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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                                   FORM 10-K
 
   [X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934
     FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998
 
                                      OR
 
   [_]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. 1-8465
 
                            STERLING SOFTWARE, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
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<S>                                            <C>
                  DELAWARE                                       75-1873956
       (STATE OR OTHER JURISDICTION OF                        (I.R.S. EMPLOYER
       INCORPORATION OR ORGANIZATION)                       IDENTIFICATION NO.)
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                        300 CRESCENT COURT, SUITE 1200
                              DALLAS, TEXAS 75201
         (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
      REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (214) 981-1000
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
 
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<S>                                            <C>
             TITLE OF EACH CLASS                 NAME OF EACH EXCHANGE ON WHICH REGISTERED
        Common Stock, $0.10 Par Value                     New York Stock Exchange
     Rights to Purchase Series A Junior                   New York Stock Exchange
  Participating Preferred Stock, $0.10 Par
                    Value
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          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                                     NONE
 
  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. [X]
 
  As of November 10, 1998, 82,441,492 shares of the Registrant's Common Stock
were outstanding.
 
  The aggregate market value of the Registrant's Common Stock held by non-
affiliates of the Registrant was $2,081,053,559, based on the $26 3/16 closing
sales price of the Registrant's Common Stock on the New York Stock Exchange on
November 10, 1998.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Portions of the proxy statement for the Annual Meeting of Stockholders of
the Registrant to be held during 1999 are incorporated by reference in Part
III.
 
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                            STERLING SOFTWARE, INC.
 
                               TABLE OF CONTENTS
 
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 FORM 10-K ITEM                                                            PAGE
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 <C>         <S>                                                           <C>
 PART I.
    Item 1.  Business...................................................     1
    Item 2.  Properties.................................................    12
    Item 3.  Legal Proceedings..........................................    13
    Item 4.  Submission of Matters to a Vote of Security Holders........    13
 PART II.
    Item 5.  Market for Registrant's Common Equity and Related
             Stockholder Matters........................................    14
    Item 6.  Selected Financial Data....................................    15
    Item 7.  Management's Discussion and Analysis of Financial Condition
             and Results of Operations..................................    16
    Item 7A. Quantitative and Qualitative Disclosure About Market Risk..    25
    Item 8.  Financial Statements and Supplementary Data................    26
    Item 9.  Changes in and Disagreements with Accountants on Accounting
             and Financial Disclosure...................................    52
 PART III.
    Item 10. Directors and Executive Officers of the Registrant.........    52
    Item 11. Executive Compensation.....................................    52
    Item 12. Security Ownership of Certain Beneficial Owners and
             Management.................................................    52
    Item 13. Certain Relationships and Related Transactions.............    52
 PART IV.
    Item 14. Exhibits, Financial Statement Schedules and Reports on Form
             8-K........................................................    53
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                                    PART I
 
ITEM 1. BUSINESS.
 
GENERAL
 
  Sterling Software, Inc. ("Sterling Software" or the "Company") was founded
in 198l and became a publicly owned corporation in l983. Sterling Software is
a worldwide developer and supplier of application development, information
management and systems management software products and services, as well as a
supplier of specialized information technology ("IT") services for sectors of
the federal government. Sterling Software's customer base includes 91 of the
100 largest U.S. industrial and service corporations, as ranked by 1997
revenues in Fortune magazine. Sterling Software's business segments are as
follows:
 
  .  The application management business segment provides solutions for both
     enterprise-scale application development and information management.
     Application development solutions include products and services for
     business modeling through code generation. These solutions provide
     customers the ability to build component-based applications through
     model-based code generation using traditional and object-oriented
     techniques, to reuse what they have built through components and to
     protect their investment in legacy assets. Information management
     solutions include products and services that enable customers to
     facilitate enterprise information access and to extend the life and
     usefulness of legacy applications. These solutions help enterprises
     address issues related to complex implementation challenges such as data
     warehousing, intranets and application management, using technologies
     that enhance business intelligence, integrate applications and improve
     information access through web browsers.
 
  .  The systems management business segment provides solutions that enable
     customers to simplify the use of multiple computing environments and to
     increase the productivity of information systems, ultimately ensuring
     that the systems meet the business needs of the organization. These
     solutions include enterprise-level network management products,
     enterprise-level storage management products and comprehensive VM
     systems management products.
 
  .  The federal systems business segment provides specialized IT services
     for sectors of the federal government, as well as state and local
     governments. Major customers include the U.S. Department of Defense
     ("DoD"), the military services, U.S. national intelligence agencies, the
     Federal Aviation Administration ("FAA") and the National Aeronautics and
     Space Administration ("NASA").
 
  Worldwide revenue from the Company's application management, systems
management and federal systems business segments represented 51%, 28% and 21%,
respectively, of the Company's total 1998 revenue. Revenue from the Company's
international operations represented 39% of the Company's total 1998 revenue.
See Notes 5 and 6 of Notes to Consolidated Financial Statements.
 
  On September 30, 1996, Sterling Software completed the spin-off of Sterling
Commerce, Inc. ("Sterling Commerce"), which owns and operates the business
conducted by Sterling Software's former electronic commerce business segment.
The results of operations of Sterling Commerce for 1996 have been classified
as discontinued operations in the accompanying Consolidated Financial
Statements. Through June 30, 1997, the Company sold, marketed and provided
first-level support outside of the United States and Canada for Sterling
Commerce's interchange and communications software products, the results of
which are included in the business segment information presented in the
accompanying Consolidated Financial Statements under "Corporate and other".
 
  A large percentage of Sterling Software's business is recurring through
annual and multi-year contracts. Product support contracts generally have
terms that range from one to three years, fixed-term product lease and rental
contracts generally have terms that range from month-to-month to year-to-year
and multi-year federal contracts generally have terms that range from one to
five years. Recurring revenue represented 46% and 48% of the Company's total
revenue in 1998 and 1997, respectively.
 
                                       1
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  Consistent with Sterling Software's decentralized operating structure, the
Company's businesses are served by independent operating groups. Within each
of these groups are divisions that focus on specific business niches. In
keeping with the Company's decentralized philosophy, the management team of
each group and division is largely autonomous. Sterling Software believes that
its decentralized organizational structure promotes operating flexibility,
improves responsiveness to customer requirements and focuses management on
achieving revenue and operating profit objectives. Sterling Software has
historically expanded its operations through internal growth and through
business and product acquisitions.
 
  At September 30, 1998, the Company employed approximately 3,500 employees in
90 offices worldwide. The Company has direct sales offices in 22 countries and
distributors and agents in an additional 38 countries.
 
APPLICATION MANAGEMENT
 
  The application management business segment provides solutions for both
enterprise-scale application development and information management through
its COOL and VISION product families, respectively. Worldwide revenue from the
application management business segment represented 51%, 39% and 36% of the
Company's total revenue during 1998, 1997 and 1996, respectively.
 
  The COOL family of products is designed to provide customers the ability to
build component-based applications through model-based code generation using
traditional and object-oriented techniques, to reuse what they have built
through components and to protect their investment in legacy assets. COOL:Biz
is a comprehensive business modeling toolset that promotes an understanding of
organizations and processes with a "common language" for communicating
business needs. The product's methodology for process mapping and job design
allows business and IT professionals to work together to design business
processes. COOL:Spex, released in February 1998, represents the latest in
component-based development technology. Using COOL:Spex, developers model
component interfaces and architect component-based applications that directly
support business requirements documented in COOL:Biz. COOL:Spex produces
technology-independent component specifications that maximize reuse. COOL:Gen
is designed to allow developers to model and generate error-free code in a
structured, repeatable manner. With COOL:Gen, high-level component
specifications are driven forward into dynamic, scalable applications
targeting multiple platforms, including the World Wide Web. COOL:Plex is a
model-based development environment that leverages pattern technology to
rapidly deliver high-quality, adaptable applications for Windows NT and AS/400
platforms. COOL:Jex is an object-oriented analysis and design solution
supporting the Unified Modeling Language industry standard notation. COOL:Jex
allows modeling of complex application requirements, driven directly from
business requirements. The COOL portfolio also includes COOL:2E, an AS/400
development environment supporting model-based code generation of AS/400
applications; COOL:Enterprise, an OS/2 development environment supporting
model-based code generation of MVS, Unix and Windows applications; and
COOL:Xtras, a set of supporting utilities for Web reporting and AS/400 model
and application management.
 
  The COOL product portfolio was expanded on October 26, 1998, with the
Company's acquisition of Cayenne Software, Inc. ("Cayenne"). See "Recent
Developments". The acquired products include COOL:BusinessTeam, a logical data
and process modeling tool; COOL:DBA, a relational database design and
generation tool; and COOL:Teamwork, a structured engineering tool for
requirements documentation and systems design of real-time and embedded
systems. Additionally, COOL:Jex now includes the functionality from Cayenne's
object-oriented analysis and design tool, which offered extensions in both the
number of language generation targets available, as well as support for key
functionality needed to satisfy bid-driven market requirements. COOL:Jex's
extensions and code generation capabilities now support the development of
real-time or embedded systems, client/server applications, as well as intranet
and Internet solutions.
 
  The VISION family of products enables customers to facilitate enterprise
information access and to extend the life and usefulness of legacy
applications. These solutions help enterprises address issues related to
complex implementation challenges such as data warehousing, intranets and
application management, using technologies
 
                                       2
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that enhance business intelligence, integrate applications and improve
information access through web browsers. VISION:Results is an information
management and report generation system for IBM enterprise servers and a
dynamic complement to COBOL. VISION:Builder and VISION:Transact are
application development tools for batch and on-line environments,
respectively, that operate on major IBM enterprise server platforms. The
VISION:Legacy suite of products addresses the functions required to assess the
quality and maintainability of applications, restructure old COBOL programs,
re-document the flow of control through legacy systems, and graphically
represent the architecture and flow of existing systems. The VISION:Legacy
suite of products, including VISION:Inspect, VISION:Assess, VISION:Recode and
VISION:Redocument, helps address the "year 2000" effort with system-wide
analysis capabilities and reports to help identify and modify date and date-
related fields. VISION:Phaseshift and VISION:Simulate, among others, were
recently added to the Company's year 2000 portfolio of products.
VISION:Phaseshift provides an interface to system resources and data files. It
intercepts requests for date and time data and "windows" the dates back 28
years in an encapsulated environment. VISION:Simulate is a testing tool that
allows for the simulation of dates into the future to test applications
without changing the system date. The VISION family also includes Business
Intelligence products such as VISION:Clearaccess, VISION:Clearmanage,
VISION:Webaccess and VISION:Dimensions. VISION:Clearaccess facilitates end-
user data access as a query and reporting tool, and VISION:Clearmanage allows
database managers to monitor and control database access in a client/server
environment. VISION:Webaccess is a Java-based, thin client computing solution
for total enterprise data access and analysis over the World Wide Web. Using
wizard technology, VISION:Webaccess allows users to point and click their way
through queries, view and refresh previously created reports and charts, and
create ad hoc reports and charts for quick analysis. VISION:Dimensions is an
online analytical processing tool that provides flexible and dynamic access to
business data in multidimensional databases for online analysis, reporting and
graphical representation.
 
  As of September 30, 1998, the application management business employed
approximately 1,400 people. See Item 7. "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Business Combinations,
Divestitures and Reorganizations--Acquisition of Synon Corporation" and "--
Acquisition of TI Software" for a description of recent acquisitions in this
business segment.
 
SYSTEMS MANAGEMENT
 
  The systems management business segment provides solutions that enable
customers to simplify the use of multiple computing environments and to
increase the productivity of information systems, ultimately ensuring that the
systems meet the business needs of the organization. The SOLVE family of
products focuses on enterprise-level network management, the SAMS family of
products focuses on enterprise-level storage management and the VM family of
products focuses on systems management solutions for the VM operating
environment. Guiding these solutions is the group's Business-Centric
Enterprise Management initiative, a pragmatic, business-focused approach to
ensuring the availability and reliability of business critical applications
and the IT infrastructure upon which they rely. Worldwide revenue from the
systems management business segment represented 28%, 32% and 33% of the
Company's total revenue during 1998, 1997 and 1996, respectively.
 
  The SOLVE family of products helps customers manage their networked
enterprise from a business-service perspective. SOLVE:Netmaster automates
network management operations across large-scale enterprises. The
SOLVE:Netmaster products provide for centralized command and control,
diagnostics, performance management and alert and status monitoring of TCP/IP
(Transmission Control Protocol/Internet Protocol), SNA (Systems Network
Architecture) and SNMP (Simple Network Management Protocol) network events.
The SOLVE:Operations products provide and participate in enterprise-wide
systems automation solutions, addressing both mainframe and distributed
systems from a single point. SOLVE:Operations products are available as stand-
alone products within the OS/390 environment and as plug-in components for
three enterprise management platforms: Hewlett-Packard's "OpenView" and
"OpenView IT/Operations" and Tivoli's "Tivoli/TME 10 NetView". SOLVE:Diplomat
allows multiple customer information applications to share information with
multiple help desk applications without modifying the applications themselves.
This allows enterprises to synchronize their business support applications and
maximize customer service, while at the same time
 
                                       3
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preserving the investment in these applications. SOLVE:Central is an
integrated suite of products for running the enterprise IT service desk and is
comprised of: SOLVE:Problem for problem tracking and resolution, SOLVE:Change
for managing the systems change process, SOLVE:Configuration for tracking
software and hardware configuration changes and SOLVE:Asset for business
management of computer assets and the services they deliver.
 
  The SAMS family of products manages, monitors and automates data storage in
both distributed and centralized environments. SAMS:Vantage, OS/390 Edition,
is a client/server system that provides comprehensive automation, interactive
reporting, analysis and predictive modeling capabilities for complex OS/390
storage environments. SAMS:Vantage, Network Edition, delivers consolidated
management of distributed storage across UNIX, Windows NT, NetWare and OS/2
environments; it also incorporates a view of mainframe storage. SAMS:Vantage,
ADSM Edition, is a tailored version of the product that adds value to IBM's
Adstar Distributed Storage Manager (ADSM). From one workstation, the product
identifies and manages critical data defects and solves problems
automatically, charts trends and forecasts capacity across platforms. The
SAMS:Vantage storage management approach is designed to remain consistent
across multiple platforms and to allow organizations to: manage enterprise
data storage in a uniform manner, implement consistent storage management
policies and standards, provide consolidated management of distributed data
and enforce the protection of critical data, regardless of where it resides.
On the OS/390 platform, SAMS:Vantage ties into the division's data management
products, providing a comprehensive OS/390 storage management suite.
SAMS:Perform, the input/output ("I/O") performance monitoring component of
SAMS:Vantage, is the first I/O performance monitor to work across multiple
RAID (redundant array of inexpensive disks) subsystems and DASD (data access
storage devices). The product analyzes I/O performance and recommends device
specific solutions to improve response times and increase efficiency. The SAMS
family of products also includes SAMS:Disk, a centralized mainframe data
storage management backup and recovery system; SAMS:Allocate, a centralized
allocation control system; and SAMS:Vista, an automated tape storage
management component of SAMS:Vantage, OS/390 Edition, that enhances tape
management systems and assists in the management of robotic tape systems and
high-capacity tape devices.
 
  The VM family of products provides systems management software and Web-
enabling software for IBM's VM/ESA operating system. The VM:Manager product
family provides integrated solutions for automated operations, storage
management, service-level management, security, recovery and SFS (Shared File
System) management. VM:Manager is designed to enable VM sites to operate at
maximum availability with minimal systems administration personnel, thereby
controlling costs, improving performance and increasing user productivity. The
VM:Webgateway product family enables customers to deliver World Wide Web
services from the VM operating system and to deliver VM applications and data
across intranets or the Internet. VM:Webgateway is a World Wide Web server for
VM that allows customers to utilize user-friendly web browsers to deliver
mainframe-based information to end-users on any platform. VM:Webgateway acts
as a repository for home pages and documents created using HTML (Hypertext
Markup Language) and also stores, retrieves and processes information in
various formats including text, graphics, sound, images, video and Java
applets. VM:Webgateway's OfficeVision interface option adds a graphical user
interface to the calendar and E-mail features of IBM's OfficeVision/VM, a
mainframe-based office automation solution.
 
  As of September 30, 1998, the Systems Management business employed
approximately 800 people.
 
FEDERAL SYSTEMS
 
  The federal systems business segment provides specialized IT services for
sectors of the federal government, as well as state and local governments.
Major customers include the DoD, the military services, U.S. national
intelligence agencies, the FAA and NASA. In 1998, Sterling Software began its
32nd year of service to both NASA and the DoD. In 1998, the Company's federal
systems business was performing work under approximately 190 contracts.
Revenue from the federal systems business segment represented 21%, 21% and 22%
of the Company's total revenue during 1998, 1997 and 1996, respectively.
 
 
                                       4
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  The Information Technology Division of this business focuses on four
operational areas: intelligence systems, advanced systems, weather systems and
state and local governments. The division specializes in secure
communications, message and data handling, weather forecast production and
distribution, and systems integration and application development in support
of various projects ranging from satellite data collection to counter-
terrorism. Division computing resources include facilities approved for
classified operations and substantial hardware and software configurations to
support software lifecycle development activities in distributed processing
environments. The division's software engineering and software development
processes are certified at Software Engineering Institute Capability Maturity
Model (SEI CMM) Level 3 and International Standards Organization (ISO) 9001.
Customers include U.S. Air Force command, control and communications
organizations, the Defense Intelligence Agency and other national intelligence
organizations.
 
  The Applied Systems Division of this business has four operational areas:
simulation, modeling and training; advanced systems; command, control,
communications, computers, surveillance and reconnaissance (C4ISR); and space
and transportation systems. The division specializes in tactical military
intelligence and data fusion; command and control; advanced database
techniques; modeling, constructive, live and virtual simulation; and strategic
planning. In addition, the division specializes in software and support
services for airborne and space flight systems, data acquisition and control
systems, and air traffic management. Customers include U.S. Army intelligence
and battle command organizations, the FAA, NASA and the U.S. Air Force.
 
  As of September 30, 1998, the federal systems business employed
approximately 1,200 people. See Item 7. "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Business Combinations,
Divestitures and Reorganizations--Acquisition of Mystech Associates, Inc." for
a description of recent acquisitions in this business segment.
 
PRODUCT LICENSES
 
  Sterling Software's products are generally licensed under perpetual use,
fixed-term or usage-based agreements. Sterling Software typically does not
sell or otherwise transfer title to its software products. The Company's
license agreements prohibit reproduction, transfer or disclosure of the
product and generally restrict the use of the product to designated sites or
central processing units. However, some license agreements may cover multiple
sites or multiple central processing units at one site. In 1998, 1997 and
1996, product revenue accounted for 40%, 41% and 42%, respectively, of the
Company's total revenue.
 
PRODUCT SUPPORT
 
  Product support is available to Sterling Software customers, typically
through annual contracts generally priced from 12% to 22% of the current
license fee. Sterling Software's product support contracts allow customers to
receive updated versions of Sterling Software's products when and if they
become available, as well as "bug fixing" and Internet and telephone access to
Sterling Software's technical personnel. In 1998, 1997 and 1996, product
support revenue accounted for 26%, 27% and 28%, respectively, of the Company's
total revenue.
 
SERVICES
 
  Services provided by Sterling Software primarily consist of specialized IT
services in support of federal government contracts provided through the
Company's federal systems business. In addition, Sterling Software provides
training and education in support of its software products in the form of
customer training seminars, videos and instruction materials. Sterling
Software also offers product-specific consulting and education services within
its application management business to better enable customers to successfully
use its products. In 1998, 1997 and 1996, services revenue accounted for 34%,
32% and 30%, respectively, of the Company's total revenue.
 
PRODUCT DEVELOPMENT
 
  Each domestic division within Sterling Software's application management,
systems management and federal systems businesses has its own development
function. Sterling Software's product development programs
 
                                       5
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in each of these businesses include the enhancement of existing products and
introduction of new products based upon current and anticipated customer
needs. The Company believes that its decentralized organizational structure
facilitates development cost control and focuses the development function on
the customers' needs. Approximately 470 of Sterling Software's employees were
engaged in product development as of September 30, 1998. Gross product
development costs in 1998, 1997 and 1996 were $63,118,000, $51,370,000 and
$44,582,000, respectively, of which the Company capitalized $26,956,000,
$21,711,000 and $18,180,000, respectively, as the cost of developing and
testing new or significantly enhanced software products.
 
  Each of the Company's product divisions has completed a year 2000 assessment
of its currently offered products. This assessment included internal testing
of the year 2000 capabilities of these products. The Company believes that the
vast majority of its currently offered products are year 2000 compliant, and
expects virtually all of its remaining currently offered products to become
compliant during the early part of calendar 1999 through new releases. In any
event, the Company expects that all of its currently offered products will be
year 2000 compliant before the end of calendar 1999. See Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Other Matters--Year 2000 Issues".
 
SALES AND MARKETING
 
  Consistent with its decentralized operating structure, Sterling Software
conducts its sales and marketing activities in multiple software divisions
focused on specific product markets. Sterling Software sells its products and
services through a combination of direct sales and telesales organizations,
and in certain foreign countries, through independent agents and distributors.
The use of telesales has proven effective in reaching customers at a minimal
cost. Each domestic division within the application management and systems
management businesses has its own U.S. sales and marketing organization. In
addition, the application management and systems management businesses have
divisions and business units that focus specifically on the international
marketplace for their respective product lines. The federal systems business
has its own sales organization, which focuses specifically on specialized IT
service offerings to the federal IT market.
 
CUSTOMERS
 
  Sterling Software's customers include 91 of the 100 largest U.S. industrial
and service corporations, ranked by 1997 revenues in Fortune magazine. In the
year ended September 30, 1998, agencies, branches and departments of the
federal government accounted for approximately 22% of the Company's total
revenue.
 
COMPETITION
 
  The computer software and services industry is rapidly evolving and highly
competitive. Sterling Software competes with both large companies with
substantially greater resources and small specialized companies that compete
in a particular geographic region or market niche. Sterling Software also
competes with internal programming staffs of corporations and with hardware
manufacturers. Competition within the Company's federal business is increasing
because of continued federal budget constraints and cutbacks. In addition,
continuing consolidation among providers of technical services to the federal
government is increasing the size and market presence of many of the Company's
competitors in this market segment.
 
  Sterling Software believes that its products will continue to be selected by
customers due to superior product functionality, reliability and technical
support, ease of product installation and use, close integration between the
products and customer business applications and, finally, the Company's
history of success and reputation for providing quality products.
 
EMPLOYEES
 
  Sterling Software's business is dependent upon its ability to attract and
retain qualified personnel, who are in limited supply. The Company's
operations could be adversely affected if it were to lose the services of a
 
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significant number of qualified employees or if it were unable to obtain
additional qualified employees when needed. The market for highly qualified
personnel in the IT industry is extremely competitive, making it difficult for
companies in this industry, including Sterling Software, to attract and retain
qualified employees. The Company strives to maintain excellent employee
relations, attractive office facilities and challenging work environments, and
offers competitive compensation and benefits packages.
 
  At September 30, 1998, the Company employed approximately 3,500 people.
 
INTELLECTUAL PROPERTY
 
  Sterling Software's success depends in part on its technology and
intellectual property. The Company relies primarily on a combination of
copyright, patent and trademark laws, confidentiality procedures and
contractual provisions to protect its intellectual property. The Company
routinely enters into nondisclosure and confidentiality agreements with
employees, contractors, consultants, vendors and customers, and its product
license agreements generally prohibit the unauthorized use or disclosure of
the Company's proprietary intellectual property. Despite the Company's efforts
to protect its proprietary rights, unauthorized parties may attempt to copy
aspects of the Company's products or to obtain and use information that the
Company regards as proprietary. In addition, the laws of some foreign
countries do not protect the Company's proprietary rights to the same extent
as the laws of the United States. In general, however, management believes
that the competitive position of the Company depends primarily on the skill,
knowledge, creativity and experience of Sterling Software's personnel and
their ability to develop, market and support software products, and that its
business is not materially dependent on copyright protection, trademarks or
patents.
 
  The Company does not believe that any of its products infringe in any
material respect on the valid proprietary rights of third parties. However, a
large number of patents, trademarks and copyrights have been, and are being,
issued, registered or asserted in the software industry and there can be no
assurance that the Company is aware of all such intellectual property rights
that may pose a risk of infringement by the Company's products, especially
with respect to United States patents, which can cover extremely broad
concepts and the applications for which are confidential until the patents are
issued.
 
  Licenses for a number of software products have been granted to the Company
for its own use or for remarketing to its customers. In the aggregate, these
licenses are significant to the business of the Company, but the Company
believes that the loss of any one of these licenses would not materially
affect the Company's business, financial condition or results of operations.
 
  The COOL, VISION, SAMS, VM and SOLVE families of product names and the mark
"Sterling Software" used herein are registered or unregistered trademarks
owned by the Company.
 
BACKLOG
 
  Sterling Software's backlog relates principally to the uncompleted portion
of multi-year professional services contracts with agencies of the federal
government, including renewal options with government agencies, a portion of
which is restricted by law to a term ending on the last day of the government
agencies' then-current fiscal year.
 
  Determination of the Company's backlog involves estimation, particularly
with respect to customer requirements contracts and multi-year contracts of a
cost-reimbursement or incentive nature. A large portion of the Company's
federal government contracts is funded for one year or less and is subject to
contract award, extension or expiration at different times during the year,
and all of the Company's federal government contracts are subject to
termination by the government (on short notice). Based upon past experience,
the Company believes that the contract renewal options included in existing
contracts will be exercised for the full period designated in such contracts,
but no assurance can be given that such contracts will be renewed.
 
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  Total backlog, including federal government contract renewal options not yet
exercised and multi-year product support contracts at September 30, 1998 and
1997, was $254,123,000 and $246,381,000, respectively. Of these amounts, 96%
and 94%, respectively, related to federal government sources, primarily in the
Company's federal systems business. The dollar value of federal government
renewal options not yet exercised or funded included in the Company's total
backlog at September 30, 1998 and 1997, was $159,421,000 and $113,981,000,
respectively. Approximately $91,526,000 of the September 30, 1998 backlog is
expected to be realized in the year ending September 30, 1999.
 
RECENT DEVELOPMENTS
 
  On October 26, 1998, Sterling Software acquired Cayenne, a global supplier
of analysis and design solutions for application and database development, in
a cash transaction valued at approximately $11,400,000. The acquisition will
be accounted for in accordance with the purchase method of accounting and,
accordingly, the results of operations of Cayenne will be included in the
Company's results of operations from the date of the acquisition and will be
reported under the application management business segment. The Company
expects to incur non-recurring charges to operations in the first quarter of
1999, currently estimated to aggregate between $25,000,000 and $40,000,000,
primarily related to the reorganization of the Company's operations and the
write-off of purchased research and development costs in connection with the
acquisition.
 
EXECUTIVE OFFICERS
 
  The following information regarding the executive and other officers of
Sterling Software is as of November 13, 1998.
 
<TABLE>
<CAPTION>
         NAME        AGE                       POSITION
   ----------------  --- ----------------------------------------------------
   <S>               <C> <C>
   Sam Wyly           64 Chairman of the Board and Director
   Charles J. Wyly,   65 Vice Chairman of the Board and Director
    Jr.
   Sterling L.        55 President, Chief Executive Officer and Director
    Williams
   Geno P. Tolari     55 Executive Vice President and Chief Operating Officer
   M. Gene Konopik    55 Executive Vice President and Group President
   John R. Cook       54 Senior Vice President, Business Development
   F.L. "Mike"        60 Senior Vice President and Group President
    Harvey
   Don J.             40 Senior Vice President, General Counsel and Secretary
    McDermett, Jr.
   B. Carole Morton   52 Senior Vice President and Group President
   Mark A. Theel      41 Senior Vice President and Group President
   R. Logan Wray      39 Senior Vice President and Chief Financial Officer
   Ivan S. Hughes*    46 Vice President, Organizational Development
   Pamela L.          39 Vice President, Financial Planning
    Isbell*
   Julie G. Kupp*     35 Vice President, Investor Relations
   Laura Appling*     36 Controller
   Susan D.           50 Treasurer
    Tiholiz*
</TABLE>
  --------
  *  Although Ivan S. Hughes, Pamela L. Isbell, Julie G. Kupp, Laura Appling
     and Susan D. Tiholiz are officers of the Company, the Company does not
     consider such employees to be "executive officers" of the Company, as
     that term is defined in regulations promulgated by the Securities and
     Exchange Commission.
 
  Sam Wyly has served as Chairman of the Board since co-founding the Company
in 1981. He also serves as Chairman of the Executive and 1996 Stock Option
Committees of the Board. Companies founded by Mr. Wyly were among the
forerunners of the computer software and electronic commerce industries. In
1963, he founded University Computing Company, which became one of the largest
computer service and software companies.
 
                                       8
<PAGE>
 
His data transmission company, Datran, Inc., was one of the pioneering
telecommunications ventures that broke up the telephone monopoly. Sterling
Commerce (a provider of electronic commerce software and network services), a
leader in this industry, was spun off to the Company's stockholders in 1996
and now has a market value in excess of $3 billion. Mr. Wyly currently serves
as Chairman of the Executive Committee of the Board of Directors of Sterling
Commerce, Chairman of Michaels Stores, Inc. and Partner of the General Partner
of Maverick Capital, Ltd., an investment fund management company that he
founded. Mr. Wyly is the father of Evan Wyly, also a director of the Company.
 
  Charles J. Wyly, Jr. co-founded the Company in 1981 and since such time has
served as a director of the Company, and as Vice Chairman since 1984. He
served as an officer and director of University Computing Company, a computer
software and services company, from 1964 to 1975, including President from
1969 to 1973. Mr. Wyly and his brother, Sam Wyly, founded Earth Resources
Company, an oil refining and silver mining company, and Charles J. Wyly, Jr.
served as its Chairman of the Board from 1968 to 1980. Mr. Wyly served as Vice
Chairman of the Bonanza Steakhouse chain from 1967 to 1989. Mr. Wyly currently
serves as Vice Chairman of Michaels Stores, Inc. and as a director of Sterling
Commerce. Charles J. Wyly, Jr. is the father-in-law of Donald R. Miller, Jr.,
also a director of the Company. Mr. Wyly is a member of the Executive
Committee and the 1996 Stock Option Committee of the Board.
 
  Sterling L. Williams co-founded the Company in 1981 and since such time has
served as President, Chief Executive Officer and a director of the Company.
Mr. Williams has served as Chairman of the Board and a director of Sterling
Commerce since December 1995. From December 1995 to October 1996, Mr. Williams
also served as Chief Executive Officer of Sterling Commerce. Mr. Williams is a
member of the Executive Committee and the 1996 Stock Option Committee of the
Board.
 
  Geno P. Tolari has served as an Executive Vice President of Sterling
Software since March 1990 and as Chief Operating Officer since April 1996.
From November 1986 to March 1990, he served as a Senior Vice President of
Sterling Software. Mr. Tolari served as President of the Systems Management
Group from December 1994 to February 1997 and as President of the Federal
Systems Group from October 1985 to December 1994.
 
  M. Gene Konopik has served as an Executive Vice President of Sterling
Software and President of Sterling Software's Federal Systems Group since
December 1994. From July 1993 to December 1994, Mr. Konopik served as the
President of Sterling Software's Information Technology Division.
 
  John R. Cook has served as Senior Vice President, Business Development of
Sterling Software since December 1997. He served as Vice President, Business
Development of Sterling Software's former Applications Management Group from
July 1997 to December 1997. From June 1995 to June 1997, he served the
Software Division of Texas Instruments Incorporated ("TI Software") as Vice
President and General Manager--The Americas (from January 1997 to July 1997)
and as Vice President--Strategy and New Business Creation (from June 1995 to
December 1996). From October 1993 to June 1995, he served as the Chief
Executive Officer of the BankA Enterprise of Andersen Consulting, an
international consulting firm.
 
  F.L. "Mike" Harvey has served as a Senior Vice President of Sterling
Software since June 1997 and as President of the Systems Management Group
since October 1998. He served as President of the former Applications
Management Group from October 1996 to October 1998. From March 1993 to June
1997, he served as President of Omega Consulting Group Inc., a software
consulting company.
 
  Don J. McDermett, Jr. has served as Senior Vice President and General
Counsel of Sterling Software since May 1997 and as Secretary since October
1998. From July 1996 to May 1997, he served as Vice President, Legal of
Sterling Software. Prior to that time Mr. McDermett was employed by Thompson &
Knight, P.C., a Dallas-based law firm, having been a senior shareholder in
that firm's corporate practice group since 1993.
 
  B. Carole Morton has served as a Senior Vice President of Sterling Software
since October 1996, as President of Sterling Software's new Information
Management Group since October 1998 and as President of
 
                                       9
<PAGE>
 
the Information Management Division since October 1995. From October 1996 to
June 1997, she also served as President of the former Information Management
Group. Ms. Morton served as President of Sterling Software's former
Applications Engineering Division from December 1994 to October 1995 and
President of the former Applications Management Division from July 1993 to
November 1994.
 
  Mark A. Theel has served as a Senior Vice President of Sterling Software
since November 1998, as President of Sterling Software's new Application
Development Group since October 1998 and as President of the Application
Development Division since January 1996. From December 1994 to December 1995,
Mr. Theel served as Vice President, Labs of the Application Development
Division and from July 1993 to November 1994, he served as Vice President,
Labs of the former Applications Management Division.
 
  R. Logan Wray has served as Senior Vice President and Chief Financial
Officer of the Company since May 1997. Prior to that time he was employed by
Ernst & Young LLP, a national accounting firm, having been a partner in that
firm since 1994.
 
  Ivan S. Hughes has served as Vice President, Organizational Development of
the Company since June 1997. Prior to joining the Company he was employed for
19 years by Texas Instruments Incorporated, where he served as Human Resources
Director for TI Software from July 1995 to June 1997 and as Human Resources
Director for the European, Middle Eastern and African operations of TI
Software from June 1992 to July 1995.
 
  Pamela L. Isbell has served as Vice President, Financial Planning of
Sterling Software since April 1996. From April 1988 to April 1996, Ms. Isbell
served as a Financial Analyst of Sterling Software.
 
  Julie G. Kupp has served as Vice President, Investor Relations of Sterling
Software since April 1996. From September 1995 to April 1996, Ms. Kupp served
as Director, Investor Relations and from April 1995 to September 1995, she
served as Senior Financial Analyst of Sterling Software. From December 1993 to
April 1995, Ms. Kupp served as Director of Accounting. Prior to December 1993,
Ms. Kupp was employed by Ernst & Young LLP, a national accounting firm, most
recently as Audit Senior Manager.
 
  Laura Appling has served as Controller of Sterling Software since April
1996. From July 1993 to April 1996, Ms. Appling served as Vice President,
Finance for Sterling Commerce's Banking Systems Group.
 
  Susan D. Tiholiz has served as Treasurer of the Company since November 1997.
She served as Director of Treasury from June 1996 to November 1997 and as a
consultant to the Company from December 1995 to June 1996. Prior to joining
the Company, Ms. Tiholiz was employed for 17 years by Atlantic Richfield
Company (ARCO), a global energy company, serving in various capacities within
finance, treasury and human resources, most recently as a financial manager in
its domestic natural gas marketing unit.
 
CERTAIN CONSIDERATIONS RELATIVE TO THE COMPANY
 
  Sterling Software and its businesses are subject to a number of risks,
including those enumerated below. Any or all of such risks could have a
material adverse effect on the business, financial condition and results of
operations of the Company and on the market price for the Company's Common
Stock. See also Item 7. "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Forward-Looking Information".
 
  Market Risks; Factors Affecting Quarterly Financial Results
 
  The market price of Sterling Software's common stock, par value $0.10 per
share ("Common Stock"), is subject to fluctuation, and there can be no
assurance that the price of the Common Stock will not decline from time to
time. Factors such as actual or anticipated fluctuations in quarterly
financial results, changes in earnings estimates by securities analysts and
announcements of material events by Sterling Software, its major customers or
its competitors, as well as general industry or global or regional economic
conditions, may cause the market price of the Common Stock to fluctuate,
perhaps substantially.
 
 
                                      10
<PAGE>
 
  Fluctuations in Sterling Software's quarterly financial results could result
from a variety of factors, including changes in the levels of revenue derived
from sales of software products and services, market acceptance of new and
enhanced versions of the products and services of Sterling Software or its
competitors, the size and timing of significant orders, changes in operating
expenses, changes in Sterling Software's strategy, the effect of acquisitions
and general industry and global or regional economic factors. Sterling
Software has limited or no control over many of these factors.
 
  Competition
 
  As noted above under "Competition," the computer software and services
industry is rapidly evolving and highly competitive. Sterling Software
generally expects competition to remain intense in the future from both
existing competitors and other companies that may enter Sterling Software's
markets. Sterling Software believes that its ability to compete successfully
in its markets depends on numerous factors, including product performance,
functionality and reliability, price and customer service and support. There
can be no assurance that new or established competitors will not offer
products and services that are superior to and/or lower in price than those of
Sterling Software.
 
  Technological Change; Dependence on New and Enhanced Products
 
  The computer software and services industry is characterized by rapid
technological change, frequent new product and service introductions and
evolving industry standards. Sterling Software's future success will depend in
significant part on its ability to anticipate industry standards, continue to
apply advances in software product and service technologies, enhance existing
software products and services and develop, introduce, acquire and support new
software products and services in order to meet changing customer needs on a
timely basis. There can be no assurance that Sterling Software will be
successful in developing, acquiring or marketing new or enhanced products or
services that respond to technological change or evolving industry standards,
that Sterling Software will not experience difficulties that could delay or
prevent the successful development, acquisition or marketing of such products
or services or that its new or enhanced products and services will adequately
meet the requirements of the marketplace or achieve market acceptance.
 
  Like most companies in the IT industry, the Company has been and is
continuing to address the impact of the so-called "year 2000" issue. See Item
7. "Management's Discussion and Analysis of Financial Condition and Results of
Operations--Other Matters--Year 2000 Issues".
 
  Growth Through Acquisitions
 
  Sterling Software's growth has been significantly enhanced through
acquisitions of other businesses, products and technologies. If Sterling
Software is unable to continue to make appropriate acquisitions on attractive
terms, it may be more difficult for Sterling Software to achieve growth levels
consistent with those historically achieved. There can be no assurance as to
Sterling Software's ability to make attractive acquisitions, the timing
thereof or the ultimate benefits therefrom to Sterling Software.
 
  The integration of operations following any significant acquisition requires
the dedication of management resources, and may be complicated by the
necessity of integrating personnel with disparate business backgrounds and
corporate cultures. In addition, the retention of key employees of any
business acquired by Sterling Software may be critical to ensure continued
advancement, development and support of the acquired business' technology, as
well as on-going sales and marketing efforts. Consequently, there can be no
assurance that Sterling Software's ability to increase or maintain revenue
will not be diminished by management distractions, loss of personnel or other
factors resulting from any significant acquisition.
 
  Dependence on Key Personnel and Ability to Attract Qualified Personnel
 
  Sterling Software's performance depends substantially on the performance of
its executive officers and key employees. Sterling Software's business is also
dependent upon its ability to attract and retain highly qualified
 
                                      11
<PAGE>
 
managerial, technical and sales personnel. Competition for such personnel is
intense. There can be no assurance that Sterling Software can retain its key
managerial, technical and sales personnel or that it can attract, assimilate
or retain such personnel in the future.
 
  Risks Associated with International Operations
 
  Revenue from Sterling Software's international operations represented 39%,
38% and 39% of Sterling Software's fiscal 1998, 1997 and 1996 revenue,
respectively. Sterling Software is currently incurring, and expects to
continue to incur, significant costs in developing and marketing its products
and services through its international operations. Sterling Software's ability
to successfully maintain and expand its software products and related services
business internationally will depend upon, among other things, its ability to
attract and retain talented and qualified managerial, technical and sales
personnel, as well as software product and related services customers outside
the United States.
 
  International operations are subject to certain inherent risks, including
unexpected changes in regulatory requirements, tariffs and other trade
barriers, software piracy, difficulties in staffing foreign operations, longer
payment cycles, increased difficulties in collecting accounts receivable and
potentially adverse tax consequences. To the extent international sales are
denominated in foreign currencies, the conversion to U.S. dollars of amounts
arising from international operations may contribute to fluctuations in
Sterling Software's results of operations. In the past, Sterling Software has
entered into, and may in the future enter into, hedging transactions in an
effort to reduce its exposure to currency exchange risks.
 
  Risks Associated with Government Contracts
 
  Federal government contracts historically have been a significant part of
Sterling Software's business, representing approximately 21%, 21% and 22% of
Sterling Software's total revenue during fiscal 1998, 1997 and 1996,
respectively. A large portion of Sterling Software's federal government
contracts is funded for one year or less and is subject to contract award,
extension or expiration at different times during the year, and all of
Sterling Software's federal government contracts are subject to termination by
the government for convenience or for failure to obtain funding. Based upon
past experience, Sterling Software believes that the contract renewal options
included in existing contracts will be exercised for the full period
designated in such contracts, but no assurance can be given that such
contracts will be renewed. See "Backlog" above.
 
  Certain Antitakeover Provisions
 
  Certain provisions of the Delaware General Corporation Law, Sterling
Software's Certificate of Incorporation (the "Certificate of Incorporation")
and Bylaws and certain agreements to which Sterling Software is a party
(including the Rights Agreement, dated December 18, 1996, between Sterling
Software and BankBoston, N.A., as amended) may have the effect of delaying,
deterring or preventing a change in control of Sterling Software. In addition,
the Certificate of Incorporation authorizes the issuance of up to 125,000,000
shares of Common Stock and 10,000,000 shares of Preferred Stock, par value
$0.10 per share ("Preferred Stock"), of Sterling Software. The Board of
Directors of Sterling Software has the power to determine the price and terms
under which any such additional capital stock may be issued and to fix the
terms of such Preferred Stock, and existing stockholders of Sterling Software
will not have preemptive rights with respect thereto.
 
ITEM 2. PROPERTIES.
 
  With its principal executive office located in Dallas, Texas, the Company
leases offices and facilities in or near more than 85 cities in the United
States and worldwide. Headquarters offices for the Company's groups and
divisions are located in the following cities: Bellevue, Nebraska; Brussels,
Belgium; London, England; Falls Church, Virginia; McLean, Virginia; Paris,
France; Plano, Texas; Rancho Cordova, California; Reston, Virginia; Sydney,
Australia; and Woodland Hills, California. Other major United States and
international facilities are located in Amsterdam, The Netherlands; Atlanta,
Georgia; Dusseldorf, Germany; Herndon, Virginia; Milan, Italy; Tokyo, Japan;
and Wiesbaden, Germany.
 
                                      12
<PAGE>
 
ITEM 3. LEGAL PROCEEDINGS.
 
  The Company is subject to various legal proceedings and claims that arise in
the normal course of its business. While many of these matters involve
inherent uncertainty, the Company's management believes that the amount of the
liability, if any, ultimately incurred by Sterling Software with respect to
any such existing proceedings and claims, net of applicable reserves and
available insurance, will not materially affect the business, financial
condition or results of operations of the Company. The foregoing statement
concerning the belief of the Company's management is a forward-looking
statement within the meaning of the Private Securities Litigation Reform Act
of 1995. Actual results could vary. See Item 7. "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Forward-Looking
Information".
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
 
  The Company did not submit any matters to a vote of security holders during
the fourth quarter of the fiscal year covered by this report.
 
                                      13
<PAGE>
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
 
  The Company's Common Stock is traded on the New York Stock Exchange under
the symbol "SSW". The high and low sales prices (as adjusted for periods prior
to April 6, 1998 to reflect a 2-for-1 stock split) for the Common Stock for
the periods indicated are set forth below.
 
<TABLE>
<CAPTION>
                                                                PRICE RANGE
                                                            -------------------
                                                              HIGH       LOW
                                                            --------- ---------
<S>                                                         <C>       <C>
Year Ended September 30, 1998:
 Quarter Ended:
  December 31, 1997........................................ $20 27/32 $16 1/4
  March 31, 1998........................................... $28 13/16 $17 3/4
  June 30, 1998............................................ $30 1/4   $23 11/16
  September 30, 1998....................................... $32 13/16 $20 1/8
Year Ended September 30, 1997:
 Quarter Ended:
  December 31, 1996........................................ $17 5/16  $14 1/8
  March 31, 1997........................................... $16 5/16  $13 5/8
  June 30, 1997............................................ $16 13/16 $13 11/16
  September 30, 1997....................................... $18 3/8   $15 7/16
</TABLE>
 
  At November 10, 1998, the Company had 1,022 holders of record of Common
Stock.
 
  The Company did not pay any cash dividends on the Common Stock during the
two years ended September 30, 1998 and does not expect to pay such dividends
in the foreseeable future.
 
                                      14
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA.
 
  The following selected financial data should be read in conjunction with the
consolidated financial statements of the Company included elsewhere herein.
The Company's financial statements for periods prior to the acquisition of
Synon Corporation ("Synon") represent the combined financial statements of the
previously separate entities. See Item 7. "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Business
Combinations, Divestitures and Reorganizations" and Note 2 of Notes to
Consolidated Financial Statements.
 
<TABLE>
<CAPTION>
                                         YEARS ENDED SEPTEMBER 30
                              --------------------------------------------------
                                1998(1)    1997(2)    1996      1995(3)   1994
                              ---------  ---------  --------- --------  --------
                               (IN THOUSANDS, EXCEPT PER SHARE INFORMATION)
<S>                           <C>        <C>        <C>       <C>       <C>
Operating data:
  Revenue.................... $ 719,943  $ 569,202  $ 513,761 $467,093  $391,283
  Cost of sales..............   287,666    236,736    217,551  191,776   169,982
  Product development and
   enhancement...............    36,162     29,659     26,402   32,644    24,609
  Selling, general and
   administrative............   264,450    231,185    206,648  181,482   145,762
  Income from continuing
   operations before
   reorganization costs,
   purchased research and
   development, other income
   (expense) and income
   taxes.....................   131,665     71,622     63,160   61,191    50,930
  Reorganization costs.......    45,162    106,037              19,512
  Purchased research and
   development...............              137,849              62,000
  Income (loss) from
   continuing operations
   before income taxes.......   119,837   (134,556)    86,912  (17,705)   48,097
  Income (loss) from
   continuing operations.....    76,044   (131,897)    62,117  (32,942)   31,900
  Income from discontinued
   operations,
   net of taxes (4)..........                          51,187   42,930    27,753
  Gain on the initial public
   offering of subsidiary,
   net of taxes (4)..........                         126,103
  Income (loss) applicable to
   common stockholders.......    76,044   (131,897)   239,407    9,843    59,457
  Weighted average common
   shares
   outstanding (5)...........    80,638     79,588     67,226   49,889    42,207
Per common share data (5):
  Income (loss) from
   continuing operations:
    Basic.................... $     .94  $   (1.66) $     .92 $   (.66) $    .75
    Diluted..................       .89      (1.66)       .86     (.66)      .64
  Net income (loss):
    Basic....................       .94      (1.66)      3.56      .20      1.41
    Diluted..................       .89      (1.66)      3.26      .20      1.13
Balance sheet data:
  Working capital............ $ 673,301  $ 556,552  $ 730,107 $214,656  $119,573
  Total assets............... 1,197,599  1,100,278  1,130,579  689,082   476,589
  Long-term debt.............                                  117,265   117,404
  Other noncurrent
   liabilities...............    68,812     49,751     37,020   22,107    19,128
  Stockholders' equity.......   861,558    757,491    887,336  354,636   182,616
</TABLE>
--------
(1) Results of operations for 1998 include reorganization costs of $45,162,000
    primarily related to the reorganization of the Company's operations in
    connection with the acquisition of Synon, and to a lesser extent, to the
    acquisition of Mystech Associates, Inc. ("Mystech"). See Item 7.
    "Management's Discussion and Analysis of Financial Condition and Results
    of Operations--Business Combinations, Divestitures and Reorganizations"
    and Note 2 of Notes to Consolidated Financial Statements.
 
                                      15
<PAGE>
 
(2) On June 30, 1997, Sterling Software completed the acquisition of
    substantially all of the assets used by TI Software for approximately
    $214,774,000. The acquisition was accounted for in accordance with the
    purchase method of accounting. Results of operations for 1997 include
    $137,849,000 of purchased research and development costs charged to
    expense in accordance with the purchase method of accounting. Results of
    operations for 1997 also include reorganization costs of $106,037,000
    primarily related to the reorganization of the Company's operations in
    connection with the acquisition of TI Software and the termination of the
    Company's international distributor arrangement with Sterling Commerce.
    See Item 7. "Management's Discussion and Analysis of Financial Condition
    and Results of Operations--Business Combinations, Divestitures and
    Reorganizations" and Notes 2 and 3 of Notes to Consolidated Financial
    Statements.
(3) Results of operations for 1995 include $62,000,000 of purchased research
    and development costs charged to expense in accordance with the purchase
    method of accounting in connection with the merger of the Company with
    KnowledgeWare, as well as $19,512,000 of reorganization costs primarily
    related to the reorganization of the Company's operations in connection
    with that merger.
(4) On March 13, 1996, Sterling Commerce, a former wholly owned subsidiary of
    Sterling Software, completed the initial public offering (the "Offering")
    of 13,800,000 shares of its common stock, par value $0.01 per share
    ("Commerce Stock"). Pursuant to the Offering, Sterling Software sold to
    the public 12,000,000 of its 73,200,000 shares of Commerce Stock and
    Sterling Commerce sold 1,800,000 previously unissued shares of Commerce
    Stock. The Offering resulted in net proceeds to Sterling Software of
    approximately $265,458,000 after deducting underwriting discounts and
    commissions and Sterling Software's pro rata share of Offering expenses.
    On September 30, 1996, Sterling Software completed the spin-off of
    Sterling Commerce with the pro rata distribution of its remaining 81.6%
    ownership in Sterling Commerce to Sterling Software's stockholders by
    means of a tax-free dividend. The distribution resulted in the reduction
    of Sterling Software's stockholders' equity in the amount of $113,549,000,
    representing the book value of net assets distributed. The results of
    operations of Sterling Commerce for 1994 to 1996 have been classified as
    discontinued operations. See Item 7. "Management's Discussion and Analysis
    of Financial Condition and Results of Operations--Business Combinations,
    Divestitures and Reorganizations" and Notes 2 and 3 of Notes to
    Consolidated Financial Statements.
(5) All share and per share data have been restated for dates and periods
    ended prior to April 6, 1998 to retroactively reflect a 2-for-1 stock
    split effected by means of a dividend of one share of Common Stock for
    each outstanding share of Common Stock and for dates and periods ended
    prior to December 31, 1997 to conform with Statement of Financial
    Accounting Standards No. 128, "Earnings per Share". See Note 1 of Notes to
    Consolidated Financial Statements.
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
 
BUSINESS COMBINATIONS, DIVESTITURES AND REORGANIZATIONS
 
  Acquisition of Mystech Associates, Inc.
 
  On July 9, 1998, Sterling Software acquired Mystech, a federal information
technology services contractor, in a stock-for-stock merger transaction (the
"Mystech Merger"). As a result of the transaction, Sterling Software issued
approximately 769,000 shares of Common Stock in exchange for the previously
outstanding shares of Mystech common stock and has reserved approximately
174,000 shares of Common Stock for issuance upon exercise of assumed Mystech
stock options. The Mystech Merger was accounted for as a pooling of interests,
and the Mystech organization was added to the Company's federal systems
business. However, the impact of the pooling of interests accounting on the
Company's historical financial statements was not material. Therefore, the
Company's financial statements for periods prior to the Mystech Merger have
not been restated for this transaction.
 
  Acquisition of Synon Corporation
 
  On July 31, 1998, Sterling Software acquired Synon, a provider of
application development software and services, in a stock-for-stock merger
transaction (the "Synon Merger") accounted for as a pooling of interests.
 
                                      16
<PAGE>
 
As a result of the transaction, Sterling Software issued approximately
2,603,000 shares of Common Stock in exchange for the previously outstanding
shares of Synon capital stock and reserved approximately 375,000 shares of
Common Stock for issuance upon exercise of assumed Synon stock options. The
Company's financial statements for periods prior to the Synon Merger,
including the results of the application management business segment, have
been restated to represent the combined financial statements of the previously
separate entities.
 
  Acquisition of TI Software
 
  On June 30, 1997, Sterling Software completed the acquisition (the "TI
Software Acquisition") of certain assets (including the capital stock of
certain foreign subsidiaries) of Texas Instruments Incorporated. Such assets
constitute substantially all of the assets used by TI Software in its
application development tools business. The results of operations of TI
Software are included in the Company's results of operations from the date of
the TI Software Acquisition.
 
  The cash purchase price paid for such assets was $165,000,000 and was funded
from the Company's available cash balances. The total cost of the TI Software
Acquisition was approximately $214,774,000, including costs directly related
to the TI Software Acquisition of approximately $49,774,000, consisting of
employee termination costs, transaction costs, costs associated with the
elimination of duplicate facilities and other direct costs. Results of
operations for 1997 include $137,849,000 of purchased research and development
costs, which is the portion of the purchase price attributed to in-process
research and development, and which was charged to expense in accordance with
the purchase method of accounting.
 
  Termination of International Distributor Arrangement
 
  Effective as of June 30, 1997, Sterling Software and Sterling Commerce, a
former wholly owned subsidiary of Sterling Software formed to operate the
business of Sterling Software's former Electronic Commerce Group, completed an
agreement terminating an international distributor arrangement pursuant to
which Sterling Software acted as the exclusive distributor of Sterling
Commerce's interchange and communications software products in markets outside
the United States and Canada. The results of the Company's international
operations related to selling, marketing and providing first level support for
these products outside the United States and Canada through June 30, 1997 are
included in the business segment information presented herein under "Corporate
and other".
 
  Reorganization Costs
 
  The Company's results of operations for 1998 include reorganization costs of
$45,162,000 primarily related to the reorganization of the Company's
operations in connection with the Synon Merger, and to a lesser extent, the
Mystech Merger. Of the total reorganization costs, approximately $9,552,000
consisted of non-cash costs and the remaining $35,610,000 required cash
outlays. These costs are comprised of employee termination costs, costs
related to the elimination of duplicate facilities, the write-down of software
products that will not be actively marketed, transaction costs and other
direct costs of the reorganization. At September 30, 1998, the remaining
balance to be paid was $22,818,000. Currently, the Company does not expect to
incur costs related to these reorganizations in excess of the amount charged
to operations in 1998.
 
  The Company's results of operations for 1997 include reorganization costs of
$106,037,000 primarily related to the reorganization of the Company's
operations in connection with the TI Software Acquisition and the termination
of an international distributor arrangement with Sterling Commerce in the
third quarter of 1997. These reorganization costs also include the write-down
of certain excess cost over net assets acquired related to the Company's
federal systems business. Of the total reorganization costs, approximately
$63,726,000 consisted of non-cash costs and the remaining $42,311,000 required
cash outlays. At September 30, 1998, the remaining balance to be paid was
$12,344,000, which consists primarily of commitments under lease arrangements
for office space and equipment. The Company does not expect to incur costs
related to this reorganization in excess of the amount charged to operations
in 1997.
 
                                      17
<PAGE>
 
SUBSIDIARY INITIAL PUBLIC OFFERING AND SPIN-OFF
 
  Sterling Commerce completed the Offering of 13,800,000 shares of Commerce
Stock on March 13, 1996. Pursuant to the Offering, Sterling Software sold to
the public 12,000,000 of its 73,200,000 shares of Commerce Stock and Sterling
Commerce sold 1,800,000 of previously unissued shares of Commerce Stock. The
Offering price was $24 per share of Commerce Stock, resulting in net proceeds
to Sterling Software of approximately $265,458,000 after deducting
underwriting discounts and commissions and Sterling Software's pro rata share
of Offering expenses. Sterling Software recorded a gain of approximately
$126,103,000, net of tax, from the sale of Commerce Stock in the Offering.
 
  On September 30, 1996, Sterling Software completed the spin-off of Sterling
Commerce with the pro rata distribution of its remaining 81.6% ownership in
Sterling Commerce to Sterling Software's stockholders by means of a tax-free
dividend. The distribution resulted in the reduction of Sterling Software's
stockholders' equity in the amount of $113,549,000, representing the book
value of net assets distributed.
 
  The results of operations of Sterling Commerce for 1996 have been classified
as discontinued operations in the accompanying Consolidated Financial
Statements.
 
RESULTS OF OPERATIONS
 
  1998 Compared to 1997
 
  Total revenue increased $150,741,000, or 26%, in 1998 over 1997 due to
revenue increases in all three of the Company's business segments, partially
offset by a decline in corporate and other revenue due to the termination of
an international distributor arrangement with Sterling Commerce in the third
quarter of 1997. Revenue from the application management, systems management
and federal systems business segments increased 64%, 11% and 22%,
respectively, in 1998 over 1997. Both the application management business
segment and the federal systems business segment benefited substantially from
the domestic and international operations acquired by Sterling Software in the
TI Software Acquisition.
 
  Total revenue generated from the Company's international operations was
$277,428,000 and $217,347,000 in 1998 and 1997, respectively, representing an
increase of $60,081,000, or 28%, due to increases in international revenue
generated by the application management business segment (up 102%) and the
systems management business segment (up 6%). The overall increase in
international revenue was partially offset by a decline in revenue from sales
of Sterling Commerce's software products due to the termination of an
international distributor arrangement in the third quarter of 1997. In
addition, international operating results in 1998 were adversely impacted by
foreign currency exchange rate fluctuations as a result of a stronger U.S.
dollar. Had foreign currency exchange rates remained consistent with the
previous year, international revenue for 1998 would have been approximately
$15,000,000 greater. Revenue from the Company's international operations
represented 39% of total revenue in 1998 compared to 38% of total revenue in
1997.
 
  The Company's recurring revenue includes revenue from product support
agreements generally having terms ranging from one to three years and federal
contracts generally having terms ranging from one to five years. Like most
federal contracts, Sterling Software's federal contracts permit termination by
the government for convenience or for failure to obtain funding. Recurring
revenue decreased to 46% of total revenue in 1998 compared to 48% in 1997,
primarily due to the significant increase in products and services revenue
from the application management business segment. Overall, services revenue
increased from 32% of total revenue in 1997 to 34% of total revenue in 1998.
This increase resulted primarily from generally higher levels of consulting
services associated with product sales in the application management segment.
 
  Revenue from the application management business segment increased
$142,847,000, or 64%, in 1998 over 1997 due to a 75% increase in products
revenue, a 58% increase in product support revenue and a 55% increase
 
                                      18
<PAGE>
 
in services revenue. The significant increase in revenue from the application
management business segment is primarily attributable to revenue from the
application development products and services acquired in the TI Software
Acquisition. Approximately 50% of the application management business
segment's total revenue in 1998 was derived from the Company's international
operations, compared to 40% in 1997.
 
  Revenue from the systems management business segment increased $19,850,000,
or 11%, in 1998 over 1997 primarily due to a 17% increase in products revenue
partially offset by a 1% decline in product support revenue due in part to the
adverse impact of foreign currency exchange rate fluctuations as a result of a
stronger U.S. dollar. The increase in products revenue was mainly attributable
to strong domestic product sales across all systems management product lines
and strong international product sales in the network management product line.
Approximately 47% of the systems management business segment's total revenue
in 1998 was derived from the Company's international operations, compared to
49% in 1997.
 
  Revenue from the federal systems business segment increased $26,983,000, or
22%, in 1998 over 1997 due primarily to a contract added to the Company's
federal systems business segment as a result of the TI Software Acquisition,
revenue added as a result of the Mystech Merger and, to a lesser extent, to
higher contract billings. As previously reported, while the Company was not
selected for continuation of a contract with NASA's Ames Research Center, the
Company continued to provide services under the pre-existing contract through
June 30, 1998, at which time the contract was terminated.
 
  Total costs and expenses decreased $108,026,000, or 15%, in 1998 compared to
1997. Excluding the reorganization costs of $45,162,000 related to the Synon
Merger and the Mystech Merger in the fourth quarter of 1998 and reorganization
costs of $106,037,000 and the write-off of purchased research and development
costs of $137,849,000 related to the TI Software Acquisition in the third
quarter of 1997, total costs and expenses increased $90,698,000, or 18%, in
1998 compared to 1997.
 
  Total cost of sales increased $50,930,000, or 22%, in 1998 compared to 1997
and represented 40% and 42% of total revenue in 1998 and 1997, respectively.
Cost of sales for products and product support decreased $8,220,000, or 10%,
in 1998 compared to 1997 and represented 15% and 21% of products and product
support revenue in 1998 and 1997, respectively. The decrease in cost of sales
for products and product support is primarily attributable to the decrease in
royalties payable to Sterling Commerce due to the termination of an
international distributor arrangement, as well as a decrease in royalties
payable to other third parties related to products no longer marketed by the
Company. Cost of sales for services increased $59,150,000, or 38%, in 1998
compared to 1997 and represented 88% and 85% of services revenue in 1998 and
1997, respectively. The significant increase in cost of sales for services is
primarily attributable to the increase in services revenue from the
application management business segment.
 
  Product development expense for 1998 was $36,162,000, net of $26,956,000 of
capitalized software development costs, as compared to 1997 product
development expense of $29,659,000, net of $21,711,000 of capitalized software
development costs. Gross product development expense was 11% of non-federal
revenue in both 1998 and 1997. Capitalized development costs represented 43%
of gross development costs in 1998 compared to 42% of gross development costs
for 1997. The increase in both total and capitalized software development
costs in 1998 over 1997 is attributable to an increase in product development
efforts that were in process. Product development expenses and the
capitalization rate historically have fluctuated, and may in the future
continue to fluctuate, from period to period depending in part upon the number
and status of software development projects that are in process.
 
  Selling, general and administrative expenses increased $33,265,000, or 14%,
in 1998 compared to 1997 and represented 37% and 41% of total revenue in 1998
and 1997, respectively. The decrease in selling, general and administrative
expenses as a percentage of total revenue is primarily attributable to the
cost structure implemented by the Company in connection with the TI Software
Acquisition and related reorganization in the third quarter of 1997 and cost
savings resulting from the termination of the Company's international
distributor arrangement with Sterling Commerce.
 
                                      19
<PAGE>
 
  Investment income decreased $4,819,000 in 1998 compared to 1997 as a result
of lower average cash and cash equivalents balances primarily due to the use
of cash in connection with the TI Software Acquisition and the related
reorganization in the third quarter of 1997.
 
  Income from continuing operations before income taxes in 1998 was
$119,837,000, compared to a loss from continuing operations before income
taxes of $134,556,000 for 1997. However, excluding the reorganization costs of
$45,162,000 related to the Synon Merger and Mystech Merger in the fourth
quarter of 1998 and the reorganization costs of $106,037,000 and the write-off
of purchased research and development costs of $137,849,000 related to the TI
Software Acquisition in the third quarter of 1997, income from continuing
operations before taxes increased $55,669,000, or 51%, primarily due to higher
profits in the application management and systems management business segments
partially offset by a decline in investment income.
 
  The Company's effective tax rate for 1998 was 37% compared to an effective
tax rate for 1997 of 34%, before the net tax benefit related to the 1997
reorganization costs and purchased research and development costs. The 1998
effective tax rate was adversely impacted by unbenefitted losses incurred by
Synon in 1998 prior to the Synon Merger. The 1997 effective tax rate benefit
of 2% varies from the U.S. statutory rate due primarily to the write-down of
excess cost over net assets acquired recorded in connection with previous
acquisitions and the effect of non-U.S. tax rates.
 
  1997 Compared to 1996
 
  Total revenue increased $55,441,000, or 11%, in 1997 over 1996 due to
revenue increases in all three of the Company's business segments. Revenue
from the application management, systems management and federal systems
business segments increased 21%, 8% and 9%, respectively, in 1997 over 1996.
 
  Total revenue generated from Sterling Software's international operations
was $217,347,000 and $202,613,000 in 1997 and 1996, respectively, representing
an increase of $14,734,000, or 7%, primarily due to increases in the
application management business segment (up 23%) and in the systems management
business segment (up 4%). The significant increase in international revenue
from the application management business segment is primarily attributable to
revenue from the sale of application development products and services
acquired in the TI Software Acquisition. The increase in international revenue
from Sterling Software's products and services was partially offset by a
decline in revenue from sales of Sterling Commerce's software products and
services due to the termination of an international distributor arrangement in
the third quarter of 1997. In addition, international operating results in
1997 were adversely impacted by foreign currency exchange rate fluctuations as
a result of a stronger U.S. dollar. Had foreign currency exchange rates
remained consistent with the previous year, international revenue for 1997
would have been approximately $11,000,000 greater. Revenue from the Company's
international operations represented 38% of total revenue for 1997 compared to
39% of total revenue for 1996.
 
  The Company's recurring revenue includes revenue from product support
agreements generally having terms ranging from one to three years and federal
contracts generally having terms ranging from one to five years. Like most
federal contracts, Sterling Software's federal contracts permit termination by
the government for convenience or for failure to obtain funding. Recurring
revenue represented 48% of total revenue in 1997 compared to 50% in 1996.
 
  Revenue from the application management business segment increased
$38,772,000, or 21%, in 1997 over 1996 due to a 16% increase in products
revenue, a 9% increase in product support revenue and a 49% increase in
services revenue. The significant increase in revenue from the application
management business segment is primarily attributable to revenue from the
application development products and services acquired in the TI Software
Acquisition. Approximately 40% of the application management business
segment's 1997 and 1996 revenue was derived from the Company's international
operations.
 
  Revenue from the systems management business segment increased $13,875,000,
or 8%, in 1997 over 1996 primarily due to an increase of 15% in products
revenue partially offset by a slight decline in product support
 
                                      20
<PAGE>
 
revenue. The increase in products revenue was mainly attributable to strong
domestic and international product sales in the network management and storage
management product lines. Approximately 49% of the systems management business
segment's total revenue in 1997 was derived from the Company's international
operations, compared to 51% in 1996.
 
  Revenue from the federal systems business segment increased $9,602,000, or
9%, in 1997 over 1996 due to higher contract billings and due to a contract
with the intelligence community added to the Company's federal systems
business segment as a result of the TI Software Acquisition.
 
  Total costs and expenses increased $290,865,000, or 65% in 1997 compared to
1996. Excluding the reorganization costs of $106,037,000 and the write-off of
purchased research and development costs of $137,849,000 related to the TI
Software Acquisition in the third quarter of 1997, total costs and expenses
increased $46,979,000, or 10%, in 1997 compared to 1996.
 
  Total cost of sales increased $19,185,000, or 9%, in 1997 compared to 1996,
roughly commensurate with the increase in total revenue. Cost of sales
represented 42% of revenue in 1997 and 1996.
 
  Product development expense for 1997 was $29,659,000, net of $21,711,000 of
capitalized software development costs, as compared to 1996 product
development expense of $26,402,000, net of $18,180,000 of capitalized software
development costs. Gross product development expense was 11% of non-federal
revenue in both 1997 and 1996. Capitalized development costs represented 42%
and 41% of gross development costs in 1997 and 1996, respectively.
 
  Selling, general and administrative expense increased $24,537,000, or 12%,
in 1997 compared to 1996 and represented 41% and 40% of total revenue in 1997
and 1996, respectively.
 
  Interest expense decreased $2,895,000 in 1997 compared to 1996 due to the
redemption in 1996 of the Company's 5.75% Convertible Subordinated Debentures.
See Note 10 of Notes to Consolidated Financial Statements. Investment income
increased $12,052,000 in 1997 over 1996 as a result of higher average cash and
cash equivalents balances.
 
  The Company's loss from continuing operations before taxes was $134,556,000
in 1997 as compared to income from continuing operations before taxes of
$86,912,000 in 1996. Excluding the TI Software Acquisition-related
reorganization costs of $106,037,000 and the write-off of purchased research
and development costs of $137,849,000, income from continuing operations
before taxes increased $22,418,000, or 26%, in 1997 compared to 1996,
primarily due to higher operating profits in all three of the Company's
business segments and increases in investment income.
 
  The Company's effective tax rate for the year ended September 30, 1997 was
34% before the net tax benefit related to the 1997 reorganization costs and
purchased research and development costs, as described above, compared to an
effective tax rate of 29% for 1996. The effective tax rate benefit for the
year ended September 30, 1997 of 2% significantly varies from the U.S.
statutory rate due primarily to the write-down of excess cost over net assets
acquired recorded in connection with previous acquisitions and the effect of
non-U.S. tax rates.
 
  Income from discontinued operations, net, for 1996 represents the
classification of the results of operations of Sterling Commerce as
discontinued. See Note 3 of Notes to Consolidated Financial Statements.
 
LIQUIDITY AND CAPITAL RESOURCES
 
  The Company maintained a strong liquidity and financial position with
$673,301,000 of working capital at September 30, 1998, which includes
$397,312,000 of cash and cash equivalents and $310,537,000 of marketable
securities. Net cash provided by operating activities was $101,685,000 in 1998
compared to $128,611,000 in 1997. Net cash provided by operating activities in
1998 was reduced by payments made during the period of approximately
$12,792,000 directly related to the Synon Merger and the Mystech Merger and
the related
 
                                      21
<PAGE>
 
reorganizations that occurred in the fourth quarter of 1998. Also, net cash
provided by operating activities in 1998 and 1997 was reduced by payments of
approximately $28,793,000 and $40,539,000, respectively, directly related to
the TI Software Acquisition and the related reorganization that occurred in
the third quarter of 1997. Operating cash flows in 1997 were negatively
impacted by royalty and certain other payments of approximately $32,000,000
made to Sterling Commerce during that year.
 
  Investing activities used $162,381,000 of cash in 1998 compared to
$216,222,000 in 1997. Net cash used in investing activities in 1997 included
the $165,000,000 payment to Texas Instruments on June 30, 1997 in connection
with the TI Software Acquisition. Capital expenditures for 1998 were
$33,200,000 compared to $29,003,000 for 1997. Purchases and capitalized costs
of computer software were $27,854,000 and $21,860,000 for 1998 and 1997,
respectively. Cash provided by operating activities, together with other
available cash, was used to fund capital expenditures and additions to
computer software.
 
  Financing activities provided $20,881,000 of cash in 1998 compared to
$281,000 in 1997. Sterling Software received proceeds of approximately
$17,895,000, $1,460,000 and $276,729,000 from the exercise of employee stock
options and warrants in 1998, 1997 and 1996, respectively. In 1996, the
Company also sold to the public 12,000,000 of its 73,200,000 shares of
Commerce Stock resulting in net proceeds to the Company of approximately
$265,458,000, after deducting underwriting discounts and commissions and the
Company's pro rata share of Offering expenses.
 
  The Company is party to a bank credit agreement (the "Credit Agreement")
which provides for unsecured revolving credit loans of up to $35,000,000.
Borrowings under the Credit Agreement, which expires on June 30, 2000, bear
interest at the lower of the lender's base rate or a Eurodollar lending rate
plus one-half percent. No amounts were borrowed under the Credit Agreement
during 1998 or 1997. At September 30, 1998, after giving effect to outstanding
standby letters of credit in the aggregate amount of $4,140,000, approximately
$30,860,000 was available for borrowing under the Credit Agreement.
 
  At September 30, 1998, the Company's short and long-term cash commitments,
including remaining costs related to the Synon Merger, the Mystech Merger, the
TI Software Acquisition and the related reorganizations, consisted primarily
of commitments under lease arrangements for office space and equipment, as
well as commitments with respect to employee severance obligations that arose
in connection with the Synon Merger and the Mystech Merger. The Company
intends to meet such obligations primarily from cash provided by operating
activities.
 
  The Company believes available cash balances, cash equivalents and short-
term investments combined with cash provided by operating activities and
amounts available under existing credit agreements are sufficient to meet the
Company's cash requirements for the foreseeable future.
 
OTHER MATTERS
 
  Foreign Currency Matters
 
  The assets and liabilities of the Company's non-U.S. operations are
translated into U.S. dollars at exchange rates in effect as of the applicable
balance sheet dates, and revenue and expense accounts of these operations are
translated at average exchange rates during the month the transactions occur.
Unrealized translation gains and losses are included as an adjustment to
retained earnings. The Company has mitigated a portion of its exposure to
foreign currency exchange rate fluctuations through decentralized sales,
marketing and support operations, and through international development
facilities, in which substantially all costs are local-currency based. In the
past, the Company has entered, and may in the future enter, into hedging
transactions in an effort to reduce its exposure to currency exchange risks.
 
  Acquisition Strategy
 
  The Company maintains a strategy of seeking to acquire businesses and
products to fill strategic market niches. This acquisition strategy has
contributed significantly to the Company's growth in revenue and operating
profit before reorganization and purchased research and development costs. The
impact of future acquisitions on
 
                                      22
<PAGE>
 
continued growth in revenue and operating profit cannot presently be
determined. The Company expects to finance future acquisitions, if any,
through a combination of cash on hand and cash from operations and the
possible issuance of equity or debt securities.
 
  Year 2000 Issues
 
  The following discussion regarding year 2000 matters constitutes a "Year
2000 Readiness Disclosure" within the meaning of the Year 2000 Information and
Readiness Disclosure Act.
 
  Like most companies in the IT industry, the Company has been and is
continuing to address the impact of the so-called "year 2000" issue. This
issue is the result of computer programs written using two digits rather than
four to define calendar years. These programs may recognize a date using "00"
as the year 1900 rather than the year 2000, potentially resulting in complete
system failures or miscalculations causing significant disruption of normal
business activities. The Company has been and is continuing to assess and
resolve year 2000 issues associated with the Company's products, its material
internal systems and its material third party relationships. These efforts
have been under way for some time and should be completed well before
December 31, 1999.
 
  Each of the Company's product divisions has completed a year 2000 assessment
of its currently offered products. This assessment included internal testing
of the year 2000 capabilities of these products. The Company has no plans to
have its products tested by an independent third party. The Company believes
that the vast majority of its currently offered products are year 2000
compliant, and expects virtually all of its remaining currently offered
products to become compliant during the early part of calendar 1999 through
new releases. In any event, the Company expects that all of its currently
offered products will be year 2000 compliant before the end of calendar 1999.
Because year 2000 compliance is generally integrated into its normal product
development activities, the Company has not incurred and does not expect to
incur any significant incremental expenses in addressing this issue in its
product lines. The Company believes that a small number of customers who
receive product support from the Company are operating product versions that
may not be year 2000 compliant or products that the Company has replaced or
intends to replace with comparable, year 2000 compliant products. The Company
believes that the vast majority of such customers are migrating and will
continue to migrate to compliant versions and products through new releases,
which the Company is strongly encouraging. In addition, certain former
customers may be operating non-compliant versions of products in respect of
which the Company's agreed-upon product support and warranty periods have
expired. The Company has not undertaken an assessment of whether these former
customers are taking appropriate steps to address any related year 2000
issues.
 
  The Company does not expect customers who purchase or migrate to year 2000
compliant versions of its products to experience any year 2000 failures caused
by such products. In addition, the Company believes that its licenses and
other agreements contain customary and appropriate limitations on the
Company's obligations with respect to any year 2000 failures that may be
caused by its current or former products. However, there can be no assurance
that the Company's expectations and beliefs as to these matters will prove to
be accurate. Moreover, the Company's products are used in IT systems comprised
of third-party hardware and software, some of which may not be year 2000
compliant. Various commentators have predicted that a significant amount of
litigation may arise out of year 2000 compliance issues. While the Company has
not been subject to any year 2000 claims or lawsuits to date, there can be no
assurance that customers or former customers will not bring claims or lawsuits
against the Company seeking compensation for losses associated with year 2000-
related failures. A material adverse outcome in a year 2000 claim or lawsuit--
as is the case with any claim or lawsuit-- could have a material adverse
effect on the Company's business, financial condition and results of
operations.
 
  An assessment of the Company's material internal systems (including embedded
systems) is nearing completion. Due to its predominant use of relatively
current "off-the-shelf" software and systems (as opposed to older legacy or
custom designed systems), the Company expects that its internal systems will
require only minimal corrective measures, some of which have already been
completed and/or are currently in process. Moreover, as a result of its
decentralized operating structure, the Company's non-compliant systems tend to
be more limited in their effect and easier to correct. Consequently, the
Company does not anticipate the internal and
 
                                      23
<PAGE>
 
external costs of the corrective measures to be significant. The vast majority
of these measures are expected to be completed by mid-1999, with remaining
measures expected to be completed before December 31, 1999.
 
  The Company has begun a year 2000 assessment of its material third party
supplier relationships. The assessment is being conducted through formal
communications with such suppliers, testing of relevant equipment, systems or
interfaces and a review of the year 2000 information made publicly available
by such suppliers. The Company plans to substantially complete the assessment
of these relationships prior to the end of calendar 1998 and, promptly upon
discovery of any readiness issues that are material to the Company, to begin
efforts to obtain adequate readiness assurances from the relevant third
parties. There can be no assurance that the Company will receive all
information necessary to fully evaluate the year 2000 readiness of all
material suppliers. Moreover, the Company relies in various ways, both
domestically and internationally, on governments, utilities, communications
service providers, financial institutions and other third parties to conduct
normal business operations. There can be no assurance that suppliers and other
third parties upon whom the Company is reliant will not suffer business
interruptions caused by year 2000 issues. Such interruptions could have a
material adverse effect on the Company's business, financial condition and
results of operations.
 
  In addition to the risks described above, some commentators predict that
historical purchasing patterns and trends in the software industry may be
affected by customers replacing or upgrading applications or systems to
address year 2000 issues. The Company has not experienced any discernable
trend indicating a recent or impending material reduction in demand for the
Company's products. However, there can be no assurance that year 2000 issues
will not affect future customer purchasing patterns, possibly resulting in
lower demand for the Company's products.
 
  Although the Company believes that its year 2000 readiness efforts are
designed to appropriately identify and address those year 2000 issues that are
within the Company's control, there can be no assurance that the Company's
efforts will be fully effective or that year 2000 issues will not have a
material adverse effect on the Company's business, financial condition or
results of operations. The novelty and complexity of the issues presented and
the Company's dependence on the preparedness of third parties are among the
factors that could cause the Company's efforts to be less than fully
effective. Moreover, year 2000 issues present many risks that are simply
beyond the Company's control, such as the potential effects of year 2000
issues on the economy in general and on the Company's business partners and
customers in particular. Except as described above, the Company has not
established "contingency plans" to address potential consequences of the year
2000 issue. However, the Company intends to continue to evaluate both existing
and newly identified year 2000 risks and to develop and implement such further
responsive measures as it deems appropriate.
 
FORWARD-LOOKING INFORMATION
 
  This report and other reports and statements filed by the Company from time
to time with the Securities and Exchange Commission (collectively, "SEC
Filings") contain or may contain forward-looking statements. Such statements
are based upon the beliefs and assumptions of, and on information available
to, the Company's management. The following statements are or may constitute
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995: (i) statements preceded by, followed by or that
include the words "may", "will", "could", "should", "believe", "expect",
"future", "potential", "anticipate", "intend", "plan", "estimate" or
"continue" or the negative or other variations thereof and (ii) other
statements regarding matters that are not historical facts. Such forward-
looking statements are subject to various risks and uncertainties, including
(i) risks and uncertainties relating to the possible invalidity of the
underlying beliefs and assumptions, (ii) possible changes or developments in
social, economic, business, industry, market, legal and regulatory
circumstances and conditions, and (iii) actions taken or omitted to be taken
by third parties, including customers, suppliers, business partners,
competitors and legislative, regulatory, judicial and other governmental
authorities and officials. In addition to any risks and uncertainties
specifically identified in the text surrounding such forward-looking
statements, the statements in the immediately preceding sentence and the
statements under captions such as "Risk Factors", "Certain Considerations
Relative to the Company" and "Special Considerations" in the SEC Filings
constitute cautionary statements identifying important factors that could
cause actual amounts, results, events and circumstances to differ materially
from those reflected in such forward-looking statements.
 
                                      24
<PAGE>
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
 
INTEREST RATE RISK
 
  The Company's exposure to market risk associated with changes in interest
rates relates primarily to the Company's investment portfolio of marketable
securities. The Company does not use derivative financial instruments in its
investment portfolio. The stated objectives of the Company's investment
guidelines are: safety of principal, liquidity, maximization of yield and
diversification of risk. The Company places its investments with high credit
quality U.S. issuers, principally the United States Treasury, highly rated
corporations and tax-exempt issuers and limits the amount of credit exposure
to any one issuer. The Company's marketable securities portfolio includes only
those securities with active secondary or resale markets to ensure portfolio
liquidity.
 
  The table below presents principal amounts and related weighted average
interest rates by date of maturity for the Company's marketable securities. A
substantial portion of the interest income earned on municipal obligations is
exempt from federal and state income taxes. At September 30, 1998, the
weighted average maturity of the marketable securities portfolio was less than
180 days. The fair value of the marketable securities portfolio is affected by
changes in short-term U.S. dollar interest rates.
 
<TABLE>
<CAPTION>
                                 MATURITY
                           ----------------------             FAIR VALUE AT
                            1999     2000   2001    TOTAL   SEPTEMBER 30, 1998
                           -------  ------  -----  -------  ------------------
<S>                        <C>      <C>     <C>    <C>      <C>
Commercial paper..........  51,734                  51,734        51,734
 Average interest rate....    5.59%                   5.59%
U.S. corporate notes......  81,402   3,017  5,182   89,601        90,319
 Average interest rate....    6.26%   6.00%  6.02%    6.24%
U.S. government
 obligations..............  20,001                  20,001        20,023
 Average interest rate....    5.39%                   5.39%
Municipal obligations..... 120,307  21,326         141,633       141,835
 Average interest rate....    4.92%   5.45%           4.97%
Other.....................   6,333                   6,333         6,626
 Average interest rate....    6.12%                   6.12%
Total investment
 portfolio................ 279,777  24,343  5,182  309,302       310,537
 Average interest rate....    5.48%   5.52%  6.02%    5.48%
</TABLE>
 
FOREIGN CURRENCY RISK
 
  The Company conducts business in various foreign currencies, primarily in
Canada, Brazil, Europe, Australia, Japan and other Asian countries. As a
result, the Company is exposed to the effect of foreign currency exchange rate
fluctuations on the U.S. dollar value of foreign currency-denominated revenues
and expenses. The Company mitigates a portion of its exposure to foreign
currency exchange rate fluctuations through decentralized sales, marketing and
support operations, and through international development facilities, in which
substantially all costs are local-currency based. In the past, the Company has
entered, and may in the future enter, into hedging transactions in an effort
to reduce exposure to foreign currency exchange rate fluctuations. As of
September 30, 1998, the Company was not engaged in a foreign currency hedging
program.
 
                                      25
<PAGE>
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
 
                            STERLING SOFTWARE, INC.
 
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
                                                                           PAGE
                                                                           ----
<S>                                                                        <C>
Report of Ernst & Young LLP, Independent Auditors.........................  27
Consolidated Financial Statements:
  Consolidated Balance Sheets as of September 30, 1998 and 1997...........  28
  Consolidated Statements of Operations for the Years Ended September 30,
   1998, 1997 and 1996....................................................  29
  Consolidated Statements of Stockholders' Equity for the Years Ended
   September 30, 1998, 1997 and 1996......................................  30
  Consolidated Statements of Cash Flows for the Years Ended September 30,
   1998, 1997 and 1996....................................................  31
  Notes to Consolidated Financial Statements..............................  32
</TABLE>
 
                                       26
<PAGE>
 
               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
 
The Board of Directors and Stockholders
Sterling Software, Inc.
 
  We have audited the accompanying consolidated balance sheets of Sterling
Software, Inc. (the "Company") as of September 30, 1998 and 1997, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for each of the three years in the period ended September 30, 1998. Our
audits also included the financial statement schedule listed under Item 14(a)
of the Company's Annual Report on Form 10-K for the year ended September 30,
1998. 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 generally accepted auditing
standards. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of the Company at September 30, 1998 and 1997, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended September 30, 1998 in conformity with 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.
 
                                          /s/ Ernst & Young LLP
 
Dallas, Texas
November 6, 1998
 
                                      27
<PAGE>
 
                            STERLING SOFTWARE, INC.
                          CONSOLIDATED BALANCE SHEETS
                          SEPTEMBER 30, 1998 AND 1997
                    (IN THOUSANDS, EXCEPT SHARE INFORMATION)
 
<TABLE>
<CAPTION>
                                                            1998        1997
                                                         ----------  ----------
<S>                                                      <C>         <C>
                        ASSETS
Current assets:
  Cash and cash equivalents............................  $  397,312  $  436,955
  Marketable securities................................     310,537     206,965
  Accounts and notes receivable, net...................     200,428     167,268
  Income tax receivable................................         750       9,941
  Prepaid expenses and other current assets............      31,503      28,459
                                                         ----------  ----------
    Total current assets...............................     940,530     849,588
Property and equipment, net............................      66,726      52,242
Computer software, net of accumulated amortization of
 $112,734 in 1998 and $98,785 in 1997..................      81,606      77,040
Excess cost over net assets of businesses acquired, net
 of accumulated amortization of $27,316 in 1998 and
 $30,718 in 1997.......................................      76,086      84,983
Noncurrent deferred income taxes.......................       4,378      23,178
Other assets...........................................      28,273      13,247
                                                         ----------  ----------
                                                         $1,197,599  $1,100,278
                                                         ==========  ==========
         LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable and accrued liabilities.............  $  161,790  $  186,188
  Deferred revenue.....................................     105,439     106,848
                                                         ----------  ----------
    Total current liabilities..........................     267,229     293,036
Noncurrent deferred revenue............................      27,649      20,432
Other noncurrent liabilities...........................      41,163      29,319
Contingencies and commitments
Stockholders' equity:
  Preferred stock, $.10 par value; 10,000,000 shares
   authorized; none issued.............................
  Common stock, $.10 par value; 125,000,000 and
   75,000,000 shares authorized in 1998 and 1997,
   respectively; 84,845,000 and 82,412,000 shares
   issued in 1998 and 1997, respectively...............       8,485       8,241
  Additional paid-in capital...........................     858,615     832,675
  Retained earnings (deficit)..........................      50,462     (25,174)
  Less treasury stock, at cost; 2,599,000 and 2,704,000
   shares in 1998 and 1997, respectively...............     (56,004)    (58,251)
                                                         ----------  ----------
    Total stockholders' equity.........................     861,558     757,491
                                                         ----------  ----------
                                                         $1,197,599  $1,100,278
                                                         ==========  ==========
</TABLE>
 
                            See accompanying notes.
 
                                       28
<PAGE>
 
                            STERLING SOFTWARE, INC.
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                 YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996
                  (IN THOUSANDS, EXCEPT PER SHARE INFORMATION)
 
<TABLE>
<CAPTION>
                                                   1998      1997       1996
                                                 --------  ---------  --------
<S>                                              <C>       <C>        <C>
Revenue:
  Products.....................................  $291,255  $ 234,240  $214,709
  Product support..............................   183,631    150,886   144,596
  Services.....................................   245,057    184,076   154,456
                                                 --------  ---------  --------
                                                  719,943    569,202   513,761
Costs and expenses:
  Cost of sales:
    Products and product support...............    71,229     79,449    81,540
    Services...................................   216,437    157,287   136,011
                                                 --------  ---------  --------
                                                  287,666    236,736   217,551
  Product development and enhancement..........    36,162     29,659    26,402
  Selling, general and administrative..........   264,450    231,185   206,648
  Reorganization costs.........................    45,162    106,037
  Purchased research and development...........              137,849
                                                 --------  ---------  --------
                                                  633,440    741,466   450,601
                                                 --------  ---------  --------
Income (loss) from continuing operations before
 other income (expense) and income taxes.......    86,503   (172,264)   63,160
Other income (expense):
  Interest expense.............................      (424)      (540)   (3,435)
  Investment income............................    34,087     38,906    26,854
  Other........................................      (329)      (658)      333
                                                 --------  ---------  --------
                                                   33,334     37,708    23,752
                                                 --------  ---------  --------
Income (loss) from continuing operations before
 income taxes..................................   119,837   (134,556)   86,912
Provision (benefit) for income taxes...........    43,793     (2,659)   24,795
                                                 --------  ---------  --------
Income (loss) from continuing operations.......    76,044   (131,897)   62,117
Discontinued operations, net of applicable
 income taxes:
 Income from discontinued operations, net......                         51,187
 Gain on the initial public offering of
  subsidiary, net..............................                        126,103
                                                 --------  ---------  --------
                                                                       177,290
                                                 --------  ---------  --------
Net income (loss)..............................  $ 76,044  $(131,897) $239,407
                                                 ========  =========  ========
Income (loss) per common share:
  Income (loss) from continuing operations
    Basic......................................  $    .94  $   (1.66) $    .92
                                                 ========  =========  ========
    Diluted....................................  $    .89  $   (1.66) $    .86
                                                 ========  =========  ========
  Net income (loss)
    Basic......................................  $    .94  $   (1.66) $   3.56
                                                 ========  =========  ========
    Diluted....................................  $    .89  $   (1.66) $   3.26
                                                 ========  =========  ========
</TABLE>
 
                            See accompanying notes.
 
                                       29
<PAGE>
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                 YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>
                          COMMON STOCK                         TREASURY STOCK
                          --------------                       ----------------
                          NUMBER          ADDITIONAL RETAINED  NUMBER                TOTAL
                            OF     PAR     PAID-IN   EARNINGS    OF              STOCKHOLDERS'
                          SHARES  VALUE    CAPITAL   (DEFICIT) SHARES    COST       EQUITY
                          ------  ------  ---------- --------  ------  --------  -------------
<S>                       <C>     <C>     <C>        <C>       <C>     <C>       <C>
Balance at September 30,
 1995, as previously
 reported...............  26,529  $2,653   $336,752  $  9,515     56   $   (582)   $348,338
 Adjustment for stock
  dividend..............  26,529   2,653     (2,653)              56
 Adjustment for pooling
  of interests with
  Synon.................   2,591     259     30,296   (24,257)                        6,298
 Net income.............                              239,407                       239,407
 Acquisition of common
  stock for treasury....                                       2,671    (59,372)    (59,372)
 Issuance of common
  stock pursuant to
  stock options and
  warrants, including
  tax benefit of
  $47,112...............  18,453   1,845    321,996                                 323,841
 Issuance of common
  stock pursuant to
  conversion of 5.75%
  Debentures............   8,112     811    111,565                                 112,376
 Proceeds from
  subsidiary initial
  public offering, net
  of minority interest
  of $7,382.............                     32,736                                  32,736
 Distribution of
  subsidiary............                             (113,549)                     (113,549)
 Issuance of common
  stock to 401(k) plan..                        127              (39)       857         984
 Adjustment to
  unrealized gains
  (losses) on available-
  for-sale securities,
  net of tax............                               (1,178)                       (1,178)
 Other..................                         41    (2,586)                       (2,545)
                          ------  ------   --------  --------  -----   --------    --------
Balance at September 30,
 1996...................  82,214   8,221    830,860   107,352  2,744    (59,097)    887,336
 Net loss...............                             (131,897)                     (131,897)
 Issuance of common
  stock pursuant to
  stock options,
  including tax benefit
  of $450...............     212      21      1,889                                   1,910
 Issuance of common
  stock to 401(k) plan..                       (295)             (40)       845         550
 Adjustment to
  unrealized gains
  (losses) on available-
  for-sale securities,
  net of tax............                                2,381                         2,381
 Other..................     (14)     (1)       221    (3,010)                1      (2,789)
                          ------  ------   --------  --------  -----   --------    --------
Balance at September 30,
 1997...................  82,412   8,241    832,675   (25,174) 2,704    (58,251)    757,491
 Net income.............                               76,044                        76,044
 Issuance of common
  stock pursuant to
  stock options,
  including tax benefit
  of $4,700.............   1,327     133     22,462                                  22,595
 Issuance of common
  stock to 401(k) plan..                       (303)            (102)     2,189       1,886
 Issuance of common
  stock to employee
  stock purchase plan...     337      34      5,494               (3)        58       5,586
 Adjustment to
  unrealized gains
  (losses) on available-
  for-sale securities,
  net of tax............                                 (418)                         (418)
 Adjustment for pooling
  of interests with
  Mystech...............     769      77     (1,713)    4,628                         2,992
 Other..................                               (4,618)                       (4,618)
                          ------  ------   --------  --------  -----   --------    --------
Balance at September 30,
 1998...................  84,845  $8,485   $858,615  $ 50,462  2,599   $(56,004)   $861,558
                          ======  ======   ========  ========  =====   ========    ========
</TABLE>
                            See accompanying notes.
 
                                       30
<PAGE>
 
                            STERLING SOFTWARE, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                 YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                    1998      1997       1996
                                                  --------  ---------  --------
<S>                                               <C>       <C>        <C>
Operating activities:
  Net income (loss).............................  $ 76,044  $(131,897) $239,407
  Less: Income from discontinued operations.....                       (177,290)
                                                  --------  ---------  --------
  Income (loss) from continuing operations......    76,044   (131,897)   62,117
  Adjustments to reconcile income (loss) from
   continuing operations to net cash provided by
   operating activities:
    Depreciation and amortization...............    44,693     38,544    35,758
    Provision for losses on accounts
     receivable.................................     5,157      5,191     6,879
    Provision (benefit) for deferred income
     taxes......................................    18,800    (19,125)   11,451
    Purchased research and development..........              137,849
    Reorganization costs........................     9,552     63,726
    Changes in operating assets and liabilities,
     net of effects of business acquisitions:
      (Increase) decrease in accounts and notes
       receivable...............................   (49,435)    26,298    (6,392)
      (Decrease) increase in amounts due to
       Sterling Commerce, Inc...................              (35,134)   35,134
      Increase in prepaid expenses and other
       assets...................................    (6,045)    (2,495)  (15,412)
      (Decrease) increase in accounts payable,
       accrued liabilities and income taxes
       payable..................................   (11,989)    40,259   (61,081)
      (Decrease) increase in deferred revenue...    (1,951)    (1,339)      484
      Other.....................................    16,859      6,734    (2,164)
                                                  --------  ---------  --------
        Net cash provided by operating
         activities.............................   101,685    128,611    66,774
Investing activities:
  Purchases of property and equipment...........   (33,200)   (29,003)  (13,959)
  Purchases and capitalized cost of development
   of computer software.........................   (27,854)   (21,860)  (18,505)
  Business acquisitions, net of cash acquired...      (634)  (194,871)   (7,001)
  Purchases of investments......................  (342,807)  (255,888) (576,299)
  Proceeds from sales of investments............   240,495    284,703   406,072
  Other.........................................     1,619        697       585
                                                  --------  ---------  --------
        Net cash used in investing activities...  (162,381)  (216,222) (209,107)
Financing activities:
  Purchases of treasury stock...................                        (59,372)
  Retirement and redemption of debt and capital
   lease obligations............................    (3,400)    (8,144)  (13,477)
  Proceeds from issuance of debt, net of
   issuance costs...............................     3,482      8,166     5,900
  Net proceeds from subsidiary public offering..                        265,458
  Proceeds from issuance of common stock
   pursuant to the exercise of stock options and
   warrants.....................................    17,895      1,460   276,729
  Proceeds from issuance of common stock to
   employee stock purchase plan.................     5,586
  Other.........................................    (2,682)    (1,201)   (4,226)
                                                  --------  ---------  --------
        Net cash provided by financing
         activities.............................    20,881        281   471,012
Cash flows provided by discontinued operations..                         17,819
Effect of foreign currency exchange rate changes
 on cash........................................       172     (2,314)     (314)
                                                  --------  ---------  --------
(Decrease) increase in cash and equivalents.....   (39,643)   (89,644)  346,184
Cash and cash equivalents at beginning of year..   436,955    526,599   180,415
                                                  --------  ---------  --------
Cash and cash equivalents at end of year........  $397,312  $ 436,955  $526,599
                                                  ========  =========  ========
Supplemental cash flow information:
  Interest paid.................................  $    369  $     544  $  4,501
                                                  ========  =========  ========
  Income taxes paid.............................  $  2,400  $   6,670  $ 91,954
                                                  ========  =========  ========
</TABLE>
 
                            See accompanying notes.
 
                                       31
<PAGE>
 
                            STERLING SOFTWARE, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                       SEPTEMBER 30, 1998, 1997 AND 1996
 
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
  The Company
 
  Sterling Software, Inc. ("Sterling Software" or the "Company") was founded
in 198l and became a publicly owned corporation in 1983. Sterling Software is
a worldwide developer and supplier of application development, information
management and systems management software products and services, as well as a
supplier of specialized information technology ("IT") services for sectors of
the federal government.
 
  Basis of Presentation
 
  The consolidated financial statements include the accounts of Sterling
Software after elimination of all significant intercompany balances and
transactions. Certain amounts for periods ended prior to September 30, 1998,
have been reclassified to conform to the current year presentation. The
financial statements have been prepared in conformity with generally accepted
accounting principles which require management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, the
disclosure of contingencies at September 30, 1998 and 1997 and the results of
operations for the years ended September 30, 1998, 1997 and 1996. While
management has based its estimates and assumptions on the facts and
circumstances known to it as of the date of this report, actual amounts may
differ from such estimates and assumptions.
 
  Revenue
 
  Revenue from license fees for standard software products is recognized when
the software is delivered, provided no significant future vendor obligations
exist and collection is probable. Service revenue and revenue from products
involving installation or other services are recognized as the services are
performed.
 
  If software product transactions include the right to receive future
products, a portion of the software product revenue is deferred and recognized
as products are delivered. Contract accounting is applied for sales of
software products requiring significant modification or customization, such
that revenue is recognized only when the modification or customization is
complete.
 
  Product support contracts allow customers to receive updated versions of
Sterling Software's products when and if they become available, as well as bug
fixing, and Internet and telephone access to the Company's technical
personnel. Revenue from product support contracts, including product support
included in initial license fees, is recognized ratably over the contract
period. All significant costs and expenses associated with product support
contracts are expensed ratably over the contract period.
 
  When products, product support and services are billed prior to the time the
related revenue is recognized, deferred revenue is recorded and related costs
paid in advance are deferred.
 
  Revenue from specialized IT services provided to the federal government
under multi-year contracts is recognized as the services are performed.
Revenue for services provided under other long-term contracts is recognized
using the percentage-of-completion method of accounting. Losses on long-term
contracts are recognized when the current estimate of total contract costs
indicates a loss on a contract is probable.
 
  Returns and allowances and other similar adjustments to revenue involving
software products historically have not been material to the Company's results
of operations.
 
  Software Development Costs
 
  The Company capitalizes the costs of developing and testing new or
significantly enhanced software products in accordance with the provisions of
Statement of Financial Accounting Standard No. 86 ("FAS 86"),
 
                                      32
<PAGE>
 
"Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise
Marketed". Pursuant to FAS 86, costs are capitalized when technological
feasibility of the product is established. Technological feasibility is
established either upon the completion of a detailed program design or the
completion of a working model. The establishment of technological feasibility
and the ongoing assessment of recoverability of capitalized software
development costs require judgment by management with respect to certain
external factors, including, but not limited to, anticipated future revenues,
estimated economic life and changes in software and hardware technologies.
Software development capitalized costs include, among other things,
programmers salaries and benefits, outside contractor costs, computer time and
allocated facilities costs. Unamortized software development costs of
$54,382,000 and $46,734,000 are included in "Computer software, net", at
September 30, 1998 and 1997, respectively.
 
  Depreciation and Amortization
 
  Property and equipment are recorded at cost and depreciated using the
straight-line method over average useful lives of three to 15 years. Computer
software costs are amortized on a product-by-product basis using the greater
of the amount computed by taking the ratio of current year net revenue to
estimated future net revenue or the amount computed by the straight-line
method over periods ranging from three to seven years. Excess costs over the
net assets of businesses acquired are amortized on a straight-line basis over
periods of seven to 40 years. Other intangible assets are amortized on a
straight-line basis over periods of three to seven years.
 
  Depreciation and amortization consists of the following for the years ended
September 30, 1998, 1997 and 1996 (in thousands):
 
<TABLE>
<CAPTION>
                                                        1998    1997    1996
                                                       ------- ------- -------
   <S>                                                 <C>     <C>     <C>
   Property and equipment............................. $16,094 $15,596 $13,396
   Purchased computer software........................   7,708   6,731   5,926
   Capitalized computer software development costs....  13,083  11,551   9,970
   Excess cost over net assets of businesses
    acquired..........................................   7,570   4,403   5,964
   Intangible assets..................................     238     263     502
                                                       ------- ------- -------
                                                       $44,693 $38,544 $35,758
                                                       ======= ======= =======
</TABLE>
 
  Income Taxes
 
  The Company's income taxes are presented in accordance with the provisions
of Statement of Financial Accounting Standard No. 109 ("FAS 109"), "Accounting
for Income Taxes", which requires the use of the asset and liability method of
accounting for income taxes. Under the asset and liability method, a deferred
tax asset or liability is recognized for estimated future tax effects
attributable to temporary differences and carryforwards. The measurement of
deferred income tax assets is adjusted by a valuation allowance, if necessary,
to recognize future tax benefit only to the extent, based on available
evidence, it is more likely than not such benefit will be realized.
 
  Stock Options
 
  The Company has elected to follow Accounting Principles Board Opinion No. 25
("APB 25"), "Accounting for Stock Issued to Employees", in accounting for its
employee stock options, employee stock purchase plan and other stock based
awards. Under APB 25, if the exercise price of an employee's stock option
equals or exceeds the market price of the underlying stock on the date of
grant, no compensation expense is recognized.
 
  Common Stock and Earnings Per Common Share
 
  Effective October 1, 1997, Sterling Software adopted Financial Accounting
Standards Board Statement of Financial Accounting Standards No. 128 ("FAS
128"), "Earnings per Share". FAS 128 sets forth new rules for
 
 
                                      33
<PAGE>
 
computing earnings per share which replace previously reported "primary" and
"fully diluted" earnings per share with "basic" and "diluted" earnings per
share. Basic earnings per common share data is computed using the weighted
average number of common shares outstanding for the relevant period. Diluted
earnings per common share data is computed using the weighted average number
of common shares outstanding plus common share equivalents represented by
stock options, warrants and convertible debentures, if such stock options,
warrants and convertible debentures have a dilutive effect in the aggregate.
Earnings per share amounts for all periods have been presented, and where
necessary restated, in accordance with FAS 128.
 
  On March 11, 1998, the Sterling Software Board of Directors authorized a 2-
for-1 stock split that was effected by means of a dividend of one share of the
Company's common stock, par value $0.10 per share ("Common Stock"), for each
share of Common Stock outstanding (the "Stock Split Dividend"). The Stock
Split Dividend was paid on April 3, 1998 to holders of record on March 20,
1998. Common share and per share amounts for all periods have been restated to
reflect the Stock Split Dividend.
 
  The following table sets forth the computation of basic and diluted earnings
per share for the years ended September 30, 1998, 1997 and 1996 (in thousands,
except per share data):
 
<TABLE>
<CAPTION>
                                                     1998     1997       1996
                                                    ------- ---------  --------
   <S>                                              <C>     <C>        <C>
   BASIC:
     Net income (loss)............................  $76,044 $(131,897) $239,407
                                                    ======= =========  ========
     Weighted average common shares outstanding...   80,638    79,588    67,226
                                                    ======= =========  ========
     Net income (loss) per common share...........  $   .94 $   (1.66) $   3.56
                                                    ======= =========  ========
   DILUTED:
     Net income (loss)............................  $76,044 $(131,897) $239,407
     Effect of dilutive convertible debentures....                        1,685
                                                    ------- ---------  --------
                                                    $76,044 $(131,897) $241,092
                                                    ======= =========  ========
     Weighted average common shares outstanding...   80,638    79,588    67,226
     Effect of dilutive employee stock options and
      warrants....................................    4,869               3,675
     Effect of dilutive convertible debentures....                        2,990
                                                    ------- ---------  --------
     Adjusted weighted average common shares and
      assumed conversions.........................   85,507    79,588    73,891
                                                    ======= =========  ========
     Net income (loss) per common share...........  $   .89 $   (1.66) $   3.26
                                                    ======= =========  ========
</TABLE>
 
  Foreign Currency Translation
 
  The financial statements of the Company's subsidiaries outside the United
States are generally prepared using the local currency as the functional
currency. Assets and liabilities of these subsidiaries are translated into
U.S. dollars at exchange rates in effect as of the applicable balance sheet
date and any resulting translation adjustments are included as an adjustment
to retained earnings. Revenue and expense items of these subsidiaries are
translated at average exchange rates during the month the transactions occur.
Gains and losses from foreign currency transactions are included in net
earnings. Foreign currency transaction gains and losses historically have not
been material to the Company's results of operations.
 
  Cash and Equivalents
 
  Cash equivalents consist primarily of highly liquid investments in
investment-grade commercial paper of various issuers and repurchase agreements
backed by U.S. Treasury securities, with maturities of three months or less
when purchased. Cash equivalents are recorded at fair value.
 
                                      34
<PAGE>
 
  Marketable Securities and Other Investments
 
  The Company currently invests excess cash in a diversified portfolio of
marketable securities consisting of a variety of investment-grade securities,
including commercial paper, medium-term notes, U.S. government obligations,
municipal obligations and certificates of deposit. The fair values for
marketable securities are based on quoted market prices.
 
  All marketable securities and long-term investments are classified as
available-for-sale securities. Unrealized holding gains and losses on
securities available-for-sale are recorded as a component of stockholders'
equity, net of any related tax effect. The amortized cost of debt securities
in this category is adjusted for amortization of premiums and accretion of
discounts to maturity. Such amortization is included in investment income.
Realized gains and losses and declines in values judged to be other-than-
temporary, if any, on available-for-sale securities are included in investment
income.
 
  Excess Cost Over Net Assets Acquired
 
  Excess cost over net assets acquired is amortized on a straight-line basis
over periods of seven to 40 years. The carrying amount of such costs which are
not associated with other assets acquired in a purchase business combination
is reviewed by management if facts and circumstances suggest that such amount
may be impaired. If this review indicates that the costs will not be
recoverable, as determined based on the estimated discounted future cash flows
of the entity acquired over the remaining amortization period, the carrying
amount is reduced by the estimated shortfall of cash flows. The carrying
amount of costs associated with other assets acquired in a purchase business
combination is included in impairment evaluations when events or circumstances
exist that indicate the carrying amount of those assets may not be
recoverable.
 
  Recent Developments
 
  In March 1998, the Accounting Standards Executive Committee issued Statement
of Position ("SOP 98-1"), "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use". SOP 98-1 requires companies to
capitalize qualifying computer software costs which are incurred during the
application development stage and amortize them over the software's estimated
useful life. SOP 98-1 is effective for fiscal years beginning after December
15, 1998. The adoption SOP 98-1 is not expected to have a material impact on
the financial position or results of operations of the Company.
 
  In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 133 ("FAS 133"), "Accounting
for Derivative Instruments and Hedging Activities". FAS 133 requires companies
to record derivatives on the balance sheet as assets or liabilities, measured
at fair value. Gains or losses resulting from changes in the values of those
derivatives would be accounted for depending on the use of the derivative and
whether it qualifies for hedge accounting. FAS 133 is effective for fiscal
quarters of fiscal years beginning after June 15, 1999. The adoption of FAS
133 is not expected to have a material impact on the financial position or
results of operations of the Company.
 
  In October 1997, the FASB approved the American Institute of Certified
Public Accountants Statement of Position ("SOP 97-2"), "Software Revenue
Recognition", which will be effective for transactions occurring after
September 30, 1998. In March 1998, the American Institute of Certified Public
Accountants issued Statement of Position ("SOP 98-4") which defers certain
provisions of SOP 97-2 for one year (until fiscal years beginning after
December 15, 1998). Detailed implementation guidelines for the provisions of
SOP 97-2 which were deferred have not been issued. The Company's accounting
policy for software revenue recognition is generally in compliance with SOP
97-2, as amended by SOP 98-4, and adoption of these SOP's, as currently
issued, is not expected to have a material impact on the financial position or
results of operations of the Company.
 
 
                                      35
<PAGE>
 
2. BUSINESS ACQUISITIONS, DIVESTITURES AND REORGANIZATIONS
 
  Acquisition of Mystech Associates, Inc.
 
  On July 9, 1998, Sterling Software acquired Mystech Associates, Inc.
("Mystech"), a federal information technology services contractor, in a stock-
for-stock merger transaction (the "Mystech Merger"). As a result of the
transaction, Sterling Software issued approximately 769,000 shares of Common
Stock in exchange for the previously outstanding shares of Mystech common
stock and has reserved approximately 174,000 shares of Common Stock for
issuance upon exercise of assumed Mystech stock options. The Mystech Merger
was accounted for as a pooling of interests and the Mystech organization was
added to the Company's federal systems business. However, the impact of the
pooling of interests accounting on the Company's historical financial
statements was not material. Therefore, the Company's financial statements for
periods prior to the Mystech Merger have not been restated for this
transaction.
 
  Acquisition of Synon Corporation
 
  On July 31, 1998, Sterling Software acquired Synon Corporation ("Synon"), a
provider of application development software and services, in a stock-for-
stock merger transaction (the "Synon Merger") accounted for as a pooling of
interests. As a result of the transaction, Sterling Software issued
approximately 2,603,000 shares of Common Stock in exchange for the previously
outstanding shares of Synon capital stock and has reserved approximately
375,000 shares of Common Stock for issuance upon exercise of assumed Synon
stock options. The Company's financial statements for periods prior to the
Synon Merger, including the results of the application management business
segment, have been restated to represent the combined financial statements of
the previously separate entities.
 
  Separate and combined results of Sterling Software and Synon are as follows
(in thousands):
 
<TABLE>
<CAPTION>
                                                  STERLING
                                                  SOFTWARE    SYNON   COMBINED
                                                  ---------  -------  --------
   <S>                                            <C>        <C>      <C>
   Nine Months Ended June 30, 1998 (unaudited)
     Revenue..................................... $ 469,771  $57,483  $527,254
     Net income (loss)...........................    75,734   (7,285)   68,449
   Year Ended September 30, 1997
     Revenue.....................................   488,978   80,224   569,202
     Net income (loss)...........................  (132,968)   1,071  (131,897)
   Year Ended September 30, 1996
     Revenue.....................................   439,171   74,590   513,761
     Income from continuing operations...........    60,598    1,519    62,117
     Net income..................................   237,888    1,519   239,407
</TABLE>
 
  Acquisition of TI Software
 
  On June 30, 1997, Sterling Software completed the acquisition (the "TI
Software Acquisition") of certain assets (including the capital stock of
certain foreign subsidiaries) of Texas Instruments Incorporated ("Texas
Instruments"). Such assets constitute substantially all of the assets used by
Texas Instruments' Software Division ("TI Software") in its business of
developing, marketing and supporting application development software and
providing related consulting services. The results of operations of TI
Software are included in the Company's results of operations from the date of
the TI Software Acquisition.
 
  The cash purchase price paid for such assets was $165,000,000 and was funded
from the Company's available cash balances. The total cost of the TI Software
Acquisition was approximately $214,774,000, including costs directly related
to the TI Software Acquisition of approximately $49,774,000, consisting of
employee termination costs, transaction costs, costs associated with the
elimination of duplicate facilities and other direct costs. Results of
operations for 1997 include $137,849,000 of purchased research and development
 
                                      36
<PAGE>
 
costs, which is the portion of the purchase price attributed to in-process
research and development, and which was charged to expense in accordance with
the purchase method of accounting. The estimates of fair value were determined
by the Company's management based on information furnished by the management
of TI Software and an independent valuation of acquired software and research
and development. The components of the aggregate cost were as follows (in
thousands):
 
<TABLE>
   <S>                                                                 <C>
   Cash paid to Texas Instruments..................................... $165,000
   TI Software employee severance and benefits........................   28,696
   Elimination of duplicate facilities and leases of TI Software......   10,578
   Transaction costs..................................................    4,904
   Other costs........................................................    5,596
                                                                       --------
                                                                       $214,774
                                                                       ========
</TABLE>
 
  The TI Software Acquisition has been accounted for in accordance with the
purchase method of accounting. The aggregate purchase price has been allocated
to the assets and liabilities acquired, with the remainder recorded as excess
cost over net assets acquired, based on estimates of fair values as follows
(in thousands):
 
<TABLE>
   <S>                                                                <C>
   Working capital (deficit)......................................... $(10,100)
   Property and equipment............................................    4,530
   Software..........................................................   24,054
   Purchased research and development costs charged to expense.......  137,849
   Other liabilities.................................................      (32)
   Excess cost over net assets acquired..............................   58,473
                                                                      --------
                                                                      $214,774
                                                                      ========
</TABLE>
 
  The following unaudited pro forma information presents the Company's results
of operations as if the TI Software Acquisition had occurred at October 1,
1996. The pro forma information has been prepared by combining the results of
operations of the Company and TI Software for the years ended September 30,
1997 and 1996, adjusted for the elimination of charges for purchased research
and development costs and reorganization costs, additional amortization
expense and the resulting impact on the provision for income taxes. This pro
forma information does not purport to be indicative of what would have
occurred had the TI Software Acquisition and related reorganization occurred
as of that date or of results of operations which may occur in the future (in
thousands, except per share data):
 
<TABLE>
<CAPTION>
                                                     YEARS ENDED SEPTEMBER 30
                                                     -------------------------
                                                         1997         1996
                                                     ------------ ------------
   <S>                                               <C>          <C>
   Revenue.......................................... $    733,577 $    784,250
   Income before other income (expense) and income
    taxes........................................... $     43,306 $     56,532
   Income from continuing operations................ $     51,840 $     52,304
   Income from continuing operations per share...... $        .65 $        .73
</TABLE>
 
  Termination of International Distributor Arrangement
 
  Effective as of June 30, 1997, Sterling Software and Sterling Commerce, Inc.
("Sterling Commerce"), formerly a wholly owned subsidiary of Sterling Software
formed to operate the business of Sterling Software's former Electronic
Commerce Group, completed an agreement terminating an international
distributor arrangement pursuant to which Sterling Software acted as the
exclusive distributor of Sterling Commerce's interchange and communications
software products in markets outside the United States and Canada. The results
of the Company's international operations related to selling, marketing and
providing first level support for these products outside of the United States
and Canada through June 30, 1997 are included in the business segment
information presented herein under "Corporate and other".
 
                                      37
<PAGE>
 
  Contemporaneously with such termination, Sterling Software sold to Sterling
Commerce certain of the assets formerly used by Sterling Software in
connection with the distribution of certain Sterling Commerce products outside
the United Stated and Canada. In consideration of the termination of the
international distributor arrangement and the sale of assets described above,
Sterling Commerce (i) paid to Sterling Software $5,226,000 on June 30, 1997
and (ii) subsequently paid to Sterling Software $10,076,000, which was equal
to the net book value of the acquired assets and certain assumed liabilities
of Sterling Software.
 
  Reorganization Costs
 
  The Company's results of operations for 1998 include reorganization costs of
$45,162,000 primarily related to the reorganization of the Company's
operations in connection with the Synon Merger and, to a lesser extent, the
Mystech Merger. Of the total reorganization costs, approximately $9,552,000
consisted of non-cash costs and the remaining $35,610,000 required cash
outlays. At September 30, 1998, the remaining balance to be paid was
$22,818,000. Currently, the Company does not expect to incur costs related to
these reorganizations in excess of the amounts charged to operations in 1998.
The components of the aggregate reorganization costs were as follows (in
thousands):
 
<TABLE>
   <S>                                                                 <C>
   Employee termination costs......................................... $17,342
   Write-down of software products which will not be actively
    marketed..........................................................   6,397
   Elimination of duplicate facilities and equipment..................   8,295
   Out of pocket costs related to the reorganization..................   9,535
   Other costs........................................................   3,593
                                                                       -------
                                                                       $45,162
                                                                       =======
</TABLE>
 
  The Company's results of operations for 1997 include reorganization costs of
$106,037,000 primarily related to the reorganization of the Company's
operations in connection with the TI Software Acquisition and the termination
of the international distributor arrangement with Sterling Commerce in the
third quarter of 1997. These reorganization costs also include the write-down
of certain excess cost over net assets acquired related to the Company's
federal systems business. Of the total reorganization costs, approximately
$63,726,000 consisted of non-cash costs and the remaining $42,311,000 required
cash outlays. At September 30, 1998, the remaining balance to be paid was
$12,344,000, which consists primarily of commitments under lease arrangements
for office space and equipment. The Company does not expect to incur costs
related to this reorganization in excess of the amount charged to operations
in 1997. The components of the reorganization costs were as follows (in
thousands):
 
<TABLE>
   <S>                                                                <C>
   Employee termination costs........................................ $ 18,539
   Write-down of software products which will not be actively
    marketed.........................................................   17,591
   Write-down of excess cost over net assets acquired................   38,955
   Elimination of duplicate facilities and equipment.................   19,993
   Out of pocket costs related to the reorganization.................    5,109
   Other costs.......................................................    5,850
                                                                      --------
                                                                      $106,037
                                                                      ========
</TABLE>
 
3. DISCONTINUED OPERATIONS
 
  Sterling Commerce completed an initial public offering (the "Offering") of
13,800,000 shares of its common stock ("Commerce Stock") on March 13, 1996.
Pursuant to the Offering, Sterling Software sold to the public 12,000,000 of
its 73,200,000 shares of Commerce Stock and Sterling Commerce sold 1,800,000
of previously unissued shares of Commerce Stock. The Offering price was $24
per share of Commerce Stock, resulting in net proceeds to Sterling Software of
approximately $265,458,000 after deducting underwriting discounts and
commissions and Sterling Software's pro rata share of Offering expenses.
Sterling Software recorded a gain of approximately $126,103,000, net of tax,
from the sale of Commerce Stock in the Offering.
 
 
                                      38
<PAGE>
 
  On September 30, 1996, Sterling Software completed the spin-off of Sterling
Commerce with the pro rata distribution of its remaining 81.6% ownership in
Sterling Commerce to Sterling Software's stockholders by means of a tax-free
dividend. The distribution resulted in the reduction of Sterling Software's
stockholders' equity in the amount of $113,549,000, representing the book
value of net assets distributed.
 
  The results of operations of Sterling Commerce for 1996 have been classified
as discontinued operations. The income from discontinued operations reflected
in the table below is inclusive of minority interest held by stockholders
other than Sterling Software. Summary operating results of discontinued
operations for the year ended September 30, 1996 are as follows (in
thousands):
 
<TABLE>
   <S>                                                                 <C>
   Revenue............................................................ $267,773
   Total costs and expenses........................................... $172,568
   Income before income taxes......................................... $ 96,422
   Income taxes....................................................... $ 38,030
   Income from discontinued operations, net........................... $ 58,392
</TABLE>
 
4. LEGAL PROCEEDINGS AND CLAIMS
 
  The Company is subject to various legal proceedings and claims that arise in
the normal course of its business. While many of these matters involve
inherent uncertainty, the Company's management believes that the amount of the
liability, if any, ultimately incurred by Sterling Software with respect to
any such existing proceedings and claims, net of applicable reserves and
available insurance, will not materially affect the business, financial
condition or results of operations of the Company.
 
5. SEGMENT INFORMATION
 
  Sterling Software is a worldwide developer and supplier of application
development, information management and systems management software products
and services, as well as a supplier of specialized IT services for sectors of
the federal government. The Company addresses these major markets through
three business segments. The application management business segment provides
solutions for both enterprise-scale application development and information
management. Application development solutions include products and services
for business modeling through code generation. Information management
solutions include products and services that enable customers to facilitate
enterprise information access and to extend the life and usefulness of legacy
applications. The systems management business segment provides solutions that
enable customers to simplify the use of multiple computing environments and to
increase the productivity of information systems, ultimately ensuring that the
systems meet the business needs of the organization. The federal systems
business segment provides specialized IT services for sectors of the federal
government, as well as state and local governments. Though June 30, 1997, the
Company's international operations sold, marketed and provided first-level
support outside of the United States and Canada for certain software products
of Sterling Commerce, the results of which are included in the business
segment information under "Corporate and other".
 
                                      39
<PAGE>
 
  Financial information concerning the Company's operations, by business
segment, for the years ended September 30, 1998, 1997 and 1996, is summarized
as follows (in thousands):
 
<TABLE>
<CAPTION>
   BUSINESS SEGMENT INFORMATION                   1998        1997        1996
   ----------------------------                ----------  ----------  ----------
   <S>                                         <C>         <C>         <C>
   Revenue:
     Application Management................... $  366,013  $  223,166  $  184,394
     Systems Management.......................    204,529     184,679     170,804
     Federal Systems..........................    148,773     121,790     112,188
     Corporate and other......................        628      39,567      46,375
                                               ----------  ----------  ----------
       Consolidated totals.................... $  719,943  $  569,202  $  513,761
                                               ==========  ==========  ==========
   Operating Profit (Loss):
     Application Management................... $   75,981  $   23,747  $   18,794
     Systems Management.......................     77,337      70,629      65,858
     Federal Systems..........................      9,911       8,689       7,982
     Reorganization costs.....................    (45,162)   (106,037)
     Purchased research and development.......               (137,849)
     Corporate and other......................    (31,564)    (31,443)    (29,474)
                                               ----------  ----------  ----------
       Consolidated totals.................... $   86,503  $ (172,264) $   63,160
                                               ==========  ==========  ==========
   Identifiable Assets:
     Application Management................... $  256,737  $  229,261  $  140,679
     Systems Management.......................    187,310     150,549     135,845
     Federal Systems..........................     67,290      58,445      68,809
     Corporate and other......................    686,262     662,023     785,246
                                               ----------  ----------  ----------
       Consolidated totals.................... $1,197,599  $1,100,278  $1,130,579
                                               ==========  ==========  ==========
   Capital Expenditures (including additions
    to computer software):
     Application Management................... $   34,239  $   13,782  $   11,224
     Systems Management.......................     19,745      16,919      14,597
     Federal Systems..........................      1,145       1,284       1,255
     Corporate and other......................      5,925      18,878       5,388
                                               ----------  ----------  ----------
       Consolidated totals.................... $   61,054  $   50,863  $   32,464
                                               ==========  ==========  ==========
   Depreciation and Amortization:
     Application Management................... $   21,084  $   17,698  $   17,085
     Systems Management.......................     16,485      16,014      12,230
     Federal Systems..........................      2,346       2,231       2,290
     Corporate and other......................      4,778       2,601       4,153
                                               ----------  ----------  ----------
       Consolidated totals.................... $   44,693  $   38,544  $   35,758
                                               ==========  ==========  ==========
   Revenue from the U.S. Government:
     Application Management................... $   10,635  $    7,455  $    5,169
     Systems Management.......................      3,364       4,140       3,521
     Federal Systems..........................    140,822     112,802     104,052
                                               ----------  ----------  ----------
       Consolidated totals.................... $  154,821  $  124,397  $  112,742
                                               ==========  ==========  ==========
</TABLE>
 
  The amounts presented for "Corporate and other" include corporate expense,
cash balances, marketable securities, income tax balances, other assets,
inter-segment eliminations and, through June 30, 1997, the results of
operations relating to the international distribution of certain Sterling
Commerce software products.
 
                                      40
<PAGE>
 
6. OPERATIONS BY GEOGRAPHIC AREA
 
  The Company's operations in North America and other markets at September 30,
1998, 1997 and 1996 and for the years then ended are summarized as follows (in
thousands):
 
<TABLE>
<CAPTION>
   GEOGRAPHICAL INFORMATION                     1998        1997        1996
   ------------------------                  ----------  ----------  ----------
   <S>                                       <C>         <C>         <C>
   Revenue:
     North America and Latin America.......  $  454,599  $  353,061  $  308,398
     Europe................................     213,601     136,311     115,743
     Asia-Pacific..........................      51,115      40,263      43,245
     Corporate and other...................         628      39,567      46,375
                                             ----------  ----------  ----------
                                             $  719,943  $  569,202  $  513,761
                                             ==========  ==========  ==========
   Operating Profit (Loss):
     North America and Latin America.......  $  125,804  $   82,344  $   79,108
     Europe................................      30,333      13,039       9,593
     Asia-Pacific..........................       7,092       7,682       3,933
     Reorganization costs..................     (45,162)   (106,037)
     Purchased research and development....                (137,849)
     Corporate and other...................     (31,564)    (31,443)    (29,474)
                                             ----------  ----------  ----------
                                             $   86,503  $ (172,264) $   63,160
                                             ==========  ==========  ==========
   Identifiable Assets:
     North America and Latin America.......  $  303,828  $  253,376  $  240,257
     Europe................................     176,026     156,401      93,547
     Asia-Pacific..........................      31,483      28,478      11,529
     Corporate and other...................     686,262     662,023     785,246
                                             ----------  ----------  ----------
                                             $1,197,599  $1,100,278  $1,130,579
                                             ==========  ==========  ==========
</TABLE>
 
  The amounts presented for "Corporate and other" include corporate expense,
cash balances, marketable securities, income tax balances, other assets, inter-
segment eliminations and, through June 30, 1997, the results of operations
relating to the international distribution of certain Sterling Commerce
software products.
 
7. MARKETABLE SECURITIES
 
  At September 30, 1998 and 1997, all of the Company's marketable securities
and other long-term investments were classified as available-for-sale and
consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                                        GROSS
                                                  AGGREGATE AMORTIZED UNREALIZED
                                                    FAIR      COST     HOLDING
                                                    VALUE     BASIS     GAINS
                                                  --------- --------- ----------
   <S>                                            <C>       <C>       <C>
   September 30, 1998
    Commercial paper............................. $ 51,734  $ 51,734
    U.S. corporate notes.........................   90,319    89,601    $  718
    U.S. government obligations..................   20,023    20,001        22
    Municipal obligations........................  141,835   141,633       202
    Other........................................    6,626     6,333       293
                                                  --------  --------    ------
                                                  $310,537  $309,302    $1,235
                                                  ========  ========    ======
</TABLE>
 
                                       41
<PAGE>
 
<TABLE>
<CAPTION>
                                                                     GROSS
                                                                  UNREALIZED
                                                                ---------------
                                                      AMORTIZED
                                           AGGREGATE    COST    HOLDING HOLDING
                                           FAIR VALUE   BASIS    GAINS  LOSSES
                                           ---------- --------- ------- -------
   <S>                                     <C>        <C>       <C>     <C>
   September 30, 1996
    Commercial paper......................  $ 14,887  $ 14,887
    U.S. corporate notes..................    96,520    96,337  $  291   $(108)
    U.S. government obligations...........    14,947    15,018             (71)
    Municipal obligations.................    74,140    73,982     161      (3)
    Other.................................     6,471     4,864   1,607
                                            --------  --------  ------   -----
                                            $206,965  $205,088  $2,059   $(182)
                                            ========  ========  ======   =====
</TABLE>
 
  At September 30, 1998, scheduled maturities of investments in debt
securities were: $277,345,000 principal amount within one year and $29,792,000
principal amount between one and five years.
 
8. ACCOUNTS AND NOTES RECEIVABLE
 
  Accounts and notes receivable consist of the following at September 30 (in
thousands):
 
<TABLE>
<CAPTION>
                                                                1998     1997
                                                              -------- --------
     <S>                                                      <C>      <C>
      Trade.................................................. $181,256 $161,861
      Unbilled...............................................   36,295   19,593
                                                              -------- --------
                                                               217,551  181,454
      Less: Allowance for doubtful accounts..................   17,123   14,186
                                                              -------- --------
                                                              $200,428 $167,268
                                                              ======== ========
</TABLE>
 
  At September 30, 1998 and 1997, accounts receivable include $45,820,000 and
$38,806,000, respectively, due under contracts with the federal government and
related agencies. The remainder of the Company's receivables are due
principally from corporations in diverse industries located in North America,
Europe and Asia-Pacific, which mitigates exposure to concentrations of credit
risk. Trade receivables are generally not collateralized. The Company performs
periodic credit evaluations of its customers' financial conditions.
 
9. PROPERTY AND EQUIPMENT
 
  Property and equipment consist of the following at September 30 (in
thousands):
 
<TABLE>
<CAPTION>
                                                                 1998    1997
                                                                ------- -------
     <S>                                                        <C>     <C>
      Computer and peripheral equipment........................ $45,729 $48,098
      Furniture, fixtures and other equipment..................  47,158  39,705
      Leasehold improvements...................................  23,671  16,710
                                                                ------- -------
                                                                116,558 104,513
      Less: Accumulated depreciation...........................  49,832  52,271
                                                                ------- -------
                                                                $66,726 $52,242
                                                                ======= =======
</TABLE>
 
10. CREDIT AGREEMENT AND LONG-TERM DEBT
 
  Effective July 1, 1997, the Company entered into an amended bank credit
agreement ("Credit Agreement"). The Credit Agreement requires that certain
financial ratios be maintained. Borrowings under the Credit Agreement will
bear interest at the lower of the lender's base rate or the Eurodollar lending
rate plus one-half percent and will mature on June 30, 2000. No amounts were
borrowed during 1998 or outstanding under the Credit Agreement at September
30, 1998. At September 30, 1998, after giving effect to outstanding standby
letters of credit in the aggregate amount of approximately $4,140,000,
approximately $30,860,000 was available
 
                                      42
<PAGE>
 
for borrowing under the Credit Agreement. Certain of the Company's foreign
subsidiaries have separate lines of credit totaling $9,305,000 that are used
for foreign exchange exposure management and working capital requirements.
These lines of credit are guaranteed by Sterling Software, Inc. At September
30, 1998, $1,500,000 was outstanding pursuant to these foreign lines of
credit.
 
  On December 20, 1995, the Company gave notice of the redemption of all of
the $114,922,000 then outstanding principal amount of its 5.75% Convertible
Subordinated Debentures (the "Debentures"), effective February 12, 1996. As a
result, approximately $114,912,000 principal amount of the Debentures were
converted into 4,056,000 shares of Common Stock.
 
11. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
 
  Accounts payable and accrued liabilities consist of the following at
September 30 (in thousands):
 
<TABLE>
<CAPTION>
                                                                1998     1997
                                                              -------- --------
     <S>                                                      <C>      <C>
      Trade accounts payable................................. $ 31,571 $ 45,723
      Accrued compensation...................................   57,169   53,951
      Accrued acquisition and reorganization costs...........   34,276   45,641
      Other accrued liabilities..............................   38,774   40,873
                                                              -------- --------
                                                              $161,790 $186,188
                                                              ======== ========
</TABLE>
 
  Accrued acquisition and reorganization costs at September 30, 1998 were
primarily due to the Synon Merger, the Mystech Merger and the TI Software
Acquisition and related reorganizations, and are primarily for the remaining
commitments pursuant to employee termination costs and the elimination of
duplicate facilities and equipment.
 
12. INCOME TAXES
 
  The provision (benefit) for income taxes on income (loss) from continuing
operations is composed of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                     YEARS ENDED SEPTEMBER 30
                                                    ---------------------------
                                                      1998     1997      1996
                                                    -------- --------  --------
   <S>                                              <C>      <C>       <C>
   Current:
     Federal....................................... $ 17,011 $ 11,309  $ 10,055
     State.........................................    2,928    2,310
     Foreign.......................................    5,054    2,098     2,822
   Deferred:
     Federal.......................................   16,557  (17,330)   10,551
     State.........................................    1,489   (1,685)    2,970
     Foreign.......................................      754      639    (1,603)
                                                    -------- --------  --------
                                                    $ 43,793 $ (2,659) $ 24,795
                                                    ======== ========  ========
</TABLE>
 
                                      43
<PAGE>
 
  The effective income tax rate on income (loss) from continuing operations
before income taxes differed from the federal income tax statutory rate for
the following reasons (in thousands):
 
<TABLE>
<CAPTION>
                                                    YEARS ENDED SEPTEMBER 30
                                                    --------------------------
                                                     1998      1997     1996
                                                    -------  --------  -------
   <S>                                              <C>      <C>       <C>
   Tax expense (benefit) at U.S. federal statutory
    rate..........................................  $41,943  $(47,095) $30,419
   Increases (reductions) in tax expense (benefit)
    resulting from:
     Purchased research and development for which
      no income tax benefit was recognized........             36,251
     Effect of non-U.S. tax rates.................   (4,553)   (1,182)
     Recognition of previously unrecognized
      deferred income tax asset...................             (3,022)  (8,062)
     Nondeductible excess cost over net assets
      acquired....................................      564    14,663    1,680
     Foreign sales corporation....................   (1,896)   (1,891)  (1,568)
     State income taxes, net of federal benefit...    4,417      (125)   2,970
     Unbenefitted losses..........................    3,112
     Other........................................      206      (258)    (644)
                                                    -------  --------  -------
                                                    $43,793  $ (2,659) $24,795
                                                    =======  ========  =======
</TABLE>
 
  Income (loss) before income taxes includes foreign pretax earnings (losses)
of $11,253,000, $(7,021,000) and $1,128,000 for the years ended September 30,
1998, 1997 and 1996, respectively.
 
  Deferred income tax assets and liabilities reflect the net tax effects of
temporary differences between the carrying amounts of assets and liabilities
for financial reporting purposes and the amounts used for income tax purposes.
Significant components of the Company's net deferred tax asset as of September
30 were as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                              1998     1997
                                                             -------  -------
   <S>                                                       <C>      <C>
   Deferred income tax assets:
     Net operating loss carryforwards....................... $37,669  $35,558
     General business and alternative minimum tax credit
      carryforwards.........................................   6,799    6,639
     Foreign tax credit carryforwards.......................   1,232    1,232
     Foreign taxes creditable on undistributed foreign
      source income.........................................   5,397    5,397
     Reserves and reorganization accruals...................  60,295   61,245
                                                             -------  -------
       Deferred income tax assets........................... 111,392  110,071
                                                             -------  -------
   Deferred income tax liabilities:
     Capitalized software costs.............................  21,729   15,283
     Depreciation and amortization..........................   5,709    2,253
     Other future income tax liabilities....................  35,438   27,491
                                                             -------  -------
       Deferred income tax liabilities......................  62,876   45,027
                                                             -------  -------
     Deferred income tax asset net of deferred income tax
      liability.............................................  48,516   65,044
     Less valuation allowance............................... (44,138) (41,866)
                                                             -------  -------
       Net deferred income tax asset........................ $ 4,378  $23,178
                                                             =======  =======
</TABLE>
 
  The valuation allowance relates principally to certain net operating loss
and credit carryforwards. Although realization is not assured, management
believes that future taxable income based on expected future earnings of the
Company will more likely than not utilize a portion of the net operating loss
carryforwards, tax credit carryforwards and other future tax deductions in
existence at September 30, 1998, equivalent to the net deferred income tax
asset. As there can be no assurances on amounts in excess of the net deferred
income tax asset, the aforementioned valuation allowance has been recorded and
may change as estimates during the carryforward periods change.
 
                                      44
<PAGE>
 
  At September 30, 1998, the Company had net operating loss and tax credit
carryforwards for federal income tax purposes of approximately $61,609,000 and
$6,799,000, respectively. These carryforwards will expire at various times
between 1999 and 2009, with approximately $61,609,000 of the net operating
loss carryforwards expiring between 2007 and 2009. The utilization of
substantially all of these carryforwards is restricted to future taxable
income of certain of the Company's wholly owned subsidiaries and limited by
Section 382 of the Internal Revenue Code of 1986, as amended ("the Code").
Thus, the Company's utilization of these carryforwards cannot be assured.
 
13. COMMITMENTS
 
  The Company leases certain facilities and equipment under operating leases.
Total rent expense for the years ended September 30, 1998, 1997 and 1996 was
$28,691,000, $26,435,000 and $23,121,000, respectively. At September 30, 1998,
minimum future rental payments due under all operating leases, net of
estimated future sublease income, were as follows (in thousands):
 
<TABLE>
       <S>                                                              <C>
       1999............................................................ $ 29,429
       2000............................................................   25,029
       2001............................................................   20,262
       2002............................................................   12,228
       2003............................................................   10,849
       Thereafter......................................................   46,198
                                                                        --------
                                                                        $143,995
                                                                        ========
</TABLE>
 
14. STOCKHOLDERS' EQUITY
 
  Preferred Stock
 
  The Company is authorized to issue up to 10,000,000 shares of preferred
stock, par value $0.10 per share ("Preferred Stock"). The Board of Directors
of Sterling Software has authorized the issuance of up to 1,250,000 shares of
Preferred Stock, designated as Series A Junior Participating Preferred Stock
("Series A Junior Preferred Stock"), pursuant to the terms of the Rights
Agreement dated as of December 18, 1996, as amended (the "Rights Plan"). The
Board of Directors of the Company is authorized, without action by the
stockholders, to issue Preferred Stock and fix for each series the number of
shares, designation, dividend rights, voting rights, redemption rights and
other rights.
 
  Increase in Authorized Common Stock
 
  On March 11, 1998, the Sterling Software stockholders approved an amendment
to the Company's Certificate of Incorporation increasing the number of
authorized shares of Common Stock from 75,000,000 shares to 125,000,000
shares.
 
  Rights Plan
 
  On December 18, 1996, the Board of Directors of the Company declared a
dividend distribution of one right (a "Right") for each share of Common Stock
outstanding at the close of business on December 31, 1996 (the "Record Date"),
pursuant to the terms of the Rights Plan. The Rights Plan also provides,
subject to specified exceptions and limitations, that shares of Common Stock
issued after the Record Date will be entitled to and accompanied by Rights.
Pursuant to the Rights Plan, one Right to purchase 1/100th of a share of
Series A Junior Preferred Stock (structured so as to be substantially the
equivalent of a share of Common Stock) is attached to each issued and
outstanding share of Common Stock. Subject to certain conditions, each Right
entitles the holder to purchase 1/100th of a share of Series A Junior
Preferred Stock at a price (the "Purchase Price") of $100.00 per 1/100th of a
share of Junior Preferred Stock (subject to adjustment).
 
  In general, the Rights will not become exercisable, or transferable apart
from the shares of Common Stock, unless a person or group of affiliated or
associated persons becomes the beneficial owner of, or commences a
 
                                      45
<PAGE>
 
tender offer that would result in beneficial ownership of, 15% or more of the
outstanding shares of Common Stock (any such person or group of persons being
referred to in the Rights Plan as an "Acquiring Person"). Thereafter, under
certain circumstances, each Right (other than any Rights that are or were
beneficially owned by an Acquiring Person, which Rights will be void) could
become exercisable to purchase at the Purchase Price a number of shares of
Common Stock (or, in certain circumstances, the common stock of a company into
which the Company is merged or consolidated or to which the Company sells all
or substantially all of its assets) having a market value equal to two times
the Purchase Price. The Rights will expire on December 31, 2006, unless
earlier redeemed by Sterling Software at a redemption price of $.01 per Right
(subject to adjustment), or otherwise exchanged or amended in accordance with
the terms of the Rights Plan.
 
  Stock Options and Warrants
 
  In May 1996 Sterling Software's stockholders approved the 1996 Stock Option
Plan. At September 30, 1998, 883,888 shares were reserved for future grants of
options under the 1996 Stock Option Plan. Options granted pursuant to the 1996
Stock Option Plan become exercisable generally at a rate of 25% per year and
expire either five or ten years from the date of grant, although options may
be granted with shorter vesting periods and shorter terms. Any tax benefit
associated with the exercise of options and warrants is credited to paid-in
capital.
 
  Options granted under previous Company option plans that were unexercised
with respect to 163,362 shares of Common Stock at the close of business on
September 30, 1996 were adjusted to thereafter be exercisable with respect to
415,900 shares at exercise prices ranging from $1.68 to $16.20 to preserve the
economic value of such options after the spin-off of Sterling Commerce. See
"Conversion adjustment" in the table below.
 
  Stock option transactions, restated to retroactively reflect the Stock Split
Dividend and the Synon Merger, are summarized below for the three years ended
September 30, 1998:
 
<TABLE>
<CAPTION>
                                        1998                 1997                  1996
                                 -------------------- -------------------- ---------------------
                                             WEIGHTED             WEIGHTED              WEIGHTED
                                             AVERAGE              AVERAGE               AVERAGE
                                             EXERCISE             EXERCISE              EXERCISE
                                  OPTIONS     PRICE    OPTIONS     PRICE     OPTIONS     PRICE
                                 ----------  -------- ----------  -------- -----------  --------
   <S>                           <C>         <C>      <C>         <C>      <C>          <C>
   Options outstanding at
    beginning of year, as
    previously reported........                                              8,085,731   $28.36
   Adjustment for the Stock
    Split Dividend.............                                              8,085,731
   Adjustment for pooling of
    interests with Synon.......                                                364,000    10.15
                                                                           -----------
   Options outstanding at
    beginning of year, as
    restated...................  18,686,785   $14.19     757,483   $ 9.63   16,535,462   $14.09
   Options assumed in the
    Mystech Merger.............     174,146    10.49
   Options granted.............     842,482    23.44  19,185,277    14.27    2,365,843    20.93
   Options exercised...........  (1,327,084)   13.48    (212,036)    6.87  (17,833,548)   14.92
   Options terminated and
    canceled...................    (635,611)   15.24  (1,043,939)   13.84     (562,812)   16.43
   Conversion adjustment.......                                                252,538
                                 ----------           ----------           -----------
   Options outstanding at end
    of year....................  17,740,718    14.61  18,686,785    14.19      757,483     9.63
                                 ==========           ==========           ===========
   Options exercisable at end
    of year....................  10,694,178    14.03   9,399,391    13.93      569,764     9.22
                                 ==========           ==========           ===========
   Options available for grant
    at end of year.............     883,888              971,090            15,500,000
                                 ==========           ==========           ===========
</TABLE>
 
                                      46
<PAGE>
 
  Information related to options outstanding at September 30, 1998 is
summarized below:
 
<TABLE>
<CAPTION>
                                OPTIONS OUTSTANDING                OPTIONS EXERCISABLE
                     ----------------------------------------- ---------------------------
                                    WEIGHTED
                                     AVERAGE
                                    REMAINING      WEIGHTED                    WEIGHTED
      RANGE OF                     CONTRACTUAL     AVERAGE                     AVERAGE
   EXERCISE PRICES     OPTIONS        LIFE      EXERCISE PRICE   OPTIONS    EXERCISE PRICE
   ---------------   ------------  -----------  -------------- ------------ --------------
   <S>               <C>          <C>           <C>            <C>          <C>
   $2.00--$13.63        2,564,985    7 Years        $13.19        1,681,241     $12.97
   $     13.64--
    $14.13             12,473,575    7 Years        $14.13        8,526,675     $14.13
   $     14.14--
    $30.06              2,702,158    5 Years        $18.19          486,262     $16.04
                     ------------                              ------------
                       17,740,718                                10,694,178
                     ============                              ============
</TABLE>
 
  During 1996, 620,194 warrants with an aggregate exercise price of
$10,734,659 were exercised for shares of Common Stock. Also in 1996, 165,300
warrants with an aggregate exercise price of $8,750,155 were canceled. At
September 30, 1998, 1997 and 1996, no warrants were outstanding.
 
  Employee Stock Purchase Plan
 
  In February 1998 Sterling Software's stockholders approved the Company's
Employee Stock Purchase Plan ("ESPP"). Under provisions of the ESPP, employees
can purchase Common Stock at a specified price through payroll deductions
during an offering period, currently established on a semi-annual basis. In
July 1998, approximately 340,000 shares were issued to employees under the
ESPP. At September 30, 1998, approximately $3,160,000 had been contributed by
employees that will be used to purchase shares at the end of the offering
period in December 1998. At September 30, 1998, the Company could issue up to
approximately 133,000 shares under the ESPP, based on withholdings through
September 30, 1998 and the Company's stock price at September 30, 1998.
 
  FAS 123
 
  FAS 123 requires disclosure of pro forma net earnings and net earnings per
common share information computed as if the Company had accounted for its
employee stock options granted subsequent to October 1, 1995 and the Company's
ESPP under the fair value method set forth in FAS 123. The fair value of the
Company's outstanding stock options was estimated at the date of grant using a
Black-Scholes option pricing model with the following weighted average
assumptions.
 
<TABLE>
<CAPTION>
                                                    YEARS ENDED SEPTEMBER 30
                                                    ------------------------
                                                     1998      1997      1996
                                                   --------  --------  --------
   <S>                                             <C>       <C>       <C>
   Expected option life in years..................      4.0       4.0       4.0
   Risk-free interest rate........................     5.59%     6.14%     5.74%
   Volatility factor..............................     0.40      0.40      0.40
</TABLE>
 
  The Company does not have a history of paying cash dividends and none have
been assumed in estimating the fair value of its options or rights under the
ESPP.
 
  The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because, among other things, changes in the subjective input assumptions can
materially affect the fair value estimate, in management's opinion, the
existing models do not necessarily provide a reliable measure of the fair
value of its employee stock options or ESPP participation rights. For purposes
of pro forma disclosures, the estimated fair value of the options and ESPP
participation rights is amortized to expense over the options' vesting periods
and the ESPP's semi-annual offering periods. In addition, because FAS 123 is
applicable only to options granted subsequent to October 1, 1995, the pro
forma information does not reflect the pro forma effect of all previous stock
option
 
                                      47
<PAGE>
 
grants of the Company. Therefore, the pro forma information is not necessarily
indicative of future results until FAS 123 is applied to all outstanding stock
options.
 
<TABLE>
<CAPTION>
                                                    YEARS ENDED SEPTEMBER 30
                                                   ---------------------------
                                                    1998     1997       1996
                                                   ------- ---------  --------
   <S>                                             <C>     <C>        <C>
   Pro forma net income (loss).................... $64,658 $(172,864) $227,556
   Pro forma net income (loss) per share:
     Basic........................................ $   .80 $   (2.17) $   3.38
     Diluted...................................... $   .76 $   (2.17) $   3.10
   Weighted average fair value of options granted
    during the year............................... $  9.24 $    6.00  $   3.29
</TABLE>
 
15. POSTRETIREMENT BENEFITS
 
  The Company has a plan to provide retirement benefits under the provisions
of Section 401(k) of the Code for full time employees and for part time
employees who have completed a specified term of service. Pursuant to this
plan, eligible participants may elect to contribute a percentage of their
annual gross compensation and the Company will contribute additional amounts,
as provided by the plan. Benefits under the plan are limited to the assets of
the plan. Company contributions charged to expense during 1998, 1997 and 1996
were $3,908,000, $2,829,000 and $2,315,000, respectively. One-half of the
Company's contributions are invested in Common Stock. Effective October 1,
1996, the portion of the plan consisting of the Company's contributions was
designated as an employee stock ownership plan. During 1998, 1997 and 1996,
the investment of the Company's contributions included 102,407, 39,542 and
39,330 shares of Common Stock, respectively.
 
16. CHANGE-IN-CONTROL AND EMPLOYMENT ARRANGEMENTS
 
  As of September 30, 1998, the Company had change-in-control agreements with
21 of its current or former officers providing for payments based on the
individual officer's respective cash compensation and/or benefits if there is
a change in control (as defined) in the Company and termination of employment
occurs. The change-in-control agreements further provide that the Company will
make certain payments to each individual party thereto to compensate such
individual for the economic effect of such individual's liability to pay
excise taxes to the extent that payments received by such individual, pursuant
to the change-in-control agreement, stock option agreements or otherwise, are
considered as "contingent on a change in ownership or control" under
Section 280G of the Code (each, a "Tax Payment"). Based on certain
assumptions, at September 30, 1998, the Company's maximum liability for cash
compensation, benefits and Tax Payments under these agreements was estimated
to be approximately $45,000,000. The Company's actual liability, if any, under
these agreements will depend on a number of factors, including the level of
salaries, bonuses and benefits being received by the then covered individuals
prior to a change in control and the price at which any change-in-control
transaction occurs.
 
  As of September 30, 1998, the Company had entered into severance agreements
with 13 of its officers providing for payments based on the individual
officer's respective cash compensation and continuation of benefits if the
Company terminates the officer's employment. In addition, the Company has
entered into an agreement with one executive officer that provides for an
annual base salary plus agreed-upon bonuses and benefits and converts to a
consulting agreement upon the occurrence of certain events. The Company has
also entered into a consulting agreement with one of its directors that
provides for termination payments, based on the director's consulting
compensation, upon the occurrence of certain events. At September 30, 1998,
the Company's maximum estimated liability for future salaries, fees, bonuses
and benefits under these agreements was approximately $15,000,000.
 
                                      48
<PAGE>
 
17. QUARTERLY FINANCIAL RESULTS (UNAUDITED)
 
  The Company's consolidated operating results for each quarter of 1998 and
1997 are summarized below (in thousands, except per share data). The Company's
financial statement for periods prior to the Synon Merger represent the
combined financial statements of the previously separate entities:
 
<TABLE>
<CAPTION>
                                               THREE MONTHS ENDED
                                   --------------------------------------------
                                   DECEMBER 31 MARCH 31  JUNE 30   SEPTEMBER 30
                                   ----------- -------- ---------  ------------
<S>                                <C>         <C>      <C>        <C>
Year ended September 30, 1998:
  Revenue
    Products......................  $ 65,917   $ 71,078 $  72,592    $ 81,668
    Product support...............    45,910     45,656    46,425      45,640
    Services......................    57,052     60,850    61,774      65,381
                                    --------   -------- ---------    --------
                                     168,879    177,584   180,791     192,689
  Cost of sales
    Products and product support..    18,072     16,991    17,007      19,159
    Services......................    51,108     53,513    54,708      57,108
                                    --------   -------- ---------    --------
                                      69,180     70,504    71,715      76,267
  Product development and
   enhancement....................    10,608      9,410     8,090       8,054
  Selling, general and
   administrative.................    69,004     67,993    66,407      61,046
  Reorganization costs............                                     45,162
  Income from continuing
   operations.....................    17,322     23,916    27,211       7,595
  Weighted average common shares
   outstanding....................    79,785     80,015    80,650      82,075
  Income per common share:
    Net income:
      Basic.......................  $    .22   $    .30 $     .34    $    .09
      Diluted.....................       .21        .28       .32         .09
Year ended September 30, 1997:
  Revenue
    Products......................  $ 44,603   $ 52,052 $  57,433    $ 80,152
    Product support...............    35,813     34,533    34,405      46,135
    Services......................    39,200     38,635    41,718      64,523
                                    --------   -------- ---------    --------
                                     119,616    125,220   133,556     190,810
  Cost of sales
    Products and product support..    18,935     21,252    20,054      19,208
    Services......................    33,018     32,852    36,435      54,982
                                    --------   -------- ---------    --------
                                      51,953     54,104    56,489      74,190
  Product development and
   enhancement....................     6,437      6,491     6,236      10,495
  Selling, general and
   administrative.................    50,301     51,178    53,281      76,425
  Reorganization costs............                        106,037
  Purchased research and
   development....................                        137,849
  Income (loss) from continuing
   operations.....................    14,363     15,283  (185,433)     23,890
  Weighted average common shares
   outstanding....................    79,477     79,530    79,666      79,699
  Income (loss) per common share:
    Net income (loss):
      Basic.......................  $    .18   $    .19 $   (2.33)   $    .30
      Diluted.....................       .18        .19     (2.33)        .29
</TABLE>
 
                                      49
<PAGE>
 
  Information concerning the Company's operations by business segment for each
quarter of 1998, 1997 and 1996 is set forth below (in thousands):
 
<TABLE>
<CAPTION>
                                              THREE MONTHS ENDED
                                  ---------------------------------------------
                                  DECEMBER 31 MARCH 31   JUNE 30   SEPTEMBER 30
                                  ----------- --------  ---------  ------------
<S>                               <C>         <C>       <C>        <C>
Year ended September 30, 1998:
 Revenue:
  Application Management.........  $ 92,525   $ 91,365  $  93,649    $ 88,474
  Systems Management.............    42,061     50,314     49,983      62,171
  Federal Systems................    33,665     35,905     37,159      42,044
  Corporate and other............       628
                                   --------   --------  ---------    --------
    Consolidated totals..........  $168,879   $177,584  $ 180,791    $192,689
                                   ========   ========  =========    ========
 Operating Profit (Loss):
  Application Management.........  $ 11,809   $ 16,591  $  20,418    $ 27,163
  Systems Management.............    13,838     18,680     19,524      25,295
  Federal Systems................     2,239      2,468      2,412       2,792
  Reorganization costs...........                                     (45,162)
  Corporate and other............    (7,799)    (8,062)    (7,775)     (7,928)
                                   --------   --------  ---------    --------
    Consolidated totals..........  $ 20,087   $ 29,677  $  34,579    $  2,160
                                   ========   ========  =========    ========
Year ended September 30, 1997:
 Revenue:
  Application Management.........  $ 44,427   $ 40,310  $  41,327    $ 97,102
  Systems Management.............    36,950     43,916     46,045      57,768
  Federal Systems................    27,858     27,954     30,919      35,059
  Corporate and other............    10,381     13,040     15,265         881
                                   --------   --------  ---------    --------
    Consolidated totals..........  $119,616   $125,220  $ 133,556    $190,810
                                   ========   ========  =========    ========
 Operating Profit (Loss):
  Application Management.........  $  4,408   $  3,120  $   3,522    $ 12,697
  Systems Management.............    12,889     17,099     18,530      22,111
  Federal Systems................     2,395      2,303      1,826       2,165
  Reorganization costs...........                        (106,037)
  Purchased research and
   development...................                        (137,849)
  Corporate and other............    (8,767)    (9,075)    (6,328)     (7,273)
                                   --------   --------  ---------    --------
    Consolidated totals..........  $ 10,925   $ 13,447  $(226,336)   $ 29,700
                                   ========   ========  =========    ========
Year ended September 30, 1996:
 Revenue:
  Application Management.........  $ 47,393   $ 45,244  $  46,838    $ 44,919
  Systems Management.............    35,210     40,969     42,558      52,067
  Federal Systems................    26,262     26,815     27,553      31,558
  Corporate and other............     8,054     10,585     12,191      15,545
                                   --------   --------  ---------    --------
    Consolidated totals..........  $116,919   $123,613  $ 129,140    $144,089
                                   ========   ========  =========    ========
 Operating Profit (Loss):
  Application Management.........  $  6,702   $  3,912  $   6,163    $  2,017
  Systems Management.............    11,625     15,535     16,389      22,309
  Federal Systems................     2,300      1,816      2,038       1,828
  Corporate and other............    (7,778)    (7,769)    (8,201)     (5,726)
                                   --------   --------  ---------    --------
    Consolidated totals..........  $ 12,849   $ 13,494  $  16,389    $ 20,428
                                   ========   ========  =========    ========
</TABLE>
 
                                       50
<PAGE>
 
18. SUBSEQUENT EVENTS
 
  On October 26, 1998, Sterling Software acquired Cayenne Software, Inc.
("Cayenne"), a global supplier of analysis and design solutions for
application and database development, in a cash transaction valued at
approximately $11,400,000. The acquisition will be accounted for in accordance
with the purchase method of accounting and, accordingly, the results of
operations of Cayenne will be included in the Company's results of operations
from the date of the acquisition and will be reported under the application
management business segment. The Company expects to incur non-recurring
charges to operations in the first quarter of 1999, currently estimated to
aggregate between $25,000,000 and $40,000,000, primarily related to the
reorganization of the Company's operations and the write-off of purchased
research and development costs in connection with the acquisition.
 
 
                                      51
<PAGE>
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
 
  None.
                                   PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
 
  Information concerning the directors of the Company will be set forth in the
Proxy Statement to be provided to stockholders in connection with the
Company's 1999 Annual Meeting of Stockholders (the "Proxy Statement") under
the heading "Proposal I--Election of Directors", which information is
incorporated herein by reference. Information concerning compliance with
Section 16 of the Securities Exchange Act of 1934, as amended, by persons
subject to such Section will be forth in the Proxy Statement under the heading
"Section 16(a) Beneficial Ownership Reporting Compliance", which information
is incorporated herein by reference. The name, age and position of each
executive officer of the Company is set forth under the heading "Executive
Officers" in Part I of this report, which information is incorporated herein
by reference.
 
ITEM 11. EXECUTIVE COMPENSATION.
 
  Information concerning executive compensation will be set forth in the Proxy
Statement under the headings "Management Compensation" and "Proposal I--
Election of Directors", which information is incorporated herein by reference.
Information contained in the Proxy Statement under the caption "Management
Compensation--Report of the Executive and Stock Option Committees on Executive
Compensation" and "--Stock Performance Chart" is not incorporated by reference
herein.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
 
  Information concerning security ownership of certain beneficial owners and
management will be set forth in the Proxy Statement under the heading
"Security Ownership of Management and Certain Stockholders", which information
is incorporated herein by reference.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
 
  Information concerning certain relationships and related transactions will
be set forth in the Proxy Statement under the headings "Management
Compensation--Executive and Stock Option Committee Interlocks and Insider
Participation" and "Certain Transactions", which information is incorporated
herein by reference.
 
                                      52
<PAGE>
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
 
  (a) The following documents are filed as a part of this Annual Report on Form
10-K.
 
  1. Consolidated Financial Statements:
 
    See Index to Consolidated Financial Statements at Item 8.
 
  2. Consolidated Financial Statement Schedule:
 
    Schedule II--Valuation and Qualifying Accounts for the Years Ended
  September 30, 1998, 1997 and 1996.
 
  3. Exhibits:
 
<TABLE>
   <C>  <S>
    2.1 Asset Purchase Agreement, dated April 18, 1997, by and between Texas
        Instruments Incorporated and the Company (1), (2)
    2.2 Amendment No. 1 to Asset Purchase Agreement, dated June 19, 1997, by
        and between Texas Instruments Incorporated, the Company and certain
        subsidiaries of the Company, and Amendment No. 2 to Asset Purchase
        Agreement, dated June 28, 1997, by and between Texas Instruments
        Incorporated, the Company and certain subsidiaries of the Company (3)
    2.3 Agreement and Plan of Merger, dated as of May 27, 1998, among the
        Company, Sterling Software (Connecticut), Inc. and Mystech Associates,
        Inc. (2), (4)
    2.4 Agreement and Plan of Merger, dated as of June 20, 1998, among the
        Company, Sterling Software (Southern), Inc. and Synon Corporation (2),
        (5)
    2.5 Agreement and Plan of Merger, dated as of August 27, 1998, among the
        Company, Sterling Software (Southern), Inc. and Cayenne Software, Inc.
        (2), (22)
    3.1 Certificate of Incorporation of the Company, as amended (6)
    3.2 Restated Bylaws of the Company (7)
    4.1 Form of Common Stock Certificate (8)
    4.2 Rights Agreement, dated December 18, 1996, by and between the Company
        and The First National Bank of Boston, as Rights Agent (9)
    4.3 First Amendment to Rights Agreement, dated as of March 12, 1998, by and
        between the Company and BankBoston, N.A., as Rights Agent (10)
   10.1 Supplemental Executive Retirement Plan II of Informatics General
        Corporation ("SERP II"), as amended by Amendment to SERP II (11), (12)
   10.2 Sterling Software, Inc. Amended and Restated Employee Stock Purchase
        Plan (effective as of March 20, 1998) (6), (12)
   10.3 Sterling Software, Inc. Deferred Compensation Plan (restated effective
        November 21, 1997) (12), (21)
   10.4 Sterling Software, Inc. Amended and Restated 1996 Stock Option Plan
        (12), (13)
   10.5 Form of Stock Option Agreement between the Company and each of Sam Wyly
        and Charles J. Wyly, Jr. (12), (14)
   10.6 Form of Stock Option Agreement between the Company and Sterling L.
        Williams (12), (14)
   10.7 Form of Stock Option Agreement between the Company and Geno P. Tolari
        (12), (14)
   10.8 Form of Stock Option Agreement between the Company and Jeannette P.
        Meier (12), (14)
   10.9 Form of Amendment to Stock Option Agreement, dated March 20, 1998,
        between the Company and each of its executive officers (6), (12)
</TABLE>
 
                                       53
<PAGE>
 
<TABLE>
   <C>   <S>
   10.10 Fiscal 1998 Executive Compensation Plan for Group Presidents (12),
         (14)
   10.11 Fiscal 1999 Executive Compensation Plan for Group Presidents (12),
         (21)
   10.12 Employment Agreement, dated September 30, 1998, between the Company
         and Jeannette P. Meier (12), (21)
   10.13 Consulting Agreement, dated October 1, 1996, between the Company and
         Michael C. French (12), (15)
   10.14 CEO Agreement, dated February 12, 1996, between the Company and
         Sterling L. Williams (12), (16)
   10.15 Amendment to CEO Agreement, dated May 31, 1998, between the Company
         and Sterling L. Williams (12), (21)
   10.16 Form of Change-in-Control Severance Agreement, dated February 12,
         1996, between the Company and each of Sam Wyly, Charles J. Wyly, Jr.,
         Sterling L. Williams and Geno P. Tolari (12), (16)
   10.17 Form of Amendment to Change-in-Control Severance Agreement, dated June
         18, 1996, between the Company and each of Sam Wyly, Charles J. Wyly,
         Jr., Sterling L. Williams and Geno P. Tolari (12), (17)
   10.18 Form of Severance Agreement, dated February 12, 1996, between the
         Company and Geno P. Tolari (12), (16)
   10.19 Form of Amendment to Severance Agreement, dated August 15, 1997,
         between the Company and Geno P. Tolari (12), (14)
   10.20 Form of Indemnity Agreement between the Company and each of its
         directors and officers (11)
   10.21 Third Amended and Restated Revolving Credit Agreement, dated July 1,
         1997, by and among the Company, BankBoston, N.A. and Bank One, Texas,
         National Association and BankBoston, N.A. as agent for itself and Bank
         One, Texas, National Association (18)
   10.22 Tax Allocation Agreement, dated March 4, 1996, between the Company and
         Sterling Commerce, Inc. (19)
   10.23 Indemnification Agreement, dated March 4, 1996, between the Company
         and Sterling Commerce, Inc. (20)
   10.24 Agreement dated September 19, 1996 by Sterling Commerce, Inc. for the
         benefit of the Company (15)
   21.1  Subsidiaries of the Company (21)
   23.1  Consent of Ernst & Young LLP (21)
   27.1  Financial Data Schedule (21)
</TABLE>
--------
 (1) Previously filed as an exhibit to the Company's Quarterly Report on Form
     10-Q for the quarter ended March 31, 1997 and incorporated herein by
     reference (SEC File No. 97605952).
 (2)  In accordance with Item 601 of Regulation S-K, the schedules and
      exhibits relating to the agreement have been omitted. The Company will
      furnish supplementally to the Securities and Exchange Commission such
      schedules and exhibits upon request.
 (3) Previously filed as an exhibit to the Company's Current Report on Form 8-
     K dated June 30, 1997, as amended, and incorporated herein by reference
     (SEC File No. 97633732).
 (4) Previously filed as Appendix A to the Proxy Statement/Prospectus forming
     a part of the Company's Registration Statement No. 333-53747 and
     incorporated herein by reference (SEC File No. 98632583).
 (5) Previously filed as an exhibit to the Company's Current Report on Form 8-
     K dated June 21, 1998 and incorporated herein by reference (SEC File No.
     98652676).
 
                                      54
<PAGE>
 
 (6) Previously filed as an exhibit to the Company's Quarterly Report on Form
     10-Q for the quarter ended March 31, 1998 and incorporated herein by
     reference (SEC File No. 98602908).
 (7) Previously filed as an exhibit to the Company's Registration Statement
     No. on Form 8-A/A filed on May 27, 1998 and incorporated herein by
     reference (SEC File No. 98632257).
 (8) Previously filed as an exhibit to the Company's Registration Statement
     No. 2-86825 and incorporated herein by reference (SEC File No. S766400).
 (9) Previously filed as an exhibit to the Company's Current Report on Form 8-
     K dated December 18, 1996 and incorporated herein by reference (SEC File
     No. 96682898).
(10) Previously filed as an exhibit to the Company's Registration Statement
     No. on Form 8-A/A filed April 3, 1998 and incorporated herein by
     reference (SEC File No. 98587026).
(11) Previously filed as an exhibit to the Company's Annual Report on Form 10-
     K for the fiscal year ended September 30, 1993 and incorporated herein by
     reference (SEC File No. 93278187).
(12) Management contract or compensatory plan or arrangement required to be
     filed as an exhibit to this form pursuant to Item 14(c) of Form 10-K.
(13) Previously filed as an exhibit to the Company's Registration Statement
     No. 333-13303 and incorporated herein by reference (SEC File No.
     96638532).
(14) Previously filed as an exhibit to the Company's Annual Report on Form 10-
     K for the fiscal year ended September 30, 1997 and incorporated herein by
     reference (SEC File No. 97724719).
(15) Previously filed as an exhibit to the Company's Annual Report on Form 10-
     K for the fiscal year ended September 30, 1996 and incorporated herein by
     reference (SEC File No. 96672084).
(16) Previously filed as an exhibit to the Company's Quarterly Report on Form
     10-Q for the quarter ended March 31, 1996 and incorporated herein by
     reference (SEC File No. 96560921).
(17) Previously filed as an exhibit to the Company's Quarterly Report on Form
     10-Q for the quarter ended June 30, 1996 and incorporated herein by
     reference (SEC File No. 96609257).
(18) Previously filed as an exhibit to the Company's Quarterly Report on Form
     10-Q for the quarter ended June 30, 1997 and incorporated herein by
     reference (SEC File No. 97660034).
(19) Previously filed as an exhibit to Registration Statement No. 33-80595
     filed by Sterling Commerce, Inc. and incorporated herein by reference
     (File/ID #001-14196, SEC File No. 96042701).
(20) Previously filed as an exhibit to the Quarterly Report on Form 10-Q for
     the quarter ended March 31, 1996 filed by Sterling Commerce, Inc. and
     incorporated herein by reference (File ID #001-14196, SEC File
     No. 96560893).
(21) Filed herewith.
(22) Previously filed as an exhibit to the Current Report on Form 8-K dated
     August 27, 1998 filed by Cayenne Software, Inc. and incorporated herein
     by reference (File ID #000-19682, SEC File No. 98700698).
 
   (b) Reports on Form 8-K.
 
   None.
 
                                      55
<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.
 
                                          STERLING SOFTWARE, INC.
 
Date: November 17, 1998                          /s/ Sterling L. Williams
                                          By __________________________________
                                              Sterling L. Williams President,
                                                Chief Executive Officer and
                                               Director (Principal Executive
                                                         Officer)
 
Date: November 17, 1998                              /s/ R. Logan Wray
                                          _____________________________________
                                                 R. Logan Wray Senior Vice
                                               President and Chief Financial
                                             Officer (Principal Financial and
                                                    Accounting Officer)
 
                                      56
<PAGE>
 
  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.
 
 
 
Date: November 17, 1998                           /s/ Robert J. Donachie
                                          -------------------------------------
                                                    Robert J. Donachie
                                                         Director
 
Date: November 17, 1998                            /s/ Michael C. French
                                          -------------------------------------
                                                     Michael C. French
                                                         Director
 
Date: November 17, 1998                            /s/ Phillip A. Moore
                                          -------------------------------------
                                                     Phillip A. Moore
                                                         Director
 
Date: November 17, 1998                          /s/ Charles J. Wyly, Jr.
                                          -------------------------------------
                                                   Charles J. Wyly, Jr.
                                              Vice Chairman of the Board and
                                                         Director
 
Date: November 17, 1998                              /s/ Evan A. Wyly
                                          -------------------------------------
                                                       Evan A. Wyly
                                                         Director
 
Date: November 17, 1998                          /s/ Donald R. Miller, Jr.
                                          -------------------------------------
                                                   Donald R. Miller, Jr.
                                                         Director
 
Date: November 17, 1998                            /s/ Alan W. Steelman
                                          -------------------------------------
                                                     Alan W. Steelman
                                                         Director
 
Date: November 17, 1998                          /s/ Sterling L. Williams
                                          -------------------------------------
                                                   Sterling L. Williams
                                            President, Chief Executive Officer
                                                       and Director
                                               (Principal Executive Officer)
 
Date: November 17, 1998                                /s/ Sam Wyly
                                          -------------------------------------
                                                         Sam Wyly
                                            Chairman of the Board and Director
 
                                       57
<PAGE>
 
                                                                    SCHEDULE II
 
                            STERLING SOFTWARE, INC.
                       VALUATION AND QUALIFYING ACCOUNTS
                 YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996
 
<TABLE>
<CAPTION>
                                            ADDITIONS
                                    --------------------------
                                                 CHARGED TO
                        BALANCE AT  CHARGED TO      OTHER                      BALANCE AT
                         BEGINNING  COSTS AND    ACCOUNTS--     DEDUCTIONS--     END OF
                         OF PERIOD   EXPENSES     DESCRIBE        DESCRIBE       PERIOD
                        ----------- ---------- --------------- --------------- -----------
<S>                     <C>         <C>        <C>             <C>             <C>
Allowance for doubtful
 accounts at September
 30, 1996.............. $ 8,640,000 $6,879,000 $(1,998,000)(1) $(5,575,000)(2) $ 7,946,000
                        =========== ========== =============== =============== ===========
Allowance for doubtful
 accounts at September
 30, 1997.............. $ 7,946,000 $5,191,000 $  4,436,000(3) $(3,387,000)(2) $14,186,000
                        =========== ========== =============== =============== ===========
Allowance for doubtful
 accounts at September
 30, 1998.............. $14,186,000 $5,157,000 $  2,048,000(1) $(4,268,000)(2) $17,123,000
                        =========== ========== =============== =============== ===========
</TABLE>
--------
(1) Offsets to deferred revenue.
(2) Accounts written off.
(3) Offsets to deferred revenue and allowances for doubtful accounts acquired
    in the acquisition of the Software Division of Texas Instruments
    Incorporated.
<PAGE>
 
 
 
 
 
 
                                                                     1490-10K-98
<PAGE>
 
                               INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
 EXHIBIT
   NO.                                 DESCRIPTION
 -------                               -----------
 <C>     <S>
  2.1    Asset Purchase Agreement, dated April 18, 1997, by and between Texas
         Instruments Incorporated and the Company (1), (2)
  2.2    Amendment No. 1 to Asset Purchase Agreement, dated June 19, 1997, by
         and between Texas Instruments Incorporated, the Company and certain
         subsidiaries of the Company, and Amendment No. 2 to Asset Purchase
         Agreement, dated June 28, 1997, by and between Texas Instruments
         Incorporated, the Company and certain subsidiaries of the Company (3)
  2.3    Agreement and Plan of Merger, dated as of May 27, 1998, among the
         Company, Sterling Software (Connecticut), Inc. and Mystech Associates,
         Inc. (2), (4)
  2.4    Agreement and Plan of Merger, dated as of June 20, 1998, among the
         Company, Sterling Software (Southern), Inc. and Synon Corporation (2),
         (5)
  2.5    Agreement and Plan of Merger, dated as of August 27, 1998, among the
         Company, Sterling Software (Southern), Inc. and Cayenne Software, Inc.
         (2), (22)
  3.1    Certificate of Incorporation of the Company, as amended (6)
  3.2    Restated Bylaws of the Company (7)
  4.1    Form of Common Stock Certificate (8)
  4.2    Rights Agreement, dated December 18, 1996, by and between the Company
         and The First National Bank of Boston, as Rights Agent (9)
  4.3    First Amendment to Rights Agreement, dated as of March 12, 1998, by
         and between the Company and BankBoston, N.A., as Rights Agent (10)
 10.1    Supplemental Executive Retirement Plan II of Informatics General
         Corporation ("SERP II"), as amended by Amendment to SERP II (11), (12)
 10.2    Sterling Software, Inc. Amended and Restated Employee Stock Purchase
         Plan (effective as of March 20, 1998) (6), (12)
 10.3    Sterling Software, Inc. Deferred Compensation Plan (restated effective
         November 21, 1997) (12), (21)
 10.4    Sterling Software, Inc. Amended and Restated 1996 Stock Option Plan
         (12), (13)
 10.5    Form of Stock Option Agreement between the Company and each of Sam
         Wyly and Charles J. Wyly, Jr. (12), (14)
 10.6    Form of Stock Option Agreement between the Company and Sterling L.
         Williams (12), (14)
 10.7    Form of Stock Option Agreement between the Company and Geno P. Tolari
         (12), (14)
 10.8    Form of Stock Option Agreement between the Company and Jeannette P.
         Meier (12), (14)
 10.9    Form of Amendment to Stock Option Agreement, dated March 20, 1998,
         between the Company and each of its executive officers (6), (12)
 10.10   Fiscal 1998 Executive Compensation Plan for Group Presidents (12),
         (14)
 10.11   Fiscal 1999 Executive Compensation Plan for Group Presidents (12),
         (21)
 10.12   Employment Agreement, dated September 30, 1998, between the Company
         and Jeannette P. Meier (12), (21)
 10.13   Consulting Agreement, dated October 1, 1996, between the Company and
         Michael C. French (12), (15)
 10.14   CEO Agreement, dated February 12, 1996, between the Company and
         Sterling L. Williams (12), (16)
 10.15   Amendment to CEO Agreement, dated May 31, 1998, between the Company
         and Sterling L. Williams (12), (21)
</TABLE>
<PAGE>
 
<TABLE>
<S>    <C>
10.16  Form of Change-in-Control Severance Agreement, dated February 12, 1996, between the Company and each
       of Sam Wyly, Charles J. Wyly, Jr., Sterling L. Williams and Geno P. Tolari (12), (16)
10.17  Form of Amendment to Change-in-Control Severance Agreement, dated June 18, 1996, between the Company
       and each of Sam Wyly, Charles J. Wyly, Jr., Sterling L. Williams and Geno P. Tolari (12), (17)
10.18  Form of Severance Agreement, dated February 12, 1996, between the Company and Geno P. Tolari (12),
       (16)
10.19  Form of Amendment to Severance Agreement, dated August 15, 1997, between the Company and Geno P.
       Tolari (12), (14)
10.20  Form of Indemnity Agreement between the Company and each of its directors and officers (11)
10.21  Third Amended and Restated Revolving Credit Agreement, dated July 1, 1997, by and among the Company,
       BankBoston, N.A. and Bank One, Texas, National Association and BankBoston, N.A. as agent for itself
       and Bank One, Texas, National Association (18)
10.22  Tax Allocation Agreement, dated March 4, 1996, between the Company and Sterling Commerce, Inc. (19)
10.23  Indemnification Agreement, dated March 4, 1996, between the Company and Sterling Commerce, Inc. (20)
10.24  Agreement dated September 19, 1996 by Sterling Commerce, Inc. for the benefit of the Company (15)
21.1   Subsidiaries of the Company (21)
23.1   Consent of Ernst & Young LLP (21)
27.1   Financial Data Schedule (21)
</TABLE>
--------
 (1) Previously filed as an exhibit to the Company's Quarterly Report on Form
     10-Q for the quarter ended March 31, 1997 and incorporated herein by
     reference (SEC File No. 97605952).
 (2) In accordance with Item 601 of Regulation S-K, the schedules and exhibits
     relating to the agreement have been omitted. The Company will furnish
     supplementally to the Securities and Exchange Commission such schedules
     and exhibits upon request.
 (3) Previously filed as an exhibit to the Company's Current Report on Form 8-
     K dated June 30, 1997, as amended, and incorporated herein by reference
     (SEC File No. 97633732).
 (4) Previously filed as Appendix A to the Proxy Statement/Prospectus forming
     a part of the Company's Registration Statement No. 333-53747 and
     incorporated herein by reference (SEC File No. 98632583).
 (5) Previously filed as an exhibit to the Company's Current Report on Form 8-
     K dated June 21, 1998 and incorporated herein by reference (SEC File No.
     98652676).
 (6) Previously filed as an exhibit to the Company's Quarterly Report on Form
     10-Q for the quarter ended March 31, 1998 and incorporated herein by
     reference (SEC File No. 98602908).
 (7) Previously filed as an exhibit to the Company's Registration Statement
     No. on Form 8-A/A filed on May 27, 1998 and incorporated herein by
     reference (SEC File No. 98632257).
 (8) Previously filed as an exhibit to the Company's Registration Statement
     No. 2-86825 and incorporated herein by reference (SEC File No. S766400).
 (9) Previously filed as an exhibit to the Company's Current Report on Form 8-
     K dated December 18, 1996 and incorporated herein by reference (SEC File
     No. 96682898).
(10) Previously filed as an exhibit to the Company's Registration Statement
     No. on Form 8-A/A filed April 3, 1998 and incorporated herein by
     reference (SEC File No. 98587026).
(11) Previously filed as an exhibit to the Company's Annual Report on Form 10-
     K for the fiscal year ended September 30, 1993 and incorporated herein by
     reference (SEC File No. 93278187).
<PAGE>
 
(12) Management contract or compensatory plan or arrangement required to be
     filed as an exhibit to this form pursuant to Item 14(c) of Form 10-K.
(13) Previously filed as an exhibit to the Company's Registration Statement
     No. 333-13303 and incorporated herein by reference (SEC File No.
     96638532).
(14) Previously filed as an exhibit to the Company's Annual Report on Form 10-
     K for the fiscal year ended September 30, 1997 and incorporated herein by
     reference (SEC File No. 97724719).
(15) Previously filed as an exhibit to the Company's Annual Report on Form 10-
     K for the fiscal year ended September 30, 1996 and incorporated herein by
     reference (SEC File No. 96672084).
(16) Previously filed as an exhibit to the Company's Quarterly Report on Form
     10-Q for the quarter ended March 31, 1996 and incorporated herein by
     reference (SEC File No. 96560921).
(17) Previously filed as an exhibit to the Company's Quarterly Report on Form
     10-Q for the quarter ended June 30, 1996 and incorporated herein by
     reference (SEC File No. 96609257).
(18) Previously filed as an exhibit to the Company's Quarterly Report on Form
     10-Q for the quarter ended June 30, 1997 and incorporated herein by
     reference (SEC File No. 97660034).
(19) Previously filed as an exhibit to Registration Statement No. 33-80595
     filed by Sterling Commerce, Inc. and incorporated herein by reference
     (File/ID #001-14196, SEC File No. 96042701).
(20) Previously filed as an exhibit to the Quarterly Report on Form 10-Q for
     the quarter ended March 31, 1996 filed by Sterling Commerce, Inc. and
     incorporated herein by reference (File ID #001-14196, SEC File
     No. 96560893).
(21) Filed herewith.
(22) Previously filed as an exhibit to the Current Report on Form 8-K dated
     August 27, 1998 filed by Cayenne Software, Inc. and incorporated herein
     by reference (File ID #000-19682, SEC File No. 98700698).