<PAGE>
 
                    U.S. SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                  FORM 10-KSB

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

        For the fiscal year ended May 31, 1998

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

                          Commission File No. 0-16250

                                 DYNATEM, INC.
                 (Name of small business issuer in its charter)

             California                             95-3627099
    -------------------------------              ----------------
    (State or other jurisdiction of              (I.R.S. Employer
     incorporation or organization)             Identification No.)

23263 Madero, Suite C
Mission Viejo, California                             92691
---------------------------------------          ---------------              
(Address of principal executive offices)           (Zip Code)

Issuer's telephone number: (949) 855-3235

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

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

   Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 [_]

   Check if there is no disclosure of delinquent filers in response to Item 405
of Regulation S-B contained in this form, and no disclosure will 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-KSB or any
amendment to this Form 10-KSB.  [X]

   The issuer's revenues for its most recent fiscal year were $1,685,512.


   The aggregate market value of voting stock held by nonaffiliates of the
registrant was $382,003 on August 1, 1998.


   On August 1, 1998, there were 1,418,400 shares of the issuer's Common Stock
outstanding.


                      DOCUMENTS INCORPORATED BY REFERENCE


Portions of the issuer's Definitive Proxy Statement to be filed for its Annual
Meeting of Shareholders to be held on October  7, 1998, are incorporated herein
by reference into Part III hereof, to the extent indicated herein.


Transitional Small Business Disclosure Format  Yes [_]  No [X]
<PAGE>
 
                                     PART I
                                     ------

Item 1. Description of Business.
------- ------------------------

History
-------

Dynatem, Inc. (the "Company" or "Dynatem") was incorporated on May 15, 1981,
under the laws of the State of California.  It was organized to design,
manufacture and market microcomputers and microcomputer-based systems and
software for industrial applications such as factory automation, sensor
monitoring, process control, robots, data acquisition, networking and displays.
The Company commenced manufacturing and marketing operations in May 1981 and has
conducted such operations continuously from such date.  As part of such
operations, the Company was, until October 1984, an authorized dealer of certain
modular board level computer products manufactured by Rockwell International
corporation.  In October 1984 the Company entered into an agreement with
Rockwell pursuant to which the Company was licensed to manufacture these
products.

In 1987, the Company began concentrating its design efforts to develop a range
of products compatible with the VMEbus.  In order to further expand the product
offering, Dynatem entered in Agreements to resell the VMEbus products of other
vendors, complimentary to the Company's products.  This allowed the Company to
more easily integrate complete embedded systems. In 1996, the Company began
concentrating most of its design effort in the development of VMEbus systems
based on the x86 family of processors. The Company was able to combine the broad
range of relatively inexpensive components and software found in desktop PC
compatible systems, with the high performance, flexibility and stability of the
VMEbus.  To accompany the new x86 hardware, it has been equally important for
the Company to develop software drivers that could enable popular Desktop
operating systems to operate across the VMEbus.  In fact, the ability to run
Windows NT in VMEbus systems has been their major appeal.  In this way, embedded
system designers can combine user friendly Windows NT, with its huge range of
software applications, on the same backplane with dedicated high-speed real-time
operating systems.

A new area of design effort has been the development of expansion cards
compatible with the PMC (PCI Mezzanine Card) standard.  This enables adding
functionality to VMEbus x86 processor boards by expansion via the local PCI bus.
The Company currently designs, manufactures, distributes and markets more than
100 products including microcomputers, microcomputer systems, microcomputer
modules, software and peripherals and markets such products and other licensed
products individually or as components of a system.

Market
------

The Company markets its products on a worldwide basis and its customers include
many Fortune 100 corporations.  Included among the export markets are the United
Kingdom, Germany, and Japan.  For the year ended May 31, 1998, export sales
accounted for 38% of the Company's net sales.

For the last two fiscal years the export net sales and the percentage to total
net sales were:

<TABLE> 
<CAPTION> 
        Year     Amount      % of Total Net Sales
        ----     --------    ---------------------------
        <S>      <C>         <C> 
        1998     $639,797            38% 
        1997     $770,780            32%
</TABLE> 

                                       2
<PAGE>
 
Products
--------

The Company's products generally consist of modular single board microcomputers
known as Central Processing Unit (CPU) boards, peripheral systems and software.
The products are intended for use by manufacturing companies seeking to increase
efficiency and productivity through factory automation, sensor monitoring,
process control and other electronic implementations.  The Company provides
warranties ranging from 90 days to one year on all products sold.


   VME.  The Company's principal product group is based on the VMEbus
   ---                                                               
   specification.  These products are used as embedded controllers for
   telecommunications, industrial controls, robotics, aerospace, and a wide
   variety of military applications.  In 1996, the Company established a
   distributor relationship with a German VMEbus manufacturer, Microsys
   Electronics GmbH ("Microsys"). Although, to date, sales of Microsys products
   have been nominal, management believes that the addition of the Microsys line
   to the Dynatem line should have the effect of augmenting the Dynatem range of
   products.

   Among the most exciting new product offering is Dynatem's own PC compatible
   VMEbus module based upon Intel's Pentium II processor and using the most
   current PC compatible components.  This new product is offered both in
   commercial and rugged, extended temperature range versions.  Combined with
   the Pentium based PC compatible processor module introduced during the past
   year, the Company is able to offer a broader range of high performance,
   highly reliable processor modules at a relatively low cost, by leveraging off
   the economies of scale inherent to components used in desktop PCs. Through
   part screening, testing and careful design, the same components found in
   state-of-the-art desktop computers can be used in high-end multiprocessor
   systems or in rugged environments.  With recent software and hardware
   improvements, these architectures, previously not suitable for use in time-
   critical multitasking applications, can now support true real-time
   environments where "deterministic" tasks need to be scheduled to the micro-
   second.

   Software.  The Company offers to its customers software that it has
   --------                                                           
   developed, and software which the Company purchases from other suppliers.
   The Company believes that there are alternative sources of supply for such
   software.  Since all of the modules offered are part of highly integrated
   real-time systems, it is essential that all boards work well together.  For
   this reason, the Company is required to provide drivers for all the boards
   which enable them to implement any of the standard real-time operating
   systems.  The Company therefore distributes, sells and supports real-time
   operating systems that have been modified to work with the Dynatem and
   Microsys products.  This is a value-added service which ties the Company more
   closely to the customer base.

Operations
----------

A majority of the Company's products are manufactured by outside assembly
contractors.  They are produced from the Company's designs with standard and
semi-custom components.

Most of the devices and components used in the Company's products are available
from several sources.  Although no assurance can be given as to the future, the
Company believes that the loss of one or more of its current suppliers would not
have a material adverse effect upon its business.

                                       3
<PAGE>
 
Marketing
---------

The Company's marketing and sales department consists of marketing, sales,
customer service, engineering and engineering application support.  The Company
has in recent years expanded its use of advertising in major trade publications,
coupling it with wide distribution of marketing brochures.  In addition, the
Company participates in regional trade shows during the year throughout the
United States and Canada.

There are over 200 VMEbus vendors worldwide.  Depending on the application, at
least one or more of these companies are in direct competition with the Company.
Details of unique characteristics of the Company's offerings are more fully
described in "Products" above.

Marketing of the Company and the Company's products is accomplished through
direct marketing and telemarketing efforts. Direct marketing efforts are
generated by responding to inquiries generated through press releases, trade
publications, advertising, current customer lists and other similar leads.
Telemarketing is utilized to inform current and potential customers of new
products and technical product changes, as well as allow the Company to evaluate
the market and customer needs.  Implementation of a World Wide Web site has been
accomplished over the past six months.  It has become an effective means of
attracting new customers throughout the world.

Research and Development
------------------------

The Company believes that its future growth greatly depends on its ability to be
an innovator in the development and application of new and existing hardware and
software technology. Expenditures for Company-sponsored research and development
for the fiscal years ended May 31, 1998 and 1997, were $185,185 and $198,477,
respectively.  In the last fiscal year the Company continued pursuing two
exciting product areas.  The Company has expanded its line of Pentium based
VMEbus products by adding a second product which supports a low-powered module
with a Pentium II.  This product offers state-of-the-art performance while still
occupying only one VMEbus slot; this is a very marketable feature.  This module
can also be designed into rugged applications unlike the Company's first Pentium
based VMEbus computer board.  The Company has taken advantage of its 3U VMEbus
experience to develop a Motorola 68360 based Single Board Computer ("SBC") as an
inexpensive Ethernet controller that has already been designed into some
potentially high volume programs.

Employees
---------

At present the Company employs 14 people, 9 of whom are working full-time
schedules in the sales, engineering, financial and manufacturing departments.
Neither the Company nor its employees are parties to a collective bargaining
agreement.  The Company believes that its employee relations are very good.

Competition
-----------

Competition within the industry is based primarily upon product line breadth,
product performance, price and customer service.  The Company competes with over
200 manufacturers of VMEbus products in North America and Europe.  One advantage
the Company believes it has is its ability to offer a "one-stop-shop" approach
which provides full support normally not provided by the Company's competitors.
As part of this approach, the Company provides high quality products, pricing
that is competitive, and technical support which includes, when needed,
customization, special

                                       4
<PAGE>
 
products and/or writing of special software programs.  In addition, the Company
provides customers with most products required for specific applications
including, but not limited to, special power supplies, special enclosures,
cables and other requisite hardware.  This approach is not customary with larger
competitors who would normally limit themselves to sales of standard products.
However, most of these manufacturers have certain other competitive advantages
over the Company, including greater financial and technological resources,
earlier access to customers, established client service programs and client
loyalty.

Item 2. Description of Property.
------- ------------------------

The Company's executive offices and manufacturing plant are located in an
approximately 6,357 square foot facility in Mission Viejo, California.  The
facility is leased from an unaffiliated party for a term expiring in January,
2001, and is currently adequate to meet the Company's needs.

Item 3. Legal Proceedings.
------- ------------------

Not applicable

Item 4. Submission of Matters to a Vote of Security Holders.
------- ----------------------------------------------------

Not applicable

                                    PART II

Item 5. Market for Common Equity and Related Stockholder Matters.
------- ---------------------------------------------------------

There is no public trading market for the Company's Common Stock. Set forth
below are the high and low bid quotations of the Company's Common Stock for the
periods indicated, as reported by a licensed marketmaker who continues to make a
market in the Common Stock.  Such quotations represent inter-dealer quotations
without adjustment for retail mark-up, mark-down or commissions, and may not
represent actual transactions.  Trading in the Company's Common Stock is limited
in volume and may not be a reliable indicator of its market value.

                      Fiscal Years Ended May 31,
                          1998         1997
                     ----------------------------
                      High    Low     High   Low
                     ----------------------------
 First Quarter       15/16    7/32   13/32    1/4
 Second Quarter      15/16    7/32     3/8   7/32
 Third Quarter       15/16     1/2   11/16   7/32
 Fourth Quarter      15/16   17/32   11/16   7/32

As of August 1, 1998, there were approximately 149 shareholders of record of the
Company's Common Stock.

The Company has never paid cash dividends on its Common Stock and the Board of
Directors intends to continue this policy for the foreseeable future.  Future
dividend policy will depend upon the Company's earnings, capital requirements,
financial condition and other factors considered relevant by the Company's Board
of Directors.

                                       5
<PAGE>
 
Item 6. Management's Discussion and Analysis or Plan of Operation.
------- ----------------------------------------------------------

Results of Operations
---------------------

Net sales for the Company's fiscal year ended May 31, 1998 were lower than the
prior fiscal year due to the termination of its distributorship of the OR
Industrial ("OR") products produced in Germany. The Company's net sales of
$1,685,512 for the fiscal year ended May 31, 1998 were 32% lower than the
$2,490,919 recorded for the fiscal year ended May 31, 1997. Of the $805,407 net
sales difference, the OR products accounted for a reduction of $1,149,231 offset
by an increase in the net sales of Dynatem and related products of $343,824.
Export sales amounted to $639,797 representing 38% of the total net sales for
the fiscal year ended May 31, 1998.

Gross profit as a percentage of net sales increased from 37% in fiscal 1997 to
43% for the fiscal year ended May 31, 1998, reflecting the emphasis on Dynatem
product sales which contribute higher margins as well as lower cost of sales.

The Company's cost of sales totaled $965,928, a 38% decline over fiscal year
1997. Taken as a percentage of net sales, cost of sales were 57% and 63% for
fiscal years 1998 and 1997, respectively. The decrease is due primarily to the
reason mentioned above including the relation of product mix.

Selling, General and Administration expenses were $602,171 for fiscal year 1998
compared to $656,986 for fiscal year 1997, an 8% decrease. This decrease is due
primarily to a cost reduction program in the administration area of 16%. Selling
expense increased to $217,321 for fiscal year 1998 compared to $199,890 for
fiscal year 1997, a 9% increase due to higher advertising expenses.

Research and development costs were $185,185 in fiscal 1998 in comparison to
$198,477 in fiscal 1997, a 7% decrease.

At May 31, 1998, the Company had Federal net operating loss carryforwards of
$1,483,200 which, if not used will expire through 2006.

During fiscal 1998, the Company received $102,000 as part of a settlement
agreement with OR as consideration for OR's premature cancellation of a master
distribution agreement.

Financial Condition
-------------------

As of May 31, 1998, inventories totaled $420,585, a 59% increase as compared to
inventories at May 31, 1997.  The increase is attributable to the Company's
shift in product mix to higher priced boards, which represent a significant
percentage of year end inventory.  The increase also results from the Company's
cessation of its sale of OR products (wherein such products were not
inventoried) and increase in the sale of its own products (wherein such products
are inventoried).

Liquidity and Capital Resources
-------------------------------

As of May 31, 1998, the Company's working capital was $1,077,988 and its current
ratio was 8 to 1.  Management believes that the Company's existing working
capital and cash flows from operations will be sufficient to meet its working
capital needs during fiscal 1999. The Company may consider additional sources of
capital should the need arise.

                                       6
<PAGE>
 
Future Trends
-------------

The Company's new PC compatible VMEbus module is now being designed into several
fairly large programs and it is being well received by the VMEbus market.  The
key to success with this type of product is to offer strong software support.
The Company has put great effort into being first to the market with error-free
versions of several popular real-time operating systems.  As the PC compatible
market changes, the Company will attempt to achieve market leadership by
offering new products based upon the latest PC compatible technology, in a
timely manner.

The Company is now in the process of using alternative methods of manufacturing,
by using outside vendor facilities on several contractual bases.

                                       7
<PAGE>
 
Item 7. Financial Statements.
------- ---------------------


                                     INDEX


Independent Auditors' Report                                         F-1

Balance Sheet as of May 31, 1998                                     F-2

Statements of Income For The Years Ended May 31, 1998 and 1997       F-3

Statements of Shareholders' Equity For The Years Ended
 May 31, 1998 and 1997                                               F-4

Statements of Cash Flows For The Years Ended May 31, 1998 and 1997   F-5

Notes to Financial Statements For The Years Ended  May 31, 1998 
 and 1997                                                            F-6 to F-15

                                       8
<PAGE>
 
                          INDEPENDENT AUDITORS' REPORT
                          ----------------------------



Board of Directors
Dynatem, Inc.



We have audited the accompanying balance sheet of Dynatem, Inc. (the "Company")
as of May 31, 1998, and the related statements of income, shareholders' equity
and cash flows for each of the years in the two-year period then ended.  These
financial statements are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of the Company as of May 31, 1998,
and the results of its operations and its cash flows for each of the years in
the two-year period then ended in conformity with generally accepted accounting
principles.



                                    CORBIN & WERTZ



Irvine, California
July 20, 1998

                                      F-1
<PAGE>
                                 DYNATEM, INC.

                                 BALANCE SHEET

                                 May 31, 1998
 
                                    ASSETS

<TABLE>
<S>                                                              <C>           
Current assets:
  Cash and cash equivalents                                      $   600,525  
  Accounts receivable, net of allowance for doubtful                          
   accounts of $9,825                                                192,125  
  Inventories                                                        420,585  
  Prepaid expenses and other                                          17,330  
                                                                 -----------  
                                                                              
     Total current assets                                          1,230,565  
                                                                              
Note receivable                                                        7,766  
                                                                              
Property and equipment, net                                           16,132  
                                                                              
Other assets                                                          15,533  
                                                                 -----------  
                                                                              
                                                                 $ 1,269,996  
                                                                 ===========  

<CAPTION>
                      LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
  Accounts payable                                               $   112,065
  Accrued expenses                                                    40,512
                                                                 -----------
 
     Total current liabilities                                       152,577
                                                                 -----------
 
Commitments and contingencies
 
Shareholders' equity:
  Common stock, no par value, 50,000,000 shares authorized;
   1,418,400 shares issued and outstanding                         2,383,385
  Accumulated deficit                                             (1,265,966)
                                                                 -----------
 
     Total shareholders' equity                                    1,117,419
                                                                 -----------
 
                                                                 $ 1,269,996
                                                                 ===========
</TABLE>

              See accompanying notes to the financial statements

                                      F-2
<PAGE>
                                 DYNATEM, INC.

                             STATEMENTS OF INCOME

                   For the Years Ended May 31, 1998 and 1997
 
<TABLE>
<CAPTION>
                                              1998          1997
                                           ----------    ---------- 
<S>                                        <C>           <C>
Net sales                                  $1,685,512    $2,490,919
 
Cost of sales                                 965,928     1,569,654
                                           ----------    ----------
 
     Gross profit                             719,584       921,265
                                           ----------    ----------
 
Operating expenses:
  Selling, general and administrative         602,171       656,986
  Research and development                    185,185       198,477
                                           ----------    ----------
 
     Total operating expenses                 787,356       855,463
                                           ----------    ----------
 
     Operating income (loss)                  (67,772)       65,802
                                           ----------    ----------
 
Other income:
  Interest income                              30,083        23,411
  Settlement income                           102,000             -
                                           ----------    ----------
 
  Total other income                          132,083        23,411
                                           ----------    ----------
 
Income before provision for taxes              64,311        89,213
 
Provision for taxes                               800           800
                                           ----------    ----------
 
Net income                                 $   63,511    $   88,413
                                           ==========    ==========
 
Basic earnings per share                   $      .04    $      .06
                                           ==========    ==========
 
</TABLE>

              See accompanying notes to the financial statements

                                      F-3
<PAGE>

                                 DYNATEM, INC.

                      STATEMENTS OF SHAREHOLDERS' EQUITY

                   For the Years Ended May 31, 1998 and 1997

 
<TABLE>
<CAPTION>

                                     Common Stock                          Total
                                ----------------------   Accumulated    Shareholders'
                                  Shares      Amount       Deficit         Equity
                                ----------  ----------  -------------  ---------------
<S>                             <C>         <C>         <C>            <C>    

Balances at June 1, 1996         1,418,400  $2,383,385  $  (1,417,890) $       965,495

Net income                               -           -         88,413           88,413
                                ----------  ----------  -------------  ---------------

Balances at May 31, 1997         1,418,400   2,383,385     (1,329,477)       1,053,908

Net income                               -           -         63,511           63,511
                                ----------  ----------  -------------  --------------- 

Balances at May 31, 1998         1,418,400  $2,383,385  $  (1,265,966) $     1,117,419
                                ==========  ==========  =============  ===============
</TABLE> 


              See accompanying notes to the financial statements

                                      F-4
<PAGE>
 
                                 DYNATEM, INC.

                           STATEMENTS OF CASH FLOWS

                   For the Years Ended May 31, 1998 and 1997

<TABLE>
<CAPTION>
                                                            1998         1997
                                                         ----------   ----------
<S>                                                      <C>          <C> 
Cash provided by operating activities:
  Net income                                              $  63,511    $ 88,413
  Adjustments to reconcile net income to net cash                      
   provided by operating activities:                                   
   Provision for doubtful accounts                            3,000      (5,818)
   Depreciation and amortization                             48,633      78,460
   Changes in current assets and liabilities:                          
     Accounts receivable                                     87,064      (4,306)
     Inventories                                           (155,885)      1,599
     Prepaid expenses and other                               7,279      (1,406)
     Accounts payable                                        35,258     (83,885)
     Accrued expenses                                       (25,395)      4,338
                                                          ---------    --------
  Net cash provided by operating activities                  63,465      77,395
                                                          ---------    --------
                                                                       
Cash flows used in investing activities:                               
  Purchases of property and equipment                       (10,820)     (7,099)
  Net (increase) decrease in note receivable                  3,120        (151)
  Increase in other assets                                  (16,751)    (41,552)
                                                          ---------    --------
  Net cash used in investing activities                     (24,451)    (48,802)
                                                          ---------    --------
                                                                       
Net increase in cash and cash equivalents                    39,014      28,593
                                                                       
Cash and cash equivalents, beginning of year                561,511     532,918
                                                          ---------    --------
Cash and cash equivalents, end of year                    $ 600,525    $561,511
                                                          =========    ========
 
Supplemental disclosures of cash flow information -
  Cash paid during the year for:
 
    Interest                                              $       -    $      -
                                                          =========    ========
    Income taxes                                          $     800    $    800
                                                          =========    ========
</TABLE>

              See accompanying notes to the financial statements

                                      F-5
<PAGE>
 
                                 DYNATEM, INC.

                       NOTES TO THE FINANCIAL STATEMENTS

                   For the Years Ended May 31, 1998 and 1997


NOTE 1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
---------------------------------------------------------

Organization and Nature of Operations
-------------------------------------

Dynatem, Inc. (the "Company") was incorporated in the state of California in May
1981.  The Company designs, manufactures, distributes and markets modular single
board microcomputers and microcomputer-based systems and software.  These
systems are used for industrial applications, including factory automation,
process control, robotics, data acquisition and networking.

Concentrations of Credit Risks
------------------------------

Cash and cash equivalent balances are maintained at various financial
institutions. The Federal Deposit Insurance Corporation ("FDIC") insures
accounts at each institution for up to $100,000. During fiscal 1998, the Company
had cash balances in various financial institutions that exceeded the FDIC
limit.

The Company sells products to customers throughout the United States and in
several foreign countries. The Company performs periodic credit evaluations of
its customers and does not obtain collateral with which to secure its accounts
receivable.  The Company maintains reserves for potential credit losses based
upon the Company's historical experience related to credit losses.  Although the
Company expects to collect amounts due, actual collections may differ.

During fiscal 1998, the Company received a significant portion of its business
from one customer.  During fiscal 1998, sales to this customer totaled 12% of
net sales.  At May 31, 1998, there were no amounts due from this customer.  At
May 31, 1998, two other customers accounted for 27% and 10% of accounts
receivable, respectively.  During fiscal 1997, there was no one customer whose
sales were in excess of 10% of total net sales. If the relationship between the
Company and these customers was altered, the future results of operations and
financial condition could be significantly affected.  Additionally, during
fiscal 1998 and 1997, export sales represented 38% and 32% of net sales,
respectively.

During fiscal 1998, the Company purchased a significant portion of its product
from two suppliers. During fiscal 1998, purchases from these suppliers totaled
30% and 13% of total cost of sales, respectively. At May 31, 1998, amounts due
to these suppliers totaled 19% and 32% of accounts payable, respectively. At May
31, 1998, another supplier accounted for 13% of accounts payable. If the
relationship between the Company and these customers was altered, the future
results of operations and financial condition could be significantly affected.

                                      F-6
<PAGE>
 
                                 DYNATEM, INC.

                 NOTES TO THE FINANCIAL STATEMENTS - CONTINUED

                   For the Years Ended May 31, 1998 and 1997


NOTE 1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES, continued
--------------------------------------------------------------------

During fiscal 1997, the Company distributed products for an international vendor
(the "International Vendor").  Distribution of the International Vendor's
products represented 55% of fiscal 1997 net sales. During fiscal 1997, the
Company purchased a significant portion of its product from the International
Vendor.  During fiscal 1997, purchases from the International Vendor totaled 66%
of total cost of sales. During fiscal 1997, the Company's distributor
relationship with the International Vendor was terminated (see Note 9).

Risks and Uncertainties
-----------------------

As discussed above, the Company's distributor relationship with the
International Vendor was terminated on April 30, 1997.  The Company has not
effectively replaced this vendor with another international vendor.  Management
intends to mitigate any potential adverse effects which may arise from the
termination of the International Vendor relationship through an increase in the
sales of its own products, which have historically produced higher margins.
However, there can be no assurances that the Company will in fact effectively
replace the sales lost, which have not been offset by the increased margins from
the Company's products, from a discontinuation of the International Vendor
relationship.  As a result, the loss of such relationship could have a
materially adverse effect on the Company's future operations.

Use of Estimates in the Preparation of Financial Statements
-----------------------------------------------------------

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements, and
the reported amounts of revenues and expenses during the reporting period.
Significant estimates made by management are, among others, provisions for
losses on accounts receivable, provisions for slow moving and obsolete
inventories and estimates for current and deferred taxes. Actual results could
materially differ from those estimates.

Cash Equivalents
----------------

Cash equivalents consist of highly liquid investments (Certificates of Deposits)
with maturities of 90 days or less when purchased.  At May 31, 1998, cash
equivalent balances totaled $407,277.

                                      F-7
<PAGE>
 
                                 DYNATEM, INC.

                 NOTES TO THE FINANCIAL STATEMENTS - CONTINUED

                   For the Years Ended May 31, 1998 and 1997


NOTE 1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES, continued
--------------------------------------------------------------------

Inventories
-----------

Inventories are stated at the lower of cost or net realizable value.  Cost is
determined under the first-in, first-out method.  The Company operates in an
industry in which its products are subject to design changes and are
manufactured based on customer specifications. Accordingly, should design
requirements change significantly or customer orders be canceled or decline, the
ultimate net realizable value of such products could be less than the carrying
value of such amounts.  At May 31, 1998, management believes that inventories
are carried at their net realizable value.

Property and Equipment
----------------------

Property and equipment are recorded at cost and are depreciated using the
straight-line method over the estimated useful lives of the related assets,
ranging from three to five years. Maintenance and repairs are charged to expense
as incurred.  Significant renewals and betterments are capitalized.  At the time
of retirement or other disposition of property and equipment, the cost and
accumulated depreciation are removed from the accounts and any resulting gain or
loss is reflected in operations.

The Company's management assesses the recoverability of property and equipment
by determining whether the depreciation and amortization of property and
equipment over its remaining life can be recovered through projected
undiscounted future cash flows.  The amount of property and equipment
impairment, if any, is measured based on fair value and is charged to operations
in the period in which property and equipment impairment is determined by
management. At May 31, 1998, the Company's management believes there is no
impairment of property and equipment.


Other Assets
------------


Certain costs incurred subsequent to establishing technological feasibility to
produce a finished product, including purchased software and other outside
costs, are capitalized (see Note 4).  The annual amortization of these costs is
computed at the lesser of the straight-line basis over the estimated product
life, not to exceed five years, or based on units sold divided by the total
estimated units to be sold.

Warranties
----------

The Company provides warranties ranging from ninety days to one year on all
products sold.  Estimated future costs of warranties are provided at the time of
sale.

                                      F-8
<PAGE>
 
                                 DYNATEM, INC.

                 NOTES TO THE FINANCIAL STATEMENTS - CONTINUED

                   For the Years Ended May 31, 1998 and 1997


NOTE 1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES, continued
--------------------------------------------------------------------

Revenue Recognition
-------------------

Revenues from product sales are recognized at the time the product is shipped.

Research and Development Costs
------------------------------

Research and development costs are expensed as incurred.

Advertising
-----------

Advertising costs are expensed as incurred.

Income Taxes
------------

The Company accounts for income taxes under Statement of Financial Accounting
Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes."  Under SFAS 109,
deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. A valuation allowance is
provided for significant deferred tax assets when it is more likely than not
that such assets will not be recovered.

Foreign Currency Transactions
-----------------------------

The Company obtains certain products from offshore facilities in Germany.
Foreign currency transaction gains or losses are included in cost of sales in
the period in which the exchange rate changes or the underlying transaction
settles.  During fiscal 1998 and 1997, the Company had foreign currency gains of
$2,184 and $111,838, respectively.

                                      F-9
<PAGE>
 
                                 DYNATEM, INC.

                 NOTES TO THE FINANCIAL STATEMENTS - CONTINUED

                   For the Years Ended May 31, 1998 and 1997



NOTE 1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES, continued
--------------------------------------------------------------------

Stock-Based Compensation
------------------------

The Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 123 ("SFAS 123"), "Accounting for Stock-Based
Compensation," which defines a fair value based method of accounting for stock-
based compensation. However, SFAS 123 allows an entity to continue to measure
compensation cost related to stock and stock options issued to employees using
the intrinsic method of accounting prescribed by Accounting Principles Board
Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to Employees."  Entities
electing to remain with the accounting method of APB 25 must make pro forma
disclosures of net income, as if the fair value method of accounting defined in
SFAS 123 had been applied. The Company has elected to account for its stock-
based compensation to employees under APB 25 (see Note 5).


Earnings Per Share
------------------

The Financial Accounting Standards Board has issued Statement of Financial
Accounting Standards 128 ("SFAS 128"), "Earnings per Share." SFAS 128 is
primarily a disclosure standard which requires public companies to present basic
earnings per share ("EPS") and, if applicable, diluted EPS.

Basic EPS is computed by dividing net income for the year by the weighted
average number of shares of common stock outstanding during the year.  The
weighted average number of shares of common stock outstanding for fiscal 1998
and 1997 totaled 1,418,400.   Diluted EPS is computed by dividing net income for
the year by the weighted average number of shares of common stock and common
stock equivalents outstanding during the year.  The weighted average number of
shares of common stock and common stock equivalents outstanding for fiscal 1998
and 1997 totaled 1,510,363 and 1,462,894, respectively.  At May 31, 1998, common
stock equivalents consist of stock options (see Note 5).  Diluted EPS for fiscal
1998 and 1997 was equal to basic EPS for such periods.


NOTE 2 - INVENTORIES
--------------------

Inventories consist of the following at May 31, 1998:

<TABLE>
 
<S>                                               <C>
          Raw materials and component parts       $153,375
          Work-in-process                           71,251
          Finished goods                           195,959
                                                  --------
 
                                                  $420,585
                                                  ========
</TABLE>

                                      F-10
<PAGE>
 
                                 DYNATEM, INC.

                 NOTES TO THE FINANCIAL STATEMENTS - CONTINUED

                   For the Years Ended May 31, 1998 and 1997


NOTE 3 - PROPERTY AND EQUIPMENT
-------------------------------

Property and equipment consist of the following at May 31, 1998:

<TABLE>
 
<S>                                                        <C>       
          Machinery and equipment                          $ 393,914 
          Product tooling                                    228,127 
          Furniture and fixtures                              53,892 
                                                           --------- 
                                                             675,933 
                                                                     
          Accumulated depreciation                          (659,801)
                                                           --------- 
                                                                     
                                                           $  16,132 
                                                           ========= 
</TABLE> 
 
During fiscal 1998 and 1997, depreciation expense totaled $12,009 and $14,697,
respectively.
 
NOTE 4 - OTHER ASSETS
---------------------
<TABLE> 
 
Other assets consist of the following at May 31, 1998:
<S>                                                        <C>  
          Capitalized software and prepaid inventory       $   9,625   
          Deposits                                             5,908   
                                                           ---------   
                                                           $  15,533   
                                                           =========   
</TABLE>
During fiscal 1998 and 1997, amortization expense on capitalized software
totaled $36,624 and $63,763, respectively.


NOTE 5 - SHAREHOLDERS' EQUITY
-----------------------------

On August 31, 1993, the Company's Board of Directors adopted, and the
shareholders approved, the Dynatem, Inc. 1993 Stock Option Plan (the "Plan"),
which provides for the grant of options intended to qualify as incentive stock
options under Section 422 of the Internal Revenue Code and for the grant of
nonqualified stock options. In connection with the Plan, 200,000 shares of the
Company's common stock have been reserved for issuance upon the exercise of
options to be granted.

                                      F-11
<PAGE>
 
                                 DYNATEM, INC.

                 NOTES TO THE FINANCIAL STATEMENTS - CONTINUED

                   For the Years Ended May 31, 1998 and 1997


NOTE 5 - SHAREHOLDERS' EQUITY, continued
----------------------------------------

Options to purchase an aggregate of 110,000 shares of the Company's common stock
were granted pursuant to the Plan to the Company's four outside directors and to
certain officers of the Company on October 15, 1993.  Such options were fully
exercisable at the date of grant and expire on various dates through October 15,
2003.  The exercise price of such options ranges from $0.20 to $0.22, which
exceeded the fair market value per share of the Company's common stock on the
date of grant.

On January 18, 1997, the Company granted options to purchase 55,000 shares of
the Company's common stock to certain officers and one outside director of the
Company.  Such options were fully exercisable at the date of grant and expire on
January 17, 2007.  The exercise price of such options was $0.35, which
approximated the fair market value of the Company's common stock on the date of
grant.

On March 13, 1998, the Company granted options to purchase 10,000 shares of the
Company's common stock to an outside director of the Company.  Such options were
fully exercisable at the date of grant and expire on March 31, 2008.  The
exercise price of such options was $0.53, which approximated the fair market
value of the Company's common stock on the date of grant.

A summary of stock option activity follows:

<TABLE>
 
<S>                                              <C>       <C>       
Outstanding at June 1, 1996                      110,000   $0.20-$0.22
       Granted                                    55,000   $0.35
                                                 -------             
                                                                     
Outstanding at May 31, 1997                      165,000   $0.20-$0.35
      Granted                                     10,000      $0.53
                                                 -------             
                                                                     
Outstanding at May 31, 1998                      175,000   $0.20-$0.53
                                                 =======              
</TABLE>
At May 31, 1998, all 175,000 options are exercisable.


Pro Forma Stock Option Information
----------------------------------

Pro forma information regarding net income is required by SFAS 123 and is
determined as if the Company had accounted for its employee stock options under
the fair value method pursuant to SFAS 123, rather than the method pursuant to
APB 25 as discussed in Note 1.  The fair value of these options is estimated at
the date of grant based on the Black-Scholes options pricing model (the
"Model").

                                      F-12
<PAGE>
 
                                 DYNATEM, INC.

                 NOTES TO THE FINANCIAL STATEMENTS - CONTINUED

                   For the Years Ended May 31, 1998 and 1997


NOTE 5 - SHAREHOLDERS' EQUITY, continued
----------------------------------------

The Model was developed for use in estimating the fair value of traded options
which have no vesting restrictions and are fully transferable.  In addition, the
Model requires the input of highly subjective assumptions including the expected
stock price volatility.  The Company's employee stock options have
characteristics significantly different from those of traded options; changes in
the subjective input assumptions can materially affect the fair value estimate.

The fair value of the options granted in fiscal 1998 and 1997 were not
significant and thus have no pro forma impact on net income and earnings per
share.


NOTE 6 - INCOME TAXES
---------------------

During fiscal 1998 and 1997, the provision for taxes consists of the following:

<TABLE>
<CAPTION>
                      Federal           State         Total  
                      -------           ------        -----  
<S>                   <C>               <C>           <C>    
Current               $     -             $800         $800  
Deferred                    -                -            -  
                      -------             ----         ----  
                      $     -             $800         $800  
                      =======             ====         ====   
</TABLE>


During fiscal 1998 and 1997, the provision for taxes totaled $800 and differs
from the amounts computed by applying the U.S. Federal income tax rate of 34% to
income before provision for taxes as a result of the following:


<TABLE>
<CAPTION>
                                                            1998        1997
                                                          --------    --------

<S>                                                       <C>         <C>
Computed "expected" tax expense                           $ 21,866    $ 30,332
 
Reduction in income taxes resulting from:
   Change in the beginning-of-the-year balance of
     the valuation allowance for deferred tax assets
     allocated to income tax expense                       (10,200)    (29,209)
 
   State income taxes and other                            (10,866)       (323)
                                                          --------    --------
 
                                                          $    800    $    800
                                                          ========    ========
</TABLE>

                                      F-13
<PAGE>
 
                                 DYNATEM, INC.

                 NOTES TO THE FINANCIAL STATEMENTS - CONTINUED

                   For the Years Ended May 31, 1998 and 1997


NOTE 6 - INCOME TAXES, continued
--------------------------------


At May 31, 1998, the significant components of the Company's deferred tax assets
are as follows:

<TABLE>
 
<S>                                                  <C>
   Net operating loss carryforwards                  $ 504,000
   Research and development credit carryforwards       122,000
   Inventory reserve and uniform capitalization         27,000
   Compensated absences                                  5,000
   Other                                                 6,000
                                                     ---------

                                                       664,000

   Valuation allowance                                (664,000)
                                                     --------- 


                                                     $       -
                                                     =========
</TABLE> 

At May 31, 1998, the Company had Federal net operating loss carryforwards of
$1,483,200, which, if not utilized to offset future taxable income, will expire
in various years through 2006.


At May 31, 1998, the Company had unused research and development credits of
$122,400, which, if not used, will expire in various years through 2010.


NOTE 7 - RELATED PARTY TRANSACTIONS
-----------------------------------

During fiscal 1998 and 1997, the Company paid fees of $4,400 and $7,200,
respectively, to a consulting firm principally owned by the Company's Chairman
of the Board.

Note receivable consists of amounts due from an officer, which bear interest at
the rate of 5% per annum and require monthly installments of principal and
interest.  The note matures in May 2000.


NOTE 8 - COMMITMENTS AND CONTINGENCIES
--------------------------------------

Leases
------

In December 1995, the Company entered into a non-cancelable operating lease for
its corporate and manufacturing facility.  In addition to monthly lease payments
for the facility, the Company is required to pay utilities and certain insurance
and maintenance costs. The lease provides for annual rental increases and a
five-year renewal option based on certain terms and conditions. The lease
expires in fiscal 2001.

                                      F-14
<PAGE>
 
                                 DYNATEM, INC.

                 NOTES TO THE FINANCIAL STATEMENTS - CONTINUED

                   For the Years Ended May 31, 1998 and 1997


NOTE 8 - COMMITMENTS AND CONTINGENCIES, continued
-------------------------------------------------

Future annual minimum lease payments under this lease are as follows:

<TABLE> 
<CAPTION> 
 Years Ending
    May 31,
---------------
<S>                                         <C>      
      1999                                  $ 58,721
      2000                                    61,072
      2001                                    36,442
                                            --------
                                                    
                                            $156,235
                                            ======== 
</TABLE>

During fiscal 1998 and 1997, the Company incurred $67,029 and $64,648,
respectively, related to this lease, of which $33,607 and $32,324 has been
classified as a component of cost of sales in the accompanying statements of
income.


Royalty and Licensing Agreements
--------------------------------

The Company is a party to a royalty agreement that requires it to pay royalties
of 25% of sales of a select hardware product and 50% of sales of a select
software product, as defined.  The Company is also a party to another royalty
agreement that requires it to pay royalties of 50% of the gross profit earned by
the Company on sales of certain hardware products, as defined.

During 1997, the Company entered into two software licensing agreements.  The
licensed software will be used with various products which the Company
manufactures and distributes.  One of the agreements provides for a one-time
licensing fee and the other agreement provides for a fixed fee on each unit of
software sold.

During fiscal 1998 and 1997, total royalty and licensing expense for the royalty
and licensing agreements mentioned herein totaled $10,975 and $21,350,
respectively.


NOTE 9 - SETTLEMENT INCOME
--------------------------

During fiscal 1998, the Company received $102,000 as part of a settlement
agreement with the International Vendor as consideration for such vendor's
premature cancellation of a master distribution agreement.

                                      F-15
<PAGE>
 
Item 8.  Changes in and Disagreements with Accountants on
-------  ------------------------------------------------
         Accounting and Financial Disclosure.
         -----------------------------------  

Not Applicable.

                                    PART III
                                    --------

Item 9.  Directors, Executive Officers, Promoters and Control Persons;
-------  -------------------------------------------------------------
         Compliance with Section 16(a) of the Exchange Act.
         --------------------------------------------------

Information concerning the Company's directors and executive officers and
compliance with Section 16(a) of the Exchange Act is incorporated herein by
reference to the portion of the Company's Definitive Proxy Statement, to be
filed for its 1998 Annual Meeting of Shareholders to be held on October 7, 1998,
set forth under the heading "ELECTION OF DIRECTORS".

Item 10.  Executive Compensation.
--------  -----------------------

Information concerning executive compensation is incorporated herein by
reference to the portion of the Company's Definitive Proxy Statement, to be
filed for its 1998 Annual Meeting of Shareholders to be held on October 7, 1998,
set forth under the heading "ELECTION OF DIRECTORS -Compensation of Executive
Officers".

Item 11.  Security Ownership of Certain Beneficial Owners and Management.
--------  ---------------------------------------------------------------

Information concerning security ownership of certain beneficial owners and
management is incorporated herein by reference to the portion of the Company's
Definitive Proxy Statement, to be filed for its 1998 Annual Meeting of
Shareholders to be held on October 7, 1998, set forth under the heading
"PRINCIPAL HOLDERS OF VOTING SECURITIES".

Item 12.  Certain Relationships and Related Transactions.
--------  -----------------------------------------------

Information concerning certain relationships and related transactions is
incorporated herein by reference to the portion of the Company's Definitive
Proxy Statement, to be filed for its 1998 Annual Meeting of Shareholders to be
held on October 7, 1998, set forth under the heading "ELECTION OF DIRECTORS -
Relationships with Outside Firms".

                                       9
<PAGE>
 
Item 13.  Exhibits and Reports on Form 8-K.
--------  ---------------------------------

(a)  Exhibits.

     Reference is made to the Exhibit Index preceding the exhibits attached
hereto for a list of all exhibits filed as part of this Report.


(b)  Reports on Form 8-K.


     The Company did not file any reports on Form 8-K during the last quarter of
the Company's fiscal year ended May 31, 1998.

                                       10
<PAGE>
 
                                   SIGNATURES
                                   ----------

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.


                                 DYNATEM, INC.



August  19, 1998            By:  /s/ Eileen Deswert
                                 --------------------------
                                 Eileen DeSwert, President

 

In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.

<TABLE>
<CAPTION>
<S>      <C>                              <C> 
 
By:      /s/ Eileen DeSwert               August 19, 1998
         ------------------------------
         Eileen DeSwert
         President/Principal Executive
         Officer/Director

 
By:      /s/ Harry Cavanaugh              August 19, 1998
         ------------------------------
         Harry Cavanaugh
         Chairman of the Board/Director
 
By:      /s/ Belen Ramos                  August 19, 1998
         ------------------------------
         Belen Ramos
         Chief Financial Officer
 
By:      /s/ Robert Anslow                August 19, 1998
         ------------------------------
         Robert Anslow
         Director
 
By:      /s/ Richard Jackson              August 19, 1998
         ------------------------------
         Richard Jackson
         Director
 
By:      /s/ Charles Spear                August 19, 1998
         ------------------------------
         Charles Spear
         Director
 
By:      ________________________         August __, 1998
         Costis Toregas
         Director
 
By:      /s/ H. Richard Anderson          August 19, 1998
         ------------------------------
         H. Richard Anderson
         Director
</TABLE>

                                       11
<PAGE>
 
                                 EXHIBIT INDEX
                                 -------------

Exhibit
Number
-------


3(a)    Restated Articles of Incorporation of the Company (1)


3(b)    Bylaws of the Company (2)


10      Standard Industrial/Commercial Multi-Tenant Lease- Modified Net dated
        August 22, 1995, between Pacific Highpark Partners, as lessor and the
        Company as lessee (3)


 

______________________

(1) Incorporated herein by reference to Exhibit 3(a) to the Company's Annual
    Report on Form 10-KSB for the fiscal year ended May 31, 1997.


(2) Incorporated herein by reference to Exhibit 3(b) to the Company's Annual
    Report on Form 10-KSB for the fiscal year ended May 31, 1997.


(3) Incorporated herein by reference to Exhibit 10 to the Company's Quarterly
    Report on Form 10-QSB for the quarter ended August 31, 1995.

                                       12