FAMILY RESTAURANTS, 10-K405/A, 1998-09-09

FAMILY RESTAURANTS
10-K405/A, 1998-09-09
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-K/A-1

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 28, 1997

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

COMMISSION FILE NUMBER: 33-14051

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FAMILY RESTAURANTS, INC.

INCORPORATED IN DELAWARE I.R.S. EMPLOYER IDENTIFICATION NO. 33-0197361

18831 VON KARMAN AVENUE, IRVINE, CA 92612

TELEPHONE: (714) 757-7900

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:

NONE.

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

NONE.

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Indicate by a 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 and (2) has been subject to the filing
requirements for at least 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. [X]

Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [X] No [_]

Index to exhibits appears on page 26.

The common stock of the registrant is not publicly traded. Therefore, the
aggregate market value of voting stock held by non-affiliates is not readily
determinable.

Number of shares of outstanding common stock as of March 27, 1998 is
988,285.

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<PAGE>

FAMILY RESTAURANTS, INC.

PART I

ITEM 1. BUSINESS

BACKGROUND

Family Restaurants, Inc. (together with its subsidiaries, the "Company") was
incorporated in Delaware in 1986 and is primarily engaged in the operation of
full-service restaurants through its subsidiaries. At December 28, 1997, the
Company operated 275 restaurants in 30 states, with approximately 65% of its
restaurants located in California, Ohio, Pennsylvania, Michigan, Illinois and
Indiana. Additionally, as of December 28, 1997, the Company was the franchisor
and licensor of two restaurants in the United States and 23 restaurants
outside the United States. See "--Franchised and Licensed Restaurants."

On January 27, 1994, Apollo FRI Partners, L.P. ("Apollo"), Green Equity
Investors, L.P. ("GEI") and Foodmaker, Inc. ("Foodmaker") acquired
approximately 98% of the then outstanding common stock, par value $.01 per
share (the "Common Stock"), of the Company. Concurrently, Chi-Chi's, Inc.
("Chi-Chi's") was merged with and into a subsidiary of the Company. On
November 20, 1995, Apollo entered into an Exchange Agreement with Foodmaker
and GEI, pursuant to which, among other things, (i) on December 20, 1995,
Foodmaker transferred all of the shares of the Common Stock and the Warrant
(as defined below) owned by it to Apollo and (ii) on November 20, 1995, GEI
transferred 19,609 shares of the Common Stock held by it to Apollo. See "--
Change in Control."

On May 23, 1996, the Company completed the sale of its family restaurant
division, which operated full-service family-style restaurants primarily under
the Coco's and Carrows names (the "Family Restaurant Division"), to FRD
Acquisition Co. ("FAC"), an indirect, wholly-owned subsidiary of Flagstar
Companies, Inc. (now known as Advantica Restaurant Group, Inc.) ("Flagstar"),
in exchange for $125 million cash, $150 million principal amount of 12 1/2%
Senior Notes due in 2004 (the "FRD Notes") and the assumption of $31.5 million
of long-term debt, primarily consisting of capitalized lease obligations.
Based on the subsequent completion of a closing balance sheet, the purchase
price was increased and such increase was satisfied by the issuance of
$6.9 million in additional FRD Notes. See "--Sale of Family Restaurant
Division."

On July 3, 1996, the Company repurchased $151.0 million aggregate principal
amount of its 9 3/4% Senior Notes due 2002 (the "Senior Notes") and $108.6
million aggregate principal amount of its 10 7/8% Senior Subordinated Discount
Notes due 2004 (the "Discount Notes" and together with the Senior Notes, the
"Notes") in exchange for (or from the proceeds from the sale of) $133.5
million aggregate principal amount of the FRD Notes. In separate transactions,
the Company repurchased (i) an additional $8.5 million aggregate principal
amount of its Discount Notes in the third quarter of 1996 and (ii) an
additional $30.0 million aggregate principal amount of its Senior Notes and an
additional $2.0 million aggregate principal amount of its Discount Notes in
the fourth quarter of 1996. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS--Liquidity and Capital
Resources--Liquidity."

On January 10, 1997, the Company entered into a five-year, $35 million
credit facility (the "Foothill Credit Facility") with Foothill Capital
Corporation ("Foothill") to provide for the ongoing working capital needs of
the Company. The Foothill Credit Facility, which replaced the Company's old
credit facility with Credit Lyonnais (the "Old Credit Facility"), provides for
up to $15 million in revolving cash borrowings and up to $35 million in
letters of credit (less the outstanding amount of revolving cash borrowings).
The Foothill Credit Facility is secured by substantially all of the real and
personal property of the Company and contains customary restrictive covenants,
including the maintenance of certain financial ratios. See "MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--
Liquidity and Capital Resources--Liquidity."

K-2
<PAGE>

approximately 75% of par. The Senior Discount Notes are due on January 24,
2002 and accrete at a rate of 15% per annum until July 31, 1999, and
thereafter, interest will be payable in cash semi-annually at the rate of 15%
per annum. The $61 million of Senior Discount Notes were issued to an existing
holder of the Company's Senior Notes in exchange for $15.6 million of Senior
Notes plus approximately $34 million of cash, and are part of an agreement
pursuant to which FRI-MRD had the ability to issue up to a maximum of $75
million of Senior Discount Notes. In January 1998, FRI-MRD issued the
remaining $14 million in face value of the Senior Discount Notes available
under such agreement to the same purchaser at a price of 83% of par. FRI-MRD
received approximately $11.6 million in cash as a result of this subsequent
sale. Proceeds from the sales of the Senior Discount Notes will be used to
fund the Company's capital expenditure programs and for general corporate
purposes. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS--Liquidity and Capital Resources--Liquidity."

Unless the context otherwise requires, reference to the "Company" refers to
The Restaurant Enterprises Group, Inc. and its consolidated subsidiaries (not
including Chi-Chi's) when used with respect to historical information relating
to periods prior to January 27, 1994 included herein, and refers to Family
Restaurants, Inc. and its consolidated subsidiaries when used with respect to
information relating to periods after January 27, 1994.

ONGOING RESTAURANT OPERATIONS

The Company operated 275 restaurants primarily under the Chi-Chi's, El
Torito and Casa Gallardo names as of December 28, 1997. The Chi-Chi's, El
Torito and Casa Gallardo restaurants serve moderately priced, high-quality
Mexican food and a wide selection of alcoholic beverages. The Company is the
largest operator of full-service Mexican restaurants in the United States,
based upon both number of restaurants and annual revenues. The average food
check per person (excluding alcoholic beverage sales) is approximately $7.62
for Chi-Chi's, $9.49 for El Torito and $8.11 for Casa Gallardo restaurants.
Chi-Chi's restaurants generally contain from 5,000 to 10,600 square feet of
floor space and accommodate approximately 200 to 400 guests in the restaurant
and lounge. El Torito restaurants generally contain from 8,000 to 10,000
square feet of floor space and accommodate approximately 300 to 400 guests in
the restaurant and lounge. The Company's restaurants are generally located in
freestanding buildings in densely populated suburban areas, and the Company
believes their festive atmosphere and moderate prices are especially appealing
to family clientele.

SITE SELECTION

The selection of sites for new restaurants is the responsibility of the
senior management of El Torito and Chi-Chi's. Typically, potential sites are
brought to the attention of the Company by real estate brokers and developers
familiar with its needs. Sites are evaluated on the basis of a variety of
factors, including demographic data, land use and environmental restrictions,
competition in the area, ease of access, visibility, availability of parking
and proximity to a major traffic generator such as a shopping mall, office
complex, stadium or university.

EMPLOYEES

At December 28, 1997, the Company had 17,520 employees, of whom 16,038 were
restaurant employees, 1,134 were field management and 348 were corporate
personnel. Employees are paid on an hourly basis, except restaurant managers,
corporate and field management and administrative personnel. Restaurant
employees include a mix of full-time and part-time, mostly hourly personnel,
enabling the Company to provide services necessary during hours of restaurant
operations. The Company has not experienced any significant work stoppages and
believes its labor relations are good.

COMPETITION AND MARKETS

The restaurant business is highly competitive and is affected by changes in
the public's eating habits and preferences, population trends and traffic
patterns, and local and national economic conditions affecting consumer
spending habits. Key competitive factors in the industry are the quality and
value of the food products offered, quality and speed of service, advertising,
name identification, attractiveness of facilities and restaurant location.

K-3
<PAGE>

The Company's restaurants compete with a wide variety of restaurants ranging
from national and regional restaurant chains to locally owned restaurants.

GOVERNMENT REGULATION

Each of the Company's restaurants is subject to Federal, state and local
laws and regulations governing health, sanitation, environmental matters,
safety, the sale of alcoholic beverages and regulations regarding hiring and
employment practices. The Company believes it has all licenses and approvals
material to the operation of its business, and that its operations are in
material compliance with applicable laws and regulations.

The Company is subject to Federal and state laws governing matters such as
minimum wages, overtime and other working conditions. Approximately half of
the Company's employees are paid at rates related to the minimum wage.
Therefore, increases in the minimum wage or decreases in the allowable tip
credit (tip credits reduce the minimum wage that must be paid to tipped
employees in certain states) increase the Company's labor costs. This is
especially true in California, where there is no tip credit. Effective October
1, 1996, the Federal minimum wage was increased from $4.25 to $4.75, and
effective September 1, 1997, it was further increased to $5.15. However, a
provision of the new measure effectively froze the minimum wage for tipped
employees at current levels by increasing the allowable tip credit in those
states which allow for a tip credit. Furthermore, California voters approved a
proposition on November 5, 1996 that increased the state's minimum wage to
$5.00 on March 1, 1997 and further increased the state's minimum wage to $5.25
on March 1, 1998. In response to the minimum wage increases on October 1,
1996, March 1, 1997 and March 1, 1998, the Company raised menu prices at its
El Torito restaurants in an effort to recover the higher payroll costs. Menu
prices were not increased at Chi-Chi's during the first nine months of 1997
due to marketing strategies and the fact that Chi-Chi's experienced a lesser
impact from the Federal minimum wage increases due to the increased allowable
tip credit in certain states. However, Chi-Chi's did raise menu prices in
October 1997 as a result of the cumulative impact of these minimum wage
increases. At the request of President Clinton, the Congress is considering
further increases in the Federal minimum wage over the next two years.

The Company is also subject to both Federal and state regulations governing
disabled persons' access to its restaurant facilities, including the Americans
with Disabilities Act ("ADA"), which became effective in January 1992. If the
ADA were interpreted to require a higher degree of accessibility for disabled
persons than presently established, it could have a significant economic
impact on the Company, inasmuch as such interpretation could require the
Company, and the restaurant industry as a whole, to make substantial
modifications to its restaurant facilities.

Currently, the Company franchises and licenses two restaurants in the United
States and 23 restaurants internationally. The Company began franchising its
El Torito concept both domestically and internationally in 1997. See "--
Franchised and Licensed Restaurants." The Company believes its franchises are
operating in substantial compliance with applicable laws and regulations
governing such operations.

TRADEMARKS AND SERVICE MARKS

The Company regards its trademarks and service marks as important to the
identification of its restaurants and believes that they have significant
value in the conduct of its business. The Company has registered various
trademarks and service marks with the United States Patent and Trademark
Office. In addition to its Federal registrations, certain trademarks and
service marks have been registered in various states and selected
international markets in which the Company operates restaurants. Also, many of
the Company's menus, training manuals and other printed manuals utilized in
conjunction with its business are copyrighted.

FRANCHISED AND LICENSED RESTAURANTS

In May 1994, El Torito Restaurants, Inc. ("El Torito") and Coco's
Restaurants, Inc. ("Coco's"), a former indirect subsidiary of the Company,
entered into a license agreement, which, among other things, granted to

K-4
<PAGE>

Coco's an exclusive right and license that permits Coco's to grant other
parties a sublicense to develop the Company's El Torito Mexican restaurant
concept in Japan. As a result, in April 1995, Coco's entered into a Technical
Assistance and License Agreement, which, among other things, granted to Coco's
Japan Co., Ltd. ("CJCL") the right to develop the Company's El Torito Mexican
restaurant concept in Japan. At December 28, 1997, CJCL operated six El Torito
restaurants in Japan.

On October 15, 1997, Chi-Chi's entered into a binding term sheet agreement
with its licensee, Chi-Chi's International Operations, Inc. ("CCIO"), whereby
the parties agreed to resolve various ongoing disputes. Under the general
provisions of the term sheet, (i) the rights to develop Chi-Chi's restaurants
throughout the world, except in areas of currently existing Chi-Chi's
franchises, have been transferred back to Chi-Chi's; (ii) for a period of five
years, CCIO shall operate the existing 16 international Chi-Chi's restaurants
for Chi-Chi's in exchange for a fee equal to all royalties and fees payable
from the international franchisees and licensees; (iii) CCIO has the right to
convert the existing 16 international Chi-Chi's restaurants to other concepts;
and (iv) under certain conditions, Chi-Chi's has the right to terminate the
management arrangement with CCIO within five years. As a result of the term
sheet, Chi-Chi's will not receive any royalties or license fees from CCIO or
the currently existing international Chi-Chi's restaurant operations until
Chi-Chi's terminates the management agreement with CCIO. In 1996, Chi-Chi's
received no royalties from CCIO due to a payment abatement, and during 1997,
Chi-Chi's received royalties of $16,000 from CCIO.

In 1996, the Company established El Torito Franchising Company ("ETFC") to
market domestically and internationally the El Torito Mexican restaurant
concept. At December 28, 1997, ETFC was authorized to sell franchises in 41
states. On January 16, 1997, ETFC entered into a Master Franchise and
Development Agreement with Evliyaoglu Ltd. ("EL"), pursuant to which EL was
granted the rights to develop 50 El Torito restaurants over 15 years in
Turkey. At December 28, 1997, EL operated one El Torito restaurant in Turkey.

As described above, under existing license and other franchise agreements,
six El Torito restaurants are operated in Japan, one El Torito restaurant is
operated in Turkey, two El Torito restaurants are operated in the United
States and 16 Chi-Chi's restaurants are operated in international markets.
Franchise and license fees were $219,000 for the year ended December 28, 1997.
This compares to $1,605,000 for the year ended December 29, 1996 and
$4,824,000 for the year ended December 31, 1995, of which 92% and 84%,
respectively, were from Coco's restaurants licensed by CJCL. The license
arrangement for Coco's restaurants was transferred to Flagstar upon completion
of the sale of the Family Restaurant Division.

CHANGE IN CONTROL

On November 20, 1995, Apollo entered into an Exchange Agreement with each of
Foodmaker and GEI (the "Exchange Agreements") pursuant to which, among other
things, (i) on December 20, 1995 Foodmaker transferred all of the shares of
Common Stock and a warrant to purchase, at an aggregate exercise price of
$26.7 million, 10% of the Common Stock outstanding assuming the full exercise
thereof (the "Warrant") held by it to Apollo, (ii) on November 20, 1995 GEI
transferred 19,609 shares of Common Stock held by it to Apollo and (iii) the
Shareholders' Agreement, dated as of January 27, 1994, by and among Apollo,
GEI and Foodmaker (the "Shareholders' Agreement") was terminated as between
themselves and the Company. In connection with the foregoing, Jackson W.
Goodall, Jr., Charles W. Duddles and Edward Gibbons, the three members of the
Company's Board of Directors (the "Board") nominated by Foodmaker pursuant to
the Shareholders' Agreement, and Leonard I. Green and Jonathan D. Sokoloff,
the two members of the Board nominated by GEI, resigned from the Board and
from all other positions, if any, held with the Company or its subsidiaries.
The foregoing transactions were consummated after the lenders under the Old
Credit Facility, in connection with their consent to an amendment thereto,
required certain of the Company's shareholders to purchase a participation in
certain loans under such agreement. See "MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--Liquidity and Capital
Resources." Apollo agreed to purchase such participation and, in consideration
therefor, Foodmaker and GEI agreed to the transactions set forth above.

K-5
<PAGE>

Prior to the consummation of the foregoing transactions, Apollo, GEI and
Foodmaker, the Company's three largest shareholders, held approximately 39%,
18% and 39%, respectively, of the Company's Common Stock, and pursuant to the
terms of the Shareholders' Agreement, controlled the Company. Upon
consummation of the foregoing transactions, Apollo, GEI and Foodmaker held
approximately 81%, 16% and 0% of the Common Stock, respectively. Consequently,
Apollo, through its ownership of the Common Stock, controls the Company.

SALE OF FAMILY RESTAURANT DIVISION

On May 23, 1996, the Company completed the sale of the Family Restaurant
Division to Flagstar in exchange for $125 million cash, $150 million principal
amount of the FRD Notes and the assumption of $31.5 million of long-term debt,
primarily consisting of capitalized lease obligations. Based on the subsequent
completion of a closing balance sheet, the purchase price was increased and
such increase was satisfied by the issuance of $6.9 million in additional FRD
Notes. The Company recorded a gain of $62.6 million on the sale of the Family
Restaurant Division, which gain included the effect of the increase in
purchase price of $6.9 million discussed above. Cash proceeds from the sale
were used to pay indebtedness outstanding under the Old Credit Facility of $82
million, help fund the repurchases of the Notes and for general corporate
purposes. As of March 27, 1998, the Company had sold or exchanged $153.65
million aggregate principal amount of the FRD Notes. The remaining balance of
$3.25 million is restricted until the fourth anniversary of the sale in
accordance with the sale agreement with Flagstar to secure potential future
indemnity claims. The remaining FRD Notes are carried at their fair value
which approximates their cost.

ITEM 2. PROPERTIES

Of the 275 restaurants operated by the Company as of December 28, 1997, the
Company owned the land and building for 34, owned the building and leased the
land for 53 and leased both land and building for the remaining 188
restaurants. The restaurants are primarily free-standing units ranging from
approximately 5,000-10,000 square feet. Most of the leases provide for the
payment of a base rental or approximately 5% to 6% of gross sales, whichever
is greater, plus real estate taxes, insurance and other expenses.

The leases (assuming exercise of all options) have terms expiring as
follows:

<TABLE>
<CAPTION>
LEASE NUMBER OF
EXPIRATION RESTAURANTS
---------- -----------
<S> <C>
1998-2002...................................................... 12
2003-2007...................................................... 19
2008-2012...................................................... 46
2013-2017...................................................... 56
2018 and later................................................. 108
---
Total........................................................ 241
===
</TABLE>

In addition, the Company owns a 43,120 square-foot building in Irvine,
California which houses support personnel for the Company. The Company leases
34,200 square feet of space in an office building in Irvine, California which
houses El Torito operations staff, the Company's headquarters personnel and
certain support functions of the Company. The Company also leases 26,270
square feet of space in a building in Louisville, Kentucky which houses the
Chi-Chi's operations and support functions and various other smaller offices
and warehouses.

Substantially all of the Company's assets have been pledged under the
Foothill Credit Facility. However, of the 87 owned restaurants at December 28,
1997 (building or land and building), six were subject to security interests
in favor of other third parties.

K-6
<PAGE>

The following table details the Company-operated restaurants by state of
operation as of December 28, 1997.

<TABLE>
<CAPTION>
TOTAL
NUMBER OF
STATE CHI-CHI'S EL TORITO RESTAURANTS
----- --------- --------- -----------
<S> <C> <C> <C>
California................................. -- 76 76
Ohio....................................... 28 -- 28
Pennsylvania............................... 25 -- 25
Michigan................................... 17 -- 17
Illinois................................... 15 1 16
Indiana.................................... 14 2 16
Maryland................................... 10 -- 10
Missouri................................... 2 8 10
Virginia................................... 10 -- 10
Wisconsin.................................. 10 -- 10
Minnesota.................................. 7 -- 7
New Jersey................................. 7 -- 7
Iowa....................................... 6 -- 6
Kentucky................................... 6 -- 6
New York................................... 5 -- 5
Florida.................................... 1 2 3
Kansas..................................... 3 -- 3
Massachusetts.............................. 3 -- 3
Oregon..................................... -- 3 3
West Virginia.............................. 3 -- 3
Arizona.................................... -- 2 2
Colorado................................... 1 -- 1
Connecticut................................ 1 -- 1
Delaware................................... 1 -- 1
Nebraska................................... 1 -- 1
Nevada..................................... -- 1 1
North Carolina............................. 1 -- 1
North Dakota............................... 1 -- 1
South Dakota............................... 1 -- 1
Washington................................. -- 1 1
--- --- ---
Total.................................... 179 96 275
=== === ===
</TABLE>

ITEM 3. LEGAL PROCEEDINGS

The Company is involved in various litigation matters incidental to its
business. The Company does not believe that any of the claims or actions filed
against it will have a material adverse effect upon the consolidated financial
position or results of operations of the Company.

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

On August 7, 1997, Apollo, the majority stockholder of the Company, acting
by written consent, consented to the contribution by the Company to FRI-MRD of
$215.4 million of debt payable by Chi-Chi's to the Company. On August 7, 1997,
Apollo, the majority stockholder of the Company, acting by written consent,
consented to the gratuitous forgiveness of $30.8 million of intercompany debt
owed by FRI-MRD to the Company. On October 20, 1997, Apollo, the majority
stockholder of the Company, acting by written consent, authorized and approved
the amendment and restatement of the Company's Value Creation Units Plan,
which Amended and Restated Value Creation Units Plan is attached to this Form
10-K as Exhibit 10(dd).

K-7
<PAGE>

PART II

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

There is no established public trading market for the Common Stock.
Accordingly, earnings per common share information has not been presented.

At March 27, 1998, there were 84 stockholders of record of Common Stock. No
other class of stock was outstanding as of that date. No dividends have been
paid by the Company to its common stockholders.

Each of the indentures, as amended, (collectively, the "Indentures")
governing the Company's outstanding Senior Notes and Discount Notes, the note
agreement governing the FRI-MRD Senior Discount Notes and the Foothill Credit
Facility imposes restrictions on the Company's ability to pay dividends.

K-8
<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
SUCCESSOR COMPANY(1) PREDECESSOR COMPANY(1)
------------------------------------------------- ----------------------------
AS OF AND FOR THE YEARS ENDED AS OF AND FOR FOR THE ONE
------------------------------- THE ELEVEN MONTH ENDED AS OF AND FOR
DEC. 28, DEC. 29, DEC. 31, MONTHS ENDED JAN. 26, THE YEAR
1997 1996 1995 DEC. 25, 1994 1994 DEC. 26, 1993
-------- --------- ---------- ------------- ----------- -------------
($ IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Sales................... $463,724 $ 724,229 $1,134,359 $1,048,674 $ 64,741 $ 884,910
Cost of Sales:
Product cost........... 123,803 200,379 322,194 293,413 19,184 259,512
Payroll and related
costs................. 162,807 273,536 419,185 377,569 24,780 331,747
Occupancy and other
operating expenses.... 129,428 181,730 275,164 243,147 13,712 197,797
Depreciation and
amortization........... 22,583 34,475 57,836 48,646 2,800 32,224
General and
administrative
expenses............... 30,186 41,742 56,245 49,059 4,071 44,164
Gain (loss) on
disposition of
properties............. (3,885) (8,600) (12,067) (5,685) 12 (4,916)
Gain on sale of
division............... 0 62,601 0 0 0 0
Provision for
divestitures and write-
down of
long-lived assets...... 2,640 0 44,500 144,780 (2) 0 10,400
Restructuring costs..... 0 6,546 4,392 0 0 0
Debt restructuring
costs.................. 0 0 0 0 0 4,239
Reorganization items.... 0 0 0 0 479,427 (1,091)
Interest expense, net... 19,476 36,725 65,277 51,419 4,097 50,276
Income tax provision.... 509 890 1,208 1,773 55 658
-------- --------- ---------- ---------- -------- ---------
Income (loss) before
extraordinary item..... (31,593) 2,207 (123,709) (166,817) 475,481 (52,114)
Extraordinary gain on
extinguishment of debt. 0 134,833 0 2,941 72,561 0
-------- --------- ---------- ---------- -------- ---------
Net income (loss)....... (31,593) 137,040 (123,709) (163,876) 548,042 (52,114)
Preferred dividends..... 0 0 0 0 1,698 20,232
-------- --------- ---------- ---------- -------- ---------
Net income (loss)
attributable to common
shares................. $(31,593) $ 137,040 $ (123,709) $ (163,876) $546,344 $ (72,346)
======== ========= ========== ========== ======== =========
BALANCE SHEET DATA:
Working capital
(deficiency)........... $(66,412) $ (85,524) $ 45,114 (3) $ (155,481) $ (95,209)
Current assets.......... 45,117 46,612 267,077 43,015 77,109
Total assets............ 289,768 307,606 551,270 734,598 366,577
Current liabilities..... 111,529 132,136 221,963 198,496 172,318
Liabilities subject to
settlement under
reorganization
proceedings............ 0 0 0 0 320,194 (4)
Non-current portion of
long-term debt,
including capitalized
lease obligations...... 199,955 165,325 455,203 (5) 536,495 78,658
Redeemable cumulative
exchangeable preferred
stock.................. 0 0 0 0 183,921
Common stockholders'
equity (deficit)....... (26,194) 5,399 (131,576) (7,259) (391,638)
SELECTED CONSOLIDATED
FINANCIAL RATIOS AND
OTHER DATA:
EBITDA(6)............... $ 17,500 $ 26,842 $ 61,571 $ 85,486 $ 2,994 $ 51,690
Net income (loss)....... (31,593) 137,040 (123,709) (163,876) 548,042 (52,114)
Net cash provided by
(used in) operating
activities............. (13,105) (21,857) 6,083 18,346 (18,252) 25,352
Capital expenditures.... 13,588 9,848 38,022 65,618 779 20,064
Net cash provided by
(used in) investing
activities............. (16,631) 165,024 (19,615) (64,167) (192,610) (10,717)
Net cash provided by
(used in) financing
activities............. 28,434 (117,717) 13,663 31,858 223,754 (19,839)
Restaurants open at end
of period.............. 275 281 670 702 524 528
Ratio of EBITDA to
interest expense....... 0.90x 0.73x 0.94x 1.66x 0.73x (7) 1.03x (7)
</TABLE>
- --------
(1) Reference to the "Predecessor Company" refers to The Restaurant
Enterprises Group, Inc. and its consolidated subsidiaries (excluding Chi-
Chi's) with respect to information relating to periods prior to January
27, 1994 included herein, and reference to the "Successor Company" refers
to Family Restaurants,

K-9
<PAGE>

Inc. and its consolidated subsidiaries, giving effect to the acquisition on
January 27, 1994, when Apollo, GEI and Foodmaker acquired approximately 98%
of the Common Stock and Chi-Chi's was merged with and into a subsidiary of
the Company.

(2) Chi-Chi's reported significant sales declines in the second half of 1994
which continued into 1995. These sales declines resulted in operating
performance for Chi-Chi's which was significantly lower than anticipated
when Chi-Chi's was acquired on January 27, 1994. These operating results
caused the Company to reevaluate its business strategy for Chi-Chi's.
Consistent with this strategic reevaluation, the Company revised its
forecasts for the future operations of Chi-Chi's which resulted in a
significant reduction in projected future cash flows and a lower valuation
of the business. The Company determined that its projected results for Chi-
Chi's would not support the future amortization of the remaining Chi-Chi's
goodwill balance of $144,780,000 at December 25, 1994. Accordingly, the
Company wrote off the remaining unamortized Chi-Chi's goodwill balance of
$144,780,000 in the fourth quarter of 1994.

(3) Includes the impact of working capital loan classification of $79,815,000
in current liabilities and the classification of $240,077,000 in property
held for sale as a current asset.

(4) Liabilities that were canceled and extinguished as part of the prepackaged
joint plan of reorganization of the Company and REG-M Corp. were separately
classified in the consolidated balance sheet at December 26, 1993 as
liabilities subject to settlement under reorganization proceedings and
include the following:

<TABLE>
<CAPTION>
1993
----------------
($ IN THOUSANDS)
<S> <C>
Old Senior Subordinated Notes............................. $191,928
Old Subordinated Notes.................................... 78,916
Accrued interest.......................................... 52,720
Debt issuance and other costs............................. (3,370)
--------
$320,194
========
</TABLE>

(5) Excludes amounts related to the Family Restaurant Division and the
traditional dinnerhouse restaurants which were held for sale.

(6) EBITDA is defined as earnings (loss) before gain (loss) on disposition of
properties, provision for divestitures and write-down of long-lived assets,
interest, taxes, depreciation and amortization. The Company has included
information concerning EBITDA herein because it understands that such
information is used by certain investors as one measure of an issuer's
historical ability to service debt. EBITDA should not be considered as an
alternative to, or more meaningful than, operating income (loss) as an
indicator of operating performance or to cash flows from operating
activities as a measure of liquidity. Furthermore, other companies may
compute EBITDA differently, and therefore, EBITDA amounts among companies
may not be comparable.

(7) Ratio of EBITDA to interest expense is based on the Company's historical
capital structure which is not representative of the Company's capital
structure subsequent to January 27, 1994.

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

Certain information and statements included in this Annual Report on Form 10-
K, including those in this Management's Discussion and Analysis of Financial
Condition and Results of Operations, including, without limitation, statements
containing the words "believes," "anticipates," "expects" and words of similar
import, constitute "forward-looking statements" within the meaning of the
Private Securities Litigation Reform Act of 1995 and involve known and unknown
risks and uncertainties that could result in actual results of the Company or
the restaurant industry differing materially from expected results expressed or
implied by such forward-looking statements. Although it is not possible to
itemize all of the factors and specific events that could affect the outlook of
a restaurant company operating in a competitive environment, factors that could
significantly impact expected results include (i) the development of successful
marketing strategies for Chi-Chi's and

K-10
<PAGE>

El Torito, (ii) the effect of national, regional and local economic
conditions, (iii) the availability of adequate working capital, (iv)
competitive products and pricing, (v) changes in legislation, (vi) demographic
changes, (vii) the ability to attract and retain qualified personnel, (viii)
changes in business strategy or development plans, (ix) business disruptions,
(x) changes in consumer preferences, tastes and eating habits and (xi)
increases in food and labor costs. The Company disclaims any obligation to
update any such factors or to publicly announce the result of any revisions to
any of the forward-looking statements contained herein to reflect future
events or developments.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity

The Company reported net cash used in operating activities for the years
ended December 28, 1997 and December 29, 1996. Liquidity requirements were
funded by proceeds from the sale of the Family Restaurant Division,
supplemented if necessary by working capital advances available under the
Foothill Credit Facility. In addition, FRI-MRD has raised approximately $45.6
million in cash from the issuance of the Senior Discount Notes to supplement
its liquidity needs. The Company's viability has been and will continue to be
dependent upon its ability to generate sufficient cash flow to meet its
obligations on a timely basis and to comply with the terms of its financing
agreements.

Statement of Cash Flows. For the year ended December 28, 1997, the Company
reported net cash used in operating activities of $13.1 million compared to
net cash used in operating activities of $21.9 million for the year ended
December 29, 1996. The improvement in net cash used in operating activities of
$8.8 million was due to a $21.6 million reduction in interest paid and no
restructuring costs in 1997 versus $6.5 million of such costs in 1996. These
improvements were partially offset by a reduction in cash received from
customers, franchisees and licensees net of cash paid to suppliers and
employees. For 1997, the Company reported net cash used in investing
activities of $16.6 million compared to net cash provided by investing
activities of $165.0 million in 1996. This difference was primarily due to a
$173.6 million reduction in proceeds from (i) the disposal of property and
equipment; (ii) the sale of the Family Restaurant Division, net; and (iii) the
sale of notes receivable, net. For 1997, the Company reported net cash
provided by financing activities of $28.4 million compared to net cash used in
financing activities of $117.7 million in 1996. During 1997, $33.9 million in
net proceeds from the issuance of notes was received, while in 1996,
repurchases of notes and repayment of working capital borrowings amounted to
$32.5 million and $79.8 million, respectively.

For the year ended December 29, 1996, the Company reported net cash used in
operating activities of $21.9 million compared to net cash provided by
operating activities of $6.1 million for the year ended December 31, 1995. A
reduction in cash received from customers, franchisees and licensees net of
cash paid to suppliers and employees and increased restructuring costs of $2.2
million more than offset an increase in interest received of $3.9 million and
a decrease in interest paid of $6.8 million. For 1996, the Company reported
net cash provided by investing activities of $165.0 million compared to net
cash used in investing activities of $19.6 million in 1995. This difference
was primarily due to proceeds from sale of the Family Restaurant Division, net
of $121.3 million and proceeds from sale of notes receivable, net of $32.1
million, both realized in 1996, combined with a $28.2 million reduction in
capital expenditures from 1995 to 1996. For 1996, the Company reported net
cash used in financing activities of $117.7 million compared to net cash
provided by financing activities of $13.7 million in 1995. During 1996,
repurchase of notes amounted to $32.5 million, while activity in the Company's
working capital line resulted in borrowings of $20.2 million in 1995 and
repayments of $79.8 million in 1996.

EBITDA. For the year ending December 28, 1997, the Company reported EBITDA
(defined as earnings (loss) before gain (loss) on disposition of properties,
provision for divestitures and write-down of long-lived assets, interest,
taxes, depreciation and amortization) of $17.5 million, compared to $8.0
million for the year ended December 29, 1996 for the comparable ongoing
operations of El Torito and Chi-Chi's. The $9.5 million improvement was due to
El Torito and Chi-Chi's cost reduction and reengineering strategies, which
have improved operating margins.

K-11
<PAGE>

The Company has included information concerning EBITDA herein because it
understands that such information is used by certain investors as one measure
of an issuer's historical ability to service debt. EBITDA should not be
considered as an alternative to, or more meaningful than, operating income
(loss) as an indicator of operating performance or to cash flows from
operating activities as a measure of liquidity. Furthermore, other companies
may compute EBITDA differently, and therefore, EBITDA amounts among companies
may not be comparable.

Working Capital Deficiency. The Company operates with a substantial working
capital deficiency because (i) restaurant operations are conducted primarily
on a cash (and cash equivalent) basis with a low level of accounts receivable,
(ii) rapid turnover allows a limited investment in inventories and (iii) cash
from sales is usually received before related accounts payable for food,
beverages and supplies become due. The Company had a working capital
deficiency of $66.4 million on December 28, 1997.

Credit Facility. On January 10, 1997, the Company entered into the Foothill
Credit Facility to provide for the ongoing working capital needs of the
Company. The Foothill Credit Facility, which replaced the Old Credit Facility,
provides for up to $15 million in revolving cash borrowings and up to $35
million in letters of credit (less the outstanding amount of revolving cash
borrowings). The Foothill Credit Facility is secured by substantially all of
the real and personal property of the Company and contains customary
restrictive covenants, including the maintenance of certain financial ratios.
The Company is in compliance with all financial ratios for the year ended
December 28, 1997. Letters of credit are issued under the Foothill Credit
Facility primarily to provide security for future amounts payable under the
Company's workers' compensation insurance program ($15.5 million of such
letters of credit were outstanding as of March 27, 1998). No revolving cash
borrowings were outstanding as of March 27, 1998.

Other. The Company sold the Family Restaurant Division on May 23, 1996 to
Flagstar for $125 million cash, $150 million principal amount of the FRD
Notes, and the assumption of $31.5 million of long-term debt, primarily
consisting of capitalized lease obligations. Upon completion of the closing
balance sheet, the purchase price was increased by $6.9 million and was
satisfied by the issuance of $6.9 million in additional FRD Notes.

On July 3, 1996, the Company repurchased $151.0 million aggregate principal
amount of the Senior Notes and $108.6 million aggregate principal amount of
the Discount Notes in exchange for (or from the proceeds from the sale of)
$133.5 million aggregate principal amount of the FRD Notes. In separate
transactions, the Company repurchased (i) an additional $8.5 million aggregate
principal amount of its Discount Notes in the third quarter of 1996 and (ii)
an additional $30.0 million aggregate principal amount of its Senior Notes and
an additional $2.0 million aggregate principal amount of its Discount Notes in
the fourth quarter of 1996.

As of March 27, 1998, the Company had sold or exchanged $153.65 million
aggregate principal amount of the FRD Notes. The remaining $3.25 million
balance is restricted until the fourth anniversary of the sale in accordance
with the sale agreement with Flagstar to secure potential future indemnity
claims.

On August 12, 1997, FRI-MRD issued the Senior Discount Notes in the face
amount of $61 million to an existing holder of the Company's Senior Notes in
exchange for $15.6 million of Senior Notes plus approximately $34 million of
cash. In January 1998, FRI-MRD issued the remaining $14 million in face value
of the Senior Discount Notes to the same purchaser for approximately $11.6
million in cash. Proceeds from the sales of the Senior Discount Notes will be
used to fund the Company's capital expenditure programs and for general
corporate purposes. The Company is currently considering additional sources of
cash, such as the sale of non-core assets.

The Company continues to be highly leveraged and has significant debt
service requirements. Although management believes that its current sources of
cash should be sufficient to meet its operating and debt service requirements
for the foreseeable future, there can be no assurance that the Company will be
able to repay or refinance the Notes, or that FRI-MRD will be able to repay or
refinance the Senior Discount Notes, at their respective maturities.

K-12
<PAGE>

Capital Resources

Net cash used in investing activities was $16.6 million for the year ended
December 28, 1997, including $13.6 million for capital expenditures, as
compared to net cash provided by investing activities of $165.0 million for
fiscal 1996 and net cash used in investing activities of $19.6 million for
fiscal 1995. The net cash provided by investing activities for 1996 was
primarily due to the completion of the sale of the Company's Family Restaurant
Division and certain notes receivable.

Capital expenditures of approximately $30 million are planned for fiscal
1998, including approximately $6 million devoted to normal improvements of the
Company's restaurants. The Company is continuing its remodeling of both El
Torito and Chi-Chi's restaurants and is committing approximately $13 million
to $14 million for this purpose in fiscal 1998. The Company also anticipates
opening up to seven new El Torito restaurants, including quick-service casual-
style restaurants, and the Company is also planning to upgrade El Torito's in-
store POS technology during fiscal 1998.

By December 28, 1997, the Company had completed the remodeling of nine El
Torito restaurants in the Los Angeles/Orange County market and 11 Chi-Chi's
restaurants, primarily in the Detroit market. In addition, Chi-Chi's had
completed the exterior painting of 78 restaurants. Certain of these newly
painted Chi-Chi's restaurants also had other exterior improvements, including
installation of new awnings. The Company has announced plans for an aggressive
remodel program for the Chi-Chi's chain over the next three years. This
program could cost up to $50 million.

Included in 1998 capital spending are continuing expenditures to replace the
Company's mainframe computer software applications with new software to be run
in a client/server environment. The new software includes work flow
capabilities allowing for improved processes and wider access to data. In
addition, acquisition of the new software will insure that the Company's
computer systems are year 2000 compliant. The Company spent $0.4 million
during fiscal 1997 and expects to spend an additional $1.6 million on the new
software and related hardware and installation costs in 1998. The project is
expected to be completed before year-end 1998. The Company is requesting year
2000 compliance reports from significant vendors and service providers. If the
computer systems of a significant vendor or service provider were not year
2000 compliant, it could have a material adverse effect on the Company.

RESULTS OF OPERATIONS

As used herein, "comparable restaurants" are restaurants operated by the
Company on the first day of the earlier fiscal year and that continued in
operation through the last day of the later year being compared.

FISCAL YEAR 1997 AS COMPARED TO FISCAL YEAR 1996

Total sales of $463,724,000 for 1997 decreased by $260,505,000 or 36.0% as
compared to 1996. The decrease was due to (i) the loss of sales from the
Family Restaurant Division which was sold by the Company on May 23, 1996, (ii)
sales decreases for restaurants sold or closed and (iii) sales declines in the
comparable El Toritos and Chi-Chi's. The breakdown of the sales decline for
1997 is detailed below:

<TABLE>
<CAPTION>
1997 SALES
DECREASES
----------------
($ IN THOUSANDS)
<S> <C>
Sales of the Family Restaurant Division..................... $(194,464)
Decrease in Sales from Restaurants Sold or Closed........... (42,995)
Decrease in Sales from Comparable Restaurants............... (23,046)
---------
$(260,505)
=========
</TABLE>

K-13
<PAGE>

Sales for comparable restaurants of $456,965,000 for 1997 decreased by
$23,046,000 or 4.8% compared to 1996. The decrease is comprised of a
$21,816,000 or 8.2% decline in Chi-Chi's and a $1,230,000 or 0.6% decline in
El Torito primarily reflecting a continuing competitive operating environment
for restaurants.

<TABLE>
<CAPTION>
1997 COMPARABLE
SALES DECREASE
-----------------
AMOUNT PERCENT
-------- -------
($ IN THOUSANDS)
<S> <C> <C>
Comparable Chi-Chi's...................................... $(21,816) (8.2)%
Comparable El Torito...................................... (1,230) (0.6)
--------
Total................................................... $(23,046) (4.8)%
======== ====
</TABLE>

El Torito comparable sales for fiscal 1997 were down slightly as compared to
the same period in 1996. El Torito has hired a new advertising agency, Grey
Advertising, to continue to refine and build upon its long-term marketing
strategy, positioning El Torito as a "Mexican Getaway." Both television and
radio commercials are being utilized to communicate this position. In
addition, the theme is incorporated into all in-store materials and menus.

Chi-Chi's continued with its new marketing direction through the end of 1997
portraying the concept as a value-oriented, fun Mexican restaurant where you
can "put a little salsa in your life." A new menu was introduced in December
that expanded the product offerings to appeal to a greater segment of the
population. Barbequed and grilled meats, related to Mexican cuisine, but not
considered traditional Mexican dishes, were added along with additional
Mexican entrees. To extend the marketing message with more emphasis on the
food and value components, Chi-Chi's will work with Evans, Hardy & Young,
formerly their media buyer, now their primary advertising agency. Chi- Chi's
comparable sales trend for 1997 improved 5.4 percentage points over that of
1996 with comparable sales down 8.2% for 1997 as compared with the 1996 versus
1995 negative trend of 13.6% for the same group of restaurants. Although the
Company believes that such improvement is a result of the new advertising
campaign that began at the end of the first quarter of 1997, there can be no
assurances that the advertising campaign will continue to result in improved
comparable sales versus prior periods.

Product cost of $123,803,000 for 1997 decreased by $76,576,000 or 38.2% in
1997 as compared to 1996 primarily due to the sale of the Family Restaurant
Division which accounts for $54,187,000 or 70.8% of the decrease, as well as
the impact of the 47 other restaurants sold or closed since the end of fiscal
1995. In addition, El Torito and Chi-Chi's cost reduction strategies further
contributed to product cost savings by revising product specifications,
reducing the number of ingredients used and controlling inventories. As a
percentage of sales, product cost declined to 26.7% in 1997 as compared to
27.7% in 1996.

Payroll and related costs of $162,807,000 for 1997 decreased by $110,729,000
or 40.5% as compared to 1996 primarily due to the sale of the Family
Restaurant Division which accounts for $72,997,000 or 65.9% of the decrease,
as well as the impact of the 47 other restaurants sold or closed since the end
of fiscal 1995. As a percent of sales, payroll and related costs decreased
from 37.8% in 1996 to 35.1% in 1997 due in part to savings realized from the
El Torito and Chi-Chi's cost reduction strategies which have focused on
improving labor scheduling and efficiencies. The improvement in payroll and
related costs was offset, in part, by the impact of the minimum wage increases
nationally on October 1, 1996 and September 1, 1997 and on March 1, 1997 in
California.

K-14
<PAGE>

current levels by increasing the allowable tip credit in those states which
allow for a tip credit. Furthermore, California voters approved a proposition
on November 5, 1996 that increased the state's minimum wage to $5.00 on March
1, 1997 and further increased the state's minimum wage to $5.25 on March 1,
1998. In response to the minimum wage increases on October 1, 1996, March 1,
1997 and March 1, 1998, the Company raised menu prices at its El Torito
restaurants in an effort to recover the higher payroll costs. Menu prices were
not increased at Chi-Chi's during the first nine months of 1997 due to
marketing strategies and the fact that Chi-Chi's experienced a lesser impact
from the Federal minimum wage increases due to the increased allowable tip
credit in certain states. However, Chi-Chi's did raise menu prices in October
1997 as a result of the cumulative impact of these minimum wage increases. At
the request of President Clinton, the Congress is considering further
increases in the Federal minimum wage over the next two years.

Occupancy and other operating expenses of $129,428,000 for 1997 decreased by
$52,302,000 or 28.8% as compared to 1996 primarily due to the sale of the
Family Restaurant Division which accounts for $37,568,000 or 71.8% of the
decrease, as well as the impact of the 47 other restaurants sold or closed
since the end of fiscal 1995. As a percentage of sales, occupancy and other
expenses increased from 25.1% in 1996 to 27.9% in 1997. These increases
primarily reflect (i) the impact of declining sales without an offsetting
reduction in fixed expenses, (ii) an increase in planned media spending in
both El Torito and Chi-Chi's in connection with the implementation of new
marketing campaigns in 1997 to reposition both concepts and (iii) the lower
occupancy and other operating expenses as a percentage of sales in the Family
Restaurant Division in the first five months of 1996.

Depreciation and amortization of $22,583,000 for 1997 decreased by
$11,892,000 or 34.5% as compared to 1996 primarily due to the sale of the
Family Restaurant Division which accounts for $11,162,000 or 93.9% of the
decrease.

General and administrative expenses of $30,186,000 for 1997 decreased by
$11,556,000 or 27.7% as compared to 1996 primarily due to the sale of the
Family Restaurant Division and the elimination of its direct and allocated
general and administrative expenses of $10,014,000. The Company eliminated 134
positions in its Louisville corporate office and 52 positions in its Irvine
corporate offices in connection with its reorganization after the sale of the
Family Restaurant Division. As a percentage of sales, general and
administrative expenses increased from 5.8% in 1996 to 6.5% in 1997 primarily
reflecting general and administrative expenses spread over fewer restaurants.
Management continues to closely evaluate the Company's general and
administrative cost structure for savings opportunities.

The Company reported a loss on disposition of properties of $3.9 million for
1997 compared to a loss of $8.6 million in 1996. These amounts reflect losses
associated with restaurant divestments and closures in such periods.

As a result of a continued review of operating results, the Company
identified 18 unprofitable Chi-Chi's restaurants which may either take too
long to recover profitability or may not recover at all, despite current
marketing and cost control programs. In connection with this analysis, the
Company analyzed the carrying value of the long-lived assets of these
restaurants and recorded a write-down of long-lived assets of $2.6 million
during the second quarter of 1997 to reduce the assets' carrying value to
their estimated fair market value. The Company is actively marketing these
restaurants for sale, and the restaurants continue in operation.

The Company reported no restructuring costs in 1997 versus $6.5 million in
1996. These costs were primarily related to amounts paid to consultants,
professional fees, severance and related costs, and other restructuring
related expenses that were not incurred in 1997.

Interest expense, net of $19,476,000 for 1997 decreased by $17,249,000 or
47.0% as compared to 1996 primarily resulting from (i) lower interest expense
due to the repurchases of $181.0 million aggregate principal amount of the
Company's Senior Notes and $119.1 million aggregate principal amount of its
Discount Notes in the third and fourth quarters of 1996 and the exchange of
$15.6 million of Senior Notes on August 12, 1997, (ii) the repayment of
outstanding revolving debt under the Old Credit Facility in May 1996 and (iii)
the

K-15
<PAGE>

elimination of the Family Restaurant Division's interest costs, primarily for
capitalized lease obligations. These decreases were partially offset by the
increase due to the issuance of the Senior Discount Notes on August 12, 1997
and the accretion of interest thereon.

The Company recorded a gain of $62,601,000 in 1996 as a result of the sale
of the Family Restaurant Division.

The Company recognized an extraordinary gain of $134,833,000 in 1996 as a
result of several repurchases of the Notes.

FISCAL YEAR 1996 AS COMPARED TO FISCAL YEAR 1995

Total sales of $724,229,000 for 1996 decreased by $410,130,000 or 36.2% as
compared to 1995. The decrease was due to (i) the loss of sales from the
Family Restaurant Division which was sold by the Company on May 23, 1996, (ii)
sales decreases for restaurants sold or closed, (iii) sales declines in the
comparable El Toritos and Chi-Chi's and (iv) the 53rd week in 1995. The
breakdown of the sales decline for 1996 is detailed below:
<TABLE>
<CAPTION>
1996 SALES
DECREASES
----------------
($ IN THOUSANDS)
<S> <C>
Sales of the Family Restaurant Division..................... $(308,021)
Decrease in Sales from Restaurants Sold or Closed........... (47,823)
Decrease in Sales from Comparable Restaurants............... (45,533)
Decrease in Sales for the 53rd Week in 1995................. (8,753)
---------
$(410,130)
=========
</TABLE>

Sales for comparable restaurants of $484,655,000 for 1996 decreased by
$45,533,000 or 8.6% compared to a 52-week 1995. The decrease is comprised of a
$38,038,000 or 12.4% decline in Chi-Chi's and a $7,495,000 or 3.4% decline in
El Torito primarily reflecting a continuing competitive operating environment
for restaurants. Also contributing to the comparable sales decline was severe
winter weather in several markets in early 1996 and an overall weakness in
summer sales during the 1996 Summer Olympics which affected three weekends and
two full weeks during July and August.

Product cost of $200,379,000 for 1996 decreased by $121,815,000 or 37.8% in
1996 as compared to 1995 primarily due to the sale of the Family Restaurant
Division which accounts for $89,347,000 or 73.3% of the decrease. Chi-Chi's
cost re-engineering project further contributed to product cost savings by
simplifying menus, reducing the number of ingredients used and controlling
inventories. As a percentage of sales, product cost declined to 27.7% in 1996
as compared to 28.4% in 1995.

Payroll and related costs of $273,536,000 for 1996 decreased by $145,649,000
or 34.7% as compared to 1995 primarily due to the sale of the Family
Restaurant Division which accounts for $108,406,000 or 74.4% of the decrease.
As a percent of sales, payroll and related costs increased from 37.0% in 1995
to 37.8% in 1996 due in part to labor inefficiencies resulting from the
declining sales without an offsetting reduction in fixed labor expense,
combined with the negative impact of the minimum wage increase on October 1,
1996.

Occupancy and other expenses of $181,730,000 for 1996 decreased by
$93,434,000 or 34.0% as compared to 1995 primarily due to the sale of the
Family Restaurant Division which accounts for $58,314,000 or 62.4% of the
decrease. As a percentage of sales, occupancy and other expenses increased
from 24.3% in 1995 to 25.1% in 1996 due primarily to declining sales without
an offsetting reduction in fixed expenses and the lower costs as a percentage
of sales in the Family Restaurant Division in 1995.

Depreciation and amortization of $34,475,000 for 1996 decreased by
$23,361,000 or 40.4% as compared to 1995 primarily due to the sale of the
Family Restaurant Division which accounts for $16,744,000 or 71.7% of the
decrease. The decrease also reflects the third quarter 1995 adjustment to the
depreciable asset base of Chi-Chi's restaurants either held for sale or having
impaired values.

K-16
<PAGE>

General and administrative expenses of $41,742,000 for 1996 decreased by
$14,503,000 or 25.8% as compared to 1995 primarily due to the sale of the
Family Restaurant Division and the elimination of its related general and
administrative expenses of $10,187,000. As a percentage of sales, general and
administrative expenses increased from 5.0% in 1995 to 5.8% in 1996 primarily
reflecting general and administrative expenses spread over fewer restaurants
due to the sale of the Family Restaurant Division.

Loss on disposition of properties of $8.6 million for 1996 compared to a
loss of $12.1 million in 1995. These amounts reflect losses associated with
restaurant divestments and closures and the 1995 write-off of costs associated
with canceled capital projects, both remodels and new restaurant expansion.

During the third quarter of 1995, the Company closed seven Chi-Chi's
restaurants and identified additional restaurants to be sold or having
impaired asset value. Approximately 32 marginally profitable or unprofitable
restaurants were offered for sale. In conjunction with this divestment
program, the Company analyzed the carrying value of the Chi-Chi's long-lived
assets to determine if any impairment had occurred. In connection with this
analysis, the Company recorded a charge for divestitures and writedowns of
long-lived assets of $41.9 million.

The Company reported restructuring costs of $6.5 million in 1996 versus $4.4
million in 1995. These costs are primarily related to amounts paid to
consultants, professional fees, severance and related costs, and other
restructuring related expenses.

Interest expense, net of $36,725,000 for 1996 decreased by $28,552,000 or
43.7% as compared to 1995 primarily resulting from (i) lower accretion of
interest expense due to the repurchases of the Notes, as previously discussed,
(ii) paying off outstanding revolving debt under the Old Credit Facility in
May 1996, (iii) the elimination of the Family Restaurant Division's interest
costs, primarily for capitalized lease obligations and (iv) interest income
related to the FRD Notes.

ACCOUNTING PRONOUNCEMENTS

In February 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per
Share." This Statement specifies the computation, presentation, and disclosure
requirements for earnings per share for entities with publicly held common
stock. Therefore, this Statement is not applicable to the Company.

In February 1997, the FASB issued SFAS No. 129, "Disclosure of Information
about Capital Structure." This Statement is effective for fiscal years ending
after December 15, 1997. This statement, requiring only additional information
disclosures, is effective for the Company's fiscal year ended December 28,
1997. The Company has complied with all requirements of this Statement.

In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income." This Statement established standards for reporting and display of
comprehensive income and its components (revenues, expenses, gains and losses)
in a full set of general-purpose financial statements. This Statement shall be
effective for fiscal years beginning after December 15, 1997. Reclassification
of financial statements for earlier periods provided for comparative purposes
is required. This statement, requiring only additional informational
disclosures, is effective for the Company's fiscal year ending December 27,
1998.

In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information." This Statement established standards
for the way that public business enterprises report information about
operating segments in annual financial statements and requires that
enterprises report selected information about operating segments in interim
financial reports issued to stockholders. This Statement shall be effective
for fiscal years beginning after December 15, 1997. In the initial year of
application, comparative information for earlier years is to be restated. This
statement, requiring only additional information disclosures, is effective for
the Company's fiscal year ending December 27, 1998.

K-17
<PAGE>

SELECTED OPERATING DATA

The Company primarily operates full-service Mexican restaurants in two
divisions under the El Torito, Chi-Chi's, Casa Gallardo and other names. At
December 28, 1997 the Company's El Torito restaurant division operated 96
full-service restaurants and the Company's Chi-Chi's restaurant division
operated 179 full-service restaurants.

The following table sets forth certain information regarding the Company,
its El Torito and Chi-Chi's restaurant divisions, and the various operations
divested in 1996.

<TABLE>
<CAPTION>
FOR THE YEAR ENDED
---------------------------
DEC. 28, 1997 DEC. 29, 1996
------------- -------------
($ IN THOUSANDS, EXCEPT
AVERAGE CHECK AMOUNTS)
<S> <C> <C>
El Torito Restaurant
Division
- --------------------
Restaurants Open at End of
Period:
Owned/operated.......... 96 97
Franchised and Licensed. 9 7
Sales..................... $217,949 $219,466
Restaurant Level Cashflow. 30,051 26,355
Divisional EBITDA(a)...... 17,627 11,956
Percentage decrease in
comparable restaurant
sales.................... (0.6)% (3.0)%
Average check............. $ 9.87 $ 9.47

Chi-Chi's Restaurant
Division
- --------------------
Restaurants Open at End of
Period:
Owned/operated.......... 179 184
Franchised and Licensed. 16 18
Sales..................... $245,775 $278,065
Restaurant Level Cashflow. 16,515 9,674
Divisional EBITDA(a)...... 36 (4,278)
Percentage decrease in
comparable restaurant
sales.................... (8.2)% (11.5)%
Average check............. $ 7.62 $ 7.54

Ongoing Operations
- ------------------
Restaurants Open at End of
Period:
Owned/operated.......... 275 281
Franchised and Licensed. 25 25
Sales..................... $463,724 $497,531
Divisional EBITDA(a)...... 17,663 7,678

Divested Operations(b)
- ----------------------
Restaurants Open at End of
Period:
Owned/operated.......... 0 0
Franchised and Licensed. 0 0
Sales..................... $ 0 $226,698
Divisional EBITDA(a)...... 0 18,877

Total Company
- -------------
Restaurants Open at End of
Period:
Owned/operated.......... 275 281
Franchised and Licensed. 25 25
Sales..................... $463,724 $724,229
EBITDA(c)................. 17,500 26,842
</TABLE>
- --------
(a) Divisional EBITDA with respect to any operating division is defined as
earnings (loss) before gain (loss) on disposition of properties, interest,
taxes, depreciation and amortization.

K-18
<PAGE>

(b) Divested Operations in 1996 includes the results of the Family Restaurant
Division until it was divested on May 23, 1996 and the traditional
dinnerhouse restaurants that were divested by year-end 1996.

(c) EBITDA is defined as earnings (loss) before gain (loss) on disposition of
properties, provision for divestitures and write-down of long-lived
assets, restructuring costs, interest, taxes, depreciation and
amortization. The Company has included information concerning EBITDA
herein because it understands that such information is used by certain
investors as one measure of an issuer's historical ability to service
debt. EBITDA should not be considered as an alternative to, or more
meaningful than, operating income (loss) as an indicator of operating
performance or to cash flows from operating activities as a measure of
liquidity. Furthermore, other companies may compute EBITDA differently,
and therefore, EBITDA amounts among companies may not be comparable.

INFLATION

The inflationary factors which have historically affected the Company's
results of operations include increases in the cost of food, alcoholic
beverages, labor and other operating expenses. In addition, most of the
Company's real estate leases require the Company to pay taxes, maintenance,
insurance, repairs and utility costs, all of which are subject to the effects
of inflation. To date, the Company has offset the effects of inflation, at
least in part, through periodic menu price increases and various cost-cutting
programs, but no assurance can be given that the Company will continue to be
able to offset such increases in the future.

During 1997 and 1996, the effects of inflation did not have a significant
impact on the Company's results of operations.

SEASONALITY

The Company, as a whole, does not experience significant seasonal
fluctuations in sales. However, the Company's sales tend to be slightly
greater during the spring and summer months.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See the Index to Financial Statements on page K-31.

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

None.

K-19
<PAGE>

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The following table sets forth certain information with respect to the
current Directors and executive officers of the Company:

<TABLE>
<CAPTION>
NAME AGE POSITION WITH COMPANY
---- --- ---------------------
<C> <C> <S>
Peter P. Copses......... 39 Director
David B. Kaplan......... 30 Director
Antony P. Ressler....... 37 Director
Kevin S. Relyea......... 43 President, Chief Executive Officer and a Director
Executive Vice President, President of El Torito
William D. Burt......... 45 Restaurants, Inc.
Executive Vice President, President of Chi-Chi's,
Roger K. Chamness....... 45 Inc.
Executive Vice President and Chief Financial
Robert T. Trebing, Jr. . 48 Officer
Michael E. Malanga...... 44 Executive Vice President, Corporate Development
Gayle A. DeBrosse....... 40 Senior Vice President, Quality Assurance and
Product Safety, Purchasing and Distribution,
Public Affairs
Todd E. Doyle........... 36 Vice President, General Counsel and Secretary
Janie M. Bereczky....... 42 Vice President, Taxes
</TABLE>

Mr. Copses has served as a Director of the Company since January 1994. Since
1990, Mr. Copses has been a principal of Apollo Advisors, L.P. ("Apollo
Advisors") which, together with an affiliate, serves as managing general
partner of Apollo Investment Fund, L.P. ("AIF"), AIF II, L.P. ("AIF II") and
Apollo Investment Fund III, L.P., private securities investment funds, and of
Lion Advisors, L.P. ("Lion Advisors"), which acts as financial advisor to and
representative for certain institutional investors with respect to securities
investments. AIF II is the general partner of Apollo. Mr. Copses is also a
director of Dominick's Supermarkets, Inc., Paragon Health Network, Inc. and
Zale Corporation.

Mr. Kaplan has served as a Director of the Company since December 1996.
Since 1991, Mr. Kaplan has been associated with and is a limited partner of
Apollo Advisors. Prior to 1991, Mr. Kaplan was a member of the Investment
Banking Department of Donaldson, Lufkin & Jenrette Securities Corporation. Mr.
Kaplan is also a director of Allied Waste Industries, Inc., Dominick's
Supermarkets, Inc., PRI Holdings, Inc. and WMC Finance Co., Inc.

Mr. Ressler has served as a Director of the Company since January 1994. In
1990, Mr. Ressler was one of the founding principals of Apollo Advisors. Mr.
Ressler is also a director of Allied Waste Industries, Inc., Dominick's
Supermarkets, Inc., United International Holdings, Inc., PRI Holdings, Inc.
and Vail Resorts, Inc.

Mr. Relyea has served as Chief Executive Officer and a Director of the
Company since December 1995. He has also served as President since August
1995. Mr. Relyea joined the Company in January 1994 as Executive Vice
President and President of the Family Restaurant Division. From 1988 to
January 1994, Mr. Relyea had been Regional Vice President of Jack In The Box
Operations for Foodmaker. Mr. Relyea received an M.B.A. from Pepperdine
University in 1988.

Mr. Burt serves as Executive Vice President and President of El Torito. He
joined the Company on April 8, 1996 in these positions. Prior to joining the
Company, Mr. Burt was the Vice President of Operations at the Krystal Company
from 1995 to 1996, and an Executive Vice President at Taco Cabana from 1994 to
1995. Prior to 1994, Mr. Burt spent 23 years with Foodmaker. Mr. Burt received
his M.B.A. from Pepperdine University in 1988.

Mr. Chamness serves as Executive Vice President and President of Chi-Chi's
and has so served since December 1995 and March 1996, respectively. He joined
the Company at its inception. His previous position was Executive Vice
President of Finance and Administration for the Family Restaurant Division
which he held

K-20
<PAGE>

from October 1995 until June 1996. Mr. Chamness received a B.A. in Business
Economics from UCLA in 1975 and an M.B.A. in Finance and International
Business from UCLA in 1980.

Mr. Trebing serves as Executive Vice President and Chief Financial Officer
and has so served since July 1995. He joined the Company at its inception and
has held the positions of Senior Vice President and Chief Financial Officer,
Senior Vice President of Finance, Vice President of Finance, Vice President
and Controller and Manager of Financial Reporting. Mr. Trebing is a Certified
Public Accountant. Mr. Trebing received a B.A. from California State
University at Fullerton in 1972 and an M.B.A. from the University of Southern
California in 1973.

Mr. Malanga serves as Executive Vice President, Corporate Development. He
joined the Company at its inception as Director of Mergers and Acquisitions.
He was promoted to his current position in October 1995. Mr. Malanga received
a B.S. in Business Administration from the University of Southern California
in 1976.

Ms. DeBrosse serves as a Senior Vice President, Quality Assurance and
Product Safety, Purchasing and Distribution, Public Affairs and has so served
since June 1996. She joined the Company in December 1994 as a Vice President.
Prior to joining the Company, she was Director of Product Development and
Continuous Improvement at Taco Bell from 1991 until 1994 and Director,
Research and Development for Flagstar from 1982 to 1991. Ms. DeBrosse received
a B.S. in Nutritional Sciences from Arizona State University in 1979 and an
M.S. in Agribusiness with Emphasis in Food Science, Quality Assurance and Food
Chemistry from Arizona State University in 1982.

Mr. Doyle serves as Vice President, General Counsel and Secretary and has so
served since October 1995. He joined the Company as Senior Legal Counsel in
1992. Prior to joining the Company, Mr. Doyle spent six years as a business
transactional attorney and a business litigation attorney with Seltzer Caplan
Wilkins & McMahon in San Diego, California. Mr. Doyle received a B.A. in
Political Science and a B.A. in Sociology from the University of California,
Santa Barbara in 1983, and he received a J.D. from Loyola Law School, Los
Angeles, California in 1986.

Ms. Bereczky serves as Vice President, Taxes and has so served since August
1992. She joined the Company in 1987 as Director of Taxes. Ms. Bereczky has
been a Certified Public Accountant since 1981. Ms. Bereczky received a B.A. in
Political Science from the University of California at Santa Barbara in 1978
and an M.B.A. in Taxation from Golden Gate University in 1985.

All directors hold office for a period of one year until their successors
have been duly elected and qualified. Directors receive no compensation for
serving as directors and received no such compensation during the last fiscal
year. Officers serve at the discretion of the Board of Directors.

K-21
<PAGE>

ITEM 11. EXECUTIVE COMPENSATION

COMPENSATION SUMMARY

Summarized below are the principal components of compensation of the
individual serving as the Company's Chief Executive Officer ("CEO") during
fiscal year 1997 and the four most highly compensated executive officers other
than the CEO, with income in excess of $100,000, for each of the last three
completed fiscal years.

SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
OTHER ANNUAL ALL OTHER
NAME AND PRINCIPAL SALARY COMPENSATION COMPENSATION
POSITION YEAR ($) BONUS ($) ($) ($)(A)
- ------------------ ---- ------- --------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Kevin S. Relyea,....... 1997 400,000 192,000 -- 4,226(b)
President and Chief
Executive Officer 1996 390,385 1,172,057(c) -- 4,145(d)
1995 312,727 149,520 -- 918
William D. Burt,....... 1997 225,000 180,000 -- 3,372(e)
Executive Vice
President 1996(f) 159,635 180,000(g) 86,762(h) 1,822(i)
Roger K. Chamness,..... 1997 275,000 99,000 -- 3,214(j)
Executive Vice
President 1996 256,940 590,856(k) 69,958(l) 2,982(m)
1995 153,086 40,357 -- 493
Michael E. Malanga..... 1997 148,886 51,943 -- 507
Executive Vice
President 1996 142,614 125,695(n) -- 478
1995 128,137 34,645 -- 457
Robert T. Trebing,
Jr.,.................. 1997 185,321 64,654 -- 1,116
Executive Vice
President Chief 1996 174,806 287,031(o) -- 1,020
and Chief Financial
Officer 1995 150,459 43,973 -- 858
</TABLE>
- --------
(a) Unless otherwise indicated, amounts shown represent the value of term life
insurance premiums paid by the Company.

(b) Mr. Relyea received $918 representing the imputed value of life insurance
provided by the Company and $3,308 representing the Company's matching
funds under its Deferred Compensation Plan.

(c) Mr. Relyea received $320,000 pursuant to the Company's 1996 Management
Incentive Compensation Plan bonus program; $548,461 pursuant to the
Company's Divestiture Bonus Plan; and $303,596 in connection with the
cancellation of Mr. Relyea's stock purchase loan with the Company.

(d) Mr. Relyea received $913 representing the imputed value of life insurance
provided by the Company and $3,232 representing the Company's matching
funds under its Deferred Compensation Plan.

(e) Mr. Burt received $1,476 representing the imputed value of life insurance
provided by the Company and $1,896 representing the Company's matching
funds under its Deferred Compensation Plan.

(f) The amount set forth in the table for fiscal 1996 for Mr. Burt represents
less than a full year's compensation. Mr. Burt joined the Company on April
8, 1996.

(g) Represents bonus earned pursuant to the Company's 1996 Management
Incentive Compensation Plan bonus program.

(h) Mr. Burt received $9,000 representing the value of automobile benefits and
$77,762 representing relocation expenses.

(i) Mr. Burt received $577 representing the imputed value of life insurance
provided by the Company and $1,245 representing the Company's matching
funds under its Deferred Compensation Plan.

(j) Mr. Chamness received $918 representing the imputed value of life
insurance provided by the Company and $2,296 representing the Company's
matching funds under its Deferred Compensation Plan.

K-22
<PAGE>

(k) Mr. Chamness received $220,000 pursuant to the Company's 1996 Management
Incentive Compensation Plan bonus program; $241,323 pursuant to the
Company's Divestiture Bonus Plan; and $129,533 in connection with the
cancellation of Mr. Chamness' stock purchase loan with the Company.

(l) Mr. Chamness received $1,600 representing the value of automobile benefits
and $68,358 representing relocation expenses.

(m) Mr. Chamness received $865 representing the imputed value of life
insurance provided by the Company and $2,117 representing the Company's
matching funds under its Deferred Compensation Plan.

(n) Mr. Malanga received $71,604 pursuant to the Company's 1996 Management
Incentive Compensation Plan bonus program; $44,635 pursuant to the
Company's Divestiture Bonus Plan; and $9,456 in connection with the
cancellation of Mr. Malanga's stock purchase loan with the Company.

(o) Mr. Trebing received $87,500 pursuant to the Company's 1996 Management
Incentive Compensation Plan bonus program; $134,765 pursuant to the
Company's Divestiture Bonus Plan; and $64,766 in connection with the
cancellation of Mr. Trebing's stock purchase loan with the Company.

EMPLOYMENT CONTRACTS, TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL
ARRANGEMENTS

Severance benefits for Messrs. Relyea, Burt and Chamness are governed by
their respective employment agreements, which agreements are described below.
The maximum salary severance benefits for Messrs. Relyea, Burt and Chamness
are one year from the date of termination or the remaining period of
employment under their respective employment agreements, whichever is greater.
In addition, upon the occurrence of certain events constituting a change of
control, the holders of stock options, including the executive officers named
above, shall be entitled to receive cash equal to the difference between the
price per share paid in connection with such change of control and the
exercise price of the underlying option.

The Company's President and Chief Executive Officer, Kevin S. Relyea,
entered into an Employment Agreement with the Company on January 1, 1996 for
the period from January 1, 1996 though January 1, 1999, providing for annual
compensation of not less than $400,000, to increase to $500,000 upon the
attainment of $40,000,000 in Company EBITDA, and other periodic increases as
determined by the Company's Board. In 1997, the Company's Board elected to (i)
increase Mr. Relyea's annual compensation by five percent (5%) effective
January 1, 1998, and again on January 1, 1999 and (ii) extend his Employment
Agreement with the Company until January 1, 2000.

The Company's Executive Vice President and the President of Chi-Chi's, Roger
K. Chamness, entered into an Employment Agreement with the Company on March 1,
1996 for the period from March 1, 1996 through March 1, 1999, providing for
annual compensation of not less than $275,000 and periodic increases as
determined by the Company's Board. In 1997, the Company's Board elected to (i)
increase Mr. Chamness' annual compensation by five percent (5%) effective
January 1, 1998, and again on January 1, 1999 and (ii) extend his Employment
Agreement with the Company until March 1, 2000.

The Company's Executive Vice President and El Torito's President, William D.
Burt, entered into an Employment Agreement with the Company on April 8, 1996
for the period from April 8, 1996 through April 8, 1999, providing for annual
compensation of not less than $225,000 and periodic increases as determined by
the Company's Board. In 1997, the Company's Board elected to (i) increase Mr.
Burt's annual compensation by five percent (5%) effective January 1, 1998, and
again on January 1, 1999 and (ii) extend his Employment Agreement with the
Company until April 8, 2000.

The employment agreements with each of Messrs. Relyea, Chamness and Burt
also provide that during the terms thereof, such executives will participate
in the Company's Management Incentive Compensation Plan, will be eligible to
participate in the Company's VCU Plan (see discussion below) and will be
entitled to participate in the Company's standard medical, dental, life,
accident, disability, retirement plans, quality review privileges and similar
plans as are generally available to executive employees of the Company from
time to time.

K-23
<PAGE>

A new supplemental bonus plan was implemented on January 1, 1996 called the
Value Creation Units Plan (the "VCU Plan"). The VCU Plan provides participants
with a contingent financial incentive to contribute to the long-term success
of the Company. In 1997 the VCU Plan was amended to, inter alia, (i) add El
Torito Restaurants, Inc. and Chi-Chi's, Inc. as obligors and (ii) provide that
payouts will be calculated based on the improvement in the Company's EBITDA
between year-end 1995 and year-end 1999 and in proportion to the amount and
type of Value Creation Units awarded to each participant. At December 28,
1997, there were 28 participants in the VCU Plan, including Kevin S. Relyea,
William D. Burt, Roger K. Chamness, Michael E. Malanga and Robert T. Trebing,
Jr.

In connection with the Company's decision to pursue the sale of the Family
Restaurant Division in January 1996, the Board adopted a Divestiture Bonus
Plan for certain members of management (the "DBP"). The purpose of the DBP was
to retain and reward key executives who would be required to assist with the
sale of the Family Restaurant Division. The DBP provided certain key
executives with a monetary bonus upon the consummation of the sale of the
Family Restaurant Division (calculated as a percentage of the purchase price
as defined in the DBP). Kevin S. Relyea, Roger K. Chamness, Michael E. Malanga
and Robert T. Trebing, Jr. received such a bonus upon the sale of the Family
Restaurant Division to Flagstar in May 1996. The DBP is no longer in effect.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth as of March 27, 1998 the number of shares and
percentage of Common Stock owned by each person known to the Company to be the
beneficial owner of more than 5% of any class of the Company's voting
securities, each director and executive officer of the Company and all
executive officers and directors of the Company as a group.

<TABLE>
<CAPTION>
COMMON STOCK
--------------------------
AMOUNT AND NATURE
OF BENEFICIAL PERCENT
OWNERSHIP(A) OF CLASS
----------------- --------
<S> <C> <C>
Apollo FRI Partners, L.P.(b)................. 909,989(c) 82.77%(c)
2 Manhattanville Rd., Purchase, NY 10577
Green Equity Investors, L.P.(d).............. 160,222 16.21%
11111 Santa Monica Blvd., Suite 2000, Los
Angeles, CA 90025
Kevin S. Relyea.............................. 12,747(e) 1.28%(e)
William D. Burt.............................. 1,500(f) (g)
Roger K. Chamness............................ 3,000(h) (g)
Robert T. Trebing, Jr. ...................... 1,300(i) (g)
Michael E. Malanga........................... 633(j) (g)
Gayle A. DeBrosse............................ 500 (g)
Todd E. Doyle................................ 574(k) (g)
Janie M. Bereczky............................ 330(l) (g)
All Executive Officers and Directors of the
Company as a Group
(11 persons)................................ 20,525 2.07%
</TABLE>

- --------
(a) All shares (other than shares held by Apollo and GEI) are subject to, and
shall be voted in accordance with, the Shareholders' Agreement.

(b) The general partner of Apollo is AIF II. The managing general partner of
AIF II is Apollo Advisors. The general partner of Apollo Advisors is
Apollo Capital Management, Inc. ("Apollo Capital"). Messrs. Copses, Kaplan
and Ressler are officers of Apollo Capital. The directors of Apollo
Capital are Leon Black and John Hannan, each of whom is also an officer of
Apollo Capital. Each of Messrs. Copses, Kaplan and Ressler and the
directors of Apollo Capital disclaim beneficial ownership of any shares
beneficially held by Apollo.

K-24
<PAGE>

(d) The general partner of GEI is Leonard Green & Associates, L.P. ("LGP").
Messrs. Green and Sokoloff are managing general partners of LGP. Each of
Messrs. Green and Sokoloff and the general partners of LGP disclaims
beneficial ownership of any shares beneficially held by GEI.

(e) Includes 938 shares of Common Stock covered by options granted to Mr.
Relyea, which are currently exercisable or exercisable within the next 60
days in the following amounts and prices: 469 shares at $160 per share,
235 shares at $40 per share and 234 shares at $100 per share.

(f) Includes 1,172 shares of Common Stock covered by options assigned to Mr.
Burt, which are currently exercisable at "Fair Market Value" as defined in
the Company's 1994 Incentive Stock Option Plan.

(g) Represents less than 1% ownership.

(h) Includes 700 shares of Common Stock covered by options granted to Mr.
Chamness, which are currently exercisable or exercisable within the next
60 days in the following amounts and prices: 150 shares at $160 per share,
475 shares at $40 per share and 75 shares at $100 per share.

(i) Includes 400 shares of Common Stock covered by options granted to Mr.
Trebing, which are currently exercisable or exercisable within the next 60
days in the following amounts and prices: 100 shares at $160 per share,
250 shares at $40 per share and 50 shares at $100 per share.

(j) Includes 148 shares of Common Stock covered by options granted and
assigned to Mr. Malanga, which are currently exercisable or exercisable
within the next 60 days in the following amounts and prices: 77 shares at
"Fair Market Value" as defined in the Company's 1994 Incentive Stock
Option Plan, 35 shares at $160 per share, 18 shares at $40 per share and
18 shares at $100 per share.

(k) Includes 199 shares of Common Stock covered by options granted and
assigned to Mr. Doyle, which are currently exercisable or exercisable
within the next 60 days in the following amounts and prices: 140 shares at
$1 per share, 29 shares at $160 per share, 15 shares at $40 per share and
15 shares at $100 per share.

(l) Includes 110 shares of Common Stock covered by options granted to Ms.
Bereczky, which are currently exercisable or exercisable within the next
60 days in the following amounts and prices: 55 shares at $160 per share,
28 shares at $40 per share and 27 shares at $100 per share.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Apollo charged a monthly fee of $100,000 during 1997 and 1996 which Apollo
will continue to earn in the future, and Apollo and GEI each charged a monthly
fee of $50,000 during 1995 for providing certain management services to the
Company. In November 1995, the management services arrangement with GEI was
terminated. For the years ended December 28, 1997, December 29, 1996 and
December 31, 1995, the Company was charged $1.2 million each year in
connection with this arrangement. The Company had management services fees
payable of $3,250,000 and $2,050,000 due to Apollo and GEI as of December 28,
1997 and December 29, 1996, respectively.

On January 27, 1994, the Company entered into the Shareholders' Agreement
and a Registration Rights Agreement with Apollo, GEI and Foodmaker. The
Shareholders' Agreement was terminated as between Apollo, GEI, Foodmaker and
the Company in connection with the Exchange Agreements. See "BUSINESS--Change
in Control."

The Company loaned $150,000 to Mr. Relyea (evidenced by recourse notes which
bore interest at a rate of 7% per annum and were due on May 31, 1999) in
connection with his purchase of Common Stock. In July 1996, the loan to Mr.
Relyea was canceled which resulted in additional income to Mr. Relyea. See "--
Directors and Executive Officers," "Executive Compensation."

The Company loaned $64,000 to Mr. Chamness (evidenced by recourse notes
which bore interest at a rate of 7% per annum and were due on May 19, 1999) in
connection with his purchase of Common Stock. In July 1996, the loan to Mr.
Chamness was canceled which resulted in additional income to Mr. Chamness.
See "--Directors and Executive Officers," "Executive Compensation."

K-25
<PAGE>

PART IV

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

<TABLE>
<CAPTION>
PAGE
----
<C> <S> <C>
(a)(1) Financial Statements. See Index to Financial Statements on page
K-31. --
(2) Financial Statement Schedule K-49
Schedule II--Valuation and qualifying accounts
(3) Exhibits
</TABLE>

<TABLE>
<C> <S>
2(a) Stock Purchase Agreement dated as of March 1, 1996 by and among Family
Restaurants, Inc., Flagstar Companies, Inc., Flagstar Corporation and
FRD Acquisition Co. (Filed as Exhibit 2.1 to the Company's Form 10-Q
filed with the SEC on May 15, 1996.)
3(a) Fourth Restated Certificate of Incorporation of the Company. (Filed as
Exhibit 4.1 to the Company's Form S-8 filed with the SEC on March 23,
1994.)
3(b) Bylaws of the Company. (Filed as Exhibit 4.2 to the Company's Form S-8
filed with the SEC on March 23, 1994.)
4(a) Indenture Dated as of January 27, 1994 Re: $300,000,000 9-3/4% Senior
Notes Due 2002. (Filed as Exhibit 4(a) to the Company's Form 10-K
filed with the SEC on March 28, 1994.)
4(b) Indenture Dated as of January 27, 1994 Re: $150,000,000 10-7/8% Senior
Subordinated Discount Notes Due 2004. (Filed as Exhibit 4(b) to the
Company's Form 10-K filed with the SEC on March 28, 1994.)
4(c) First Supplemental Indenture, dated as of July 3, 1996, between the
Registrant and IBJ Schroder Bank & Trust Company, a New York Banking
corporation, as Trustee. (Filed as Exhibit 10.1 to the Company's Form
8-K filed with the SEC on July 9, 1996.)
4(d) First Supplemental Indenture, dated as of July 3, 1996, between the
Registrant and Fleet National Bank, as successor by merger to Fleet
National Bank of Massachusetts, formerly known as Shawmut Bank, N.A.,
as Trustee. (Filed as Exhibit 10.2 to the Company's Form 8-K filed
with the SEC on July 9, 1996.)
4(e) Note Agreement Dated as of August 12, 1997 Re: Up to $75,000,000 FRI-
MRD Corporation Senior Discount Notes Due January 24, 2002. (Filed as
Exhibit 4(e) to the Company's Form 10-Q filed with the SEC on November
12, 1997.)
4(f) Joinder Agreement Dated as of January 14, 1998 Re: FRI-MRD Corporation
Senior Discount Notes due January 24, 2002.
9 Shareholders' Agreement, dated as of January 27, 1994, among the
Company and certain of its Shareholders. (Filed as Exhibit 4.3 to the
Company's Form S-8 filed with the SEC on March 23, 1994.)
10(a) The Company's 1994 Incentive Stock Option Plan. (Filed as Exhibit 10(g)
to the Company's Form 10-K filed with the SEC on March 28, 1994.)
10(b) The Company's Deferred Compensation Plan. (Filed as Exhibit 10(k) to
the Company's Form 10-K filed with the SEC on March 27, 1995.)
10(c) The Company's Severance Plan. (Filed as Exhibit 10(m) to the Company's
Form 10-K filed with the SEC on March 27, 1995.)
10(d) Form of Management Stock Subscription Agreement of the Company. (Filed
as Exhibit 10(bb) to the Company's Form 10- K filed with the SEC on
March 28, 1994.)
10(e) Form of Management Pledge Agreement of the Company. (Filed as Exhibit
10(cc) to the Company's Form 10-K filed with the SEC on March 28,
1994.)
</TABLE>

K-26
<PAGE>

<TABLE>
<C> <S>
10(f) Management Services Agreement, dated as of January 27, 1994, by and
between the Company and Apollo Advisors, L.P. (Filed as Exhibit 10(ff)
to the Company's Form 10-K filed with the SEC on March 28, 1994.)
10(g) Lease Indemnification Agreement, dated as of January 27, 1994, by and
between the Company and W. R. Grace & Co.-Conn. (Filed as Exhibit
10(ii) to the Company's Form 10-K filed with the SEC on March 28,
1994.)
10(h) Tax Sharing Agreement, dated as of January 27, 1994, by and among the
Company, Foodmaker, Inc. and Chi-Chi's, Inc. (Filed as Exhibit 10(ll)
to the Company's Form 10-K filed with the SEC on March 28, 1994.)
10(i) Registration Rights Agreement, dated as of January 27, 1994, by and
among the Company and certain of its shareholders. (Filed as Exhibit
10(mm) to the Company's Form 10-K filed with the SEC on March 28,
1994.)
10(j) Agreement, dated as of January 5, 1996, by and between Kevin S. Relyea
and the Company. (Filed as Exhibit 10(w) to the Company's Form 10-K
filed with the SEC on April 1, 1996.)
10(k) The Company's 1996 Management Incentive Compensation Plan Description.
(Filed as Exhibit 10(r) to the Company's Form 10-K filed with the SEC
on March 31, 1997.)
10(l) Termination of Management Services Agreement between Leonard Green &
Associates, L.P. and the Company, dated as of November 20, 1995.
(Filed as Exhibit 10(s) to the Company's Form 10-K filed with the SEC
on March 31, 1997.)
10(m) Employment Agreement, dated as of January 1, 1996 by and between Kevin
S. Relyea and the Company. (Filed as Exhibit 10(t) to the Company's
Form 10-K filed with the SEC on March 31, 1997.)
10(n) Employment Agreement, dated as of March 1, 1996 by and between Roger K.
Chamness and the Company. (Filed as Exhibit 10(u) to the Company's
Form 10-K filed with the SEC on March 31, 1997.)
10(o) Employment Agreement, dated as of April 8, 1996, by and between William
D. Burt and the Company. (Filed as Exhibit 10(v) to the Company's Form
10-K filed with the SEC on March 31, 1997.)
10(p) Loan and Security Agreement, dated as of January 10, 1997, between
Foothill Capital Corporation and the Company and its subsidiaries
named therein. (Filed as Exhibit 10(w) to the Company's Form 10-K
filed with the SEC on March 31, 1997.)
10(q) General Continuing Guarantee, dated as of January 10, 1997, by the
Company in favor of Foothill Capital Corporation. (Filed as Exhibit
10(x) to the Company's Form 10-K filed with the SEC on March 31,
1997.)
10(r) Form of subsidiary General Continuing Guarantee, dated as of January
10, 1997. (Filed as Exhibit 10(y) to the Company's Form 10-K filed
with the SEC on March 31, 1997.)
10(s) Security Agreement, dated as of January 10, 1997, between Foothill
Capital Corporation and the Company. (Filed as Exhibit 10(z) to the
Company's Form 10-K filed with the SEC on March 31, 1997.)
10(t) Form of subsidiary Security Agreement, dated as of January 10, 1997,
between Foothill Capital Corporation and the subsidiary named therein.
(Filed as Exhibit 10(aa) to the Company's Form 10-K filed with the SEC
on March 31, 1997.)
10(u) Stock Pledge Agreement, dated as of January 10, 1997, between the
Company and Foothill Capital Corporation. (Filed as Exhibit 10(bb) to
the Company's Form 10-K filed with the SEC on March 31, 1997.)
</TABLE>

K-27
<PAGE>

<TABLE>
<C> <S>
10(v) Form of subsidiary Stock Pledge Agreement, dated as of January 10,
1997, between the subsidiary named therein and Foothill Capital
Corporation. (Filed as Exhibit 10(cc) to the Company's Form 10-K
filed with the SEC on March 31, 1997.)
10(w) Trademark Security Agreement, dated as of January 10, 1997, by Chi-
Chi's, Inc. in favor of Foothill Capital Corporation. (Filed as
Exhibit 10(dd) to the Company's Form 10-K filed with the SEC on March
31, 1997.)
10(x) Trademark Security Agreement, dated as of January 10, 1997, by El
Torito Restaurants, Inc. in favor of Foothill Capital Corporation.
(Filed as Exhibit 10(ee) to the Company's Form 10-K filed with the
SEC on March 31, 1997.)
10(y) First Amendment to the Loan and Security Agreement dated as of May 23,
1997 by and among the parties thereto. (Filed as Exhibit 10(gg) to
the Company's Form 10-Q filed with the SEC on August 13, 1997.)
10(z) Amendment Number Two to Loan and Security Agreement dated as of August
12, 1997 by and among the parties thereto. (Filed as Exhibit 10(hh)
to the Company's Form 10-Q filed with the SEC on November 12, 1997.)
10(aa) The Company's Divestiture Bonus Plan for Key Management, dated January
9, 1996. (Filed as Exhibit 10(ff) to the Company's Form 10-K filed
with the SEC on March 31, 1997.)
10(bb) Distribution Service Agreement, dated as of November 1, 1997, between
El Torito Restaurants, Inc. and The SYGMA Network, Inc. (Portions of
this document have been omitted pursuant to a request for
confidential treatment.) (Filed as Exhibit 10(bb) to the Company's
Form 10-K filed with the SEC on March 30, 1998.)
10(cc) Distribution Service Agreement, dated as of April 30, 1997, between
Chi-Chi's, Inc. and Sysco Corporation. (Portions of this document
have been omitted pursuant to a request for confidential treatment.)
(Filed as Exhibit 10(cc) to the Company's Form 10-K filed with the
SEC on March 30, 1998.)
10(dd) Family Restaurants, Inc., FRI-MRD Corporation, Chi-Chi's, Inc. and El
Torito Restaurants, Inc. Amended and Restated Value Creation Units
Plan and Sample Value Creation Units Agreement. (Filed as Exhibit
10(dd) to the Company's Form 10-K filed with the SEC on March 30,
1998.)
21(a) List of Subsidiaries. (Filed as Exhibit 21(a) to the Company's Form
10-K filed with the SEC on March 30, 1998.)
21(b) Names Under Which Subsidiaries Do Business. (Filed as Exhibit 21(b) to
the Company's Form 10-K filed with the SEC on March 30, 1998.)
23 Consent of KPMG Peat Marwick LLP. (Filed as Exhibit 23 to the
Company's Form 10-K filed with the SEC on March 30, 1998.)
27 Financial Data Schedule. (Filed as Exhibit 27 to the Company's Form
10-K filed with the SEC on March 30, 1998.)
99(a) Press Release, dated May 23, 1996. (Filed as Exhibit 99.1 to the
Company's Form 8-K filed with the SEC on May 30, 1996.)
99(b) Press Release, dated July 3, 1996. (Filed as Exhibit 99.1 to the
Company's Form 8-K filed with the SEC on July 9, 1996.)
</TABLE>

(b) Reports on Form 8-K

None.

K-28
<PAGE>

SIGNATURES

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

FAMILY RESTAURANTS, INC.

/s/ Robert T. Trebing, Jr.
By: _________________________________
Robert T. Trebing, Jr.
Executive Vice President and
Chief Financial Officer

Pursuant to the requirements of the Securities 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.

<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----

<S> <C> <C>
/s/ Kevin S. Relyea Director, President and September 9, 1998
____________________________________ Chief Executive Officer
Kevin S. Relyea (Principal Executive
Officer)

/s/ Peter P. Copses Director September 9, 1998
____________________________________
Peter P. Copses

/s/ David B. Kaplan Director September 9, 1998
____________________________________
David B. Kaplan

/s/ Antony P. Ressler Director September 9, 1998
____________________________________
Antony P. Ressler

/s/ Robert T. Trebing, Jr. Executive Vice President and September 9, 1998
____________________________________ Chief Financial Officer
Robert T. Trebing, Jr. (Principal Financial and
Accounting Officer)
</TABLE>

K-29
<PAGE>

SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT
TO SECTION 15(D) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED
SECURITIES PURSUANT TO SECTION 12 OF THE ACT

No annual report covering the registrant's last fiscal year has been or will
be sent to security holders, other than a copy of this Annual Report on Form
10-K.

No proxy statement, form of proxy or other proxy solicitation materials with
respect to any annual or other meeting of security holders were sent in 1997,
and none will be sent with respect to 1997, to security holders.

K-30
<PAGE>

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
FAMILY RESTAURANTS, INC.
Independent Auditors' Report............................................. K-32
Consolidated Balance Sheets as of December 28, 1997 and December 29,
1996.................................................................... K-33
Consolidated Statements of Operations for the Years Ended December 28,
1997, December 29, 1996
and December 31, 1995................................................... K-34
Consolidated Statements of Common Stockholders' Equity (Deficit) for the
Years Ended December 28, 1997, December 29, 1996 and December 31, 1995.. K-35
Consolidated Statements of Cash Flows for the Years Ended December 28,
1997, December 29, 1996 and December 31, 1995........................... K-36
Notes to Consolidated Financial Statements............................... K-38
</TABLE>

K-31
<PAGE>

INDEPENDENT AUDITORS' REPORT

Board of Directors
Family Restaurants, Inc.:

We have audited the accompanying consolidated balance sheets of Family
Restaurants, Inc. and its subsidiaries as of December 28, 1997 and December
29, 1996, and the related consolidated statements of operations, common
stockholders' equity (deficit) and cash flows for the years ended December 28,
1997, December 29, 1996 and December 31, 1995. In connection with our audits
of the consolidated financial statements, we also audited the financial
statement schedule as listed in the accompanying index. These consolidated
financial statements and financial statement schedule are the responsibility
of the Company's management. Our responsibility is to express an opinion on
the consolidated financial statements and financial statement schedule based
on our audits.

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

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Family
Restaurants, Inc. and its subsidiaries at December 28, 1997 and December 29,
1996, and the results of their operations and their cash flows for the years
ended December 28, 1997, December 29, 1996 and December 31, 1995 in conformity
with generally accepted accounting principles. Also, in our opinion, the
related financial statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly in all
material respects the information shown therein.

KPMG Peat Marwick LLP

Orange County, California
March 5, 1998

K-32
<PAGE>

FAMILY RESTAURANTS, INC.

CONSOLIDATED BALANCE SHEETS
($ IN THOUSANDS EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>
DECEMBER 28, DECEMBER 29,
1997 1996
------------ ------------
<S> <C> <C>
ASSETS
------
Current assets:
Cash and cash equivalents.......................... $ 32,518 $ 33,820
Receivables........................................ 3,944 5,043
Inventories........................................ 4,569 4,537
Other current assets............................... 4,086 3,212
--------- ---------
Total current assets............................. 45,117 46,612
Property and equipment, net.......................... 183,601 196,872
Reorganization value in excess of amounts allocable
to identifiable assets, net......................... 36,529 37,930
Other assets......................................... 24,521 26,192
--------- ---------
$ 289,768 $ 307,606
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
----------------------------------------------
Current liabilities:
Current portion of long-term debt, including
capitalized lease obligations..................... $ 2,694 $ 3,927
Accounts payable................................... 13,959 19,000
Self-insurance reserves............................ 32,515 34,972
Other accrued liabilities.......................... 58,573 70,696
Income taxes payable............................... 3,788 3,541
--------- ---------
Total current liabilities........................ 111,529 132,136
Other long-term liabilities.......................... 4,478 4,746
Long-term debt, including capitalized lease
obligations, less current portion................... 199,955 165,325
Stockholders' equity (deficit):
Common stock--authorized 1,500,000 shares, par
value $.01, 997,277 shares issued................. 10 10
Additional paid-in capital......................... 157,317 157,317
Accumulated deficit................................ (182,138) (150,545)
Less treasury stock, at cost (8,992 shares)........ (1,383) (1,383)
--------- ---------
Total stockholders' equity (deficit)............. (26,194) 5,399
--------- ---------
$ 289,768 $ 307,606
========= =========
</TABLE>

See accompanying notes to consolidated financial statements.

K-33
<PAGE>

FAMILY RESTAURANTS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
($ IN THOUSANDS)

<TABLE>
<CAPTION>
FOR THE YEAR ENDED
--------------------------------------
DECEMBER 28, DECEMBER 29, DECEMBER 31,
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
Sales................................... $ 463,724 $724,229 $1,134,359
--------- -------- ----------
Product cost............................ 123,803 200,379 322,194
Payroll and related costs............... 162,807 273,536 419,185
Occupancy and other operating expenses.. 129,428 181,730 275,164
Depreciation and amortization........... 22,583 34,475 57,836
General and administrative expenses..... 30,186 41,742 56,245
Loss on disposition of properties, net.. 3,885 8,600 12,067
Provision for divestitures and write-
down of long-lived assets.............. 2,640 0 44,500
Restructuring costs..................... 0 6,546 4,392
--------- -------- ----------
Total costs and expenses.............. 475,332 747,008 1,191,583
--------- -------- ----------
Operating loss.......................... (11,608) (22,779) (57,224)
Interest expense, net................... 19,476 36,725 65,277
Gain on sale of division................ 0 62,601 0
--------- -------- ----------
Income (loss) before income tax
provision and extraordinary item....... (31,084) 3,097 (122,501)
Income tax provision.................... 509 890 1,208
--------- -------- ----------
Income (loss) before extraordinary item. (31,593) 2,207 (123,709)
Extraordinary gain on extinguishment of
debt................................... 0 134,833 0
--------- -------- ----------
Net income (loss)....................... $ (31,593) $137,040 $ (123,709)
========= ======== ==========
</TABLE>

See accompanying notes to consolidated financial statements.

K-34
<PAGE>

FAMILY RESTAURANTS, INC.

CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' EQUITY (DEFICIT)

FOR THE THREE YEARS IN THE PERIOD ENDED DECEMBER 28, 1997
($ IN THOUSANDS)

<TABLE>
<CAPTION>
NOTES
ADDITIONAL RECEIVABLE TREASURY
COMMON PAID-IN FROM ACCUMULATED STOCK,
STOCK CAPITAL STOCKHOLDERS DEFICIT AT COST TOTAL
------ ---------- ------------ ----------- -------- ---------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 25,
1994................... $10 $159,554 $(2,947) $(163,876) $ 0 $ (7,259)
Net loss.............. 0 0 0 (123,709) 0 (123,709)
Payments and
cancellation of notes
receivable from
stockholders......... 0 (1,303) 2,078 0 0 775
Purchase of treasury
stock................ 0 0 0 0 (1,383) (1,383)
--- -------- ------- --------- ------- ---------
Balance at December 31,
1995................... 10 158,251 (869) (287,585) (1,383) (131,576)
Net income............ 0 0 0 137,040 0 137,040
Cancellation of notes
receivable from
stockholders......... 0 (934) 869 0 0 (65)
--- -------- ------- --------- ------- ---------
Balance at December 29,
1996................... 10 157,317 0 (150,545) (1,383) 5,399
Net loss.............. 0 0 0 (31,593) 0 (31,593)
--- -------- ------- --------- ------- ---------
Balance at December 28,
1997................... $10 $157,317 $ 0 $(182,138) $(1,383) $ (26,194)
=== ======== ======= ========= ======= =========
</TABLE>

See accompanying notes to consolidated financial statements.

K-35
<PAGE>

FAMILY RESTAURANTS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
($ IN THOUSANDS)

<TABLE>
<CAPTION>
FOR THE YEAR ENDED
--------------------------------------
DECEMBER 28, DECEMBER 29, DECEMBER 31,
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS
Cash flows from operating activities:
Cash received from customers........... $ 464,780 $ 727,849 $ 1,133,206
Cash received from franchisees and
licensees............................. 2,074 2,762 7,897
Cash paid to suppliers and employees... (465,069) (711,462) (1,084,758)
Interest received...................... 2,119 4,176 266
Interest paid.......................... (16,747) (38,392) (45,198)
Restructuring costs.................... 0 (6,546) (4,392)
Income taxes paid...................... (262) (244) (938)
--------- --------- -----------
Net cash provided by (used in)
operating activities................ (13,105) (21,857) 6,083
--------- --------- -----------
Cash flows from investing activities:
Proceeds from disposal of property and
equipment............................. 1,492 25,115 20,425
Proceeds from sale of FRD, net......... 0 121,342 0
Proceeds from sale of notes receivable,
net................................... 3,514 32,116 0
Capital expenditures................... (13,588) (9,848) (38,022)
Mandatory lease buyback, net........... (2,690) 0 0
Lease termination payments............. (2,891) (3,398) 0
Capitalized opening costs.............. (532) (235) (2,155)
Other.................................. (1,936) (68) 137
--------- --------- -----------
Net cash provided by (used in)
investing activities................ (16,631) 165,024 (19,615)
--------- --------- -----------
Cash flows from financing activities:
Repurchases of notes................... 0 (32,513) 0
Net proceeds from issuance of notes.... 33,947 0 0
Proceeds from (repayment of) working
capital borrowings, net............... 0 (79,815) 20,215
Payment of debt issuance costs......... (2,418) (278) 0
Reductions of long-term debt, including
capitalized lease obligations......... (3,095) (5,111) (7,794)
Decrease in restricted cash and
collateral deposit.................... 0 0 1,850
Purchase of treasury stock............. 0 0 (1,383)
Payments of notes receivable from
stockholders.......................... 0 0 775
--------- --------- -----------
Net cash provided by (used in)
financing activities................ 28,434 (117,717) 13,663
--------- --------- -----------
Net increase (decrease) in cash and cash
equivalents............................. (1,302) 25,450 131
Cash and cash equivalents at beginning of
period.................................. 33,820 8,370 8,239
--------- --------- -----------
Cash and cash equivalents at end of
period.................................. $ 32,518 $ 33,820 $ 8,370
========= ========= ===========
</TABLE>

K-36
<PAGE>

FAMILY RESTAURANTS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS--(CONTINUED)
($ IN THOUSANDS)

<TABLE>
<CAPTION>
FOR THE YEAR ENDED
--------------------------------------
DECEMBER 28, DECEMBER 29, DECEMBER 31,
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
Reconciliation of Net Income (Loss) to
Net Cash Provided by (Used in)
Operating Activities
Net income (loss)...................... $(31,593) $ 137,040 $(123,709)
-------- --------- ---------
Adjustments to reconcile net income
(loss) to net cash provided by (used
in) operating activities:
Depreciation and amortization........ 22,583 34,475 57,836
Amortization of debt issuance costs.. 1,084 2,125 6,726
Loss on disposition of properties.... 3,885 8,600 12,067
Provision for divestitures and write-
down of long-lived assets........... 2,640 0 44,500
Gain on sale of division............. 0 (62,601) 0
Extraordinary gain on extinguishment
of debt............................. 0 (134,833) 0
Accretion of interest on notes....... 2,845 9,025 13,454
Decrease in receivables.............. 304 1,661 708
(Increase) decrease in inventories... (32) 1,176 1,976
(Increase) decrease in other current
assets.............................. (530) 2,890 (3,382)
Increase (decrease) in accounts
payable............................. (5,041) (4,792) 1,403
Increase (decrease) in self-insurance
reserves............................ (2,457) (382) 1,664
Decrease in other accrued
liabilities......................... (7,040) (17,507) (7,430)
Increase in income taxes payable..... 247 1,266 270
-------- --------- ---------
Total adjustments.................. 18,488 (158,897) 129,792
-------- --------- ---------
Net cash provided by (used in)
operating activities.................. $(13,105) $ (21,857) $ 6,083
======== ========= =========
</TABLE>

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:

See Note 6 for discussion of repurchases of the Notes.

DISCLOSURE OF ACCOUNTING POLICY:

The Company considers all highly liquid debt instruments purchased with a
maturity of three months or less to be cash equivalents.

See accompanying notes to consolidated financial statements.

K-37
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 28, 1997

NOTE 1--ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Fiscal year

The Company reports results of operations based on 52 or 53 week periods
ending on the last Sunday in December. The fiscal years ended December 28,
1997 and December 29, 1996 included 52 weeks, and the fiscal year ended
December 31, 1995 included 53 weeks.

Principles of consolidation

The consolidated financial statements include the accounts of the Company
and all its subsidiaries. All significant intercompany balances and
transactions have been eliminated.

Estimations

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

Inventories

Inventories consist primarily of food and liquor and are stated at the lower
of cost or market. Costs are determined using the first-in, first-out (FIFO)
method.

Property and equipment

Property and equipment are stated at cost and are depreciated on a straight-
line basis over their estimated useful lives (buildings principally over 25 to
35 years and furniture, fixtures and equipment over 3 to 10 years). Leasehold
improvements are amortized on a straight-line basis over the shorter of their
estimated useful lives or the terms of the related leases. Property under
capitalized leases is amortized over the terms of the leases using the
straight-line method.

Losses on disposition of properties are recognized when a commitment to
divest a restaurant property is made by the Company and include estimated
carrying costs through the expected date of disposal.

Advertising

Production costs of commercials and programming are charged to operations
when aired. The costs of other advertising, promotion and marketing programs
are charged to operations in the year incurred.

K-38
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Franchise and license fees

Initial franchise and license fees are recognized when all material services
have been performed and conditions have been satisfied. Initial fees for the
periods presented are insignificant. Monthly fees for all franchise and
license arrangements are accrued as earned based on the respective monthly
sales. Such fees totaled $2,215,000 for 1997, $2,802,000 for 1996 and
$6,036,000 for 1995 and are included as an offset to general and
administrative expenses.

The Company previously hedged its foreign currency royalties through forward
exchange contracts. These contracts reduced the exposure to currency movements
affecting the royalty receivable. Each contract's duration typically ended
when the receivable was expected to be paid. The future value of each contract
and the related currency position were subject to off-setting market risk. On
December 4, 1995, these contracts were terminated, resulting in a realized
gain of $2,405,000, which is included as a reduction to general and
administrative expenses in the consolidated financial statements.

Reorganization value

Reorganization value in excess of amounts allocable to identifiable assets
is amortized using the straight-line method over 30 years. Accumulated
amortization of reorganization value amounted to $5,496,000 at December 28,
1997 and $4,095,000 at December 29, 1996. During 1995, the Company determined
that an impairment of the portion of this asset related to its traditional
dinnerhouse restaurants had occurred and wrote off $2,049,000.

Impairment of long-lived assets

Effective January 1, 1996, the Company adopted SFAS No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of," which generally requires the assessment of certain long-lived assets for
possible impairment when events or circumstances indicate the carrying value
of these assets may not be recoverable.

The Company evaluates property and equipment for impairment by comparison of
the carrying value of the assets to estimated undiscounted cash flows (before
interest charges) expected to be generated by the asset over its estimated
useful life. In addition, the Company's evaluation considers data such as
continuity of personnel, changes in the operating environment, name
identification, competitive information and market trends. Finally, the
evaluation considers changes in management's strategic direction or market
emphasis. When the foregoing considerations suggest that a deterioration of
the financial condition of the Company or any of its assets has occurred, the
Company measures the amount of an impairment, if any, based on the estimated
fair value of each of its assets.

K-39
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Income taxes

The Company accounts for income taxes using the principles specified in
Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes" (see Note 9).

Reclassifications

Certain amounts as previously reported have been reclassified to conform to
the 1997 presentation.

NOTE 2--RECEIVABLES:

A summary of receivables follows:

<TABLE>
<CAPTION>
1997 1996
------ ------
($ IN
THOUSANDS)
<S> <C> <C>
Trade, principally credit cards............................... $2,057 $2,027
License and franchise fees and related receivables............ 341 195
Interest on FRD Notes......................................... 186 370
Notes receivable.............................................. 127 926
Other......................................................... 1,233 1,525
------ ------
$3,944 $5,043
====== ======
</TABLE>

NOTE 3--SALES OF RESTAURANTS:

On March 1, 1996, the Company entered into a definitive agreement (the "Sale
Agreement") to sell its family restaurant division which operated full-service
family restaurants (the "Family Restaurant Division") to an indirect wholly-
owned subsidiary of Flagstar Companies, Inc. (now known as Advantica
Restaurant Group, Inc.) ("Flagstar"). On May 23, 1996, the Company completed
the sale of the Family Restaurant Division in exchange for $125 million cash,
$150 million principal amount of 12 1/2% Senior Notes due in 2004 (the "FRD
Notes"), and the assumption of $31.5 million of long-term debt, primarily
consisting of capitalized lease obligations. Based on the subsequent
completion of a closing balance sheet, the purchase price was increased and
such increase was satisfied by the issuance of $6.9 million in additional FRD
Notes. The Company recorded a gain of $62.6 million on the sale of the Family
Restaurant Division, which gain included the effect of the increase in
purchase price of $6.9 million discussed above. Cash proceeds from the sale
were used to pay indebtedness outstanding under the Old Credit Facility (see
Note 6) of $82 million, help fund the repurchases of the Notes and for general
corporate purposes. As of December 28, 1997, the Company had sold or exchanged
$153.65 million aggregate principal amount of the FRD Notes. The remaining
balance of $3.25 million is restricted until the fourth anniversary of the
sale in accordance with the sale agreement with Flagstar to secure potential
future indemnity claims. The remaining FRD Notes are carried at their fair
value which approximates their cost (see Note 5).

During the fourth quarter of 1995, the Company determined that its
traditional dinnerhouse restaurants would be held for sale. The net assets of
these restaurants were written down to their estimated fair value (based in
part on a previously received offer in late 1995), less estimated selling
costs, of $12,908,000, resulting in a loss of $3,565,000 (including the write-
off of reorganization value of $2,049,000 associated with these restaurants,
which is included in loss on disposition of properties in the accompanying
consolidated statement of operations for the year ended December 31, 1995).
During 1996, the net losses associated with the sale of the traditional
dinnerhouse restaurants totalled $4,076,000, which is included in loss on
disposition of properties in the accompanying consolidated statement of
operations.

K-40
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 4--PROPERTY AND EQUIPMENT:

A summary of property and equipment follows:

<TABLE>
<CAPTION>
1997 1996
-------- --------
($ IN THOUSANDS)
<S> <C> <C>
Land................................................... $ 26,890 $ 26,729
Buildings and improvements............................. 150,223 152,350
Furniture, fixtures and equipment...................... 73,218 69,342
Projects under construction............................ 5,684 4,638
-------- --------
256,015 253,059
Accumulated depreciation and amortization.............. (72,414) (56,187)
-------- --------
$183,601 $196,872
======== ========
</TABLE>

Property under capitalized leases in the amount of $20,880,000 at December
28, 1997 and $21,323,000 at December 29, 1996 is included in buildings and
improvements. Accumulated amortization of property under capitalized leases
amounted to $8,871,000 at December 28, 1997 and $6,894,000 at December 29,
1996. Capitalized leases primarily relate to the buildings on certain
restaurant properties; the land portions of these leases are accounted for as
operating leases.

Depreciation and amortization relating to property and equipment was
$20,994,000 for 1997, $30,253,000 for 1996 and $45,766,000 for 1995, of which
$2,236,000, $4,357,000 and $7,578,000, respectively, was related to
amortization of property under capitalized leases.

A majority of the capitalized and operating leases have original terms of 25
years, and substantially all of these leases expire in the year 2008 or later.
Most leases have renewal options. The leases generally provide for payment of
minimum annual rent, real estate taxes, insurance and maintenance and, in most
cases, contingent rent, calculated as a percentage of sales, in excess of
minimum rent. The total amount of contingent rent under capitalized leases for
the years ended December 28, 1997, December 29, 1996 and December 31, 1995 was
$934,000, $2,425,000 and $5,491,000, respectively. Total rental expense for
all operating leases comprised the following:

<TABLE>
<CAPTION>
1997 1996 1995
------- ------- -------
($ IN THOUSANDS)
<S> <C> <C> <C>
Minimum rent.................................... $35,521 $45,063 $56,577
Contingent rent................................. 1,235 2,058 3,775
Less: Sublease rent............................. (6,434) (6,293) (5,815)
------- ------- -------
$30,322 $40,828 $54,537
======= ======= =======
</TABLE>

K-41
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

At December 28, 1997, the present value of capitalized lease payments and
the future minimum lease payments on noncancellable operating leases were:

<TABLE>
<CAPTION>
CAPITALIZED OPERATING
DUE IN LEASES LEASES
------ ----------- ---------
($ IN THOUSANDS)
<S> <C> <C>
1998................................................. $ 3,430 $ 33,350
1999................................................. 3,164 32,886
2000................................................. 2,909 32,427
2001................................................. 2,584 29,931
2002................................................. 2,419 27,334
Later years.......................................... 6,713 108,647
------- --------
Total minimum lease payments......................... 21,219 $264,575
========
Interest............................................. (6,624)
-------
Present value of minimum lease payments.............. $14,595
=======
</TABLE>

The future lease payments summarized above include commitments for leased
properties included in the Company's divestiture program.

NOTE 5--OTHER ASSETS:

A summary of other assets follows:

<TABLE>
<CAPTION>
1997 1996
------- -------
($ IN
THOUSANDS)
<S> <C> <C>
Liquor licenses............................................ $ 5,910 $ 5,977
Debt issuance costs........................................ 4,918 3,931
Notes receivable........................................... 9,898 9,239
FRD Notes.................................................. 3,250 6,500
Other...................................................... 545 545
------- -------
$24,521 $26,192
======= =======
</TABLE>

Debt issuance costs are amortized over the terms of the respective loan
agreements.

K-42
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 6--LONG-TERM DEBT, INCLUDING CAPITALIZED LEASE OBLIGATIONS:

Long-term debt, including capitalized lease obligations, is comprised of the
following:

<TABLE>
<CAPTION>
1997 1996
-------- --------
($ IN THOUSANDS)
<S> <C> <C>
9 3/4% Senior Notes..................................... $103,456 $119,034
10 7/8% Senior Subordinated Discount Notes.............. 30,900 30,606
15% Senior Discount Notes 48,514 0
Capitalized lease obligations........................... 14,595 16,795
Mortgage notes, 12 1/4%-12 1/2%, due 1998............... 169 353
Other................................................... 1,753 2,464
-------- --------
199,387 169,252
Deferred gain on debt exchange.......................... 3,262 0
-------- --------
202,649 169,252
Amounts due within one year............................. 2,694 3,927
-------- --------
$199,955 $165,325
======== ========
</TABLE>

On January 27, 1994, the Company sold $300.0 million principal amount of 9
3/4% Senior Notes due in full in 2002 (the "Senior Notes") and $150.0 million
principal amount ($109.0 million in proceeds) of 10 7/8% Senior Subordinated
Discount Notes due in full in 2004 (the "Discount Notes" and, together with
the Senior Notes, the "Notes"), and the Company and certain of its
subsidiaries entered into a $150.0 million senior secured revolving credit
facility with a $100.0 million sub-limit for standby letters of credit, which
was to be used for general corporate purposes including working capital, debt
service and capital expenditure requirements (the "Old Credit Facility").

On January 10, 1997, the Company entered into a five-year, $35 million
credit facility with Foothill Capital Corporation (the "Foothill Credit
Facility"), which replaced the Old Credit Facility, to provide for the ongoing
working capital needs of the Company. The Foothill Credit Facility provides
for up to $15 million in revolving cash borrowings and up to $35 million in
letters of credit (less the outstanding amount of revolving cash borrowings).
The Foothill Credit Facility is secured by substantially all of the real and
personal property of the Company and contains customary restrictive covenants,
including the maintenance of certain financial ratios. The Company is in
compliance with all financial ratios for the year ended December 28, 1997.
Standby letters of credit are issued under the Foothill Credit Facility
primarily to provide security for future amounts payable by the Company under
its workers' compensation insurance program ($18,381,000 of such letters of
credit were outstanding as of December 28, 1997). No revolving cash borrowings
were outstanding as of December 28, 1997.

The Senior Notes require semiannual interest payments on February 1 and
August 1 of each year and will mature on February 1, 2002. The Senior Notes
will not be redeemable at the option of the Company prior to February 1, 1999.
Thereafter, such notes may be redeemed at prices starting at 102.786% and
declining ratably to 100% at February 1, 2001. Cash interest payments on the
Discount Notes began on August 1, 1997 and will continue to be paid on
February 1 and August 1 of each year, and such notes will mature on February
1, 2004. The Discount Notes will not be redeemable at the option of the
Company prior to February 1, 1999. Thereafter, such notes may be redeemed at
prices starting at 104.078% and declining ratably to 100% at February 1, 2002.

K-43
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

transactions, the Company repurchased (i) an additional $8.5 million aggregate
principal amount of the Discount Notes in the third quarter of 1996 and (ii)
$2.0 million aggregate principal amount of the Discount Notes in the fourth
quarter of 1996. The Company recognized an extraordinary gain of $134.8
million as a result of these repurchases.

On August 12, 1997, FRI-MRD Corporation (a wholly-owned subsidiary of the
Company) ("FRI-MRD") issued new senior discount notes (the "Senior Discount
Notes") in the face amount of $61 million at a price of approximately 75% of
par. The Senior Discount Notes are due on January 24, 2002 and accrete at a
rate of 15% per annum until July 31, 1999, and thereafter, interest will be
payable in cash semi-annually at the rate of 15% per annum. The $61 million of
Senior Discount Notes were issued to an existing holder of the Company's
Senior Notes in exchange for $15.6 million of Senior Notes plus approximately
$34 million of cash, and are part of an agreement pursuant to which FRI-MRD
had the ability to issue up to a maximum of $75 million of Senior Discount
Notes. The gain of $3,548,000 realized on the exchange of Senior Notes has
been deferred and classified as an element of long-term debt in accordance
with the guidelines of Emerging Issues Task Force Issue No. 96-19 because the
present value of the cash flows of the Senior Discount Notes was not at least
10% different from the present value of the cash flows of the Senior Notes
exchanged. The deferred gain is being amortized as a reduction of interest
expense over the life of the Senior Discount Notes. In January 1998, FRI-MRD
issued the remaining $14 million in face value of the Senior Discount Notes
available under such agreement to the same purchaser at a price of 83% of par.
FRI-MRD received approximately $11.6 million in cash as a result of this
subsequent sale. Proceeds from the sales of the Senior Discount Notes will be
used to fund the Company's capital expenditure programs and for general
corporate purposes.

The mortgage notes were issued to a group of institutional lenders and are
collateralized by mortgages covering five restaurants having a net book value
of approximately $6,689,000 at December 28, 1997.

Maturities of long-term debt, including capitalized lease obligations,
during the four years subsequent to December 27, 1998 are as follows:
$2,141,000 in 1999, $2,083,000 in 2000, $1,954,000 in 2001 and $166,439,000 in
2002.

K-44
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 7--DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS:

The recorded amounts of the Company's cash and cash equivalents,
receivables, accounts payable, self-insurance reserves, other accrued
liabilities and certain financial instruments included in other assets at
December 28, 1997 and December 29, 1996 approximate fair value. The fair value
of the Company's long-term debt, excluding capitalized lease obligations, is
estimated as follows:

<TABLE>
<CAPTION>
1997 1996
---------------- ----------------
RECORDED FAIR RECORDED FAIR
AMOUNT VALUE AMOUNT VALUE
-------- ------- -------- -------
($ IN THOUSANDS)
<S> <C> <C> <C> <C>
Senior Notes............................... $103,456 $82,765 $119,034 $86,895
Discount Notes............................. 30,900 22,866 30,606 11,742
Senior Discount Notes...................... 48,514 50,630 0 0
Mortgage notes............................. 169 165 353 347
Other...................................... 1,753 1,527 2,464 2,096
</TABLE>

The fair values of the Notes are based on an average market price of these
instruments as of the end of fiscal 1997 and 1996. The fair value of the
Senior Discount Notes is based on the subsequent issuance of the remaining $14
million in face value at a price of 83% of par. The fair value of the mortgage
notes and other debt was estimated using a discount rate which the Company
believes would be currently available to it for debt with similar terms and
average maturities.

The Company does not maintain investments or commitments for which the
application of SFAS 119, "Disclosure about Derivative Financial Instruments
and Fair Value of Financial Instruments," would cause a material effect.

NOTE 8--OTHER ACCRUED LIABILITIES:

A summary of other accrued liabilities follows:

<TABLE>
<CAPTION>
1997 1996
-------- --------
($ IN THOUSANDS)
<S> <C> <C>
Wages, salaries and bonuses................................ $ 16,251 $ 22,249
Carrying costs of closed properties........................ 12,407 10,500
Reserve for divestitures................................... 0 10,004
Interest................................................... 5,773 5,038
Property taxes............................................. 2,993 3,110
Sales tax.................................................. 2,612 2,132
Utilities.................................................. 1,996 1,313
Accrued rent............................................... 452 537
Other...................................................... 16,089 15,813
-------- --------
$ 58,573 $ 70,696
======== ========
</TABLE>

Carrying costs of closed properties represent the estimated future costs
associated with the Company's closed and subleased restaurants which consists
primarily of the net present value of lease subsidies which are mainly
comprised of the excess of future lease payments for which the Company is
liable, over amounts estimated to be received from related subleases.

K-45
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

NOTE 9--INCOME TAXES:

The Company reported a loss for tax purposes in 1997, 1996 and 1995.
Accordingly, the income tax provisions for each year primarily reflect certain
state, local and foreign taxes. On a tax return basis, the Federal regular
operating loss carryforwards amounted to approximately $203.6 million ($200.6
million of alternative minimum tax operating loss carryforwards) and expire in
2003 through 2013. The Company had approximately $711,000 of tax credit
carryforwards which expire in 2003 and 2004.

Upon consummation of the acquisition of the Company on January 27, 1994, the
Company's net operating loss carryovers and other tax attributes were reduced
significantly for Federal income tax purposes. In addition, because the
consummation of the acquisition of the Company triggered an ownership change
of the Company for Federal income tax purposes, the Company's use of its
remaining net operating loss carryovers for regular and alternative minimum
Federal income tax purposes is subject to an annual limitation in an amount
equal to the product of (i) the long-term tax-exempt rate prevailing on
January 27, 1994 and (ii) the value of the Company's stock, increased to
reflect the cancellation of indebtedness pursuant to the prepackaged joint
plan of reorganization of the Company and REG-M Corp. (but without taking into
account contributions to capital pursuant to the acquisition of the Company).
The Company's annual limit is approximately $5.3 million. The amount of NOL
subject to the annual limit is approximately $22.2 million.

At December 28, 1997, the Company and its subsidiaries had tax credit
carryforwards of approximately $2.1 million not utilized by W. R. Grace & Co.-
Conn. ("Grace"). In accordance with the 1986 acquisition from Grace, the
Company must reimburse Grace for 75% of the benefit of these tax credits if
they are utilized in future Company tax returns. Further, El Torito
Restaurants, Inc. (a wholly owned subsidiary of the Company) has approximately
$12.0 million of tax depreciation deductions not claimed in Grace tax returns
as a result of a tax sharing agreement. The Company will also reimburse Grace
for 75% of any tax savings generated by these deductions.

Further, as a result of the acquisition of Chi-Chi's, the Company has net
operating loss and credit carryforwards not used by Chi-Chi's of $53.2 million
and $6.8 million, respectively. The net operating losses expire beginning in
2004 through 2009 and the credit carryovers expire in various years from 1998
through 2009. The acquisition of Chi-Chi's, as well as the 1992 acquisition of
a previous franchisee by Chi-Chi's, triggered ownership changes for Federal
income tax purposes which result in separate annual limitations on the
availability of these losses and credits.

A reconciliation of income tax expense to the amount of income tax benefit
that would result from applying the Federal statutory rate (35% for 1997, 1996
and 1995) to loss before income taxes is as follows:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
----------------------------
DEC. 28, DEC. 29, DEC. 31,
1997 1996 1995
-------- -------- --------
($ IN THOUSANDS)
<S> <C> <C> <C>
Provision (benefit) for income taxes at
statutory rate............................... $(10,879) $ 48,276 $(42,875)
State taxes, net of Federal income tax
benefit...................................... 219 249 332
Foreign taxes................................. 0 92 270
Nondeductible goodwill........................ 490 1,242 3,312
Change in deferred tax asset which is subject
to a full valuation reserve and other........ 10,679 (48,969) 40,169
-------- -------- --------
$ 509 $ 890 $ 1,208
======== ======== ========
</TABLE>

At December 28, 1997 and December 29, 1996, the Company's deferred tax asset
was $134,717,000 and $124,838,000, respectively, and deferred tax liability
was $17,456,000 and $17,969,000, respectively. The major

K-46
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

components of the Company's net deferred taxes of $117,261,000 at December 28,
1997 and $106,869,000 at December 29, 1996 are as follows:

<TABLE>
<CAPTION>
1997 1996
--------- ---------
($ IN THOUSANDS)
<S> <C> <C>
Depreciation........................................... $ (17,456) $ (17,969)
Net operating loss and credit carryforwards............ 103,909 91,176
Capitalized leases..................................... 817 719
Carrying costs and other reserves...................... 5,120 8,787
Self-insurance reserves................................ 12,915 14,700
Straight-line rent..................................... 1,811 1,872
Reorganization costs................................... 4,700 4,913
Other.................................................. 5,445 2,671
--------- ---------
117,261 106,869
Valuation allowance.................................... (117,261) (106,869)
--------- ---------
$ 0 $ 0
========= =========
</TABLE>

The increase in the valuation allowance for 1997 resulted primarily from the
normal occurrence of temporary differences and the current year tax loss.

NOTE 10--BENEFIT PLANS:

The Company maintains certain incentive compensation and related plans for
executives and key operating personnel, including restaurant and field
management. Total expenses for these plans were $4,062,000, $10,374,000 and
$10,151,000 for 1997, 1996 and 1995, respectively.

The Company maintains a savings plan pursuant to Section 401(k) of the
Internal Revenue Code, which allows administrative and clerical employees who
have satisfied the service requirements to defer from 2% to 12% of their pay
on a pre-tax basis. The Company contributes an amount equal to 20% of the
first 4% of compensation that is deferred by the participant. The Company's
contributions under this plan were $156,000, $164,000 and $288,000 in 1997,
1996 and 1995, respectively. The Company also maintains an unfunded, non-
qualified deferred compensation plan, which was created in 1994 for key
executives and other members of management who were then excluded from
participation in the qualified savings plan. This plan allows participants to
defer up to 50% of their salary on a pre-tax basis. The Company contributes an
amount equal to 20% of the first 4% contributed by the employee. The Company's
contributions under the non-qualified deferred compensation plan were $37,000,
$38,000 and $67,000 in 1997, 1996 and 1995, respectively. In each plan, a
participant's right to Company contributions vests at a rate of 25% per year
of service. The Company has no defined benefit plans.

NOTE 11--RELATED PARTY TRANSACTIONS:

Foodmaker, Inc. ("Foodmaker") provided distribution services through May
1997 to a portion of the Company's restaurants, principally those operated
under the Chi-Chi's name. Distribution sales to those restaurants for the
years ended December 28, 1997, December 29, 1996 and December 31, 1995
aggregated $21,844,000, $63,785,000 and $76,423,000, respectively. Due to the
termination of distribution sales, there were no accounts payable due to
Foodmaker at December 28, 1997. The Company had accounts payable of $2,301,000
due to Foodmaker at December 29, 1996.

Apollo FRI Partners, L.P. ("Apollo") charged a monthly fee of $100,000
during 1997 and 1996 which Apollo will continue to earn in the future, and
Apollo and Green Equity Investors, L.P. ("GEI") each charged a

K-47
<PAGE>

FAMILY RESTAURANTS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

monthly fee of $50,000 during 1995 for providing certain management services
to the Company. In November 1995, the management services arrangement with GEI
was terminated. For the years ended December 28, 1997, December 29, 1996 and
December 31, 1995, the Company was charged $1.2 million each year in
connection with this arrangement. The Company had management services fees
payable of $3,250,000 and $2,050,000 due to Apollo and GEI at December 28,
1997 and December 29, 1996, respectively.

NOTE 12--COMMON STOCK:

Certain officers and employees of the Company were granted the right to
purchase up to 40,900 shares of Common Stock (constituting up to 4.1% of the
Common Stock outstanding immediately following such purchases) at $160 per
share, the same per share price paid by Apollo and GEI in January 1994. The
Employee Stock Purchase was consummated on January 27, 1994 with respect to
certain officers (15,625 shares of Common Stock) and on May 19, 1994 and July
31, 1994 with respect to the other participants (22,552 shares of Common
Stock). No more than fifty percent of the purchase price was authorized to be
financed through interest-bearing recourse notes payable to the Company. In
July 1996, the Company canceled all such interest-bearing recourse notes. The
Company has repurchased 8,992 shares of Common Stock due to employee
terminations, leaving 28,905 shares currently owned by management stockholders
and terminated employees. The individuals who purchased Common Stock were also
granted options to purchase 20,822 shares of Common Stock in the future at an
exercise price initially set at $160 per share. The Company also granted
options to purchase approximately 30,000 shares of Common Stock to
approximately 800 other employees. All these options expire in 2004 and 2005
and become exercisable at a rate of 25% on the grant date and 25% on each of
the next three anniversaries of the grant date. Approximately 44,500 options
have expired due to terminations.

NOTE 13--CONTINGENCIES:

K-48
<PAGE>

SCHEDULE II

FAMILY RESTAURANTS, INC.

VALUATION AND QUALIFYING ACCOUNTS
($ IN THOUSANDS)

<TABLE>
<CAPTION>
ADDITIONS
-------------------
BALANCE AT CHARGED TO CHARGED BALANCE
BEGINNING COSTS AND TO OTHER AT END
DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS OF PERIOD
- ----------- ---------- ---------- -------- ---------- ---------
<S> <C> <C> <C> <C> <C>
Allowance for
uncollectible
receivables:
For the year 1997..... $879 $ 78 $300 $(206)(1) $1,051
For the year 1996..... 997 0 0 (118)(1) 879
For the year 1995..... 813 184 0 0 997
</TABLE>
- --------
(1) Represents write-off of uncollectible receivables against allowance and
includes transfers to other accounts.

K-49