
CEO of Allen Canning Co. He also served as a director of Allen Canning Co. from
1967 to 1999. Mr. Allen has served as director of Arkansas State Bancshares Inc.
and Arkansas State Bank in Siloam Springs since 1971, and was recently named its
Chairman of the Board. Mr. Allen is presently Chairman Emeritus and director of
the National Food Processors Association (NFPA). He served the NFPA as chairman
in 1983-1984 and has been a director in excess of thirty years. He is a past
member of the NFPA's executive committee. Mr. Allen is a director on the

14

Agricultural Development Council-University of Arkansas. Mr. Allen is also past
president and director of the Siloam Springs Hospital Board.

MELINDA DAVIS was elected to the board of directors in July 2001. Since
December 2000 to the present, Ms. Davis has provided professional consulting
services in the areas of financial management and cost accounting for
manufacturing operations. Ms. Davis retired as senior vice-president and
treasurer from Allen Canning Co. in December 2000, after serving for 39 years in
various accounting and financial management positions.

Joe G. Brooks, Stephen W. Brooks and J. Douglas Brooks are brothers and
sons of Marjorie S. Brooks. There are no other familial relationships between
the current directors and executive officers.

Each of the Company's directors has been elected to serve until the next
annual meeting of stockholders or until their successors are elected and
qualified. Officers serve at the discretion of the Board of Directors.

The audit committee of the board of directors consists of three outside
directors of Melinda Davis (chairman), Jerry B. Burkett, and Sal Miwa. The audit
committee recommends engagement of the Company's independent accountants and is
primarily responsible for approving the services performed by the Company's
independent accountants and for reviewing and evaluating the Company's
accounting principles and its system of internal accounting controls.

The compensation and stock option committee consists of Samuel L. "Tony"
Milbank (chairman), Marjorie S. Brooks and Michael M. Tull. The compensation and
stock option committee establishes and administers the Company's compensation
and stock option plans on behalf of the board of directors and approves stock
options granted thereunder.

The executive committee consists of three board members with Delbert E.
"Pete" Allen, Jr. (chairman), Melinda Davis and Stephen W. Brooks and two
executive management members of J. Douglas Brooks and Alford Drinkwater. The
executive committee establishes corporate policies, manpower, technology, cost
accounting and day-to-day operations of the Company.

The litigation committee consists of Joe G. Brooks (chairman), Sal Miwa and
Jerry B. Burkett. The litigation committee establishes and administers the
Company's litigation plans on behalf of the board of directors.

The nominating committee consists of Michael M. Tull (chairman) and Samuel
L. "Tony" Milbank. The nominating committee evaluates the efforts of AERT and
board of directors to maintain effective corporate governance practices. The
committee identifies candidates for election to the board of directors.

ITEM 11. EXECUTIVE COMPENSATION

DIRECTOR COMPENSATION

Non-employee directors do not receive cash compensation for serving on the
Company's board of directors, however; such persons are reimbursed for
out-of-pocket expenses in connection with their attendance at meetings.
Directors are paid long-term compensation in the form of stock option grants
under the Company's Non-Employee Director Stock Option Plan. Such plan provides
for annual grants of options to purchase 25,000 shares of Class A common stock
at the fair market value of said stock on the date of such grant.

15

The following table sets forth the aggregate cash compensation paid by the
Company during the three years ended December 31, 2002, to each executive
officer of the Company whose aggregate cash compensation in 2002 exceeded
$100,000, and to the chief executive officers.

SUMMARY COMPENSATION TABLE

- ---------------

(a) There is an agreement between AERT and Weyerhaeuser where each pays
one-half of Mr. Precht's annual salary. The above accounts for AERT's
portion of the annual salary

AGGREGATED OPTION EXERCISES IN YEAR ENDED DECEMBER 31, 2002
AND OPTION VALUES AT DECEMBER 31, 2002

EQUITY COMPENSATION PLAN INFORMATION

The following table provides information as of December 31, 2002, regarding
shares outstanding and available for issuance under the Company's existing stock
option plans.

16

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

The board of directors, as a whole, reviews and acts upon personnel
policies and executive compensation matters. Joe G. Brooks and Stephen W. Brooks
serve as executive officers of the Company; however, such individuals do not
participate in compensation decisions or in forming compensation policies in
which they have a personal interest, nor do they vote on any such matters.

LIMITED LIABILITY OF OFFICERS AND DIRECTORS

The Delaware Supreme Court has held that a director's duty of care to a
corporation and its stockholders requires the exercise of an informed business
judgment. Having become informed of all material information reasonably
available to them, directors must act with requisite care in the discharge of
their duties. The Delaware general corporation law permits a corporation through
its certificate of incorporation to exonerate its directors from personal
liability to the corporation or its stockholders for monetary damages for breach
of the fiduciary duty of care as a director, with certain exceptions. The
exceptions include a breach of the director's duty of loyalty, acts or omissions
not in good faith or which involve intentional misconduct or knowing violations
of law, improper declarations of dividends and transactions from which the
directors derived an improper personal benefit. The Company's certificate of
incorporation exonerates its directors, acting in such capacity, from monetary
liability to the extent permitted by this statutory provision. The limitation of
liability provision does not eliminate a stockholder's right to seek
non-monetary, equitable remedies such as injunction or rescission to redress an
action taken by directors. However, as a practical matter, equitable remedies
may not be available in all situations and there may be instances in which no
effective remedy is available.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS

The following table sets forth, as of December 31, 2002, certain
information with regard to the beneficial ownership of the Company's capital
stock by each holder of 5% or more of the outstanding stock, by each director of
the Company, and by all officers and directors as a group:

- ---------------

* Less than 1%

(1) The Class B common stock is substantially identical to the Class A common
stock, except that each share of Class B common stock has five votes per
share and each share of Class A common stock has one vote per share. Each
share of Class B common stock is convertible into one share of Class A
common stock. Each share of Preferred Stock is convertible at the lower of
$1.20 and the ten-trading day average of the Company's Class A common
stock, and would be convertible into 833 shares of Class A common stock,
based upon the trading price prevailing at December 31, 2002. The Series B
Preferred Stock (900 shares) has voting rights of 2,500 votes per share. No
other Preferred Stock carries any voting rights.

(2) Beneficial ownership of shares was determined in accordance with Rule
13d-3(d)(1) of the Exchange Act and included shares underlying outstanding
warrants and options which the named individual had the right to acquire
within sixty days (March 1, 2003) of December 31, 2002.

(3) Includes 2,837,148 shares owned directly, 693,057 in trusts or corporations
controlled by Mrs. Brooks, 1,150,000 shares issuable upon exercise of stock
options, 3,000 shares issuable upon exercise of bonus warrants, 325,000
shares issuable upon exercise of Class C Warrants, 3,974,080 shares
issuable upon exercise of Class F and Class G Warrants issued in connection
with a private placement of Class A common stock in May of 1994, 1,771,792
shares issuable upon exercise of Class H Warrants, 323,000 shares issuable
upon exercise of Series X and Y warrants owned directly and 493,333 shares
issuable upon exercise of Series X and Series Y Warrants owned indirectly
through two corporations controlled by Mrs. Brooks.

(4) Includes 403,946 shares owned directly by Mrs. Brooks and 433,642 shares
owned by two corporations controlled by Mrs. Brooks. (Razorback Farms, Inc.
is the record owner of 312,320 shares and SMF is the record owner of
121,322 shares, representing approximately 21.3% and 8.3%, respectively, of
the Class B common stock). Excludes additional shares owned by adult
children of Mrs. Brooks, including Joe G. Brooks, Stephen W. Brooks and J.
Douglas Brooks, as to which she disclaims a beneficial interest.

(5) Includes 425 shares of Series A preferred stock owned directly and 400
shares of Series B Preferred Stock owned indirectly by Mrs. Brooks.
Razorback Farms, Inc. is the record owner of 165 shares. Brooks Investment
Company is the record owner of 235 shares.

(6) Includes 607,400 shares owned directly, 4,500 shares owned as custodian for
Joe G. Brooks' minor child, 38,205 shares owned as custodian for Brooks'
Children's Trust, 1,500 shares issuable upon exercise of Bonus Warrants
owned as custodian for Mr. Brook's minor child, 38,250 shares issuable upon
exercise of Bonus Warrants owned as custodian for Brook's Children's Trust,
1,875 shares issuable upon exercise of Bonus Warrants owned directly and
246,667 shares issuable upon exercise of stock options.

(7) Includes 313,212 shares owned directly, 84,741 shares owned indirectly,
7,620 shares issuable upon exercise of bonus warrants and 530,000 shares
issuable upon exercise of stock options.

18

(8) Includes 13,000 shares owned directly, 2,000 shares owned by Mr. Burkett as
custodian for his minor child, 10,000 shares owned by a partnership
controlled by Mr. Burkett and 215,000 shares issuable upon exercise of
stock options.

(9) Includes 3,000 shares owned directly and 478,963 shares issuable upon
exercise of stock options.

(10) Includes 296,112 shares owned directly and 550,000 shares issuable upon
exercise of stock options.

(11) Includes 438,590 shares owned directly, 350,936 shares owned indirectly,
160,000 Bonus warrants owned directly, 34,374 Bonus warrants owned
indirectly, and 25,000 stock options.

(12) Represents 25,000 shares issuable upon exercise of stock options and 60,800
shares issuable upon exercise of Series X and Series Y warrants.

(13) Includes 120,413 shares owned directly and 100,000 shares issuable upon
exercise of stock options.

(14) Includes 337,562 shares owned directly, 112,697 shares issuable upon
exercise of Series X Warrants, 41,604 shares issuable upon exercise of
Series Y Warrants, 31,886 shares issuable upon exercise of Class I
Warrants, and 25,000 shares issuable upon exercise of stock options.

(15) Class A common stock beneficial ownership is calculated based on 49,891,564
shares outstanding as of December 31, 2002, which includes 21,560,252
shares which may be acquired through the exercise of outstanding options
and warrants within 60 days of December 31, 2002. Class B common stock
beneficial ownership is calculated based on 1,465,530 shares outstanding on
December 31, 2002. Preferred stock beneficial ownership is calculated based
on 2,760 shares outstanding on December 31, 2002.

(16) Calculated based on 61,019,214 shares outstanding on December 31, 2002,
which includes voting rights on all classes of stock, options and warrants
which can be acquired within 60 days of December 31, 2002.

At December 31, 2002, there were 28,331,312 shares of Class A common stock
and 1,465,530 shares of Class B common stock issued and outstanding. The
previous table sets forth those directors, officers and 5% shareholders, as a
group, beneficially owned shares representing approximately 42.2% of the votes
entitled to be cast upon matters submitted to a vote of the Company's
stockholders, and Marjorie S. Brooks and corporations controlled by her
beneficially owned shares representing approximately 27.5% of the votes entitled
to be cast and may be in a position to control the Company.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

During 2002, the Company had an agreement with an affiliate, Brooks
Investment Co., controlled by Marjorie S. Brooks whereby the Company agreed to
transfer certain of its trade receivables as collateral, which Brooks Investment
Co. deemed acceptable, up to $2.5 million at any one time. Upon acceptance of a
transfer of a receivable, the Brooks Investment Co. remitted to the Company 85%
of the receivable, as defined in the agreement. Upon collection of the
receivable, the Company remitted to the Brooks Investment Co. 0.8% of the
receivable as a factoring charge, and the additional 14.2% of the receivable was
remitted to the Company, less interest costs, which were based on the time
period over which the receivable was outstanding. The Company indemnified the
Brooks Investment Co. for any loss arising out of rejections or returns of any
merchandise, or any claims asserted by the Company's customers. During 2002, the
Company transferred an aggregate of approximately $42.8 million in receivables
under this agreement, of which $2.3 million remained to be collected as of
December 31, 2002. During 2001 and 2000, the Company transferred an aggregate of
approximately $34 million and $28.2 million, respectively, in receivables under
this agreement, none of which remains to be collected. Costs of approximately
$343,752, $517,349 and $470,794 associated with the factoring agreement were
included in selling and administrative costs at December 31, 2002, 2001 and
2000, respectively.

At December 31, 2002, accounts payable-related parties included advances on
factored receivables of approximately $2.0 million and $300,000 relating to
other items owed to related parties.

ITEM 14. CONTROLS AND PROCEDURES

Each of our Co-Chief Executive Officers, Joe G. Brooks and Stephen W.
Brooks, and our Chief Financial Officer, Edward J. Lysen, have reviewed and
evaluated the disclosure controls and procedures that we have in place with
respect to the accumulation and communication of information to management and
the recording, processing,
19

summarizing and recording thereof for the purpose of preparing and filing this
Annual Report on Form 10-K. Such review was conducted during the week ended
March 15, 2003. Based upon their review, these executive officers have concluded
that we have an effective system of internal controls and an effective means for
timely communication of information required to be disclosed in this Report.
Since March 15, there have been no significant changes in our internal controls
or in other factors that could significantly affect such controls.

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a1), (a2), and (d). The Financial Statements listed in the accompanying
Index to Financial Statements are filed as part of this report and such Index is
hereby incorporated by reference. All schedules for which provision is made in
the applicable accounting regulation on the Securities and Exchange Commission
are not required under the related instructions or are inapplicable, and
therefore have been omitted.

(a3) and (c). The exhibits listed in the accompanying Index to Exhibits
are filed or incorporated by reference as part of this report and such Index is
hereby incorporated by reference.

(b) No reports on Form 8-K were filed during the last quarter of the
period covered by this report.

On March 4, 2002, the Corporation filed a Current Report on Form 8-K under
Item 4. Changes in Registrant's Certifying Accountant and subsequent Exhibit 16
on March 8, 2002.

On March 18, 2002, the Corporation filed a Current Report on Form 8-K/A
under Item 4. Changes in Registrant's Certifying Accountant. The report amended
the Corporations' Current Report on Form 8-K dated March 4, 2002, for the
purpose of clarifying the language of the filing and included Exhibit 16.

20

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.

ADVANCED ENVIRONMENTAL RECYCLING
TECHNOLOGIES, INC.

By: /s/ JOE G. BROOKS
-------------------------------------
Joe G. Brooks,
Chairman, Co-Chief Executive Officer
and President

By: /s/ EDWARD J. LYSEN
-------------------------------------
Edward J. Lysen,
Chief Financial and Accounting
Officer

Date: April 11, 2003

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.

21

CERTIFICATION

I, Joe G. Brooks, the chairman, co-chief executive officer, and president,
certify that:

1. I have reviewed this annual report on Form 10-K of Advanced
Environmental Recycling Technologies, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly represent in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize, and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

/s/ JOE G. BROOKS
---------------------------------------
Joe G. Brooks
Chairman, Co-Chief Executive
Officer, and President

Dated: April 11, 2003

22

CERTIFICATION

I, Stephen W. Brooks, the co-chief executive officer, certify that:

1. I have reviewed this annual report on Form 10-K of Advanced
Environmental Recycling Technologies, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly represent in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize, and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

/s/ STEPHEN W. BROOKS
---------------------------------------
Stephen W. Brooks
Co-Chief Executive Officer

Dated: April 11, 2003

23

CERTIFICATION

I, Edward J. Lysen, the chief financial officer, certify that:

1. I have reviewed this annual report on Form 10-K of Advanced
Environmental Recycling Technologies, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly represent in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize, and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

/s/ EDWARD J. LYSEN
---------------------------------------
Edward J. Lysen
Chief Financial Officer

Dated: April 11, 2003

24

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

INDEX TO FINANCIAL STATEMENTS

INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders of
Advanced Environmental Recycling Technologies, Inc.

We have audited the accompanying balance sheets of Advanced Environmental
Recycling Technologies, Inc. as of December 31, 2002 and 2001, and the related
statements of operations, stockholders' equity and cash flows for the years then
ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits. The financial statements of Advanced
Environmental Recycling Technologies, Inc. for the year ended December 31, 2000,
were audited by other auditors who have ceased operations and whose report dated
March 30, 2001, on those financial statements included an explanatory paragraph
that expressed substantial doubt about the Company's ability to continue as a
going concern.

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 2002 and 2001 financial statements referred to above
present fairly, in all material respects, the financial position of Advanced
Environmental Recycling Technologies, Inc. as of December 31, 2002 and 2001, and
the results of its operations and its cash flows for the years then ended in
conformity with accounting principles generally accepted in the United States of
America.

/s/ TULLIUS TAYLOR SARTAIN & SARTAIN LLP

Fayetteville, Arkansas
March 14, 2003, except for Note 12 as to
the subsequent event, which the
date is April 8, 2003

F-2

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

BALANCE SHEETS

The accompanying notes are an integral part of these financial statements.
F-3

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

STATEMENTS OF OPERATIONS

The accompanying notes are an integral part of these financial statements.
F-4

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY

The accompanying notes are an integral part of these financial statements.

F-5

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these financial statements.
F-6

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS

NOTE 1: DESCRIPTION OF THE COMPANY

Advanced Environmental Recycling Technologies, Inc. (the Company or AERT)
manufactures a line of composite building materials from reclaimed plastic and
wood fiber waste for certain specialized applications in the construction
industry. The Company markets this material as a substitute for wood and plastic
filler materials for standard door components, windowsills, brick mould, fascia
board, decking and heavy industrial flooring. The Company is comprised of two
manufacturing facilities located in Junction, Texas and Springdale, Arkansas.
The Company's customers primarily consist of a number of regional and national
door and window manufacturers, industrial-flooring companies and Weyerhaeuser,
the Company's primary decking customer.

NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

REVENUE RECOGNITION

The Company recognizes revenue in accordance with SEC Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements" (SAB 101). Under
SAB 101, revenue is recognized when the title and risk of loss have passed to
the customer, there is persuasive evidence of an arrangement, delivery has
occurred or services have been rendered, the sales price is determinable and
collectibility is reasonably assured. The Company typically recognizes revenue
at time of shipment. Sales are recorded net of discounts, rebates and returns.

STATEMENTS OF CASH FLOWS

In order to determine net cash used in operating activities, net income
(loss) has been adjusted by, among other things, changes in current assets and
current liabilities, excluding changes in cash, current maturities of long-term
debt and current notes payable. Those changes, shown as an (increase) decrease
in current assets and an increase (decrease) in current liabilities, are as
follows:

F-7

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING ACTIVITIES

BUILDINGS AND EQUIPMENT

Buildings and equipment contributed to the Company in exchange for Class B
common stock are carried at the contributor's historical book value. Property
additions and betterments include capitalized interest and acquisition,
construction and administrative costs allocable to construction projects and
property purchases.

Gains or losses on sales or other dispositions of property are credited or
charged to income in the period incurred. Repairs and maintenance costs are
charged to income in the period incurred, unless it is determined that the
useful life of the respective asset has been extended.

Provision for depreciation of buildings and equipment is provided on a
straight-line basis for buildings, leasehold improvements, machinery,
transportation equipment and office equipment over the lesser of the estimated
useful life of the asset or the term of the lease. Depreciation expense
recognized by the Company for the years ended December 31, 2002, 2001 and 2000
was approximately $3.0 million, $2.8 million and $2.3 million, respectively.
Estimated useful lives are: buildings -- 5 to 19 years, leasehold
improvements -- 6 years, transportation equipment -- 3 to 5 years, office
equipment -- 5 years and machinery and equipment -- 3 to 8 years. The Company
had $5.8 million of fully depreciated assets as of December 31, 2002.

The Company has adopted Statement of Financial Accounting Standards (SFAS)
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS
144 addresses the financial accounting and reporting for the impairment or
disposal of long-lived assets. SFAS supersedes FASB Statement No. 121 but
retains Statement 121's fundamental provisions for (a) recognition/measurement
of impairment of long-lived assets to be held and used and (b) measurement of
long-lived assets to be disposed of by sale. SFAS 144 requires an assessment of
the recoverability of the Company's investment in long-lived assets to be held
and used in operations whenever events or circumstances indicate that their
carrying amounts may not be recoverable. Such assessment requires that the
future cash flows associated with the long-lived assets be estimated over their
remaining useful lives and an impairment loss recognized when the future cash
flows are less than the carrying value of such assets.

The Company has assessed the recoverability of its investment in long-lived
assets to be held and used in operations under the guidelines set forth in SFAS
No. 144 and has determined that no impairment loss was required as of December
31, 2002. Such assessment required the Company to make certain estimates of
future production volumes, costs, sales volumes and prices, which are expected
to occur over the remaining useful lives of its long-lived assets. Such
long-lived assets primarily consist of the Company's Springdale and Junction
manufacturing facilities. The Company's estimates of these factors are based
upon management's belief that future production volumes will significantly
increase over previous

F-8

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

historical production levels achieved by the Company's manufacturing facilities
and that future production costs per unit will also decrease below previous
historical cost levels. Actual performance could materially differ from these
estimates.

INVENTORIES

Inventories are stated at the lower of cost (first-in, first-out method) or
market. Inventories consisted of the following at December 31:

OTHER ASSETS

At December 31, 2002 and 2001, respectively, other assets consisted
primarily of debt acquisition costs in the amount of $1,750,422 and $1,557,761,
net, which are amortized over the term of the related debt, and the costs for
the preparation of patent applications of $207,306 and $235,879, net, which are
amortized using the straight-line method over 17 years.

USE OF ESTIMATES

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States 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.

ACCOUNTS RECEIVABLE

Accounts receivable are uncollateralized customer obligations due under
normal trade terms generally requiring payment within 30 days from the invoice
date. Trade accounts are stated at the amount management expects to collect from
outstanding balances. Delinquency fees are not assessed. Payments of accounts
receivable are allocated to the specific invoices identified on the customers'
remittance advice.

Accounts receivable are carried at original invoice amount less an
estimated reserve made for returns and discounts based on quarterly review of
historical rates of returns and expected discounts to be taken. The carrying
amount of accounts receivable is reduced, if needed, by a valuation allowance
that reflects management's best estimate of the amounts that will not be
collected. Management individually reviews all accounts receivable balances that
exceed 60 days from invoice date and based on an assessment of current
creditworthiness, estimates the portion, if any, of the balance that will not be
collected. Management provides for probable uncollectible amounts through a
charge to earnings and a credit to a valuation based on its assessment of the
current status of the individual accounts. Balances that remain outstanding
after management has used reasonable collection efforts are written off through
a charge to the valuation allowance and a credit to trade accounts receivable.
Changes in the valuation allowance have not been material to the financial
statements. Recoveries of trade receivables previously written off are recorded
when received.

F-9

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

EARNINGS PER SHARE

The Company calculates and discloses earnings per share (EPS) in accordance
with SFAS No. 128, "Earnings Per Share" (SFAS 128). SFAS 128 requires dual
presentation of Basic and Diluted EPS on the face of the statements of
operations and requires a reconciliation of the numerator and denominator of the
Basic EPS computation to the numerator and denominator of the Diluted EPS
computation. Basic EPS excludes dilution and is computed by dividing income
available to common stockholders by the weighted-average number of common shares
outstanding for the period. Diluted EPS reflects the potential dilution that
could occur if securities or other contracts to issue common stock were
exercised or converted into common stock or resulted in the issuance of common
stock that then shared in the earnings of the Company.

In computing Diluted EPS, only potential common shares that are
dilutive -- those that reduce earnings per share or increase loss per
share -- are included. Exercise of options and warrants or conversion of
convertible securities is not assumed if the result would be antidilutive, such
as when a loss from continuing operations is reported. The "control number" for
determining whether including potential common shares in the Diluted EPS
computation would be antidilutive is income from continuing operations. As a
result, if there is a loss from continuing operations, Diluted EPS would be
computed in the same manner as Basic EPS is computed, even if an entity has net
income after adjusting for discontinued operations, an extraordinary item or the
cumulative effect of an accounting change. The Company incurred a loss from
continuing operations and a net loss for the year ended December 31, 2000.
Therefore, Basic EPS and Diluted EPS are computed in the same manner for that
year.

The Company has additional options and warrants that were not included in
the calculation of diluted earnings per share. Those options (1,402,500 for the
year ended December 31, 2002) and warrants (2,333,933 for the year ended
December 31, 2002) were either antidilutive and/or not exercisable at December
31, 2002. Although the above financial instruments were not included due to
being antidilutive and/or not exercisable, such financial instruments may become
dilutive and would then need to be included in future calculations of Diluted
EPS.

CONCENTRATIONS OF CREDIT RISK

The Company's revenues are derived principally from a number of regional
and national door and window manufacturers, industrial-flooring companies and
Weyerhaeuser, the Company's primary decking

F-10

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

customer. The Company extends unsecured credit to its customers. This industry
concentration has the potential to impact the Company's exposure to credit risk
because changes in economic or other conditions in the construction industry may
similarly affect the customers. The Company derived more than 10% of its revenue
from the following customers:

DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

The following methods and assumptions were used to estimate the fair value
of each class of financial instrument held by the Company:

Current assets and current liabilities -- The carrying value approximates
fair value due to the short maturity of those items.

Long-term debt -- The fair value of the Company's long-term debt has been
estimated by the Company based upon each obligation's characteristics, including
remaining maturities, interest rate, credit rating, collateral and amortization
schedule. The carrying amount approximates fair value.

STOCK-BASED COMPENSATION

The Company accounts for stock-based compensation under Statement of
Financial Accounting Standards No. 148 "Accounting for Stock-Based Compensation
- -Transition and Disclosure -- An amendment of FASB Statement No. 123", (SFAS
148). SFAS 148 provides alternative methods of transition for a voluntary change
to the fair value based method of accounting for stock-based employee
compensation. SFAS 148 further amends the disclosure requirements of SFAS 123 to
provide prominent disclosure in the annual and interim financial statements
about the method of accounting elected by the Company and the effect of the
method on reported results. As available under SFAS 148, the Company continues
to account for its stock option plans and other stock-based compensation using
the "intrinsic value" method of accounting set forth in Accounting Principles
Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees", and
related interpretations. Accordingly, compensation cost for stock options is
measured as the excess, if any, of the quoted market price of the Company's
common stock at the date of the grant over the amount an employee must pay to
acquire the stock. Had compensation cost for the Company's stock option plans
and other stock-based compensation been

F-11

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

determined consistent with SFAS No. 148, the Company's net income (loss) and net
income (loss) per share of common stock would have been reduced (increased) to
the following pro forma amounts:

The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option pricing model with the following weighted-average
assumptions used for grants in 2002, 2001 and 2000, respectively: risk-free
interest rates of 4.3, 4.9, and 5.8 percent; expected lives of 8, 7, and 9
years; and expected volatilities of 74, 103 and 95 percent. Since no dividends
are expected to be paid by the Company during the expected lives of the options,
a dividend yield of zero was used for purposes of computing the fair value of
the options. The weighted-average fair value of options granted during 2002,
2001 and 2000 was $1.19, $0.87 and $1.77, respectively.

RECLASSIFICATIONS

Certain reclassifications have been made to prior years' financial
statements to conform to the current year presentation. These reclassifications
had no effect on the Company's net income.

NOTE 3: RELATED PARTY TRANSACTIONS

The Company accounts for transfers of receivables, with recourse, to a
related party under the guidelines of SFAS No. 125, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities", (SFAS
125). This statement provides accounting and reporting standards for, among
other things, the transfer and servicing of financial assets, such as transfers
of receivables with recourse, and provides standards for distinguishing
transfers of financial assets that are sales from transfers that are secured
borrowings. Based on the requirements of SFAS No. 125, the receivables
transferred to the related party with recourse are accounted for as a secured
borrowing because the Company is not considered to have surrendered control over
the transferred assets. Accounts receivable and accounts payable-related parties
at December 31, 2002 and 2001, include $1,982,782 and $2,902,925, respectively,
to reflect these requirements.

During 2002, the Company had an agreement with an affiliate, Brooks
Investment Co., controlled by Marjorie S. Brooks, whereby the Company agreed to
transfer certain of its trade receivables as collateral, which Brooks Investment
Co. deemed acceptable, up to $2.5 million at any one time. Upon acceptance of a
transfer of a receivable, Brooks Investment Co. remitted to the Company 85% of
the receivable, as defined in the agreement. Upon collection of the receivable,
the Company remitted to Brooks Investment Co. 0.8% of the receivable as a
factoring charge and the additional 14.2% of the receivable was remitted to the
Company, less interest costs, which were based on the time period over which the
receivable was

F-12

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

outstanding. The Company indemnified Brooks Investment Co. for any loss arising
out of rejections or returns of any merchandise, or any claims asserted by the
Company's customers. During 2002, the Company transferred an aggregate of
approximately $42.8 million in receivables under this agreement, of which $2.3
million remained to be collected as of December 31, 2002. During 2001 and 2000,
the Company transferred an aggregate of approximately $34 million and $28.2
million, respectively, in receivables under this agreement, none of which
remains to be collected. Costs of approximately $343,752, $517,349 and $470,794
associated with the factoring agreement were included in selling and
administrative costs at December 31, 2002, 2001 and 2000, respectively.

At December 31, 2002, accounts payable-related parties included advances on
factored receivables of approximately $2.0 million and $300,000 relating to
other items owed to related parties.

NOTE 4: NOTES PAYABLE AND LONG-TERM DEBT

NOTES PAYABLE -- OTHER

The Company has had five bridge financing agreements. The first was
completed on October 30, 1997, and was paid off in 2001. The second bridge
financing was completed on February 5, 1998, at which time the Company issued
notes payable totaling $800,000 which were originally due and payable on
November 2, 1998, but have since been extended without penalty warrants to
December 31, 2003. Interest on the notes is payable every three months at 12% in
either cash or the Company's Class A common stock, at the option of the Company.
In connection with the notes, the Company issued 1,600,000 consulting warrants
and 96,000 placement warrants and paid loan origination costs of $104,000 to the
placement agent. If the notes are extended beyond December 31, 2003, the Company
may be required to issue 448,000 penalty warrants (400,000 consulting warrants
and 48,000 placement warrants). The warrants expire February 5, 2005, and are
exercisable at a price of $0.375 per share of Class A common stock for each
warrant exercised. In 2000, 2001 and 2002, $50,000, $150,000 and $50,000,
respectively, was paid on the notes bringing the note balance to $550,000 at
December 31, 2002. Of the $550,000 note balance,

F-13

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

$23,833 is owed to a related party and is classified in the "Notes
payable -- related parties" line item on the balance sheet.

A third bridge financing was completed on April 7, 1998. The Company issued
notes payable totaling $410,000 which were originally due and payable on January
2, 1999, but have since been extended without penalty warrants to December 31,
2003. Interest on the notes is payable every three months at 12% in either cash
or the Company's Class A common stock, at the option of the Company. In
connection with the notes, the Company issued 820,000 consulting warrants and
49,200 placement warrants and paid loan origination costs of $53,300 to the
placement agent. If the notes are extended beyond December 31, 2003, an
additional 205,000 consulting warrants and 24,600 placement warrants may be
issued. The warrants expire April 6, 2005, and are exercisable at a price of
$0.375 per share of Class A common stock for each warrant exercised.

A fourth bridge financing was completed on June 3, 1998. The Company issued
notes payable totaling $359,963 which were originally due and payable on
February 28, 1999, but have since been extended without penalty warrants to
December 31, 2003. Of the $359,963 note amount, $40,000 is owed to a related
party and is classified in the "Notes payable -- related parties" line item on
the balance sheet. Interest on the notes is payable every three months at 12% in
either cash or the Company's Class A common stock, at the option of the Company.
In connection with the notes, the Company issued 719,926 consulting warrants and
43,195 placement warrants and paid loan origination costs of $46,795 to the
placement agent. If the notes are extended beyond December 31, 2003, an
additional 179,981 consulting warrants and 21,597 placement warrants may be
issued. The warrants expire June 3, 2005, and are exercisable at a price of
$0.375 per share of Class A common stock for each warrant exercised.

A fifth bridge financing was completed on August 21, 1998. The Company
issued notes payable totaling $287,500 which were originally due and payable on
May 18, 1999, but have since been extended without penalty warrants to December
31, 2003. Interest on the notes is payable every three months at 12% in either
cash or the Company's Class A common stock, at the option of the Company. In
connection with the notes, the Company issued 575,000 consulting warrants and
34,500 placement warrants and paid loan origination costs of $37,375 to the
placement agent. If the notes are extended beyond December 31, 2003, an
additional 143,750 consulting warrants and 17,250 placement warrants may be
issued. The warrants expire August 21, 2005, and are exercisable at a price of
$0.375 per share of Class A common stock for each warrant exercised.

Under a placement agency agreement entered into concurrently with the
October 30, 1997 bridge financing agreement, for a two-year period the placement
agent has the right, but not the obligation, to offer and place on behalf of the
Company up to an additional $342,537 aggregate principal amount of notes to the
Company. This two-year period has been extended in conjunction with the
extension of the bridge financing. If the additional notes are issued, then the
Company will issue 685,074 consulting warrants and 41,104 placement warrants in
connection with the notes. If the notes are extended, an additional 171,268
consulting warrants and 20,552 placement warrants may be issued. Both the
additional notes and related consulting and placement warrants will have terms
and provisions similar to those of previous bridge financings.

F-14

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

NOTES PAYABLE -- RELATED PARTIES

LONG-TERM DEBT

- ---------------

(a) The note contains certain financial covenants including a minimum debt to
net worth ratio, as defined, of no more than 3 to 1 and a minimum current
ratio of 2 to 1. The Company was not in compliance as of December 31, 2002,
and the bank granted a waiver of the financial covenants discussed above.

The aggregate maturities of long-term debt, net of debt discount, as of
December 31, 2002, were as follows:

F-15

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

BONDS PAYABLE

In October 1999, the Company entered into an agreement with the City of
Springdale, Arkansas for the issuance of Series 1999 Industrial Development
Revenue Bonds (the Bonds). The Bonds are private activity bonds issued for a
limited number of purposes, including solid waste disposal projects. The Company
received the Bond allocation; however, given their current financial position
and current market conditions, the Bonds are not marketable. As a result, the
Bonds have been issued and retained in escrow until such time in which the
Company is able to remarket the Bonds on terms satisfactory to the Company. The
bonds are secured by cash deposits sufficient to retire the debt.

Proceeds of the Bonds have been invested until the Reset Date (April 16,
2003). Any gain realized as a result of any investments of monies shall be paid
to the IRS as arbitrage on tax-exempt financing. Should the escrow funds be
devalued by the Reset Date, the Company is liable for any deficiencies.

The Bonds carry a maturity date of October 1, 2029 and an original issue
date of October 14, 1999. Interest from the Reset Date to the maturity date will
be calculated at a variable rate equal to the lesser of (i) 9.75% per annum and
(ii) a variable rate of interest certified by a remarketing agent appointed by
the Company. If a remarketing agent fails to properly certify a new variable
rate, the rate shall be the same as the rate preceding the Reset Date until the
variable rate is so certified.

The Bonds are issuable only as fully registered bonds in the minimum
denominations of $100,000 and in any integral multiple of $5,000 in excess
thereof. At or prior to disbursement of the bond proceeds, the Company must
deliver to the Trustee such general items as project plans and specifications,
cost estimates, construction contracts and insurance coverage. Although the
Bonds will be called if the Company does not break escrow by the Reset Date, if
a negative arbitrage position does not exist, it is possible that the bondholder
will waive/roll the call for another year or sell to another investor. However,
the risk does exist that if another investor cannot be identified, the Company
will be required to buy back the Bonds at the Reset Date.

The Company's interest in the land purchased in Springdale, Arkansas in
March 2000, the improvements, the plans and specifications, and any fixtures or
appurtenances secure all advancements under this agreement now or hereafter
erected thereon. In addition, the Company granted the Issuer a present security
interest in the pledged accounts, the funds, any trust accounts referred to in
the agreement, all tangible personal property, furniture, and machinery and
equipment located on the site.

The Bonds are subject to mandatory redemption under various circumstances
including, but not limited to, casualty loss or condemnation and occurrence of a
determination of taxability as defined in the Indenture of Trust. Furthermore,
the Bonds shall be subject to mandatory tender for purchase by the Company in
whole on the Reset Date, at a purchase price equal to the principal amount of
Series 1999 Bonds so tendered plus accrued interest to the Reset Date.

The Bonds are subject to mandatory sinking fund redemption at a redemption
price equal to 100 percent of the principal amount thereof and accrued interest
to the redemption date. As of October 1 of each year, subsequent to the year the
bonds break escrow, there shall be deposited in the Bond

F-16

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

Principal Fund and Bond Interest Fund a sum which is sufficient to redeem the
following principal amounts and accrued interest to the redemption date:

The Company will incur certain costs related to remarketing the Bonds.
During 1999, the Company entered into an agreement with an investment company
whereby the Company has committed to pay the investment company 5% of Bond
proceeds plus 495,000 shares of common stock upon satisfactory completion of the
Bond remarketing.

NOTE 5: STOCKHOLDERS' EQUITY

PREFERRED STOCK

The Company issued 1,500 Series A preferred shares, 900 Series B preferred
shares and 500 Series C preferred shares at a price of $1,000 per share in 1998.
Such stock was purchased by the major stockholder, a 5% holder and accredited
institutional investors. The preferred stock bears an interest premium of 10%
per year and is payable in cash or common stock. The Company has reserved
6,079,989 shares of Class A common stock for conversion under the preferred
stock agreement. During 2002, 140 shares of the Series A preferred stock was
converted into 116,667 shares of Class A common stock. Also during 2002, the
Company converted $353,778 of accrued premiums to common stock. This transaction
is considered a non-cash financing activity for statement of cash flow purposes.

On the 7th anniversary date of the issuance of preferred stock, the
preferred stock will automatically be converted into shares of common stock with
the conversion price equal to the lower of the average of the closing bid prices
for the common stock for the 5 trading days immediately preceding the 7th
anniversary of the issuance or the fixed conversion price. The fixed conversion
price is $1.20. If the preferred stock is converted prior to the 7th anniversary
of its date of issuance, the conversion price is the lower of $1.20 or the
variable conversion price. The variable conversion price is the average of the
closing bid prices for the common stock during the 10 consecutive trading days
ending on the trading date immediately preceding the date of determination. The
Company, at its option and two years from the issuance date, can redeem the
stock prior to conversion at a premium of 150 percent. The stock was issued with
series of X and Y warrants, which can be exercised at $1.20 and $2.50 per share,
respectively, as described in the warrants section below.

The preferred stock agreements contain potential redemption events which
would cause the Company to have to redeem the preferred stock, all of which are
within the control of the Company. The agreements state that if a redemption
event occurs, the Company must pay each holder of preferred stock an amount
equal to ten percent of the aggregate stated value of the shares of preferred
stock then outstanding.

F-17

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

COMMON STOCK

The Class A common stock and the Class B common stock are substantially
similar in all respects except that the Class B common stock has five votes per
share while the Class A common stock has one vote per share. Each share of Class
B common stock is convertible at any time at the holder's option to one share of
Class A common stock and, except in certain instances, is automatically
converted into one share of Class A common stock upon any sale or transfer.

WARRANTS

The Company has reserved 16,590,122 shares of the Company's Class A common
stock for issuance under the following warrant agreements.

Class C Warrants

Each Class C Warrant is exercisable into one share of Class A common stock
at an exercise price of $1.075 per share. During 1998, the Company received net
proceeds of $330,000 from the exercise of 275,000 Class C Warrants. One Bonus
Warrant (described below) was granted to the holder for each warrant exercised.
On February 12, 1999, 50,000 Class C Warrants expired. The remaining 325,000
Class C Warrants were set to expire in June 2003, but the expiration date was
extended to June 2005.

Class F Warrants

In 1999, 350,864 Class F Warrants were exercised at a price of $0.61 per
share, resulting in proceeds of $214,027. The remaining 987,040 Class F Warrants
were set to expire in June 2004, but the expiration date was extended to June
2006. The Warrants are exercisable at a price of $0.61 per share of Class A
common stock for each Class F Warrant exercised.

Class G Warrants

In 1999, 481,810 Class G Warrants were exercised at prices ranging from
$0.91 to $0.92 per share, resulting in proceeds of $441,956. The remaining
2,987,040 Class G Warrants were set to expire in June 2004, but the expiration
date was extended to June 2006. The Warrants are exercisable at a price of $0.92
per share of Class A common stock for each Class G Warrant exercised.

Class H Warrants

In 1995, in connection with the note payable to Marjorie S. Brooks and the
accounts payable-related parties (see Notes 3 and 4), the Company's Board of
Directors authorized the issuance of up to 2,000,000 Class H Warrants on a
one-for-one basis for each dollar advanced under the agreement and having an
exercise price equal to the per share market value of the Company's Class A
common stock on the date of such advances. The warrants are exercisable at
prices from $0.39 to $0.49 per share of Class A common stock for each Class H
Warrant exercised. In 2000, 228,208 shares of Class H Warrants were exercised at
prices ranging from $0.39 to $0.49 per share, resulting in proceeds of $100,000.
The remaining 1,771,792 Class H Warrants were set to expire in February 2005,
but the expiration date was extended to February 2007. The Warrants are
exercisable at prices from $0.46 to $0.48 per share of Class A common stock for
each Class H Warrant exercised.

Class I Warrants

In June 1996, the Company completed an offering to qualified foreign
investors under Regulation S of the Securities Act of 1933 with the issuance of
1,666,893 shares of Class A common stock. Net offering proceeds consisted of
$1,146,000 in cash. As part of the offering, the Company issued 242,878 Class I
F-18

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

Warrants to the Stock Placement Distributor. The Class I Warrants were to expire
three years from the date of issue and were exercisable at prices ranging from
$0.9375 to $1.125 per share of Class A common stock for each Class I Warrant
exercised. In May 1997, an additional 150,466 Class I warrants were issued in
connection with the December 1996 Regulation S Offering, as described below, at
exercise prices ranging from $0.31 to $0.56 per share of Class A common stock
for each Class I Warrant exercised.

In December 1996, the Company received $185,000 in cash relating to an
offering to qualified foreign investors under Regulation S of the Securities Act
of 1933 with the issuance of 228,571 and 134,454 shares of Class A common stock
in 1996 and 1997, respectively. Also, in 1997, $228,999 was received and 977,367
shares of Class A common stock were issued.

In 1999, 29,367 Class I Warrants were exercised at a price of $0.9375 per
share, resulting in proceeds of $27,532, and 42,866 Class I Warrants expired.
Also in 1999, 321,111 Class I Warrants were extended to June 22, 2003, and have
since been extended to June 22, 2005. In 2001, 45,616 Class I Warrants were
exercised at prices ranging from $0.31 to $0.9375 per share, resulting in
proceeds of $22,048. In 2002, 95,107 Class I Warrants were exercised at prices
ranging from $0.31 to $1.125 per share, resulting in proceeds of $62,881.

Class J and K Warrants

In December 1996, in connection with a note payable of $100,000, the
Company authorized and issued two sets of Warrants, Class J for 200,000 and
Class K for 150,000. Each Class J and Class K Warrant is exercisable on a
one-for-one basis into common stock. Each Class J Warrant is exercisable at
$0.50 per share and each Class K Warrant is exercisable at $0.75 per share. In
2000, 100,000 shares of Class J Warrants were exercised at a price of $0.50 per
share, through the conversion of a note payable to the warrant holder of
$50,000. This transaction is considered a non-cash financing transaction for
statement of cash flow purposes. The remaining 100,000 Class J Warrants and
150,000 Class K Warrants were exercised in 2001.

X and Y Warrants Issued in Connection with Preferred Stock

The preferred stock carries a series of X and Y Warrants, which will
convert at $1.20 and $2.50 per share. In connection with the 2,900 preferred
shares, the Company issued 2,900 X Warrants and 2,900 Y Warrants. Each of the
Series X Warrants entitles the holder to the right to acquire 555 shares (for X
Warrants issued with Series A shares) and 833.33 shares (for X Warrants issued
with Series B and C shares) of the Company's common stock (1,999,162 shares).
Each of the Series Y Warrants entitles the holder to the right to acquire 205
shares (for Y Warrants issued with Series A shares) and 400 shares (for Y
Warrants issued with Series B and C shares) of the Company's common stock
(867,500 shares). Each of the warrants has cashless exercise features that are
based on various conversion amounts and terms. The expiration date of the
warrants was extended from November 2005 to November 2007. In 2002, 1,000 Series
X Warrants were exercised at $1.20, resulting in proceeds of $1,200.

X and Y Warrants to Placement Agent

The Series A preferred stock shares were placed through a placement agent.
The placement agent and certain officers of the placement agent were given
Series X Warrants to purchase, in the aggregate, 278.33 shares of the Company's
common stock for each $1,000 of purchase price (417,495 shares) and Series Y
Warrants to purchase, in the aggregate, 102.7 shares of the Company's common
stock for each $1,000 of Purchase Price (154,050 shares). The Series X Warrants
were originally exercisable for a period of six years from the first anniversary
of the date of issuance at a price per share equal to $1.20 and the Series Y
Warrants were originally exercisable for a period of five years from the second
anniversary of the date of issuance at a price per share equal to $2.50. The
exercise period for both the Series X and
F-19

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

Series Y Warrants was extended by two years. No placement agent was used for the
Series B and C shares.

Bonus Warrants

In connection with the exercise of the Class B and C Warrants during 1998
and 1999, the Company granted a new warrant on a one-for-one basis for each
Class B and C Warrant exercised. The Bonus Warrants, 1,054,670 and 257,994
issued in 1998 and 1999, respectively, were originally to expire February 12,
2001, but were extended to June 22, 2003, and later extended to June 22, 2005,
and are exercisable at a price of $3.00 per share of Class A common stock for
each Bonus Warrant exercised.

Consulting and Placement Warrants

In October 1997, the Company obtained bridge financing of $1.3 million (see
Note 4). In connection with the financing obtained, 2,756,000 stock warrants
were issued. The stock warrants were originally to expire on October 30, 2002,
but the expiration date was extended to October 30, 2004, and are exercisable at
a price of $0.375 per share of Class A common stock for each warrant exercised.
The debt and stock warrants were recorded at their estimated fair market value
at the date of the transaction. The value of the stock warrants was treated as a
debt discount and amortized over the initial life of the loan as interest
expense. In 1998 and 1999, 120,000 and 628,500, Consulting and Placement
Warrants were exercised at a price of $0.375 per share, resulting in proceeds of
$45,000 and $235,688, respectively. In 2000 and 2002, 39,000 and 384,200
Consulting and Placement warrants were exercised at a price of $0.375 resulting
in proceeds of $14,625 and $144,075, respectively.

In February 1998, the Company obtained bridge financing of $800,000 (see
Note 4). In connection with the financing obtained, 1,696,000 stock warrants
were issued. The stock warrants were originally to expire on February 5, 2003,
but the expiration date was extended to February 5, 2005, and are exercisable at
a price of $0.375 per share of Class A common stock for each warrant exercised.
The debt and stock warrants were recorded at their estimated fair market value
at the date of the transaction. The value of the stock warrants was treated as a
debt discount and amortized over the life of the loan as interest expense. In
2000 and 2001, 69,334 and 59,334 Consulting and Placement warrants were
exercised at a price of $0.375 resulting in proceeds of $26,000 and $22,250,
respectively. In 2000, 2001 and 2002, 21,240, 13,427 and 102,300 Consulting and
Placement warrants were exercised at a price of $0.375 per share resulting in
proceeds of $7,965, $5,035 and $38,363, respectively.

In April 1998, the Company obtained bridge financing of $410,000 (see Note
4). In connection with the financing obtained, 869,200 stock warrants were
issued. The stock warrants were originally to expire on April 7, 2003, but the
expiration date was extended to April 7, 2005, and are exercisable at a price of
$0.375 per share of Class A common stock for each warrant exercised. The debt
and stock warrants were recorded at their estimated fair market value at the
date of the transaction. The value of the stock warrants was treated as a debt
discount and amortized over the life of the loan as interest expense. In 2001
and 2002, 63,099 and 46,101 Consulting and Placement warrants were exercised at
a price of $0.375 per share resulting in proceeds of $23,662 and $17,288,
respectively.

In June 1998, the Company obtained bridge financing of $359,963 (see Note
4). In connection with the financing obtained, 763,121 stock warrants were
issued. The stock warrants were originally to expire on June 3, 2003, but the
expiration date was extended to June 3, 2005, and are exercisable at a price of
$0.375 per share of Class A common stock for each warrant exercised. The debt
and stock warrants were recorded at their estimated fair market value at the
date of the transaction. The value of the stock warrants was treated as a debt
discount and amortized over the life of the loan as interest expense. In 2001
and 2002, 80,000 and 53,795 Consulting and Placement warrants were exercised at
a price of $0.375 per share resulting in proceeds of $30,000 and $20,173,
respectively.
F-20

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

In August 1998, the Company obtained bridge financing of $287,500 (see Note
4). In connection with the financing obtained, 609,500 stock warrants were
issued. The stock warrants were originally to expire on August 21, 2003, but the
expiration date was extended to August 21, 2005, and are exercisable at a price
of $0.375 per share of Class A common stock for each warrant exercised. The debt
and stock warrants were recorded at their estimated fair market value at the
date of the transaction. The value of the stock warrants was treated as a debt
discount and amortized over the life of the loan as interest expense. In 2001
and 2002, 8,624 and 25,876 Placement warrants were exercised at a price of
$0.375 per share resulting in proceeds of $3,234 and $9,704, respectively.

Extension Warrants

In connection with the extension of the October 30, 1997 bridge financing,
310,000 extension warrants were issued. The stock warrants were originally to
expire on November 5, 2003, but the expiration date was extended to November 5,
2005, and are exercisable at a price of $0.375 per share of Class A common stock
for each warrant exercised.

Series Z Placement Warrants

In 1998, the Company issued 300,000 Placement Warrants in connection with
the issuance of the Series C Preferred Stock. These warrants are exercisable at
a price of $1.00 per share of Class A common stock for each warrant exercised,
and were originally to expire on November 12, 2003, but the expiration date was
extended to November 12, 2005.

At December 31, 2002, the Company had outstanding warrants as follows:

Effective June 30, 2001, the Company adopted Financial Accounting Standards
Board SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities", (SFAS 133) with no effects with the exception of warrants that are
indexed to and potentially settled in the Company's common stock. These warrants
have been accounted for under the provisions of Emerging Issues Task Force
abstract 00-19, "Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled

F-21

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

in, a Company's Own Stock" (EITF 00-19). The Company modified certain of its
warrant related registration rights agreements as of June 30, 2001, so that
those warrants would be classified as equity rather than debt in its balance
sheet under the provisions of EITF 00-19. As a result of these modifications,
there was no impact on earnings from the cumulative effect of a change in
accounting principle.

In accounting for its derivative contracts at June 30, 2001, the Company
recorded $8,419,345 in warrants outstanding in the equity section of its balance
sheet and decreased its additional paid-in capital by the same amount, leaving
its total stockholder's equity amount unaffected. The warrant valuation was
determined as of June 30, 2001 using the Black-Scholes option-pricing model,
with the following details and assumptions. The underlying stock price was
$0.87. Exercise prices of the warrants ranged from $0.31 to $3.00. The
volatility of the stock underlying the warrants ranged from 46.42% to 87.27%,
and the risk-free rates of return ranged from 3.63% to 4.82%.

NOTE 6: STOCK OPTION PLANS

The Company's Stock Option Plans (the 1997 Plan, 1994 Plan, Director Plan,
Chairman Plan and the 1989 Plan, collectively "the Plans") authorize the
issuance of 7,600,000 shares of the Company's Class A common stock to its
directors, employees and outside consultants. The option price of the stock
options awarded must be at least equal to the market value of the Class A common
stock on the date of grant. Stock options may not be granted to an individual to
the extent that in any calendar year in which options first become exercisable,
the shares subject to options first exercisable in such year have a fair market
value on the date of grant in excess of $100,000. No option may be outstanding
for more than ten years after its grant. The purpose of the Plans is to enable
the Company to encourage key employees, directors and outside consultants to
contribute to the success of the Company by granting such persons incentive
stock options (ISOs) and/or non-incentive stock options (nonqualified stock
options). The ISOs are available for employees only. In order to provide for
disinterested administration of the Plans for purposes of Rule 16b-3 under the
Securities Exchange Act of 1934, the Director Plan also provides that outside
directors will automatically receive annual awards of nonqualified stock
options.

The Company's stockholders approved the Non-Employee Director Stock Option
Plan (the Director Plan), in June 1994. The Director Plan provides for the
issuance of options to purchase up to an aggregate of 500,000 shares of the
Company's Class A common stock to eligible outside directors of the Company.
Each eligible outside director will be granted options to purchase 25,000 shares
of common stock annually commencing in 1995 and each year thereafter.

In June 1994, stockholders of the Company approved the adoption of the
Amended and Restated Stock Option Plan (the 1994 Plan), which superseded and
replaced the Company's 1990 Stock Option Plan. The new Plan provides for the
granting of options to purchase up to 1,000,000 shares of the Company's Class A
common stock by recipients of incentive stock options or nonqualified stock
options as granted by the Company's Board of Directors.

Also, in June 1994, stockholders of the Company approved the Chairman Stock
Option Plan. The Plan provided for a grant of 500,000 shares of the Company's
Class A common stock.

In July 1997, stockholders of the Company approved the adoption of the
Advanced Environmental Recycling Technologies, Inc. 1997 Securities Plan (the
1997 Plan). The 1997 Plan provides for certain awards to be given to senior and
executive management of the Company to encourage and reward superior
performance. The awards can be in the form of stock options, restricted stock
and other performance awards to be given. The aggregate number of shares which
may be offered pursuant to incentive stock options under the 1997 Plan
originally was not to exceed 3,000,000, but this amount was increased by
approval of the stockholders to 5,000,000 in July 1999. The aggregate number of
shares which may be

F-22

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

offered for purchase pursuant to non-qualified stock options shall not exceed
500,000 shares. The stock options may not be granted with an exercise price less
than the fair market value of a share on the date the option is granted, unless
granted to a 10% shareholder, then the exercise price must be at least 110% of
the fair market value per share on the date such option is granted. The
Incentive Stock Options may not be exercised after ten years from the date the
option is granted unless the option is given to a 10% shareholder, and then the
expiration date is five years from the date the option is granted. The options
must be exercised within three months after termination of employment.

During June 1989, stockholders of the Company approved the adoption of the
Advanced Environmental Recycling Technologies, Inc. 1989 Stock Option Plan (the
1989 Plan). The 1989 Plan was designed to increase the interest of the directors
and executives and other employees of the Company. The total number of shares of
the Company's Class A common stock which may be issued under options granted
pursuant to the Plan shall not exceed 600,000. The option price will be the fair
market value of the shares on the date on which the respective shares are
granted unless granted to a 10% stockholder, then the exercise price must be at
least 110% of the fair market value per share on the date such option is
granted. Each option's expiration date can not exceed ten years from the date
such option was granted, unless the option is granted to a 10% shareholder, and
then the expiration date is five years from the date the option is granted. The
1989 Plan terminated June 4, 1999 and no additional options can be granted after
such date.

A summary of the activity in the Company's Stock Option Plans during the
years ended December 31, 2002, 2001 and 2000, follows:

The following table summarizes information about stock options outstanding
under the Company's Stock Option Plans as of December 31, 2002:

F-23

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

The weighted-average fair value of options granted during 2002, 2001 and
2000 was $1.19, $0.87 and $1.77, respectively.

NOTE 7: LEASES

In 1997, the Company entered into a non-cancelable sublease for a
production facility that was renewed on August 31, 2002, and expires on August
31, 2007. Lease payments on the facility are $22,000 per month. The sublease
contains an option to purchase the facility for $1.8 million, exercisable at any
time during the sublease, and a renewal option to lease the property for an
additional five years at an increased rate. At December 31, 2002, the Company
was obligated under various operating leases covering certain equipment. Rent
expense under operating leases for the years ended December 31, 2002, 2001 and
2000 was $958,883, $671,762 and $695,478, respectively. Future minimum lease
payments required under operating leases as of December 31, 2002, are as
follows:

NOTE 8: INCOME TAXES

The Company records income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes". Under this method, deferred income taxes reflect
the net tax effects of temporary differences between the carrying amounts of
assets and liabilities for financial reporting purposes and the amounts used for
income tax purposes.

As of December 31, 2002, the Company had net operating loss carryforwards
of approximately $24 million for federal income tax purposes, which are
available to reduce future taxable income and will expire in 2004 through 2021,
if not utilized.

The tax effects of significant temporary differences representing deferred
tax assets and liabilities are as follows:

As the Company generated net operating losses from its inception through
2000 and there is no assurance of the Company's ability to generate adequate
future taxable income to enable the Company to realize these carryforwards prior
to expiration, a valuation allowance of approximately $7.5 million has

F-24

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

been established at December 31, 2002, to recognize its deferred tax assets only
to the extent of its deferred tax liabilities. The Company will continue to
evaluate the need for such valuation allowance in the future.

NOTE 9: COMMITMENTS AND CONTINGENCIES

We were sued in May 2000, in a federal action in the Western District of
Texas, for breach of contract seeking royalties allegedly owed but unpaid from a
1987 settlement of prior litigation against a predecessor entity and two of our
founders in the United States District Court for the Western District. The
plaintiffs were seeking approximately $1.2 million in past royalties, plus
attorneys' fees, any applicable pre-judgment and post-judgment interest, and a
declaration that the Company pay an ongoing royalty in the amount of $10 per ton
on future sales from the Company's Junction, Texas facility on production
utilizing cedar fiber and recycled plastic. In 2001, the plaintiffs amended the
complaint to include two of our founders as co-defendants. At trial, the
plaintiffs obtained a judgment for past royalties in the amount of approximately
$821,000, plus prejudgment and post-judgment interest and attorneys' fees. We
settled the lawsuit in December 2002 for $1,100,000. The court, in May 2002,
declined to enter a declaratory judgment requested by the plaintiff requiring
the Company to pay a royalty on a monthly basis in the future on the Company's
products, and the release executed in connection with the December 2002
settlement does not release any potential claims for royalties after January 1,
2002. As to the requested declaratory judgment, the court noted that the
plaintiffs had not properly sought a declaratory judgment from a procedural
standpoint and also took note that the changes to the initial process developed
over the years by the Company have brought the Company's manufacturing
operations farther away from the plaintiff's technology.

NOTE 10: SEGMENT INFORMATION

SFAS No. 131 "Disclosures About Segments of an Enterprise and Related
Information", (SFAS 131), establishes standards for the way that public business
enterprises report information about operating segments in annual financial
statements and requires that those enterprises report selected information about
operating segments in interim financial reports issued to shareholders. SFAS 131
requires that a public business enterprise report financial and descriptive
information about its reportable operating segments. Reportable operating
segments are defined as a component of an enterprise:

- That engages in business activities from which it may earn revenues and
expenses,

- Whose operating results are regularly reviewed by the enterprise's chief
operating decision maker,

- For which discrete financial information is available.

F-25

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

As of December 31, 2002, the Company does not have available discrete
financial information to disclose gross margin by product line. All operating
expenses are allocated primarily on capacity. Corporate overhead is not
allocated by product line, neither are selected assets. Net sales segregated by
product line and gross margin by plant location are as follows:

NOTE 11: 401(k) PLAN

During December 2000, the Company initiated the A.E.R.T. 401(k) Plan (the
Plan) for the benefit of all eligible employees. The Plan qualifies under
Section 401(k) of the Internal Revenue Code thereby allowing eligible employees
to make tax-deductible contributions to the Plan. The Plan provides that the
Company may elect to make employer-matching contributions equal to a percentage
of each participant's voluntary contribution. The Company may also elect to make
a profit sharing contribution to the Plan. Profit sharing contributions to the
Plan can range from 0% to 15% of participants' annual compensation. During 2002
and 2001, no matching or profit sharing contributions were made to the Plan.

NOTE 12: SUBSEQUENT EVENT

As reported on Friday, March 28, 2003, there was an accidental fire at the
Junction, Texas plant, which was caused when a power pole adjacent to the plant
exploded. As of April 8, 2003, engineers and insurance carries were still
evaluating the full extent of the damage, and the insurance company had not
released control of the site. It appears, however, that the extrusion lines, a
portion of the building they were housed in and its infrastructure, and the
plastic processing area are severely damaged. The Company is in the process of
determining the costs to rebuild less severely damaged portions of the plant and
one extrusion line, with the intent of having one line fully operational as soon
as possible. Simultaneously, the Company is expediting the installation of an
additional extrusion line in the Springdale, Arkansas plant. It should be
operational during the second quarter of 2003. When the Junction rebuilding and
Springdale installations are complete, the capacity lost in the fire will have
been replaced. The Company expects minimal disruptions of product distribution
to current customers.

F-26

ADVANCED ENVIRONMENTAL RECYCLING TECHNOLOGIES, INC.

NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)

The Junction plant is fully insured for fire damage, as well as for
business interruption during the time required to rebuild. There is no assurance
as to the timing of the completion of the rebuilding of the Junction plant, or
if all of the facility will be rebuilt.

F-27

INDEX TO EXHIBITS

- ---------------

* The Registrant has no exhibits corresponding to Exhibits 1, 2, 5, 6, 7, 8, 9,
11, through 23, or 26 through 29.

** Filed herewith.

(a) Contained in Exhibits to Registration Statement on Form S-1, No. 33-29595,
filed June 28, 1989.

(b) Contained in Exhibits to Amendment No. 1 to Registration Statement on Form
S-1, No. 33-29595, filed August 24, 1989.

(c) Contained in Exhibits to Amendment No. 2 to Registration Statement on Form
S-1, No. 33-29595, filed November 8, 1989.

(d) Filed with Form 10-K for December 31, 1989.

(e) Filed with Form 10-K for December 31, 1990.

(f) Contained in Exhibits to Post Effective Amendment No. 1 to Registration
Statement on Form S-1, No. 33-29593, filed December 24, 1991.

(g) Filed with Form 10-K for December 31, 1992.

(h) Filed with Form 10-K for December 31, 1992.

(i) Filed with Form 10-K for December 31, 1994.

(j) Filed with Form 10-K for December 31, 1996.

(k) Filed with Form 10-K for December 31, 1996.

(l) Filed with Form 10-K for December 31, 1996.

(m) Filed with Form 10-K for December 31, 1996.

(n) Filed with Form 10-K for December 31, 1997.

(o) Contained in Exhibits to Registration Statement on Form S-3, No. 333-42555
filed December 18, 1997.

(p) Filed with Form 10-K for December 31, 1998.

(q) Filed with Form 10-K for December 31, 2002