SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                AMENDMENT NO. 3
                                    FORM 10-K
    



                Annual Report Pursuant to Section 13 or 15(d) of
                       the Securities Exchange Act of 1934

For the Fiscal Year Ended                            Commission File No. 0-11550
December 31, 1997

                               Pharmos Corporation
             (Exact name of registrant as specified in its charter)

            Nevada                                              36-3207413
(State or other jurisdiction of                           (IRS Employer Id. No.)
incorporation or organization)

                        33 Wood Avenue South, Suite 466
                                Iselin, NJ 08830
              (Address of principal executive offices) (zip code)

       Registrant's telephone number, including area code: (732) 603-3526

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

                                      None
                                (Title of Class)

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

                          Common Stock, $.03 par value
                                (Title of Class)

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

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

     The aggregate  market value of the  registrant's  Common Stock at March 13,
1998  held by  those  persons  deemed  to be  non-affiliates  was  approximately
$87,691,458

     As of March 13, 1998, the Registrant had outstanding  36,296,751  shares of
its $.03 par value Common Stock.


<PAGE>




                               Pharmos Corporation
                   Index to Consolidated Financial Statements


Report of Independent Accountants                                          F - 2

Consolidated balance sheets as of December 31, 1997 and 1996               F - 3

Consolidated statement of operations for the years ended
   December 31, 1997, 1996 and 1995                                        F - 4

Consolidated statement of changes in shareholders' (deficit) equity 
    for the years ended December 31, 1997, 1996 and 1995                   F - 5

Consolidated statement of cash flows for the years ended
    December 31, 1997, 1996 and 1995                                       F - 6

Notes to consolidated financial statements                           F - 7 - F21






                                      F-1

<PAGE>


                        Report of Independent Accountants


March 16, 1998

To the Board of Directors and
Shareholders of Pharmos Corporation

In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of changes in shareholders' (deficit)
equity and of cash flows present fairly, in all material respects, the financial
position of Pharmos Corporation and its subsidiary at December 31, 1997 and
1996, and the results of their operations and their cash flows for each of the
three years in the period ended December 31, 1997 in conformity with generally
accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audit. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which 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, assessing the
accounting principles used and significant estimates made by management and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. The Company has suffered recurring
losses from operations and at December 31, 1997 has an accumulated deficit of
$72,069,727 that raise substantial doubt about its ability to continue as a
going concern. Management's plans in regard to these matters are described in
Note 2. The financial statements do not include any adjustments that might
result from the outcome of this uncertainty.


/s/ Price Waterhouse LLP
    Melville, New York

                                      F-2


<PAGE>


Pharmos Corporation

Consolidated Balance Sheets
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                                December 31,
                                                                            1997            1996
<S>                                                                      <C>             <C>         
Assets

Current assets:
   Cash and cash equivalents                                             $  4,423,389    $  5,132,906
   Inventories                                                              1,804,627            --
   Grants  and other receivables                                              237,655         359,019
   Prepaid royalties                                                          143,333            --
   Prepaid expenses and other current assets                                  171,299         247,363
                                                                         ------------    ------------
        Total current assets                                                6,780,303       5,739,288

Fixed assets, net                                                             703,428         629,413
Prepaid royalties, net of current portion                                     573,334         573,334
Intangible assets, net                                                        291,262         337,786
Other assets                                                                   73,514         188,472
                                                                         ------------    ------------
        Total assets                                                     $  8,421,841    $  7,468,293
                                                                         ============    ============
Liabilities and Shareholders' (Deficit) Equity

Current liabilities:
   Long term debt, current portion                                       $     55,253    $    115,244
   Accounts payable                                                         2,576,968         847,415
   Accrued expenses                                                           809,869         497,621
   Accrued wages and other compensation                                       401,285         357,981
   Advances against future sales                                            1,000,000            --
                                                                         ------------    ------------
        Total current liabilities                                           4,843,375       1,818,261

Advances against future sales, net of current portion                       4,000,000       4,000,000
Long term debt, net of current portion                                           --           110,648
Other liabilities                                                             100,000          51,119
                                                                         ------------    ------------
        Total liabilities                                                   8,943,375       5,980,028

Shareholders' (deficit) equity:

   Preferred stock, $.03 par value, 1,250,000 shares authorized:
      Series A convertible, with a $1,000 liquidation preference,
        0 and 1,900 shares issued and outstanding in 1997
        and 1996, respectively                                                   --                57
      Series B convertible, with a $1,000 liquidation preference,
        2,755 and 0 shares outstanding in 1997 and 1996, respectively              83            --
   Common stock, $.03 par value; 50,000,000 shares authorized,
      34,391,638 and 30,727,525 shares issued and
        outstanding (excluding $551 in 1997 and 1996,
        held in Treasury) in 1997 and 1996, respectively                    1,031,197         921,274
   Paid in capital                                                         70,516,913      62,668,886
   Accumulated deficit                                                    (72,069,727)    (62,101,952)
                                                                         ------------    ------------
        Total shareholders' (deficit) equity                                 (521,534)      1,488,265
                                                                         ------------    ------------
Commitments and contingencies

        Total liabilities and shareholders' (deficit) equity             $  8,421,841    $  7,468,293
                                                                         ============    ============
</TABLE>



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

                                       F-3

<PAGE>


Pharmos Corporation

Consolidated Statement of Operations
--------------------------------------------------------------------------------


<TABLE>
<CAPTION>
                                                                          Year Ended December 31,
                                                                    1997             1996           1995

<S>                                                            <C>              <C>             <C>       
Revenues:

License fees, royalties, net                                   $       --      $       --      $     75,000

Expenses:

    Research and development, net                                 5,463,508       5,604,592       4,679,079
    Patents                                                         211,316         281,412         480,859
    General and administrative                                    2,034,092       2,123,392       2,557,718
    Marketing                                                       598,385            --              --
    Depreciation and amortization                                   255,718         345,595         536,010
                                                               ------------    ------------    ------------
          Total operating expenses                                8,563,019       8,354,991       8,253,666
                                                               ------------    ------------    ------------
Loss from operations                                             (8,563,019)     (8,354,991)     (8,178,666)

Other income (expenses):

    Interest income                                                 330,453         323,097         209,584
    Other income (expenses), net                                     16,365          (9,393)           --
    Interest expense                                                (17,346)        (35,923)       (127,003)
                                                               ------------    ------------    ------------
          Other income (expenses), net                              329,472         277,781          82,581
                                                               ============    ============    ============
Loss before extraordinary item                                   (8,233,547)     (8,077,210)     (8,096,085)

Extraordinary gain from forgiveness of debt,
    net of $0 of income taxes (Note 3)                              416,248            --              --
                                                               ------------    ------------    ------------
Net loss                                                         (7,817,299)     (8,077,210)     (8,096,085)
                                                               ------------    ------------    ------------
Less:  Dividend embedded in convertible preferred
             stock (Note 9)                                      (1,952,767)           --              --
          Preferred stock dividends                                (240,375)           --              --
                                                               ------------    ------------    ------------
Net loss applicable to common shareholders                     $(10,010,441)   $ (8,077,210)   $ (8,096,085)
                                                               ============    ============    ============
Loss per share applicable to common shareholders
    before extraordinary gain - basic                                  (.32)           (.28)           (.37)

Extraordinary gain per share                                            .01            --              --
                                                               ------------    ------------    ------------
Net loss per share applicable to common shareholders - basic   $       (.31)   $       (.28)   $       (.37)
                                                               ============    ============    ============
Weighted average shares outstanding - basic                      32,442,981      29,291,401      21,885,862
                                                               ============    ============    ============
</TABLE>



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

                                       F-4
<PAGE>


Pharmos Corporation

Consolidated Statement of Changes in Shareholders' (Deficit) Equity (Note 9)
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                                       Series A Convertible  Series B Convertible
                                                                    Common Stock          Preferred Stock      Preferred Stock  
                                                                 Shares         Amount   Shares     Amount    Shares      Amount 
<S>                                                           <C>          <C>           <C>       <C>          <C>      <C>
December 31, 1994                                             14,631,726   $  438,952      --      $   --        --      $  --   
                                                                                                   --------   -------    -------
Issuance of common stock to purchase Oculon Corp.              6,000,000      180,000      --          --        --         --   
Conversion of debentures to common stock                       2,442,309       73,269      --          --        --         --   
Warrant exercise                                                  75,000        2,250      --          --        --         --   
Issuance of common stock, net of offering costs
     of $900,000                                               6,000,000      180,000      --          --        --         --   
Warrant grant to consultants                                        --           --        --          --        --         --   
Share adjustment for reverse split                                     4         --        --          --        --         --   
Net loss                                                            --           --        --          --        --         --   
                                                              ----------   ----------  --------    --------   -------    -------

December 31, 1995                                             29,149,039      874,471      --          --        --         --   

Warrant exercise                                                  99,286        2,978      --          --        --         --   
Issuance of Series A preferred stock, net of offering costs
     of $18,000                                                     --           --       1,900          57      --         --   
Private placement of common stock                              1,479,200       44,376      --          --        --         --   
Warrant grant to consultants                                        --           --        --          --        --         --   
Net loss                                                            --           --        --          --        --         --   
                                                              ----------   ----------  --------    --------   -------    -------

December 31, 1996                                             30,727,525      921,825     1,900          57      --         --   

Issuance of Series B preferred stock,
    net of offering costs of $260,000                               --           --        --          --       6,000        180
Warrant exercises                                                 37,500        1,125      --          --        --         --   
Conversion of Series A preferred stock                         1,492,943       44,788    (1,900)        (57)     --         --   
Preferred stock dividend paid with common stock                  133,455        4,004      --          --        --         --   
Conversion of Series B preferred stock                         2,000,215       60,006      --          --      (3,245)       (97)
Dividend embedded in convertible preferred stock                    --           --        --          --        --         --   
Net loss                                                            --           --        --          --        --         --   
                                                              ----------   ----------  --------    --------   -------    -------

December 31, 1997                                             34,391,638   $1,031,748      --      $   --       2,755    $    83
                                                              ==========   ==========  ========    ========   =======    =======
<CAPTION>
                                                                                                                         Total 
                                                                                            Treasury                  Shareholders'
                                                                 Paid-in      Accumulated    Stock                      (Deficit)  
                                                                 Capital        Deficit      Shares        Amount        Equity    
                                                              ------------  ------------  -----------   ------------   ------------
<S>                                                           <C>           <C>                <C>      <C>            <C>          
December 31, 1994                                             $ 46,669,890  $(45,928,657)      18,356   $    (551)     $  1,179,634 
                                                                 
Issuance of common stock to purchase Oculon Corp.                2,892,426          --           --          --           3,072,426 
Conversion of debentures to common stock                         1,196,731          --           --          --           1,270,000 
Warrant exercise                                                    36,750          --           --          --              39,000 
Issuance of common stock, net of offering costs                                                                                     
     of $900,000                                                 7,920,000          --           --          --           8,100,000 
Warrant grant to consultants                                        48,000          --           --          --              48,000 
Share adjustment for reverse split                                    --            --           --          --                --   
Net loss                                                              --      (8,096,085)        --          --          (8,096,085)
                                                              ------------  ------------  -----------   ---------      ------------ 
December 31, 1995                                               58,763,797   (54,024,742)      18,356        (551)        5,612,975 
                                                                                                                                    
Warrant exercise                                                    55,522          --           --          --              58,500 
Issuance of Series A preferred stock, net of offering costs                                                                         
     of $18,000                                                  1,881,943          --           --          --           1,882,000 
Private placement of common stock                                1,955,624          --           --          --           2,000,000 
Warrant grant to consultants                                        12,000          --           --          --              12,000 
Net loss                                                              --      (8,077,210)        --          --          (8,077,210)
                                                              ------------  ------------  -----------   ---------      ------------ 
December 31, 1996                                               62,668,886   (62,101,952)      18,356        (551)        1,488,265 
                                                                                                                                    
Issuance of Series B preferred stock,                                                                                               
    net of offering costs of $260,000                            5,739,820          --           --          --           5,740,000 
Warrant exercises                                                   66,375          --           --          --              67,500 
Conversion of Series A preferred stock                             (44,731)         --           --          --                --   
Preferred stock dividend paid with common stock                    193,705      (197,709)        --          --                --   
Conversion of Series B preferred stock                             (59,909)         --           --          --                --   
Dividend embedded in convertible preferred stock                 1,952,767    (1,952,767)        --          --                --   
Net loss                                                              --      (7,817,299)        --          --          (7,817,299)
                                                              ------------  ------------  -----------   ---------      ------------ 
December 31, 1997                                             $ 70,516,913  $(72,069,727)      18,356   $    (551)     $   (521,534)
                                                              ============  ============  ===========   =========      ============ 
</TABLE> 


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

                                       F-5

<PAGE>

Pharmos Corporation

Consolidated Statement of Cash Flows
--------------------------------------------------------------------------------


<TABLE>
<CAPTION>
                                                                                           Year Ended December 31,
                                                                                     1997            1996            1995
                                                                                 ------------    ------------    ------------
<S>                                                                              <C>             <C>             <C>          
Cash flows from operating activities:
    Net loss                                                                     $ (7,817,299)   $ (8,077,210)   $ (8,096,085)
    Adjustments to reconcile net loss to net
       cash flow used in operating activities:
          Depreciation and amortization                                               255,718         345,595         536,010
          Loss on disposal of fixed assets                                             41,560            --              --
          Warrant grant to consultants                                                   --            12,000          48,000
          Extraordinary gain from forgiveness of debt                                (416,248)
    Changes in operating assets and liabilities, net of effects of acquisition
       in 1995:
          Inventories                                                              (1,804,627)           --              --
          Grants receivable                                                           121,364        (254,758)        158,389
          Prepaid expenses and other current assets                                    76,064         239,000         202,240
          Advanced royalties                                                         (143,333)       (573,334)           --
          Other assets                                                                114,958            --              --
          Accounts payable                                                          2,145,801         108,059      (1,180,748)
          Accrued expenses                                                            312,248         (18,413)         89,219
          Accrued wages and other compensation                                         43,304         152,645            --
          Other liabilities                                                            48,881        (184,360)           --
                                                                                 ------------    ------------    ------------
          Net cash used in operating activities                                    (7,021,609)     (8,250,776)     (8,242,975)
                                                                                 ------------    ------------    ------------
Cash flows from investing activities:
    Purchases of fixed assets, net                                                   (324,769)        (73,028)        (56,647)
                                                                                 ------------    ------------    ------------
          Net cash used in investing activities                                      (324,769)        (73,028)        (56,647)
                                                                                 ------------    ------------    ------------
Cash flows from financing activities:
    Advances against future sales                                                   1,000,000       2,122,859       1,877,141
    Proceeds from issuance of common stock
       and exercise of warrants, net                                                   67,500       2,058,500       8,139,000
    Proceeds from issuance of preferred stock, net                                  5,740,000       1,882,000            --
    Proceeds from issuance of convertible debentures                                     --              --         1,270,000
    Proceeds from acquisition of Oculon, net                                             --              --         3,072,426
    Payments of loans payable                                                        (170,639)        (49,440)       (480,219)
                                                                                 ------------    ------------    ------------
          Net cash provided by financing activities                                 6,636,861       6,013,919      13,878,348
                                                                                 ------------    ------------    ------------

Net (decrease) increase in cash and cash equivalents                               (709,517)     (2,309,885)      5,578,726


Cash and cash equivalents at beginning of year                                      5,132,906       7,442,791       1,864,065
                                                                                 ------------    ------------    ------------
Cash and cash equivalents at end of year                                         $  4,423,389    $  5,132,906    $  7,442,791
                                                                                 ============    ============    ============
</TABLE>


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


                                      F-6

<PAGE>


Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

1.     The Company

       Pharmos  Corporation  (the  "Company")  is a  bio-pharmaceutical  company
       incorporated  under the laws of the state of Nevada and is engaged in the
       design and development of novel pharmaceutical products in various fields
       including:    site   specific   drugs   for    ophthalmic    indications,
       neuroprotective  agents for treatment of central  nervous  system ("CNS")
       disorders, systemic drugs designed to avoid CNS related side effects, and
       emulsion-based  products  for  topical  and  systemic  applications.  The
       Company  uses a variety  of  patented  and  proprietary  technologies  to
       improve the efficacy and/or safety of drugs. The Company's  compounds are
       in various stages of development,  from preclinical to advanced  clinical
       trials.  On of March 9,  1998,  the  Company  received  approval  for two
       separate  New Drug  Applications  ("NDA")  from  the  U.S.  Food and Drug
       Administration  ("FDA").  These approvals were for LotemaxTM and AlrexTM.
       Lotemax  has  been   approved  for  the   treatment  of  several   ocular
       inflammatory  indications,   including  uveitis  and  for  post-operative
       inflammation.  Alrex has been  approved  for the  treatment  of  seasonal
       allergic conjunctivitis. In conjunction with its development efforts, the
       Company has also  undertaken  research and  development  contracts in the
       past  and  has  sold  fine  chemicals  to  the  pharmaceutical   research
       community.  The Company's  administrative  offices are located in Iselin,
       New Jersey and conducts  operations  through its wholly owned subsidiary,
       Pharmos, Ltd., in Rehovot, Israel.

2.     Liquidity and Business Risks

       The Company  currently  has had no sources of recurring  revenues and has
       incurred operating losses since its inception.  At December 31, 1997, the
       Company  has an  accumulated  deficit of  $72,069,727.  Such  losses have
       resulted  principally from costs incurred in research and development and
       from  general  and  administrative  expenses.  The Company has funded its
       operations through the use of cash obtained  principally from third party
       financing.  Management  believes that cash and cash  equivalents  of $4.4
       million as of December 31, 1997,  combined with anticipated cash inflows,
       including revenues expected to be derived from sales of Lotemax and Alrex
       (See Notes 4 and 17) and the  proceeds  from the February 4, 1998 private
       placement  (see  "Subsequent  Events")  will  be  sufficient  to  support
       operations  through first quarter of 1999. The Company's  success depends
       upon many  factors  that are  beyond  the  Company's  immediate  control,
       including market  acceptance of Lotemax and Alrex,  competition,  and the
       ability to obtain  additional  financing.  The Company is  continuing  to
       actively  pursue various funding  options,  including  equity  offerings,
       strategic   corporate   alliances,   business   combinations,   and   the
       establishment  of research  and  development  partnerships  to obtain the
       additional financing necessary to complete the development of its product
       candidates  and  bring  them  to  commercial  markets.  There  can  be no
       assurance  that Lotemax or Alrex will achieve  market  acceptance or that
       the Company  will be  successful  in  obtaining  additional  financing or
       commercializing its product candidates.

3.     Significant Accounting Policies

       Basis of consolidation The accompanying consolidated financial statements
       include  the  Company's  wholly  owned   subsidiary,   Pharmos  Ltd.  All
       significant intercompany transactions are eliminated in consolidation.

                                      F-7
<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

       Use of Estimates

       The  preparation  of financial  statements in conformity  with  generally
       accepted accounting principles requires the Company 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,  costs and
       expenses  during the reporting  period.  Actual results could differ from
       those estimates.

       Net loss per common share

       The Company adopted Statement of Financial  Accounting  Standards No.128,
       "Earnings per Share" ("SFAS 128") effective December 1997.


       Basic  net loss  per  common  share  is  computed  by  dividing  net loss
       applicable  to  common  shareholders  for  the  period,  reduced  by  any
       preferred stock dividends (embedded,  declared or in arrears), by the sum
       of the  weighted  average  number of shares of common  stock  issued  and
       outstanding.  Diluted earnings per share is computed by dividing net loss
       for the  period by the sum of the  weighted  average  number of shares of
       common stock issued and  outstanding,  increased to include the number of
       common  shares that would have been issued if all  outstanding  preferred
       stock, stock options,  and stock warrants were converted.  Diluted common
       shares are based on the most  advantageous  convertible  rate or exercise
       price available to the security holder.


       At  December  31,  1997,  outstanding  shares  of  Series  B  Convertible
       Preferred  Stock,  convertible  into 1,721,875 shares of common stock and
       outstanding  options and warrants to purchase  5,568,411 shares of common
       stock,  with exercise prices ranging from $.75 to $5.20 could potentially
       dilute basic  earnings per share in the future but have not been included
       in the  computation  of diluted net loss per share because to do so would
       be antidilutive for the periods presented.

       Cash and cash equivalents

       The Company  considers all highly liquid debt instruments  purchased with
       an original maturity of three months or less to be cash equivalents. Cash
       equivalents  primarily  consist  of  commercial  paper and  money  market
       accounts in 1997 and 1996, respectively.

       Revenue recognition

       Revenue for contracted research and development services is recognized as
       performed.  Revenue  from  these  contracts  is  recognized  as costs are
       incurred  (as  defined  in the  contract),  generally  direct  labor  and
       supplies plus agreed  overhead rates.  Any advance  payments on contracts
       are deferred until the related  services are performed.  License fees and
       royalties are  recognized  when earned in accordance  with the underlying
       agreements. Sales revenue is recognized upon shipment of products.

       Inventories

       Inventories  consist of loteprednol  etabonate,  the compound used in the
       Company's products, Lotemax and Altrex and is stated at the lower of cost
       or market with cost determined on a weighted average basis.


                                      F-8

<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


       Certain purchases of Loteprednol Etabonate, totaling  $598,385, have been
       expensed in 1997. This amount represents inventory to be used in testing,
       manufacturing and various marketing programs.


       Fixed assets

       Fixed assets are recorded at cost. Property,  furniture and equipment are
       depreciated on a straight-line  basis over their  estimated  useful lives
       which  range from three to fourteen  years.  Leasehold  improvements  are
       amortized on a straight-line  basis over the shorter of the lease term or
       the estimated  lives of the related  assets.  Maintenance and repairs are
       expensed as incurred.

       Intangible assets

       Intangible   assets   represent  the  Company's  rights  to  develop  and
       commercialize    certain   products   derived   from   certain   licensed
       technologies.  The assets are being  amortized over fifteen years.  As of
       December  31, 1997 and 1996,  accumulated  amortization  was $748,518 and
       $701,994, respectively.  Amortization expense amounted to $46,524 in each
       of the years ended December 31, 1997, 1996 and 1995.

       As a result of the current period  operating loss combined with a history
       of operating  losses,  management  assessed  whether or not the Company's
       intangible assets were recoverable.  As of December 31, 1997,  management
       estimates  that the net future cash  inflows  expected to result from the
       commercial  marketing  of  the  licensed  technologies  will  exceed  the
       carrying amount of the Company's  intangible  assets and accordingly,  no
       impairment loss was recognized.

       On a periodic basis, the Company will assess whether there are conditions
       present that  indicate an  impairment of long lived assets and long lived
       assets to be  disposed  of. In the event such an  impairment  is present,
       management will consider the undiscounted  cash flows from such assets to
       quantify the amount of such impairment and the loss to be recorded.

       Research and development costs

       All  research  and  development  costs are expensed  when  incurred.  The
       Company has  accounted  for  reimbursements  of research and  development
       costs as a reduction of research and development expense.

       Income taxes

       The Company  accounts for income taxes in accordance  with the provisions
       of Statement of Financial  Accounting  Standards No. 109, "Accounting for
       Income Taxes" ("SFAS 109").  Under the asset and liability method of SFAS
       109,  deferred tax assets and  liabilities  are recognized for the future
       tax  consequences  attributable  to  differences  between  the  financial
       statement  carrying  amounts of existing assets and liabilities and their
       respective  tax bases and  operating  loss and tax credit  carryforwards.
       Deferred tax assets and  liabilities,  if any, are measured using enacted
       tax rates expected to apply to taxable income in the years in which those
       temporary differences are expected to be recovered or settled. Under SFAS
       109, the effect on deferred tax assets and liabilities of a change in tax
       rates is  recognized  in income in the period that includes the enactment
       date.


                                      F-9

<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

       Foreign exchange
   
       The  Company's  foreign  operations  are  principally  conducted  in U.S.
       dollars.  Any  transactions  or  balances in  currencies  other than U.S.
       dollars are remeasured and any resultant gains and losses are included in
       the  determination of current period income and loss. To date, such gains
       and losses have been insignificant.

       Concentration of Credit Risk

       Financial   instruments   which   potentially   expose  the   Company  to
       concentrations  of  credit  risk  consist  primarily  of  cash  and  cash
       equivalents.  The Company maintains some of its cash balances in accounts
       which exceed federally  insured limits. It has not experienced any losses
       to date resulting from this practice.

       Equity Based Compensation

       The Company  accounts for its employee  stock option plans in  accordance
       with the  provisions  of  Accounting  Principles  Board  Opinion  No. 25,
       Accounting for Stock Issued to Employees, and related interpretations. As
       such,  compensation expense related to employee stock options is recorded
       only if, on the date of grant,  the fair  value of the  underlying  stock
       exceeds  the  exercise  price.  The Company  adopted the  disclosure-only
       requirements  of SFAS No. 123  Accounting for  Stock-Based  Compensation,
       which allows  entities to continue to apply the provisions of APB Opinion
       No. 25 for  transactions  with employees and provide pro forma net income
       and pro forma  earnings per share  disclosures  for employee stock grants
       made in 1996  and  future  years  as if the  fair-value-based  method  of
       accounting in SFAS No. 123 had been applied to these transactions.


       Reclassifications

       Certain  amounts for 1996 and 1995 have been  reclassified  to conform to
       the fiscal  1997  presentation.  Such  reclassifications  did not have an
       impact on the Company's financial position or results of operations.

       Recent Accounting Standards

       Statement  of  Financial   Accounting   Standards  No.  130,   "Reporting
       Comprehensive Income" ("SFAS 130") On June 30, 1997, the FASB issued SFAS
       No. 130. This statement  establishes  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.  SFAS No.
       130 requires that an enterprise (a) classify items of other comprehensive
       income by their  nature in a  financial  statement  and (b)  display  the
       accumulated  balance  of  other  comprehensive   income  separately  from
       retained earnings and additional paid-in capital in the equity section of
       a statement of financial position.

       This statement is effective for fiscal years beginning after December 15,
       1997.  Reclassification  of  financial  statements  for  earlier  periods
       provided for  comparative  purposes is required.  It is not expected that
       the adoption of SFAS No. 130 will have a material impact on the Company.


                                      F-10

<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

       Statement of Financial  Accounting  Standards No. 131,  "Disclosure about
       Segments of an Enterprise" ("SFAS 131")

       In June 1997, the FASB issued SFAS No. 131. This statement  requires that
       public business  enterprises  report certain  information about operating
       segments in complete sets of financial  statements of the  enterprise and
       in condensed financial statements of interim periods to shareholders.  It
       also requires that  enterprises  report certain  information  about their
       products and  services,  the  geographic  areas in which they operate and
       their major  customers.  This  statement  is  effective  for fiscal years
       beginning  after  December 15,  1997.  The effect of the adoption of this
       statement is not expected to have a significant impact on the Company.

4.     Collaborative Agreements

       In June  1995,  the  Company  entered  into a  marketing  agreement  (the
       "Marketing Agreement") with Bausch & Lomb Pharmaceuticals,  Inc. ("Bausch
       & Lomb") to market  Lotemax,  on an exclusive  basis in the United States
       following  receipt of FDA approval.  The Marketing  Agreement also covers
       the Company's two other Loteprednol  etabonate based products,  which are
       referred to as Alrex and LE-T.  Under the Marketing  Agreement,  Bausch &
       Lomb will purchase the active drug substance (loteprednol etabonate) from
       the Company.  Through December 31, 1997, Bausch and Lomb has provided the
       Company  with $5  million  in cash  advances  against  future  sales.  An
       additional $1 million is due upon the receipt of regulatory  approval for
       LE-T in the  United  States.  Bausch & Lomb will be  entitled  to credits
       against future  purchases or sales of the active drug substance  based on
       the advances made,  until all the advances have been repaid.  The Company
       may be obligated to repay such  advances if it is unable to supply Bausch
       & Lomb with certain  specified  quantities of the active drug  substance.
       The  portion of  advances  expected  to be recouped by Bausch and Lomb in
       1998, based on management's estimate of product sales to Bausch & Lomb in
       1998,  has been  presented  as a current  liability  in the  accompanying
       balance sheet at December 31, 1997.

       Bausch & Lomb also  collaborates in the development of products by making
       available  amounts up to 50% of the Phase III clinical  trial costs.  The
       Company has retained certain  conditional  co-marketing  rights to all of
       the products covered by the Marketing Agreement.  Net reimbursements from
       Bausch & Lomb were  approximately  $.2  million,  $1.2  million  and $0.1
       million in 1997,  1996 and 1995,  respectively,  and were offset  against
       research and development in the accompanying  consolidated  statements of
       operations.

       In December 1996,  the Company and Bausch & Lomb signed an  international
       marketing  agreement  for the  marketing  of  Lotemax,  Alrex and LE-T in
       certain territories outside of the U.S. The Company expects to receive an
       additional  $1.6  million of  advances  that will  follow the  receipt of
       regulatory clearance in those markets.



                                      F-11

<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

5.     Fixed Assets

       Fixed assets consist of the following:

                                                             December 31,
                                                         1997           1996

       Laboratory, pilot plant and other equipment     $ 1,339,688  $ 1,810,310
       Leasehold improvements                              240,462      402,936
       Office furniture and fixtures                       107,251      235,663
       Computer equipment                                   78,795      133,973
       Vehicles                                             53,307       52,873
                                                       -----------  -----------

                                                        1,819,503    2,635,755

       Less - Accumulated depreciation and amortization (1,116,075)  (2,006,342)
                                                       -----------  -----------

                                                       $   703,428  $   629,413
                                                       ===========  ===========


       Depreciation and amortization of fixed assets was $209,194, $299,071 and
       $489,486 in 1997, 1996 and 1995, respectively.

6.     Grants for Research and Development


       The Company has entered into  agreements with U.S.  federal  agencies and
       the State of Israel which provide for grants for research and development
       relating  to  certain  projects.   Amounts  received  pursuant  to  these
       agreements have been reflected as a reduction of research and development
       expense.  Such  reductions  amounted to  $418,245,  $245,302 and $331,546
       during 1997, 1996 and 1995, respectively. The agreements with agencies of
       the State of Israel place certain legal  restrictions  on the transfer of
       technology and  manufacture of resulting  products  outside  Israel.  The
       Company will be required to pay  royalties,  at rates  ranging from 2% to
       5%, to such  agencies from the sale of products,  if any,  developed as a
       result of the research activities carried out with the grant funds.

       As of December 31, 1997,  the total  amounts  received  under such grants
       amounted  to  $2,952,972,  of which  $2,752,972  pertain  to grants  that
       contain royalty provisions.  Aggregate future royalty payments related to
       sales of products developed,  if any, as a result of these grants will be
       limited to $3,215,862 based on grants received through December 31, 1997.
       As of  December  31,  1997,  the  products  for  which  grants  have been
       received, are still under development.


       In April 1997,  the  Company  also signed an  agreement  with  Consortium
       Magnet for developing generic  technologies for design and development of
       drugs and diagnostic kits, operated by the Office of the Chief Scientist.
       Under such agreements the Company is entitled to a  non-refundable  grant
       amounting

                                      F-12

<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

       to  approximately  60% of actual  research and  development and equipment
       expenditures on approved  projects.  No royalty  obligations are required
       within the framework.  The Company  received grants totaling  $200,000 in
       1997 pursuant to this agreement.

7.     Licensing Arrangements

       The  Company  is  both  a  licensor  and  licensee  of  certain  research
       technologies.

       As a licensor,  the Company has entered  into  various  agreements  under
       which the rights to certain of its  technologies  are licensed to others.
       The  Company  is to be  compensated  by  receipt  of its share of defined
       future  product  sales  or  royalties  earned  by  the  licensee.   These
       agreements  have provided for funding of research,  either in whole or in
       part by the licensee.

       As a licensee,  the Company has various  license  agreements  wherein the
       Company has  acquired  exclusive  or  co-exclusive  rights to develop and
       commercialize  certain research  technologies.  These  agreements,  which
       include agreements  related to Lotemax,  generally require the Company to
       pay  royalties  on the  sale of  products  developed  from  the  licensed
       technologies and fees on revenues from sublicenses, where applicable. The
       royalty  rates,  as defined in the  respective  license  agreements,  are
       customary and usual in the pharmaceutical industry. The royalties will be
       payable  for  periods  up to  fifteen  years  from the date of  specified
       events,  including  the date of the first sale of such  products,  or the
       date  from  which  the  first   registered   patent  from  the  developed
       technologies  is in  force,  or the  year  following  the  date on  which
       approval from the FDA received for a developed  product.  No amounts have
       been recorded as a liability with respect to any contingent  royalties as
       of December 31, 1997.

       Certain of the license  agreements  require  annual  payments for periods
       extending   through  2012.   Minimum  annual   payments  under  licensing
       agreements are $103,500.  License fee expense  amounted to  approximately
       $103,500 during 1997 and 1996, and $355,000 in 1995.


       In March 1997,  the Company  paid a licensor,  who is a former  director,
       $143,333.  This  payment  represented  prepaid  royalties  to the  former
       director  against  future  royalties  on  sales of  Lotemax.  Prepayments
       totaled  $716,667  and  $573,334  and are  reflected  as an  asset on the
       balance  sheet at December 31, 1997 and 1996,  respectively.  The Company
       has agreed to prepay  additional  royalties  based on future advances and
       other non-royalty  payments from Bausch & Lomb or other parties with whom
       the Company enters into marketing or similar arrangements.


8.     Common and Preferred Stock Transactions

       1997 transactions


       On  February  12,  1997,  the  Company  issued  warrants  to  purchase an
       aggregate of 955,000 shares of common stock at an exercise price of $1.59
       per  share,  the fair  market  value of the  common  stock on the date of
       grant, to 14 employees of the Company. Prior to December 31, 1997, 65,000
       of these warrants were canceled in connection  with the  termination of 2
       employees.  Such warrants become exercisable in increments of 25% each on
       February 12, 1998,  February 12, 1999, February 12, 2000 and February 12,
       2001. All of such warrants expire on February 12, 2007. Also, on February
       12, 1997, the 



                                      F-13

<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

       Company  issued  warrants to purchase an aggregate  of 115,000  shares of
       common  stock at an  exercise  price of $1.59 per share to the  Company's
       five outside directors and one outside consultant.  These warrants become
       exercisable  on the same basis as the warrants  issued to employees,  but
       expire  on  February  12,  2003.   Upon   termination  of  employment  or
       termination as a director, all warrants held by such employee or director
       will expire,  except that any warrant that was exercisable on the date of
       termination  may, to the extent then  exercisable,  be  exercised  within
       three months thereafter (or one year thereafter if the termination is the
       result of death or permanent disability of such employee or director).


       In March 1997,  the Company  issued  warrants to purchase an aggregate of
       75,000  shares of common  stock at an exercise  price of $1.66 per share,
       the fair  market  value of the common  stock on the date of grant,  to an
       employee of the Company.  Such warrants become  exercisable in increments
       of 25% each on March 1, 1998,  March 1, 1999,  March 1, 2000 and March 1,
       2001. All of such warrants expire on March 1, 2007.  Upon  termination of
       employment,  all warrants held by such employee will expire,  except that
       any warrant that was  exercisable on the date of termination  may, to the
       extent then exercisable,  be exercised within three months thereafter (or
       one  year  thereafter  if the  termination  is the  result  of  death  or
       permanent disability of such employee).

       On March  31,  1997,  the  Company  completed  a private  placement  with
       institutional  investors  of  Series B  Convertible  Preferred  Stock and
       warrants  to  purchase  common  stock,  generating  gross  proceeds of $6
       million.  The Series B preferred stock carries a 5% dividend rate payable
       in cash or common stock, at the option of the Company, and is convertible
       into common shares over a period  ranging from 90 to 270 days  subsequent
       to March 31, 1997. The conversion  price will be based on the share price
       at the time of conversion  less discounts  ranging from 17% to 20%. Until
       converted  into common stock,  the preferred  stock has no voting rights.
       The 159,000  warrants  issued to the investors are exercisable at a price
       of $1.75 per share,  commencing  March 31, 1998, for a three year period.
       The Company  also issued  warrants  to purchase an  aggregate  of 239,473
       shares of common stock at an exercise price of $1.38 per share to certain
       parties who  assisted in the  completion  of the private  placement.  The
       warrants are exercisable from March 31, 1998 and will expire in 2007.


       On April 30, 1997, the Company  issued  warrants to purchase an aggregate
       of 15,000 shares of common stock at an exercise  price of $1.22 per share
       to an outside consultant of the Company. Such warrants became exercisable
       on April 30, 1998 and expire on April 30, 2003.

       During 1997, the Company issued 3,493,158 shares of its common stock upon
       conversion  of  5,145  shares  of the  Company's  Series  A and  Series B
       Convertible  Preferred  Stock.  The shares were  issued  with  conversion
       prices  ranging from $.93 per share to $2.04 per share.  The Company also
       issued  133,455  shares of common  stock in payment of  dividends  on the
       Series A and Series B Convertible Preferred Stock. As of the date of such
       issuances,  these  dividends are valued at $197,709.  The Company  issued
       37,500  shares of its common stock upon  exercise of warrants to purchase
       shares of the Company's common stock at $1.80 per share.

       As of December 31, 1997, cumulative dividends in arrears on the Company's
       outstanding Series B Convertible Preferred Stock were $42,666.


                                      F-14

<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

       In  connection  with the  issuances  of the  Series  A and B  convertible
       preferred stock, the Company was required to recognize in the calculation
       of earnings per share (EPS),  the value of the  conversion  discount as a
       dividend to the preferred stockholders.  The dividend has been recognized
       in the EPS calculation on a pro rata basis over the period beginning with
       issuance to the earliest  date that  conversion  can occur.  For the year
       ended December 31, 1997, the Company  recorded a preferred stock dividend
       of  $1,952,767  on the  outstanding  shares of Series A and B convertible
       preferred stock in connection with the conversion discount.

       1996 transactions

       In January 1996,  the Company issued 89,286 shares of its common stock as
       a result of the  exercise of certain  warrants.  Of this  amount,  75,000
       shares  were  issued at an  exercise  price of $.52 per share and  14,286
       shares were issued at an exercise price of $.84 per share.


       On  September  30,  1996,  the Company  completed a private  placement of
       Series A  convertible  preferred  stock and  warrants to purchase  common
       stock,  with  institutional  investors  generating gross proceeds of $1.9
       million.  The Series A preferred stock carried a 5% dividend rate payable
       in  cash  or  common  stock,  at the  option  of  the  Company,  and  was
       convertible  into common shares over a period ranging from 80 days to 360
       days subsequent to September 30, 1996. The conversion  price was based on
       the share price at the time of conversion less discounts ranging from 17%
       to 20%.  Until  converted into common stock,  the preferred  stock had no
       voting  rights.   The  50,000   warrants  issued  to  the  investors  are
       exercisable at a price of $1.75 per share,  commencing one year after the
       closing for a three year  period.  The  investors  were  granted  limited
       rights to approve  certain  financing  by the  Company  for 180 days from
       closing.


       In December 1996, the Company issued 10,000 shares of its common stock as
       a result of the exercise of warrants to purchase  shares of the Company's
       common stock.  The 10,000 shares were issued at an exercise price of $.75
       per share.

       In December  1996,  Bausch & Lomb  purchased  1,479,200  shares of common
       stock  from the  Company  for $2  million  in a  private  placement.  The
       purchase price of $1.35 per share was equal to the average  closing price
       for the prior 15 days.

       During 1996, the Company issued  warrants to consultants who assisted the
       Company on various business and financial matters as follows: warrants to
       purchase  15,000  shares at an exercise  price of $2.31 per share,  which
       expire in March 2002; warrants to purchase 65,000 shares of the Company's
       common  stock at an exercise  price of $1.34 per share,  which  expire in
       September  2007;  warrants to purchase 10,000 shares at an exercise price
       of $1.39 per share, which expire in November 2006. The Company recognized
       compensation expense of $12,000 related to warrants in 1996.

       1995 transactions

       On January 18, 1995, the Company's  stockholders  authorized an amendment
       to the Company's Restated Articles of Incorporation which provided for an
       increase  in the  number of shares of  authorized  common  stock  from 20
       million shares to 50 million  shares,  and the elimination of the Class B
       convertible  common stock. 


                                      F-15

<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


       In February 1995, the Company completed the sale of $1,270,000  principal
       amount  convertible  debentures  in a private  placement  transaction  to
       several   accredited   investors,   including   a   large   institutional
       shareholder.  A member  of the  Company's  Board of  Directors  purchased
       $70,000 of such  debentures.  During  1995,  all of the  debentures  were
       converted  into  2,442,309  shares of the  Company's  common  stock at an
       exchange price of $.52 per share.  Imputed  interest  associated with the
       below  market  conversion  price  was not  recorded  as it did not have a
       material  impact on the results of operations in 1995. In connection with
       this  transaction the Company issued warrants to purchase  150,000 shares
       of common  stock at an  exercise  price of $.52 per share.  During  1995,
       warrants  to purchase  75,000  shares were  exercised  and the  remaining
       75,000 warrants were exercised in January 1996.


       The Company issued  6,000,000  shares of its common stock and warrants to
       purchase   500,000  shares  of  common  stock  in  connection   with  the
       acquisition of Oculon.

       On  September  14,  1995,  the Company  completed  a private  offering of
       6,000,000 units at $1.50 per unit. The proceeds of the private  offering,
       net of costs of $900,000,  were  $8,100,000.  Each unit  consisted of one
       share of the Company's  common stock and one warrant to purchase 0.075 of
       one share of common  stock  (450,000  shares).  In  addition  the Company
       issued  warrants to purchase  450,000  shares of common  stock to the two
       finders who assisted in this transaction. Both groups of warrants have an
       exercise  price  of  $1.80  per  share  and may be  exercised  commencing
       September  14, 1996 and expire on September  14, 2000.  During 1995,  the
       Company  issued  warrants  to  consultants  who  assisted  the Company on
       various business and financial  matters as follows:  warrants to purchase
       10,000  shares at an exercise  price of $1.88 per share,  which expire on
       October 31, 2001;  warrants to purchase  10,000  shares of the  Company's
       common  stock at an  exercise  price of $.78 per share,  which  expire on
       April 10, 2005; warrants to purchase 75,000 shares,  25,000 each of which
       have an exercise price of $.75, $1.00 and $1.50 per share,  respectively,
       and may be exercised  beginning May 1, 1996 and expire on April 30, 2000.
       The  Company  recognized  compensation  expense  of  $48,000  related  to
       warrants in 1995.


                                      F-16

<PAGE>


Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

9.     Warrants

       Many of the warrants issued in connection  with various equity  financing
       and related  transactions during 1991 through 1997 contain  anti-dilution
       provisions requiring adjustment, if at a later date securities are issued
       at prices below the respective  warrant's  exercise price.  The following
       table   summarizes   the  shares   issuable  upon  exercise  of  warrants
       outstanding  at December  31, 1996 as adjusted  for the events which have
       triggered  anti-dilution  provisions  contained in the respective warrant
       agreements:


                                                            Shares  
                                                           Issuable 
       Issuance Date                        Expiration       Upon     Exercise
                                               Date        Exercise    Price 
       November 1991                                                         
                                            March 1998      269,490  $   2.01
                                            March 1998      303,338      2.50
       August 1993                          March 1998      361,844      1.52
       September 1994                      August 1998      454,121      2.67
       October 1994                       September 1999     65,044      2.26
       April 1995                          October 1999     200,000       .84
                                            April 2005      500,000      2.75
                                            April 2005       10,000       .78
                                            April 2000       15,000       .75
                                            April 2000       25,000      1.00
       September 1995                       April 2000       25,000      1.50
       October 1995                       September 2000    862,500      1.80
       March 1996                          October 2001      10,000      1.88
       September 1996                       March 2002       15,000      2.31
                                          September 2000     50,000      1.75
       November 1996                      September 2007     65,000      1.34
       February 1997                      November 2006      10,000      1.39
                                          February 2003     115,000      1.59
       March 1997                         February 2007     890,000      1.59
                                            March 2001      159,000      1.75
                                            March 2007       75,000      1.66
       April 1997                           March 2007      239,473      1.38
                                            April 2003       15,000      1.22
                                          --------------  ---------  --------
         Total shares and average 
           exercise price                                 4,734,810   $  1.90
                                                          ---------  --------
       
                                             F-17
       
<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

10.    Stock Option Plans

       The Company's shareholders have approved incentive stock option plans for
       officers and employees.  Options granted are generally exercisable over a
       specified  period,  not less than one year  from the date of  grant,  and
       generally  expire ten years from the date of grant.  The following  table
       summarizes  activity in approved  incentive stock options approved by the
       Company's Board of Directors:

                                                        Under    Exercise
                                                        Option     Price

          Options outstanding at 12/31/95               544,186    $2.20  
          Granted                                         4,000     2.28  
          Expired                                       (34,933)    2.18  
                                                       --------    -----  
                                                                          
          Options Outstanding at 12/31/96               513,253     2.13  
          Expired                                       (86,834)    1.74  
                                                       --------    -----  
                                                                          
          Options outstanding at 12/31/97               426,419    $2.21  
                                                       --------    -----  
                                                                          
          Options exercisable at 12/31/97               306,935    $2.26  
                                                       --------    -----  
                                                       
       The Company's Board of Directors approved  nonqualified stock options for
       key  employees,  directors  and  certain  non-employee  consultants.  The
       following table summarizes activity in Board-approved  nonqualified stock
       options:

                                                        Under    Exercise
                                                        Option     Price

          Options outstanding at 12/31/95              442,182    $ 3.10
          Expired                                      (10,000)     1.94
                                                       -------    ------
          Options Outstanding at 12/31/96              432,182      3.12
          Expired                                      (25,000)    10.50
                                                       -------    ------
          Options outstanding at 12/31/97              407,182    $ 2.67
                                                       -------    ------
          Options exercisable at 12/31/97              357,566    $ 2.65
                                                       -------    ------


       The  Company  applies   Accounting   Principles  Board  Opinion  No.  25,
       Accounting for Stock Issued to Employees,  and related interpretations in
       accounting  for  its  plans.  As all  options  and  warrants  granted  to
       employees  were granted with  exercise  prices equal to the fair value of
       the common stock on the



                                      F-18
<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------



       respective  grant dates, no compensation  expense has been recognized for
       its  stock-based  compensation  plans.  Had  compensation  cost  for  the
       Company's  stock option plans and warrant  grants been  determined  based
       upon the fair  value at the  grant  date for  awards  under  these  plans
       consistent with the methodology  prescribed  under Statement of Financial
       Accounting  Standards No. 123,  Accounting for Stock-Based  Compensation,
       the  Company's  net loss and loss per share would have been  increased by
       approximately  $305,000, or $.01. per share in 1997 and $203,000, or $.01
       per share in 1996 and $320,000 or $.01 per share in 1995 before deducting
       the value of stock options that were canceled in 1995.  The fair value of
       options and warrants granted to employees,  officers,  and directors from
       1995  through  1997 are  estimated  at $.51 to $1.17 on the date of grant
       using  the   Black-Scholes   option-pricing   model  with  the  following
       assumptions:  dividend yield 0%,  volatility of 50%,  risk-free  interest
       rate of 6.5%, assumed forfeiture rate of 3%, and an expected life of 3 to
       5 years.


11.    Long Term Debt

       As of December 31, 1997,  Pharmos Limited has an unused line of credit of
       $50,000 denominated in New Israeli Shekels.

       In 1996,  the  Company  incurred a liability  relating to the  negotiated
       buy-out of a lease  obligation.  The termination  agreement  provides for
       monthly installment payments of $4,375 through December 1998. At December
       31, 1997, the outstanding  balance was $52,233 and has been classified as
       a current liability in the accompanying balance sheet.

12.    Income Taxes

       No  provision  for income  taxes was  recorded  for the three years ended
       December 31, 1997 due to net  operating  losses  incurred.  Net operating
       loss  carryforwards  for U.S. tax purposes of  approximately  $50,485,000
       expire from 2000 through 2012.

       The Company's gross deferred tax assets of $25,087,000 and $22,870,000 at
       December 31, 1997 and 1996,  respectively,  represented primarily the tax
       effect of both the net operating loss carryforwards and deferred research
       and   development   costs,   and  research  and  development  tax  credit
       carryforwards.  As a result of previous business combinations and changes
       in stock ownership,  substantially  all of these net operating losses and
       tax credit  carryforwards  are subject to  significant  restriction  with
       regard  to  annual  utilization.  A full  valuation  allowance  has  been
       established with regard to the gross deferred tax assets.

13.    Commitments and Contingencies

       Leases

       The  Company  leases  research  and office  facilities  in Israel and New
       Jersey.  The  facilities  in  Israel  are  used in the  operation  of the
       Company's research and administration activities. The New Jersey facility
       which serves as the corporate  headquarters  is leased under an agreement
       which expires in September  1998 and contains  unlimited one year renewal
       options.  The research and development facility in Israel is leased under
       an agreement  which expires in May 1998. 

                                      F-19

<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

       The Company also has a long term lease on office  facilities in New York,
       which previously served as the Company's  executive  headquarters,  which
       expires in March 2000.  The Company  has  entered  into a  non-cancelable
       sublease agreement for this facility which expires in March 2000.

       All of the leases and  subleases  described  above call for base rentals,
       payment of certain  building  maintenance  costs (where  applicable)  and
       future increases based on the consumer price indices.

       At December 31, 1997, the future minimum lease  commitments  and sublease
       rental  receivables with respect to non-cancelable  operating leases with
       initial terms in excess of one year are as follows:

                                             Lease            Sublease
                                           Commitments        Rentals

                              1998          $279,347          $145,834
                              1999           145,834           145,834
                              2000            36,458            36,458
                                            --------          --------
                                            $461,639          $328,126
                                            --------          --------

       Rent expense  during 1997,  1996 and 1995 amounted to $410,856,  $371,526
       and $542,885, respectively. Rent expense in 1997, 1996 and 1995 is net of
       $308,608, $499,106 and $88,698 of sublease income, respectively.

       Consulting contracts and employment agreements

       In the  normal  course  of  business,  the  Company  enters  into  annual
       employment   and  consulting   contracts   with  various   employees  and
       consultants.

       Dividend restrictions
    
       Dividends may be paid by the Company's subsidiary,  Pharmos Limited, only
       out of retained  earnings as determined for Israeli  statutory  purposes.
       There are no retained  earnings in Israel  available for  distribution as
       dividends  as of December 31,  1997,  1996 or 1995.  The Company does not
       intend to pay a cash dividend in the foreseeable future.

14.    Employee Benefit Plan

       The Company has a 401-K defined contribution profit-sharing plan covering
       certain  employees.  Contributions  to  the  plan  are  based  on  salary
       reductions  by  the  participants,  matching  employer  contributions  as
       determined by the Company, and allowable discretionary contributions,  as
       determined  by the  Company's  Board of  Directors,  subject  to  certain
       limitations.  Contributions  by the  Company  to  the  plan  amounted  to
       $10,090, $11,363 and $10,731 and in 1997, 1996 and 1995, respectively.


                                      F-20

<PAGE>

Pharmos Corporation

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


15.   Estimated Fair Value of Financial Instruments

       The  carrying  amounts  of cash and cash  equivalents,  grants  and other
       receivables,   accounts  payable  and  accrued  expenses  are  reasonable
       estimates of their fair values.  Due to the  uncertainty of the timing of
       future  product  sales it is not  practical to estimate the fair value of
       advances  against  future sales which have a carrying value of $5,000,000
       at December 31, 1997.  The estimated  fair values of all other  financial
       instruments  approximate,  or are not  materially  different,  than their
       carrying values.


16.    Subsequent Events


       In January 1998, the shareholders of the Company approved the increase in
       the  number of  authorized  shares of common  stock  from  50,000,000  to
       60,000,000 and adopted the 1997 Incentive and Non-Qualified  Stock Option
       Plan,  which has  reserved  for  issuance up to 600,000  shares of common
       stock upon the  exercise  of stock  options  to be granted to  employees,
       directors, consultants and other key personnel.


       On February  4, 1998,  the Company  completed  a private  placement  with
       institutional  investors  of  Series C  Convertible  Preferred  Stock and
       warrants to purchase  650,000  shares of common stock,  generating  gross
       proceeds of $5 million. The preferred stock carries a 5% dividend payable
       in common stock and is convertible into common shares of the Company,  60
       days  subsequent to the date of issuance.  For the period ending 180 days
       after the date of issuance, the conversion price is 90% of the average of
       the low trade prices of the Common Stock for the five consecutive trading
       days  ending on the day  immediately  prior to the  conversion  date (the
       "Variable Conversion Price"). Following such period, the conversion price
       is the lower of the Variable  Conversion  Price or 120% of the average of
       the closing bid prices of the Common Stock for the trading days beginning
       on the date which is 151 days,  and ending on the date which is 180 days,
       following the date of issuance.  Until  converted into common stock,  the
       preferred  stock  has  no  voting  rights.  The  warrants  issued  to the
       investors  are  exercisable  at prices  ranging  from  $2.28 to $2.67 per
       share, commencing one year after the closing for a three year period.


       On March 10, 1998, the Company  received  approval,  from the FDA, of its
       NDA's for Lotemax and Alrex.


                                      F-21


<PAGE>


                                   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.

                              PHARMOS CORPORATION


                             By: /s/ HAIM AVIV
                                 ---------------------------- 
                                 Dr. Haim Aviv, Chairman of the Board and Chief
                                 Executive Officer (Principal Executive Officer)


                                 Date: June 16, 1998


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

<TABLE>
<CAPTION>

Signature                             Title                                           Date
---------                             -----                                           ----
<S>                                   <C>                                             <C> 
/s/ Robert Cook                       Chief Financial Officer (Principal              June 16, 1998
----------------------------
Robert Cook                           Financial and Accounting Officer),
                                      and Secretary
/s/ Dr. Gad Riesenfeld                President, Chief Operating Officer              June 16, 1998
----------------------------
Dr. Gad Riesenfeld
/s/ Marvin P. Loeb                    Director                                        June 16, 1998
------------------
Marvin P. Loeb
/s/ E. Andrews Grinstead III          Director                                        June 16, 1998
----------------------------
E. Andrews Grinstead III
/s/ Stephen C. Knight                 Director                                        June 16, 1998
----------------------------
Stephen C. Knight
/s/ David Schlachet                   Director                                        June 16, 1998
----------------------------
David Schlachet
/s/ Fredric D. Price                  Director                                        June 16, 1998
----------------------------
Fredric D. Price
/s/ Mony Ben Dor                      Director                                        June 16, 1998
----------------------------
Mony Ben Dor
</TABLE>