Edgar Filing: FRIENDLY ICE CREAM CORP

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K/A

(Amendment No. 1)

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

For the fiscal year ended December 31, 2006

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

For the transition period from to

Commission File No. 001-13579

FRIENDLY ICE CREAM CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Massachusetts		04-2053130
(State or Other Jurisdiction of		(IRS Employer
Incorporation or Organization)		Identification No.)
1855 Boston Road
Wilbraham, Massachusetts		01095
(Address of Principal Executive Offices)		(Zip Code)

(413) 731-4000

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:

Title of class

Common Stock, $.01 par value
Rights to Purchase Series A Junior
Preferred Stock, $.01 par value

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. Yes o No x

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

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. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer o

Accelerated Filer x

Non-Accelerated Filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant on July 2, 2006, based upon the closing sales price of the common stock on the American Stock Exchange, was $53,301,000. For purposes of the foregoing calculation only, all members of the Board of Directors and executive officers of the registrant have been deemed affiliates. The number of shares of common stock outstanding was 8,117,235 as of January 31, 2007.

Documents Incorporated By Reference

Part III of this Form 10-K incorporates information by reference from the registrant’s definitive proxy statement which will be filed no later than 120 days after December 31, 2006.

Introductory Note:

This Amendment No. 1 to Form 10-K for the year ended December 31, 2006 (“Form 10-K/A”) has been filed by Friendly Ice Cream Corporation (the “Company”) solely to amend Item 8, Financial Statements and Supplementary Data, to correct typographical errors in the Consolidated Statement of Cash Flows included on page F-6 of the Company’s Annual Report on Form 10-K filed on March 6, 2007. The amounts reported in the line item “Contribution to defined benefit pension plan” for each of the years ended January 1, 2006 and January 2, 2005 should have been zero, but inadvertently duplicated the amounts reported in the immediately preceding line item under the “Accrued expenses and other long-term liabilities” for the same periods. This inadvertent duplication also impacted the amounts reported for net cash provided by operating activities, net increase (decrease) in cash and cash equivalents, and cash and cash equivalents, end of year, for the years ended January 1, 2006 and January 2, 2005. The Consolidated Statement of Cash Flows has been revised in this Form 10-K/A to reflect that (1) contribution to defined benefit pension plan was $0 for both years ended January 1, 2006 and January 2, 2005, and not $2,422 and $3,253, respectively, (2) net cash provided by operating activities for the years ended January 1, 2006 and January 2, 2005 was $13,995 and $6,609, respectively, and not $11,573 and $3,356, respectively,(3) net increase (decrease) in cash and cash equivalents for the years ended January 1, 2006 and January 2, 2005 was $1,192 and ($12,226), respectively, and not ($1,230) and ($15,479), respectively, and (4) cash and cash equivalents, end of year for the years ended January 1, 2006 and January 2, 2005 was $14,597 and $13,405, respectively, and not $12,175 and $10,152, respectively. This Form 10-K/A does not amend, modify or update any other information.

SIGNATURES

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

				Friendly Ice Cream Corporation
			By:	/s/ PAUL V. HOAGLAND
				Name: Paul V. Hoagland
				Title: Executive Vice President of Administration and Chief Financial Officer
			Date:	March 12, 2007

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

	Page
Report of Independent Registered Public Accounting Firm		F-2
Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 2006 and January 1, 2006		F-3
Consolidated Statements of Operations for the Years Ended December 31, 2006, January 1, 2006 and January 2, 2005		F-4
Consolidated Statements of Changes in Stockholders’ Deficit for the Years Ended December 31, 2006, January 1, 2006 and January 2, 2005		F-5
Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, January 1, 2006 and January 2, 2005		F-6
Notes to Consolidated Financial Statements		F-7

F-1

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders of Friendly Ice Cream Corporation:

We have audited the accompanying consolidated balance sheets of Friendly Ice Cream Corporation and subsidiaries as of December 31, 2006 and January 1, 2006 and the related consolidated statements of operations, stockholders’ deficit and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Friendly Ice Cream Corporation and subsidiaries at December 31, 2006 and January 1, 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Friendly Ice Cream Corporation and subsidiaries internal control over financial reporting as of December 31 2006 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 21, 2007 expressed an unqualified opinion thereon.

	/s/ Ernst & Young LLP
Boston, Massachusetts
February 21, 2007

F-2

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

	December 31,				January 1,
	2006				2006
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	25,077		$	14,597
Restricted cash		517			2,549
Accounts receivable, net		11,435			10,757
Inventories		17,059			15,775
Assets held for sale		896			933
Prepaid expenses and other current assets		3,127			5,044
TOTAL CURRENT ASSETS		58,111			49,655
DEFERRED INCOME TAXES		928			—
PROPERTY AND EQUIPMENT, net of accumulated depreciation and amortization		137,425			143,514
INTANGIBLE ASSETS AND DEFERRED COSTS, net of accumulated amortization of $13,204 and $11,247 at December 31, 2006 and January 1, 2006, respectively		17,783			19,063
OTHER ASSETS		5,920			6,010
TOTAL ASSETS		$	220,167		$	218,242
LIABILITIES AND STOCKHOLDERS’ DEFICIT
CURRENT LIABILITIES:
Current maturities of long-term debt		$	1,563		$	1,426
Current maturities of capital lease and finance obligations		1,541			1,419
Accounts payable		22,247			24,968
Accrued salaries and benefits		8,230			8,212
Accrued interest payable		1,173			1,324
Insurance reserves		11,462			9,002
Restructuring reserves		—			72
Other accrued expenses		22,475			19,866
TOTAL CURRENT LIABILITIES		68,691			66,289
CAPITAL LEASE AND FINANCE OBLIGATIONS, less current maturities		4,682			6,173
LONG-TERM DEBT, less current maturities		222,650			224,894
LIABILITY FOR PENSION BENEFITS		20,302			28,904
OTHER LONG-TERM LIABILITIES.		30,738			33,820
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ DEFICIT:
Common stock, par value $.01 per share; authorized 50,000,000 shares; 8,117,235 and 7,898,591 shares issued and outstanding at December 31, 2006 and January 1, 2006, respectively		81			79
Preferred stock, par value $.01 per share; authorized 1,000,000 shares; no shares issued and outstanding		—			—
Additional paid-in capital		146,398			144,675
Accumulated other comprehensive loss		(23,514		)	(31,785		)
Accumulated deficit		(249,861		)	(254,807		)
TOTAL STOCKHOLDERS’ DEFICIT.		(126,896		)	(141,838		)
TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT.		$	220,167		$	218,242

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

F-3

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

	For the Years Ended
	December 31,				January 1,			January 2,
	2006				2006			2005
								(53 weeks)
REVENUES:
Restaurant		$	395,999		$	400,821		$	431,763
Foodservice		120,055			116,072			112,637
Franchise		15,401			14,454			13,199
TOTAL REVENUES		531,455			531,347			557,599
COSTS AND EXPENSES:
Cost of sales		200,828			205,332			210,477
Labor and benefits		141,148			143,973			158,133
Operating expenses		104,030			105,809			104,681
General and administrative expenses		43,284			38,746			40,006
Pension settlement expense (Note 11)		—			—			2,204
Restructuring expense (Note 9)		—			—			2,627
Gain on litigation settlement (Note 19)		—			—			(3,644		)
Write-downs of property and equipment (Note 5)		719			2,478			91
Depreciation and amortization		22,913			23,435			22,592
Gain on franchise sales of restaurant operations and properties		(3,927		)	(2,658		)	(1,302		)
Loss on disposals of other property and equipment, net		901			1,030			213
OPERATING INCOME		21,559			13,202			21,521
OTHER EXPENSES (INCOME):
Interest expense, net of capitalized interest of $103, $25 and $61 and interest income of $1,097, $682 and $702 for the years ended December 31, 2006, January 1, 2006 and January 2, 2005, respectively		20,491			20,924			22,295
Other (income) expense		(334		)	(130		)	9,235
INCOME (LOSS) BEFORE BENEFIT FROM PROVISION FOR INCOME TAXES		1,402			(7,592		)	(10,009		)
Benefit from (provision for)income taxes		83			(20,002		)	7,145
INCOME (LOSS) FROM CONTINUING OPERATIONS		1,485			(27,594		)	(2,864		)
Income (loss) from discontinued operations, net of income tax effect of ($538), ($232) and $385 for the years ended December 31, 2006, January 1, 2006 and January 2, 2005, respectively.		3,461			335			(553		)
NET INCOME (LOSS)		$	4,946		$	(27,259	)	$	(3,417	)
BASIC NET INCOME (LOSS) PER SHARE:
Income (loss) from continuing operations		$	0.19		$	(3.53	)	$	(0.38	)
Income (loss) from discontinued operations		0.44			0.04			(0.07		)
Net income (loss)		$	0.63		$	(3.49	)	$	(0.45	)
DILUTED NET INCOME (LOSS) PER SHARE:
Income (loss) from continuing operations		$	0.18		$	(3.53	)	$	(0.38	)
Income (loss) from discontinued operations		0.43			0.04			(0.07		)
Net income (loss)		$	0.61		$	(3.49	)	$	(0.45	)
WEIGHTED AVERAGE SHARES:
Basic		7,939			7,802			7,637
Diluted		8,084			7,802			7,637

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

F-4

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT

(In thousands, except share data)

								Accumulated
					Additional			Other
	Common Stock				Paid-In			Comprehensive				Accumulated
	Shares	Amount			Capital			(Loss) Income				Deficit				Total
BALANCE, DECEMBER 28, 2003.	7,489,478		$	75		$	140,826		$	(19,922	)		$	(224,131	)	$	(103,152	)
Comprehensive (loss) income:
Net loss	—		—			—			—				(3,417		)	(3,417		)
Minimum pension liability (net of income tax benefit of $540)	—		—			—			(777		)		—			(777		)
Net unrealized gains on marketable securities (net of income tax expense of $20)	—		—			—			29				—			29
Total comprehensive loss	—		—			—			(748		)		(3,417		)	(4,165		)
Stock options exercised	223,801		2			976			—				—			978
Income tax benefit of stock options exercised	—		—			818			—				—			818
Stock compensation expense	—		—			495			—				—			495
BALANCE, JANUARY 2, 2005	7,713,279		$	77		$	143,115		$	(20,670	)		$	(227,548	)	$	(105,026	)
Comprehensive loss:
Net loss	—		—			—			—				(27,259		)	(27,259		)
Minimum pension liability (net of income tax benefit of $4,545)	—		—			—			(6,541		)		—			(6,541		)
Deferred tax valuation allowance	—		—			—			(4,545		)		(4,545		)
Net unrealized gains on marketable securities (net of income tax expense of $20)	—		—			—			(29		)		—			(29		)
Total comprehensive loss	—		—			—			(11,115		)		(27,259		)	(38,374		)
Stock options exercised	185,312		2			1,035			—				—			1,037
Income tax benefit of stock options exercised	—		—			450			—				—			450
Stock compensation expense	—		—			75			—				—			75
BALANCE, JANUARY 1, 2006	7,898,591		$	79		$	144,675		$	(31,785	)		$	(254,807	)	$	(141,838	)
Comprehensive income:
Net income	—		—			—			—				4,946			4,946
Defined benefit plan:
Net actuarial gain (Note 11)
(net of income tax benefit of $3,283)	—		—			—			4,724				—			4,724
Deferred tax valuation allowance	—		—			—			3,283				—			3,283
Total comprehensive income	—		—			—			8,007				4,946			12,953

Adjustment to initially apply SFAS No. 158 (net of income tax benefit of $108)	—		—			—			156				—			156
Deferred tax valuation allowance	—		—			—			108				—			108

Stock options exercised	218,644		2			1,141			—				—			1,143
Income tax benefit of stock options exercised	—		—			145			—				—			145
Stock compensation expense	—		—			437			—				—			437
BALANCE, DECEMBER 31, 2006	8,117,235		$	81		$	146,398		$	(23,514	)		$	(249,861	)	$	(126,896	)

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

F-5

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

	For the Years Ended
	December 31,				January 1,				January 2,
	2006				2006				2005
									(53 weeks)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)		$	4,946			$	(27,259	)	$	(3,417	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Stock compensation expense		437				75			495
Depreciation and amortization		22,913				23,435			22,592
Non-cash (income) loss from discontinued operations		(4,359		)		(1,560		)	639
Write-offs of deferred financing costs		—				—			2,445
Write-downs of property and equipment		719				2,478			91
Deferred income tax (benefit) expense		(928		)		17,849			(7,383		)
Tax benefit from exercise of stock options		(145		)		(450		)	(818		)
Gain on disposals of property and equipment, net		(2,828		)		(1,616		)	(1,107		)
Pension settlement expense		—				—			2,204
Changes in operating assets and liabilities:
Accounts receivable		(678		)		(309		)	(64		)
Inventories		(1,284		)		1,770			(1,876		)
Other assets		4,039				(1,428		)	(3,000		)
Accounts payable		(2,721		)		3,432			(939		)
Accrued expenses and other long-term liabilities		3,746				(2,422		)	(3,253		)
Contribution to defined benefit pension plan		(2,150		)		—			—
NET CASH PROVIDED BY OPERATING ACTIVITIES		21,707				13,995			6,609
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(21,670		)		(16,902		)	(19,734		)
Proceeds from sales of property and equipment		13,360				8,245			6,035
Purchases of marketable securities		—				(665		)	(1,130		)
Proceeds from sales of marketable securities		—				1,643			152
NET CASH USED IN INVESTING ACTIVITIES		(8,310		)		(7,679		)	(14,677		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of New Senior Notes		—				—			175,000
Proceeds from borrowings under revolving credit facility		8,000				16,250			26,250
Proceeds from issuance of mortgages		—				9,615			—
Repayments of debt		(10,107		)		(30,521		)	(199,338		)
Payments of deferred financing costs		(675		)		(429		)	(6,650		)
Repayments of capital lease and finance obligations		(1,423		)		(1,526		)	(1,216		)
Stock options exercised		1,143				1,037			978
Tax benefit from exercise of stock options		145				450			818
NET CASH USED IN FINANCING ACTIVITIES		(2,917		)		(5,124		)	(4,158		)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		10,480				1,192			(12,226		)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR.		14,597				13,405			25,631
CASH AND CASH EQUIVALENTS, END OF YEAR.		$	25,077			$	14,597		$	13,405
SUPPLEMENTAL DISCLOSURES:
Cash paid during the period for:
Interest		$	20,138			$	20,169		$	21,953
Income taxes		60				691			70
Capital lease obligations incurred		54				256			3,445
Capital lease obligations terminated		—				51			—

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

F-6

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. NATURE OF OPERATIONS

As of December 31, 2006, Friendly’s operated 316 full-service restaurants and franchised 198 full-service restaurants and seven non-traditional units. The Company manufactures and distributes a full line of premium ice cream dessert products. These products are distributed to Friendly’s restaurants, supermarkets and other retail locations in 12 states. The restaurants offer a wide variety of breakfast, lunch and dinner menu items as well as premium ice cream dessert products. For the years ended December 31, 2006, January 1, 2006 and January 2, 2005, restaurant sales were approximately 75%, 75% and 78%, respectively, of the Company’s total revenues. As of December 31, 2006, January 1, 2006 and January 2, 2005, approximately 94%, 97% and 96%, respectively, of the Company-operated restaurants were located in the Northeast United States.

References herein to “Friendly’s” or the “Company” refer to Friendly Ice Cream Corporation, its predecessor and its consolidated subsidiaries; references herein to “FICC” refer to Friendly Ice Cream Corporation and not its subsidiaries; and as used herein, “Northeast” refers to the Company’s core markets, which include Connecticut, Maine, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island and Vermont.

Following is a summary of Company-operated and franchised units:

	For the Years Ended
	December 31,			January 1,			January 2,
	2006			2006			2005
Company Units:
Beginning of year		314			347			355
Openings		2			2			4
Acquired from franchisees		11			—			—
Acquired by franchisees		(6	)		(15	)		(27	)
Closings		(5	)		(20	)		(5	)
End of year		316			314			327
Franchised Units:
Beginning of year		213			195			163
Openings		4			6			8
Acquired by franchisees		6			15			27
Acquired from franchisees		(11	)		—			—
Closings		(7	)		(3	)		(3	)
End of year		205			213			195

2. SUMMARY OF BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation—

The consolidated financial statements include the accounts of FICC and its wholly owned subsidiaries after elimination of intercompany accounts and transactions.

Reclassifications—

Certain prior year amounts have been reclassified on the statement of cash flows related to the tax benefit from the exercise of stock options to conform with current year presentation.

Fiscal Year—

Friendly’s fiscal year ends on the last Sunday in December, unless that day is earlier than December 27, in which case the fiscal year ends on the following Sunday. The fiscal year ended January 2,

F-7

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

2005 included 53 weeks. All other years presented included 52 weeks. The additional week in 2004 contributed $10,689,000 in total revenues.

Use of Estimates in the Preparation of Financial Statements—

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The critical accounting policies and most significant estimates and assumptions relate to revenue recognition, insurance reserves, recoverability of accounts receivable and notes receivable, pension and post-retirement medical and life insurance benefits expense, asset impairment analysis, income tax valuation allowances and tax contingency reserves. Actual amounts could differ significantly from the estimates.

Revenue Recognition—

The Company’s revenues are derived primarily from the operation of full-service restaurants, the distribution and sale of premium ice cream desserts through retail and institutional locations and franchising. The Company recognizes restaurant revenue upon receipt of payment from the customer and foodservice revenue (product sales to franchisees and retail customers), net of discounts and allowances, upon delivery of product. Reserves for discounts and allowances from retail sales (trade promotions) are estimated and accrued when revenue is recorded based on promotional plans prepared by the Company’s retail sales force. Due to the high volume of trade promotion activity and the difficulty of coordinating trade promotion pricing with its customers, differences between the Company’s accrual and the subsequent settlement amount occur frequently. To address the financial impact of these differences, the Company’s estimating methodology takes these smaller differences into account. The Company believes its methodology has been reasonably reliable in recording trade promotion accruals. The accrual for future trade promotion settlements as of December 31, 2006 and January 1, 2006 and was $5,373,000 and $5,127,000, respectively. A variation of five percent in the 2006 accrual would change retail sales by approximately $269,000. Franchise royalty income, generally calculated as 4% of net sales of franchisees, is recorded monthly based upon the actual sales reported by each franchisee for the month just completed. Franchise fees are recorded as revenue upon completion of all significant services, generally upon opening of the restaurant.

Shipping and Handling Costs—

Costs related to shipping and handling are included in cost of sales in the accompanying consolidated statements of operations for all periods presented.

Insurance Reserves—

The Company is self-insured through retentions or deductibles for the majority of its workers’ compensation, automobile, general liability, employer’s liability, product liability and group health insurance programs. Self-insurance amounts vary up to $500,000 per occurrence. Insurance with third parties, some of which is then reinsured through Restaurant Insurance Corporation (“RIC”), the

F-8

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

Company’s wholly owned subsidiary, is in place for claims in excess of these self-insured amounts. RIC reinsures 100% of the risk from $500,000 to $1,000,000 per occurrence through September 2, 2000 for FICC’s workers’ compensation, general liability, employer’s liability and product liability insurance. Subsequent to September 2, 2000, the Company discontinued its use of RIC as a captive insurer for new claims. FICC’s and RIC’s liabilities for estimated incurred losses are actuarially determined and recorded in the accompanying consolidated financial statements on an undiscounted basis. Actual incurred losses may vary from the estimated incurred losses and could have a material effect on the Company’s insurance expense.

Accounts Receivable and Allowance for Doubtful Accounts—

At December 31, 2006 and January 1, 2006, accounts receivable of $11,435,000 and $10,757,000 were net of allowances for doubtful accounts totaling $1,310,000 and $758,000, respectively. Accounts receivable consists primarily of amounts due from the sale of products to franchisees and supermarkets. Accounts receivable also includes amounts related to franchise royalties, rents and other miscellaneous items.

The Company recognizes allowances for doubtful accounts to ensure receivables are not overstated due to uncollectibility. Bad debt reserves are maintained for customers in the aggregate based on a variety of factors, including the length of time receivables are past due, significant one-time events and historical experience. An additional reserve for individual accounts is recorded when the Company becomes aware of a customer’s inability to meet its financial obligations, such as in the case of bankruptcy filings or deterioration in the customer’s operating results or financial position. If circumstances change, estimates of the recoverability of receivables would be further adjusted.

Pension and Post-Retirement Medical and Life Insurance Benefits—

The determination of the Company’s obligation and expense for pension and post-retirement medical and life insurance benefits is dependent upon the selection of certain assumptions used by actuaries in calculating such amounts. Those assumptions include, among other things, the discount rate, expected long-term rate of return on plan assets and rates of increase in health care costs. In accordance with accounting principles generally accepted in the United States, actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, generally affect the recognized expense and recorded obligation in such future periods. Significant differences in actual experience or significant changes in the assumptions may materially affect the future pension and post-retirement medical and life insurance obligations and expense.

Cash and Cash Equivalents—

The Company considers all investments with an original maturity of three months or less when purchased to be cash equivalents.

Restricted Cash—

RIC is required to hold assets in trust whose value is at least equal to certain of RIC’s outstanding estimated insurance claim liabilities. Accordingly, as of December 31, 2006 and January 1, 2006, cash of $517,000 and $899,000, respectively, was restricted.

F-9

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

Pursuant to the terms of the Mortgage Financing, the Company may sell properties securing its obligations provided that other properties are substituted in place of the sold properties. The substituted properties must meet certain requirements under the terms of the Mortgage Financing. In August 2005, proceeds of $415,000 and $2,650,000 were received in connection with the sale of two mortgaged properties, of which $400,000 and $1,250,000 of such amounts was placed in escrow pending the inclusion of a substitute property. As of January 1, 2006, these balances were held as collateral and were included in restricted cash on the accompanying consolidated balance sheet as of January 1, 2006. In connection with the Variable Refinancing, the mortgage on one of these properties was released and the remaining $400,000 related to the sale of this property was released from escrow during the first quarter of 2006. A substitute property for the second property was obtained during the second quarter of 2006 in compliance with the substitution agreement. On June 15, 2006, the remaining $1,250,000 was released from escrow.

Inventories—

Inventories are stated at the lower of first-in, first-out cost or market and consisted of the following at December 31, 2006 and January 1, 2006 (in thousands):

	December 31,			January 1,
	2006			2006
Raw materials		$	1,640		$	1,657
Goods in process		158			106
Finished goods		15,261			14,012
Total		$	17,059		$	15,775

Long-Lived Assets—

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company reviews its trademarks and service marks, which were assigned to the Company by Hershey in September 2002, for impairment on a quarterly basis. The Company recognizes impairment has occurred when the carrying value of these marks exceeds the estimated future undiscounted cash flows of the trademarked products. Additionally, the Company reviews long-lived assets related to each restaurant to be held and used in the business quarterly for impairment, or whenever events or changes in circumstances indicate that the carrying amount of a restaurant may not be recoverable. The Company evaluates restaurants using a “two-year history of cash flow” as the primary indicator of potential impairment. Based on the best information available, the Company writes down an impaired restaurant to its estimated fair market value, which becomes its new cost basis. Estimated fair market value is based on the Company’s experience selling similar properties and local market conditions, less costs to sell for properties to be disposed of. In addition, restaurants scheduled for closing are reviewed for impairment and depreciable lives are adjusted. The impairment evaluation is based on the estimated cash flows from continuing use through the expected disposal date and the expected terminal value. SFAS No. 144 requires a long-lived asset to be disposed of other than by sale to be classified as held and used until it is disposed of.

Store closure costs include costs of disposing of the assets as well as other facility-related expenses from previously closed stores. These store closure costs are expensed as incurred. Additionally, at the date

F-10

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

the closure occurs, the Company records a liability for the amount of any remaining operating lease obligations subsequent to the expected closure date, net of estimated sublease income, if any.

SFAS No. 144 requires the results of operations of a component of an entity that is classified as held for sale or that has been disposed of to be reported as discontinued operations in the statement of operations if certain conditions are met. These conditions include commitment to a plan of disposal after the effective date of this statement, elimination of the operations and cash flows of the entity component from the ongoing operations of the Company and no significant continuing involvement in the operations of the entity component after the disposal transaction.

Considerable management judgment is necessary to estimate future cash flows, including cash flows from continuing use, terminal value, closure costs and sublease income. Accordingly, actual results could vary significantly from estimates.

Property and Equipment—

Property and equipment are carried at cost. Depreciation of property and equipment is computed using the straight-line method over the following estimated useful lives:

Buildings—30 years
Building improvements and leasehold improvements—lesser of lease term or 20 years
Equipment—3 to 10 years

At December 31, 2006 and January 1, 2006, property and equipment included (in thousands):

	December 31,				January 1,
	2006				2006
Land		$	24,796		$	25,960
Buildings and improvements		97,558			98,015
Leasehold improvements		41,405			38,908
Assets under capital leases		12,190			12,272
Equipment		212,801			227,749
Construction in progress		4,982			2,326
Property and equipment		393,732			405,230
Less:
accumulated depreciation and amortization property and equipment		(246,701		)	(253,098		)
accumulated depreciation and amortization assets under capital leases		(9,606		)	(8,618		)
Property and equipment, net		$	137,425		$	143,514

Depreciation expense was $20,958,000, $21,576,000 and $20,780,000 for the years ended December 31, 2006, January 1, 2006 and January 2, 2005, respectively. Additionally, depreciation of $0, $555,000 and $639,000 was included in discontinued operations for the years ended December 31, 2006, January 1, 2006 and January 2, 2005, respectively.

F-11

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

Major renewals and betterments are capitalized. Replacements and maintenance and repairs which do not extend the lives of the assets are charged to operations as incurred.

Other Assets—

Other assets included notes receivable of $4,688,000 and $4,401,000, which were net of allowances for doubtful accounts totaling $48,000 and $263,000 as of December 31, 2006 and January 1, 2006, respectively. Also included in other assets as of December 31, 2006 and January 1, 2006 were payments made to fronting insurance carriers of $1,439,000 and $1,556,000, respectively, to establish loss escrow funds.

Other Accrued Expense—

Other accrued expenses consisted of the following at December 31, 2006 and January 1, 2006 (in thousands):

	December 31,			January 1,
	2006			2006
Accrued rent		$	5,178		$	4,739
Gift cards outstanding		4,317			4,280
Accrued bonus		3,635			58
Accrued meals and other taxes		2,241			2,219
Income taxes payable		1,962			2,761
Unearned revenues		1,153			1,205
Accrued advertising		1,150			1,211
Accrued construction costs		918			1,335
Current portion of deferred gains (Note 7)		638			638
All other		1,283			1,420
Total		$	22,475		$	19,866

Income Taxes—

The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. The Company records deferred tax assets to the extent it believes there will be sufficient future taxable income to utilize those assets prior to their expiration. To the extent deferred tax assets may be unable to be utilized, the Company records a valuation allowance against the potentially unrealizable amount and records a charge against earnings. The calculation of the Company’s tax liabilities involves dealing with uncertainties in the application of complex tax regulations in several different tax jurisdictions. The Company is periodically reviewed by tax authorities regarding the amount of taxes due. These reviews include questions regarding the timing and amount of deductions. In evaluating the exposure associated with various filing positions, the Company records estimated reserves for probable exposures.

F-12

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

Due to ever-changing tax laws and income tax rates, significant judgment is required to estimate the effective tax rate expected to apply to tax differences that are expected to reverse in the future. The Company must also make estimates about the sufficiency of taxable income in future periods to offset any deductions related to deferred tax assets currently recorded. Accordingly, the Company believes estimates related to income taxes are critical.

During the fourth quarter of 2005, the Company entered a three-year cumulative loss position and revised its projections of the amount and timing of profitability in future periods. As a result, the Company increased the valuation allowance during the fourth quarter of 2005 by $26,729,000 ($22,184,000 to income tax expense and $4,545,000 to stockholders’ deficit) to reduce the carrying value of deferred tax assets to zero.

As of December 31, 2006 the Company remains in a three-year cumulative loss position and expects to record valuation allowances on future tax benefits until it can sustain an appropriate level of profitability. However, the Company has incurred approximately $1,093,000 of federal tax liabilities for 2005 and 2006 combined. Approximately $928,000 of the $1,093,000 would be available for refund if 2007 resulted in a loss for income tax purposes. As a result, the valuation allowances as of December 31, 2006 of $27,429,000 will reduce the carrying value of net deferred tax assets to $928,000. Should the Company’s future profitability provide sufficient evidence, in accordance with SFAS No. 109, to support the ultimate realization of income tax benefits attributable to net operating loss (“NOL”) and credit carryforwards and other deductible temporary differences, a reduction in the valuation allowance may be recorded and the carrying value of deferred tax assets may be restored, resulting in a non-cash credit to earnings.

Derivative Instruments and Hedging Agreements—

The Company enters into commodity option and/or futures contracts from time to time to manage dairy cost pressures. On September 19, 2005, the Chicago Mercantile Exchange launched the first electronically traded, cash-settled butter futures contract. This new futures contract is designed to meet the needs of food and dairy companies that have exposure to butterfat price risk but do not want to expose themselves to the possibility of being compelled to take physical delivery of butter. The size of the contract is 20,000 pounds of AA butter, versus the traditional butter futures contract, which is 40,000 pounds. The contract is cash settled based upon the U.S. Department of Agriculture’s monthly weighted average price for butter in the United States. With this new type of futures contract, there is no risk of delivery of butter; therefore it offers the Company the ability to hedge the price risk of cream (on a butter basis), without having to take delivery of commodity butter. The Company has evaluated this new hedging instrument and believes it is an attractive way to hedge the price risk related to cream.

The Company’s commodity option contracts and the cash-settled butter futures contracts do not meet hedge accounting criteria as defined by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and its related amendment, SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities,” and, accordingly, are marked to market each period with the resulting gains or losses recognized in cost of sales. During 2006, 2005 and 2004, (losses) gains of approximately ($497,000), ($238,000) and $623,000 were included in cost of sales related to these contracts,

F-13

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

respectively. The fair value of the contracts outstanding at December 31, 2006 and January 1, 2006 was $35,000 and $71,000, respectively.

At December 31, 2006, the Company held 70 contracts, four of them for December 2006 and the remainder spread over the first nine months of 2007. These contracts correspond to approximately 20% of the Company’s anticipated cream purchases for the periods represented.

Advertising—

The Company expenses advertising costs as incurred. For the years ended December 31, 2006, January 1, 2006 and January 2, 2005, advertising expenses were $16,801,000, $18,694,000 and $20,734,000, respectively.

Leases and Deferred Straight-Line Rent Payable—

The Company leases many of its restaurant properties. Leases are accounted for under the provisions of SFAS No. 13, “Accounting for Leases,” as amended, which requires that leases be evaluated and classified as operating or capital leases for financial reporting purposes. The lease term used for lease evaluation includes option periods only in instances in which the exercise of the option period can be reasonably assured and failure to exercise such options would result in an economic penalty. Leasehold improvements that are acquired subsequent to the inception of a lease are amortized over the lesser of the useful life of the asset or a term that includes option periods that are reasonably assured at the date of the purchase.

For leases that contain rent escalations, the Company records the total rent payable during the lease term, as determined above, on a straight-line basis over the term of the lease and records the difference between the rents paid and the straight-line rent as a deferred straight-line rent payable.

Certain leases contain provisions that require additional rental payments based upon restaurant sales volume (“contingent rentals”). Contingent rentals are accrued each period as the liabilities are incurred utilizing prorated periodic sales targets.

Lease Guarantees and Contingencies—

Primarily as a result of the Company’s strategy to sell Company-operated restaurants to franchisees, the Company remains liable for certain lease assignments and guarantees. These leases have varying terms, the latest of which expires in 2020. As of December 31, 2006, the potential amount of undiscounted payments the Company could be required to make in the event of non-payment by the primary lessees was $6,648,000. The present value of these potential payments discounted at the Company’s pre-tax cost of debt at December 31, 2006 was $5,041,000. The Company generally has cross-default provisions with franchisees that would put them in default of their franchise agreement in the event of non-payment under the lease. The Company believes these cross-default provisions significantly reduce the risk that the Company will be required to make payments under these leases and, historically, the Company had not been required to make such payments. Accordingly, no liability has been recorded for exposure under such leases at December 31, 2006 and January 1, 2006.

F-14

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

Net Income (Loss) Per Share—

Basic net income (loss) per share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is calculated by dividing net income (loss) by the weighted average number of shares of common stock and common stock equivalents outstanding during the period. Common stock equivalents are dilutive stock options and warrants that are assumed exercised for calculation purposes. The number of common stock options which could dilute basic earnings per share in the future, that were not included in the computation of diluted income (loss) per share because to do so would have been antidilutive, was 151,000, 273,000 and 320,000 for the years ended December 31, 2006, January 1, 2006 and January 2, 2005, respectively.

Presented below is the reconciliation between basic and diluted weighted average shares (in thousands):

	For the Years Ended
	December 31,		January 1,		January 2,
	2006		2006		2005
Basic weighted average number of common shares outstanding during the year		7,939		7,802		7,637
Adjustments:
Assumed exercise of stock options and vesting of restricted stock units		145		—		—
Diluted weighted average number of common shares outstanding during the year		8,084		7,802		7,637

Stock-Based Compensation—

Prior to January 2, 2006, the Company accounted for stock-based compensation for employees under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company had adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and the disclosures required by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.” In accordance with APB Opinion No. 25, the Company generally recognized no stock-based compensation cost, as all options granted during that period had an exercise price equal to the market value of the stock on the date of grant. Stock-based compensation cost of $68,000 and $238,000 related to modified option awards was included in net loss for the years ended January 1, 2006 and January 2, 2005, respectively, for the Company’s 1997 Stock Option Plan and the Company’s 2003 Equity Incentive Plan.

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R supersedes APB Opinion No. 25 and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. However, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values at the date of grant. Pro forma disclosure is no longer an alternative.

F-15

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

On January 2, 2006 (the first day of its 2006 fiscal year), the Company adopted SFAS No. 123R using the modified prospective method as permitted under SFAS No. 123R. Under this transition method, compensation cost recognized for the year ended December 31, 2006 included: (a) compensation cost for all share-based payments granted prior to but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. In accordance with the modified prospective method of adoption, the Company’s results of operations and financial position for prior periods have not been restated.

Recently Issued Accounting Pronouncements—

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in tax positions. FIN 48 requires that the Company recognize in its financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of the Company’s 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The adoption of FIN 48 is not expected to have a material effect on the Company’s consolidated financial position or results of operations.

3. STOCK BASED COMPENSATION

In 1997, the Board of Directors adopted a restricted stock plan (the “Restricted Stock Plan”), pursuant to which 371,285 shares were authorized for issuance. The Restricted Stock Plan provides for the award of common stock, the vesting of which is subject to conditions and limitations established by the Board of Directors. Such conditions may include continued employment with the Company or the achievement of performance measures. Upon the award of common stock, the participant has the rights of a stockholder, including but not limited to the right to vote such stock and the right to receive any dividends paid on such stock. The Board of Directors, in its sole discretion, may designate employees and persons providing material services to the Company as eligible for participation in the Restricted Stock Plan. In connection with the approval of the 2003 Incentive Plan, discussed elsewhere herein, the shares authorized for issuance under the Restricted Stock Plan were reduced by 156,217 shares of stock.

The issued shares vested on a straight-line basis over eight years or on an accelerated basis if certain performance criteria were met. The Company recorded the fair value of the shares issued at the issuance dates as compensation expense over the estimated vesting periods. During the year ended January 2, 2005, the Company recorded stock compensation expense of $257,000, which was included in general and administrative expenses in the accompanying consolidated statements of operations.

Equity Compensation Plans—

The Company currently grants stock awards under the following equity compensation plans:

1997 Stock Option Plan (“1997 Plan”)— The 1997 Plan was adopted by the Company’s Board of Directors and stockholders in November 1997 and was subsequently amended on March 27, 2000 and

F-16

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. STOCK BASED COMPENSATION (Continued)

October 24, 2001. Under the 1997 Plan, the Company’s Board of Directors may grant options to purchase up to 1,034,970 shares of common stock to employees, executive officers and directors. The 1997 Plan provides for the issuance of nonqualified stock options and incentive stock options (which are intended to satisfy the requirements of Section 422 of the Internal Revenue Code) and stock appreciation rights (“SARs”). The Compensation Committee of the Board of Directors determines the employees who will receive awards under the 1997 Plan and the terms of such awards. The exercise price of a stock option or SAR granted or awarded under the 1997 Plan may not be less than the fair market value of one share of common stock on the date the stock option or SAR is granted.

The 2003 Equity Incentive Plan (the “2003 Incentive Plan”)—On April 9, 2003, the Board of Directors adopted an equity incentive plan, which was approved by shareholders on May 14, 2003. On May 10, 2006, the shareholders approved an amendment to the 2003 Incentive Plan to increase the number of shares of common stock reserved for issuance under the 2003 Incentive Plan from 307,000 to 607,000 shares. The 2003 Incentive Plan provides for the issuance of nonqualified stock options and incentive stock options (which are intended to satisfy the requirements of Section 422 of the Internal Revenue Code), SARs, bonus stock, stock units, performance shares, performance units, restricted stock and restricted stock units. The Compensation Committee of the Board of Directors determines the employees who will receive awards under the 2003 Incentive Plan and the terms of such awards. The exercise price of a stock option or SAR granted or awarded under the 2003 Incentive Plan may not be less than the fair market value of one share of common stock on the date the stock option or SAR is granted.

Outstanding options issued prior to December 20, 2004 are fully vested. Options issued on and subsequent to December 20, 2004 generally vest over three years. Options issued prior to July 24, 2002 expire 10 years from the date of grant. Options issued subsequent to that date have a five year expiration date.

As of December 31, 2006, no SARs had been issued.

Grant-Date Fair Value—

The Company uses the Black-Scholes option pricing model to calculate the grant-date fair value of an award. The fair value of options granted during the years ended December 31, 2006, January 1, 2006 and January 2, 2005 were calculated based on the following:

	2006	2005	2004
Options granted	168,409	142,453	160,819
Weighted-average exercise price	$8.44	$9.02	$11.43
Weighted-average grant date fair value	$3.96	$4.28 - $4.70	$5.03 - $7.72
Estimated Weighted Average Assumptions:
Risk free interest rate	4.52%-4.68%	3.58%-4.50%	3.03%-3.87%
Expected life (in years)	4	4-5	4-5
Expected volatility	52.92-54.86%	55.98%-58.16%	71.23%-73.59%
Expected dividend yield	0.00%	0.00%	0.00	%

F-17

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. STOCK BASED COMPENSATION (Continued)

Risk-free interest rate—the yield on zero-coupon U.S. Treasury securities for a period that is commensurate with the expected term assumption is used as the risk-free interest rate.

Expected life—the Company uses historical employee exercise and option expiration data to estimate the expected life assumption for the Black-Scholes grant-date valuation. The Company believes that this historical data is currently the best estimate of the expected life of a new option.

Expected volatility—the Company is responsible for estimating volatility and has used historical volatility to estimate the grant-date fair value of stock options. Management considered the guidance in SFAS No. 123R and believes that the historical estimated volatility is materially indicative of expectations about future volatility.

Expected dividend yield—the Company has not paid any dividends in the last five years and currently intends to retain any earnings to finance future growth and, therefore, does not anticipate paying any cash dividends on its common stock in the foreseeable future.

Expense—

The Company used the straight-line attribution method to recognize expense for all options granted. Stock-based compensation is included in general and administrative expenses in the accompanying consolidated statements of operations.

The amount of stock-based compensation recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The term “forfeitures” is distinct from “cancellations” or “expirations” and represents only the unvested portion of the surrendered option. In September 2006, John Cutter, the Company’s former President and Chief Executive Officer, resigned. As of December 31, 2006, the Company adjusted its stock compensation expense to reflect his forfeitures. The Company will apply an annual forfeiture rate to all options outstanding as of December 31, 2006 and future options granted based on an analysis of its historical forfeitures. This analysis will be re-evaluated quarterly and the forfeiture rate will be adjusted as necessary. Ultimately, the actual expense recognized over the vesting period will only be for those shares that vest.

The adoption of SFAS No. 123R on January 2, 2006 resulted in lower income from continuing operations, lower operating income before tax and lower net income of $437,000 for the year ended December 31, 2006. Additionally, the adoption of SFAS No. 123R on January 2, 2006 resulted in lower basic and diluted net income per share of $0.06 and $0.05, respectively. The total income tax benefit recognized in the accompanying consolidated statement of operations for the year ended December 31, 2006 for share-based compensation arrangements was $2,000.

F-18

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. STOCK BASED COMPENSATION (Continued)

The following table details the effect on net loss and net loss per share had stock-based compensation expense been recorded in fiscal 2005 and fiscal 2004 based on the fair-value method under SFAS No. 123 (in thousands, except per share data). The reported and pro forma net income and net income per share for the year ended December 31, 2006 are the same since stock-based compensation expense was calculated under the provisions of SFAS No. 123R.

	For the Years Ended
	January 1,			January 2,
	2006			2005
Net loss as reported	$	(27,259	)		$	(3,417	)
Add stock-based compensation expense included in reported net loss, net of related income tax effect of $0 and $97, respectively	75				140
Less stock-based compensation expense determined under fair value method for all stock options, net of related income tax benefit of $0 and $752, respectively(a)	(172		)		(1,082		)
Pro forma net loss	$	(27,356	)		$	(4,359	)
Basic and diluted net loss per share, as reported.	$	(3.49	)		$	(0.45	)
Basic and diluted net loss per share, pro forma	$	(3.51	)		$	(0.57	)

(a) On December 20, 2004, the Company’s Board of Directors approved the vesting of all outstanding and unvested options for the Company’s Stock Option Plan and the Company’s 2003 Incentive Plan. This action was taken to reduce, or eliminate to the extent permitted, the transition expense related to outstanding stock option awards under SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). The 259,850 options that were vested included 145,239 options with exercise prices greater than the Company’s closing stock price on the modification date. Under the accounting guidance of APB Opinion No. 25, the accelerated vesting resulted in stock-based compensation cost of $9,400 (net of related income tax benefit of $6,600), which was included in net loss for the year ended January 2, 2005. Additionally, the effect of the accelerated vesting in the Company’s pro-forma disclosure was incremental stock-based compensation of approximately $666,000 (net of related income tax benefit of $463,000). This stock-based compensation expense would otherwise have been recognized in accordance with SFAS No. 123R in the Company’s consolidated statements of operations over the next two fiscal years.

F-19

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. STOCK BASED COMPENSATION (Continued)

Option Activity—

A summary of the activity under the Company’s equity compensation plans as of December 31, 2006 and changes during the three years ended December 31, 2006 is presented below:

				Weighted-
				Average
				Remaining		Weighted-			Aggregate
	Options			Contractual		Average			Intrinsic
	Outstanding			Life in Years		Exercise Price			Value
Options outstanding at December 28, 2003		809,075					$	5.60
Granted		160,819					$	11.43
Cancelled		(9,730	)				$	11.84
Forfeited		(50,697	)				$	8.48
Exercised		(223,801	)				$	4.37
Options outstanding at January 2, 2005		685,666					$	7.06
Granted		142,453					$	9.02
Cancelled		(10,893	)				$	13.01
Forfeited		(10,464	)				$	8.86
Exercised		(185,312	)				$	5.59
Options outstanding at January 1, 2006		621,450					$	7.82
Granted		168,409					$	8.44
Cancelled		(37,021	)				$	12.33
Forfeited		(81,914	)				$	8.38
Exercised		(218,644	)				$	5.23
Options outstanding at December 31, 2006		452,280			3.33		$	8.83	$	2,094,153
Options exercisable at December 31, 2006		277,788			2.91		$	8.87	$	1,133,873

A summary of the status of the Company’s non-vested shares as of December 31, 2006, and changes during the year ended December 31, 2006, is presented below:

				Weighted-
				Average
	Options			Grant Date
	Outstanding			Fair Value
Non-vested options at January 1, 2006		131,989			$	4.68
Granted		168,409			$	3.96
Forfeited		(81,914	)		$	4.15
Vested		(43,992	)		$	4.68
Nonvested options at December 31, 2006		174,492			$	4.01

During the years ended December 31, 2006, January 1, 2006 and January 2, 2005, the total intrinsic value of options exercised (i.e., the difference between the market price at exercise and the price paid by the employee to exercise the options) was $1,100,000, $1,097,000 and $1,989,000, respectively and the total amount of cash received from exercise of stock options was $1,143,000, $1,037,000 and $978,000, respectively.

F-20

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. STOCK BASED COMPENSATION (Continued)

As of December 31, 2006, there was $547,000 of unrecognized compensation cost related to unvested stock options. That cost is expected to be recognized over a weighted-average period of 2.16 years.

The total fair value of shares vested during the years ended December 31, 2006, January 1, 2006 and January 2, 2005 was $206,000, $0 and $1,519,000, respectively.

Pursuant to a stockholder rights plan (the “Stockholder Rights Plan”) that FICC adopted in 1997, the Board of Directors declared a dividend distribution of one purchase right (a “Right”) for each outstanding share of common stock. The Stockholder Rights Plan provides, in substance, that should any person or group (other than certain management and affiliates) acquire 15% or more of FICC’s common stock, each Right, other than Rights held by the acquiring person or group, would entitle its holder to purchase a specified number of shares of common stock for 50% of their then current market value. Until a 15% acquisition has occurred, the Rights may be redeemed by FICC at any time prior to the termination of the Stockholder Rights Plan.

Restricted Stock Unit Activity—

On December 2, 2005, 30,000 restricted stock units were issued to directors with a weighted average fair value of $8.90 at grant date. On November 1, 2006, 30,000 restricted stock units were issued to directors with a weighted average fair value of $10.61 at grant date. The restricted stock units were issued pursuant to and subject to the terms of the Company’s 2003 Incentive Plan. Subject to the terms of the 2003 Incentive Plan, each restricted stock unit provides the holder with the right to receive one share of Common Stock of the Company when the restrictions lapse or vest. The restricted stock units granted to the directors vest three years after the date of grant if the recipient is a member of the Company’s Board of Directors on such date, subject to accelerated vesting in the event of a change in control or the director’s death, disability or retirement.

During the years ended December 31, 2006 and January 1, 2006, stock-based compensation cost of $106,400 and $7,400, respectively, was recorded related to these units. As of December 31, 2006, there was $471,500 of total unrecognized compensation cost related to unvested restricted stock units. That cost is expected to be recognized over a weighted-average period of 2.38 years.

Pursuant to a long-term incentive plan for fiscal 2006 approved by the Compensation Committee of the Board of Directors under the Company’s 2003 Incentive Plan, the Compensation Committee established target EBITDA levels for the Company for fiscal 2006 and target awards for each officer named below based on a percentage (ranging from 50% to 100%) of each such officer’s base salary.

F-21

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. STOCK BASED COMPENSATION (Continued)

In August 2006, the Compensation Committee approved terms of awards under the long-term incentive for fiscal 2006 which provides that, if the Company meets or exceeds a threshold EBITDA for fiscal 2006, then the officer would be entitled to receive an award payable in shares of Common Stock of the Company. The award value is determined based on the Company’s actual EBITDA for fiscal 2006 compared to projected EBITDA for fiscal 2006 and the percentage (ranging from 50% to 150%) of the officer’s target award applicable to those results (the “2006 Award Value”). The following table sets forth the range of award values each officer was eligible to receive:

Name	Value of Award
John Cutter	$	174,267	To	$	522,801
Paul Hoagland	$	82,028	To	$	246,084
Gregory Pastore	$	34,438	To	$	103,314
Kenneth Green	$	39,698	To	$	119,093
Garrett Ulrich	$	39,865	To	$	119,595

During the year ended December 31, 2006, stock-based compensation of $98,000 was recorded related to the foregoing awards.

On February 28, 2007 the Compensation Committee determined that the Company exceeded the threshold EBITDA for fiscal 2006, and awarded shares of Common Stock under the Company’s 2003 Incentive Plan to each of the officers named below. The number of shares of Common Stock issued to each officer was determined by dividing the officer’s 2006 Award Value by 90% of the closing price of the Company’s Common Stock on the date of grant as reported on the American Stock Exchange. 25% of the shares of Common Stock issued to each officer are fully vested upon issuance. The remaining 75% of the shares of Common Stock will vest in three equal annual installments following issuance if the officer remains employed by the Company. The unvested shares will also fully vest upon a change in control, as provided in the 2003 Incentive Plan.

The following table sets forth each officer’s 2006 Award Value and the number of shares of Common Stock the officer received under the long-term incentive plan for fiscal 2006.

Name	Award Value			Number of Shares
Paul Hoagland		$	188,664		17,469
Gregory Pastore		$	79,207		7,334
Kenneth Green		$	91,304		8,454
Garrett Ulrich		$	91,690		8,490

John Cutter, the Company’s former President and Chief Executive Officer, resigned in September 2006 and did not receive any shares of Common Stock under the long-term incentive plan for fiscal 2006. Accordingly, no expense was recognized related to Mr. Cutter’s awards.

F-22

FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

4. INTANGIBLE ASSETS AND DEFERRED COSTS

Intangible assets and deferred costs as of December 31, 2006 and January 1, 2006 were (in thousands):

	December 31,			January 1,
	2006			2006
1988 Non-Friendly Marks license agreement fee amortized over 40 years on a straight-line basis		$	18,650	$	18,650
Deferred financing costs amortized over the terms of the related loans on an effective yield basis		11,234		10,557
Other		1,103		1,103