SECURITIES AND EXCHANGE COMMISSION

                              Washington, DC 20549

                     --------------------------------------

                                    FORM 10-K

                |X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
              OF THE SECURITIES EXCHANGE ACT OF 1934 (Fee Required)

                   For the fiscal year ended December 31, 1996

                           Commission File No. 0-20097

                                   ARC Capital
             (Exact name of registrant as specified in its charter)

                 California                         33-0256103
       (State or other jurisdiction of           (I.R.S. Employer
        incorporation or organization)          Identification No.)

             2067 Commerce Drive
               Medford, Oregon                        97504
     (Address of principal executive offices)       (Zip Code)

     Registrant's telephone number, including area code:  (541) 776-7700

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

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

                                   Class A Common Stock, no par value
                                   Class A Warrants
                                   Class B Warrants
                                   Units, each Unit consisting of two shares of
                                    Class A Common Stock, two Class A Warrants,
                                    and one Class B Warrant.

                     --------------------------------------


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

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

     The aggregate  market value of the voting stock held by  non-affiliates  of
the  registrant  as of March  10,  1997,  was  approximately  $17,261,000.  (All
officers and directors of the  registrant  are  considered  affiliates;  Class B
Common Stock is assumed to be equal in value to Class A Common Stock.)

     On March 10, 1997, the  registrant had 13,289,857  shares of Class A Common
Stock and 101,835 shares of Class B Common Stock,  all no par value,  issued and
outstanding.

                          See Page 39 for Exhibit Index



<PAGE>




                                     PART I


--------------------------------------------------------------------------------

ITEM 1.  BUSINESS

--------------------------------------------------------------------------------


HISTORY
=======

     From  inception  in 1987 until  early  1990,  ARC  Capital's  ("ARC" or the
"Company")  predecessor  company,  Applied Laser Systems ("ALS") was principally
engaged in  research  and  development  and  organizational  activities  and its
revenues  were  insignificant.  Beginning  in early  1990,  ALS  engaged  in the
business of  designing,  developing,  manufacturing  and  marketing  laser diode
devices  incorporating  its Visible  Laser Module ("VLM  (TM)"),  a device which
generates  a  directed  bright  red spot of light for  pointing  out  details on
presentation boards, movie and television screens, slides or other surfaces from
up to 300 feet away, and laser aimers,  devices which can be mounted on pistols,
rifles and other weapons to enhance shooting  accuracy by directing a bright red
spot of light onto a target.

     In March 1992, ALS completed its initial public  offering,  the proceeds of
which were used to repay  bridge  financing  and other  loans,  and for  working
capital.

     In the  latter  part of 1993,  ALS  conceived  of a new  business  strategy
whereby ALS would restructure its organizational and capital structure to become
the parent company of various operating subsidiaries (i.e., the platform company
concept).  ALS began  implementing this platform company concept by transferring
its operating assets (except cash), consisting of its laser business, and all of
its  liabilities  to  Applied  Laser  Systems,  Inc.,  its  newly-formed  Oregon
subsidiary  (ALSO),  effective as of December 31, 1993.  In February  1994,  ALS
acquired  all of  the  issued  and  outstanding  capital  stock  of  Simco/Ramic
Corporation,  now SRC Vision, Inc. ("SRC") for $8.1 million in cash. During late
1993 and 1994, ALS entered a number of other proposed acquisition  transactions.
By September 1994, ALS terminated these  acquisition  transactions  resulting in
significant  losses  in 1994  (see  "Management's  Discussion  and  Analysis  of
Financial  Condition and Results of Operations").  Following these terminations,
the  Company  restructured  to  concentrate  on  its  SRC-based  vision  systems
business.  In October 1995, ALS sold the ALSO operation for cash and changed its
name to ARC  Capital.  In March  1996,  the Company  acquired  Netherlands-based
Pulsarr Holding b.v.  ("Pulsarr"),  and, in July 1996, the Company  acquired the
assets and operations of Ventek, Inc. ("Ventek"), both of which are also engaged
in designing and marketing automated vision systems.  Following its acquisition,
Ventek, Inc. was subsequently renamed Veneer Technology,  Inc.  ("Veneer").  The
current operating subsidiaries of ARC are SRC, Pulsarr and Ventek. ARC continues
to operate as the parent company,  coordinating  public  relations,  managerial,
financial and accounting  functions,  as well as developing and implementing its
growth strategy.


BUSINESS
========

The Company
===========

     The Company  designs,  develops,  manufactures  and markets  machine vision
systems that process  images not  discernible  to the human eye.  These  systems
combine  technologies  in four key  areas  (lighting,  cameras,  processors  and
software)  to  improve  quality,  enhance  yield,  reduce  production  costs and
increase  throughput in a variety of markets and applications where human vision
is inadequate due to fatigue,  visual acuity or speed. Where needed, ARC employs
highly specialized  mechanical  technologies to help customers integrate machine
vision systems into their production processes. The Company's products currently
serve  two  principal  markets,  the  processing  industry  and the  wood  panel
production  industry.  Applications include quality control in the processing of
food, pulp wood,  tobacco,  and plastics for recycling,  and quality control and
automated process control in wood panel production.

     Since its founding in 1964, SRC has evolved from a  single-product  company
(an optical  device to measure  length and diameter of freshly cut logs) serving
the timber  industry,  into a provider of machine vision systems for a number of
processing industries. In 1984, SRC released its first machine vision product, a
fully  automated  defect removal system for the french fry processing  industry,
designed to improve  productivity and quality.  The system utilized  proprietary
material  conveying  systems,  light  sources,  linear array CCD cameras,  image
processing  software,  and standard bus based  electronics  to detect  defective
french fries and  efficiently  remove them from a rapidly moving product stream.
SRC built upon its  experience in potato  processing to develop  machine  vision
systems for other food  processing  customers.  These new  systems  increasingly
possessed more sophisticated  capabilities,  such as fully automated sorting and
continuous high volume product analysis.

     From 1984 through the present,  SRC,  Pulsarr and Ventek have  continued to
advance and refine their core technologies to increase the speed and improve the
accuracy of its machine  vision  products.  Over 22 patents have  resulted  from
these  ongoing  efforts.  Early SRC  systems  for the food  processing  industry
benefited from  state-of-the-art  microprocessors  which have been replaced with
more powerful  microprocessors  as they became  available  over time.  When full
color  recognition  systems were first  introduced in 1987, SRC responded to the
need for color signal  processing by developing a three-color  image  processing
system.  SRC then  invented a high  resolution  "RGB" (red green  blue) or "true
color"  camera  because  commercially  available  cameras  lacked the ability to
detect  the  precise  color of  objects  being  viewed.  The true  color  camera
significantly  increased the accuracy of SRC's color  processing  machine vision
systems.  SRC used the experience it gained  developing the true color camera to
develop a high  resolution  panchromatic  camera,  so that customers who require
only black and white image  processing  can achieve the same level of  precision
made possible by SRC's true color camera.

     SRC has further  increased the visual  discrimination  capabilities  of its
machine  vision  systems  with  lighting,   spectral   analysis  and  mechanical
technologies.  Since 1989, SRC has developed specialty lamps that take advantage
of the  different  reflective  properties  of items being  processed on a single
conveyer. SRC began adding to its spectral characterization  capability in 1992.
During this period,  SRC developed several  mechanical  technologies,  including
high-speed   ejection  modules,   high-speed   material   handling,   air-assist
stabilization and high-speed video motion analysis to facilitate processing on a
high speed conveyer.  SRC continued to make significant  technological  advances
until  1993  when  previous  management  reduced  expenditure  on  research  and
development resulting in a technology gap.

     Following the acquisition of SRC in 1994, the Company  embarked upon a plan
to revitalize its growth potential through significantly  increased research and
development efforts and a reassessment of marketing goals. At the same time, the
Company  established a new management  team  dedicated to  identifying  untapped
markets for machine vision systems. New management targeted marketing efforts at
niche markets in non-food processing  industries such as plastics for recycling,
pulp wood and  tobacco,  which have  resulted  in higher  average per unit sales
prices.

     The addition of Pulsarr in March 1996 greatly expanded the Company's market
presence outside North America, especially in the food processing industry.

     The  addition  of Ventek in July 1996 gave the  Company  its first  machine
vision system  application  in the wood panel  production  industry.  Ventek was
founded in 1991 by three  engineers  who were an integral part of the design and
development  of the  "Infrascan"  scanner.  In the early  1970's,  the Infrascan
became  the  industry  standard  for  detecting  defects  in wood  veneer and it
remained  the  standard  until 1994,  when Ventek  introduced  its "New  Vision"
system.  Ventek's experience in wood panel production  complements the Company's
lighting,  camera,  processing and software  capabilities.  The Company believes
that an enhanced level of precision will be achieved by incorporating SRC's high
speed line-scan camera into Ventek's veneer scanning systems, thereby increasing
their ability to separate the product into various grades,  as well as to detect
and remove defects. This improved grading capability is expected to increase the
yield of high margin grades by correctly  identifying them and minimizing waste,
enabling  customers to increase  margins on the product  produced from any given
amount of raw inputs.


Industry Background
===================

     Machine Vision:
     ---------------
     Like human  vision,  machine  vision  requires  sensing  elements and image
processors.  The camera and lighting  components of machine  vision  systems are
capable  of sensing  images  beyond  the  region of the  electromagnetic  energy
spectrum  called  "visible  light."  Machine vision systems  working outside the
visible  light range can often  provide  significantly  enhanced  discrimination
capabilities  beyond that detectable to the human eye. For example,  in plastics
recycling, this capability allows machine vision systems to discriminate between
two different types of plastics,  PVC and PET, both of which are the same color.
Under the right kind of non-visible light, the different  reflective  properties
of these two plastics make them easily  distinguishable  to a high speed camera.
In addition,  machine vision systems are capable of clearly viewing and reacting
to objects  moving at speeds of up to 1,200 feet per minute.  The  processor and
software  components of machine vision systems are capable of rapidly processing
and analyzing  signals with a high level of uniformity.  Because  machine vision
systems do not fatigue,  they are often  preferable  for high speed,  repetitive
scanning or viewing of objects over  indefinite  periods of time, as required in
many production processes.

     Quality Control:
     ----------------
     Processing  applications typically combine a computer-based conveyor system
with a machine  vision  system.  The  conveyor  presents a moving  stream of raw
product  to a  high-speed  inspection  camera.  Data  gathered  by the camera is
processed by the computer using specially developed software with the purpose of
identifying  the  location on the  conveyor of  defective  items for the express
purpose of rejecting such  defective  material.  Processors of food,  pulp wood,
tobacco and recycled  plastic  products  must process  large  quantities  of raw
product through  different  stages,  including  defect  detection and sorting to
remove defective pieces and inspect for quality.  In the agricultural  area, the
frequency  and  severity  of  defects  in the raw  product  is highly  variable,
depending upon a variety of factors affecting crops.

     Historically,   defect  detection,  removal  and  quality  control  in  the
industries  addressed the Company have been labor  intensive and dependent  upon
and limited by the variability of the work force.  These functions are performed
by a work force that is  frequently  unskilled  and  subject to a high  turnover
rate.  Large numbers of  individual  workers stand along a conveyor and visually
identify and manually remove defective pieces from the stream of moving product.
These manual  methods  cause  inconsistent  defect  removal,  as well as limited
throughput  that  varies  based upon the number and  abilities  of the  workers.
Manual  methods  also  usually  cause  excessive  amounts of good  product to be
discarded along with defective product. The industry has sought to replace these
manual  methods with  automated  systems  that  achieve  higher yield and better
quality at reduced costs.

     Automated Process Control:
     --------------------------
     Many types of manufacturing  and processing  require machine vision systems
because  of the  increasing  demands  for speed  and  accuracy.  In  high-volume
manufacturing  processes,  the demand for  production  of quality  products  has
driven  the  need  for 100%  inspection.  The  identification  of  defects  in a
continuous  stream of plywood veneer for wood panel  production is the Company's
first  such  application.  However,  while  machine  vision  systems  have  been
successfully  used to identify and remove defects in panel  production and other
industries,  human eyes and hands are  typically  still used to repair  defects,
grade  and sort  various  types of  products.  Other  companies,  such as Cognex
Corporation,  have and are addressing  this need, but must combine their pattern
recognition software and computer hardware with lighting and cameras provided by
other entities.  The Company  believes that its ability to adapt its proprietary
lighting and cameras  gives it an  advantage  over  companies  that must rely on
outside suppliers for these key components.


ARC Solutions
=============

     The Company seeks to provide its customers with a competitive  advantage by
reducing  high labor  costs,  increasing  yields and  throughput  and  improving
quality control.  The Company's  machine vision systems are capable of automated
defect  detection  and removal and  real-time  quality  analysis.  These machine
vision  systems use advanced  optical  inspection  technology to help  customers
recover more of the good product  (higher yield) and remove a higher  percentage
of  defective  product  (quality  control)  than the manual  sorting  and defect
removal  methods  historically  used  by  food  processors.  In the  wood  panel
production  industry,  increasing the number of decisions made by machine vision
systems can also result in increased throughput and higher yield with fewer line
workers.  Machine vision systems of the type produced by ARC can add significant
value in  environments  where raw product is highly  variable by  improving  the
uniformity of finished product.

     Machine  vision  technology  used for  inspection  and control of processes
(beyond defect removal)  throughout  manufacturing can eliminate adding value to
defective  products,  thereby reducing the finished product scrap rate.  Machine
vision  systems  can be used for  automated  process  control  to add  value and
improve  efficiency  in  highly  repetitive  processes,   such  as  grading  and
statistical  collection,  that require speed, accuracy and rapid throughput.  In
addition,  machine  vision systems are capable of providing  real-time  feedback
that  could  enable   manufacturers  to  rapidly  alter  or  modify   production
specifications  to achieve a high level of  consistent  quality  not  previously
achievable.  Thus, automated process control applications present an opportunity
for ARC to achieve higher margins,  while achieving substantial cost savings for
customers through the reduction of direct labor and improved product quality.


Strategy
========

     The  Company  seeks to  establish  itself as the  technological  leader and
premier  provider of machine vision systems in the markets it serves by adapting
its core  competencies  in camera,  lighting,  processing  and  software to meet
customer needs.  The Company  believes that the 1996  acquisitions of Ventek and
Pulsarr,  and continuous  development  of vision  systems apart from  mechanical
product handling  equipment can increase gross margins and enable the Company to
enter new higher margin  markets.  Important  elements of the  Company's  growth
strategy include:

   * Leverage   Expertise   in   Lighting,  Camera,  Processing   and   Software
     Technologies:  The Company  believes its core  competitive  strength is its
     breadth  and  depth of  expertise  in  optical,  lighting,  processing  and
     software technologies. The Company and its predecessors have developed this
     expertise  over a period of  thirteen  years  and  continue  to expand  its
     capabilities through research and development.  The Company seeks to expand
     the  applications  for its  technology  and to capitalize on its ability to
     apply its technology to develop new products and product enhancements.

   * Identify  and Target Key Niche  Markets:  The Company will seek to identify
     well-defined,  niche  markets with the  potential of higher per unit profit
     margins.  The Company  believes that it will achieve  higher  margins where
     customers   require  the  full  range  of  its  machine   vision   systems'
     capabilities in automated process control as well as in quality control. In
     order to gain increased  acceptance and market  penetration for its machine
     vision   systems,   ARC  will  continue  to  focus  on  forming   strategic
     relationships  with leading  companies in its target  markets.  The Company
     believes this method of strategic market  penetration to be very effective.
     The Company believes that its previous relationship with Union Carbide, and
     current  relationships  with  VTT  and  CAE  Machinery,   Ltd.  and  others
     demonstrate recognition of the technical advantages of its systems.

   * Customize Technology to Meet Customer Needs: ARC designs its products to be
     adaptable to  individual  customer  requirements.  ARC  believes  that this
     flexibility,  particularly in lighting and camera capabilities,  gives it a
     competitive advantage in being able to respond rapidly to changing needs in
     existing and new markets. ARC adapts, customizes and integrates its machine
     vision  systems  to solve  customers'  particular  problems  and  therefore
     satisfy customers' needs.

   * Expand  Sales and  Distribution:  The Company  intends to expand  sales and
     distribution  by  implementing a regional sales and service office concept.
     The Company is currently building upon its Pulsarr-based European sales and
     service  center.  An additional  office in another  geographic  location is
     planned within 18 months.  These regional sales and services  offices would
     oversee  and direct the  efforts of  representatives  for ARC.  The Company
     plans to strategically  locate these regional sales and service offices and
     to  equip  them,  financing  permitting,   with  demonstration  systems  to
     facilitate  customers'  testing  their  products on systems  similar to the
     equipment that they would order from ARC.

   * Aggressively  Pursue Use of Trial Units at Customer Sites: The Company will
     seek to place  increased  numbers of trial  units at  potential  customers'
     sites.  ARC's  experience  with trial units has been  successful  because a
     company  which has a trial unit  machine  vision  system  installed  in its
     facility  will  frequently  decide to retain and purchase  the unit.  Trial
     units provide  potential  customers  with the  opportunity  to experience a
     reduction in their  production cost prior to making the capital  commitment
     involved in purchasing one or more of the Company's machine vision systems.

   * Evaluate and Pursue New Vision Related  Products:  The Company will seek to
     identify  technologies and capabilities  that enhance its product offerings
     and market applications through joint ventures, acquisitions,  partnerships
     or other business relationships.


Products
========

     ARC currently offers the following products:


        Product                   Industry                Applications
 -------------------------------------------------------------------------------
    VHS OPTISORT(TM)(1)      Food processing,        Potato Chips, French
    RX Series                Plastic recycling       Fries, Whole Potatoes,
    RU Series                                        Vegetables, Polyethyl
    POM Series                                       Teraphthalate Green/Clear

 -------------------------------------------------------------------------------
    KROMA-SORT(r)            Food processing,        Vegetables, Plastic Flake
                             Plastic

 -------------------------------------------------------------------------------
    SPECTRA-SORT(TM)         Food processing,        Potato Products, Cereals,
                             Plastic's recycling     Vegetables

 -------------------------------------------------------------------------------
    Length & Defect          Food processing         French Fry Sorter
    Analyzer(TM)

 -------------------------------------------------------------------------------
    Pulpwood Sorter          Forest industry         Wood Chip Sorter

 -------------------------------------------------------------------------------
    Tobacco Sorter II        Tobacco                 Tobacco, Dry Food Products

 -------------------------------------------------------------------------------
    "New Vision" Veneer      Plywood Veneer          Screen defects, instruct
    Scanning System                                  other machines in Defect
                                                     Removal

 -------------------------------------------------------------------------------


     ARC's  machine  vision  systems  utilize  lighting,   camera  and  software
components,  and housing and structural components made principally of stainless
steel. They are modular in design,  which provides  flexibility in configuration
to allow  adaptability  to products of many types of industries.  The mechanical
design of these  systems is extremely  sturdy and  conforms to various  industry
regulations and standards.

     Defect Detection and Removal:
     -----------------------------
     The technology  used in ARC's machine vision systems is capable of viewing,
discriminating between usable versus defective pieces in periods ranging from 20
to 60 milliseconds  (thousandths of a second), and removing the defect while the
product is traveling at speeds of 500 to 1,200 feet per minute.  Initially,  the
product  stream is  mono-layered  (arranged  into a single layer) by a vibrating
infeed  conveyor  belt,  and fed onto the main conveyor by a steep infeed chute.
The  chute  accelerates  the  product  to  separate  product  units  in the flow
direction.  Mono-layering  and creating a sufficient space between each piece of
product  inspected,  such as individual  raisins,  facilitates  rapid,  accurate
analysis by ARC's image processing hardware and software.

     Once separated,  product is moved through the system by the high speed main
belt conveyor.  Customers select the belt color to provide a sharp contrast with
the product being sorted. Lighting is selected to maximize the difference in the
images  reflected  by  acceptable  and  defective  pieces of  product.  Intense,
specially  conditioned  fluorescent,  or  exotic  gas  discharge-produced  light
illuminates the product beneath ARC's high speed  line-scan  camera.  High speed
imaging in the camera module stores and compares light levels  reflected by each
piece of product. Levels that fall within discrimination windows selected by the
operator are considered defects.

     During the  scanning  and  analysis,  the  system  processor  monitors  the
conveyor belt position of each  defective  piece and tracks it through the short
distance to the downstream end of the main  conveyor.  The distance  between the
point at which the camera  detects the moving product and the point at which the
jet of air expels the defective piece ranges from two to 25 inches. Just as each
defective  piece is leaving  the main  conveyor,  a short jet of air is released
from one or more of the finely tuned  ejectors.  This jet of air rapidly changes
the paths of the  defective  pieces  downward so that they miss the main outfeed
chute.  Accepts are unaffected,  pass across the gap to be gently decelerated on
the outfeed chute, and then travel on to downstream processing equipment.

     ARC's machine vision systems allow the customer to establish  basic sorting
criteria  prior to running the system and are easily  fine-tuned  for day-to-day
changes in product characteristics and light levels.


Markets, Customers and Applications
===================================

     To further its growth strategy,  the Company is actively pursuing expansion
in both its  current  markets and by  identifying  and  entering  into new niche
markets  (i.e.,  markets  that are well defined  have the  potential  for higher
profit margins and in which there is little competition).  At the same time, ARC
engages in continuous  modifications  of its lighting,  camera,  processing  and
software  technologies to adapt them for new applications.  Until recently,  the
Company  marketed its machine  vision systems  primarily for quality  control in
sorting  applications.  However,  the  Company  believes  that  many  additional
applications  for its machine  vision  systems  exist in both food and  non-food
markets,  particularly  in the area of automated  process  control.  The Company
believes  its  ability  to  respond  to  customers'  needs in niche  markets  by
customizing,  developing and  integrating  its core  technology will allow it to
penetrate these markets.

     Food:
     -----
     The Company's largest market is the food processing  industry.  Within food
processing,  the largest  market  segments for the Company's  products have been
potatoes (principally french fries), vegetables and snack foods. The Company has
also penetrated fruits,  cereals and confections,  as well as a variety of other
market segments.  Customers in the food industry include J.R. Simplot, Del Monte
Foods, PepsiCo, Inc. (Frito-Lay, Inc.), and Hershey Chocolate USA.

     ARC's   systems  are  used  by  fruit  and   vegetable   processors   where
field-harvested products are cleaned, graded, automatically sorted, blanched and
processed prior to freezing,  canning or packaging for sale to institutional and
retail markets.  Principal  fruit and vegetable  market segments for the Company
are green  beans,  peas,  corn,  carrots,  onions,  raisins,  and  peaches.  The
Company's  prospects for sales in the vegetable and fruit industry  benefit from
its proprietary  color automated defect removal systems,  since defect detection
in most fruit and vegetable segments requires color analysis.  In contrast,  the
potato  industry  has been able to achieve  effective  detection of good and bad
product using black and white optical scanning technology.

     Snack food  processors  use ARC's  machine  vision  systems in a variety of
applications.  Candy  manufacturers  scan  product to remove  partially  wrapped
pieces.  Potato  chip  manufacturers  use ARC's  vision  capabilities  to ensure
consistent color and quality.

     Tobacco:
     --------
     ARC's machine vision systems provide tobacco companies  sorting  capability
to remove  impurities and foreign  matter from a stream of raw tobacco.  ARC has
sold systems to leading U.S. and international  tobacco companies,  particularly
in Japan and  Indonesia.  ARC believes  market growth for tobacco  systems shows
great  promise  based upon the high  degree of  acceptance  demonstrated  by its
customers and the significant size of the worldwide tobacco  processing  market.
The Company has entered into an agreement with COMAS S.p.A.,  a manufacturer and
seller of tobacco  processing  machinery systems  worldwide,  whereby COMAS will
represent ARC in all areas of the world outside of North America and Japan.

     Plywood Veneer:
     ---------------
     The Company has targeted the need for  detecting  and  eliminating  defects
(edge cuts,  knots and dark color) from the peeled ribbon of veneer used in wood
panel  production for the plywood  market.  Since its  introduction in 1994, the
Company's New Vision veneer  scanning  system has gained wide  acceptance in the
North American plywood industry. The Company believes that it has placed systems
in approximately  70% of U.S.  softwood veneer production lines, but has not yet
penetrated  foreign  markets to any significant  extent,  with only four systems
sold outside the U.S.

     The New Vision veneer scanning machine vision system allows  identification
of open voids,  wane and closed  defects in a fast-moving  stream of wood veneer
used  in  plywood   production  just  after  a  log  is  peeled.   After  defect
identification,  the New Vision  instructs  a clipper  (manufactured  by another
company)  to cut the veneer  immediately  before and after the  defect.  The New
Vision  reduces  the amount of good wood  attached  to the  defect  and  ensures
complete  defect  identification  at the  beginning  of the  plywood  production
process,  which  decreases  the number of  downgraded  panels,  increases  dryer
efficiency by eliminating material that ultimately becomes dry waste and reduces
re-clipping of previously  undetected  defects.  The savings provided by the New
Vision  system in the form of higher  portions  of good  wood  recovered  create
significant added value for customers.  Major customers include Georgia-Pacific,
International Paper and Columbia Forest Products.

     The  Company  believes  that its  market  share in  green  veneer  scanning
reflects the level of confidence  that  customers have for the  reliability  and
performance  of  its  products.  However,  green  veneer  scanning,  or  initial
inspection  of the veneer  represents  only one point in the vertical wood panel
production  market.   There  are  approximately  eight  other  potential  defect
detection  applications  in both the green and dry  (i.e.,  after the veneer has
been dried before lay-up and lamination)  veneer  processing.  In addition,  the
Company believes that further market potential exists in grading and matching of
hardwood and furniture-grade veneers. Thus, existing and potential new customers
who process wood at other steps in the multi-step panel  production  process are
an untapped market for the Company's  machine vision  systems.  The Company will
seek to leverage  Ventek's brand name  recognition  in green veneer  scanning to
reach  customers  at  multiple  points in the  vertical  market  for wood  panel
production so that existing and new customers can benefit from the full range of
the Company's technological capabilities.

     Forest Products:
     ----------------
     The  pulpwood  industry is  beginning  to  recognize  the benefits of using
machine  vision to separate  contaminants  in  pulpwood.  Heavy duty ARC machine
vision systems,  such as the Pulpwood Sorter,  have been developed to sort bark,
rot and other undesirable wood parts from high quality wood chips used in making
paper.  The sorter is able to  identify  bark,  rot and trash and  automatically
remove unwanted material from a fast-moving, continuous stream of wood chips. As
a result, high value chips can be economically  recovered from lower quality and
formerly  unusable  limbs and small  trees.  After  sorting  for bark and darker
content,  the wood chips command a higher market price because they require less
chemical  processing  in the  manufacture  of paper  products.  Customers in the
forest  products  industry  include VTT and CAE  Machinery,  Ltd., the Company's
exclusive distributor of the Pulpwood Sorter in North America.

     Based upon  interest from major pulp  producers,  ARC believes that a large
potential market for this process exists worldwide. Other potential applications
for  ARC  machine  vision  systems  for the  forest  products  industry  include
inspection and grading for finished lumber and reclamation of wood yard wastes.

     Plastics Recycling:
     -------------------
     World-wide  demand for plastics  drives the need for ARC's  machine  vision
systems in the plastics recycling business. Two key factors may cause demand for
recycled  plastics to increase:  increasing raw input costs for new plastics and
more stringent recycling regulations. These developments will increase potential
customers'  interest in using ARC's machine vision systems to perform  automated
sorting of a variety of post-consumer  materials.  In the future, prices for new
plastic  material are expected to rise, which may result in increased demand for
products made from recycled post-consumer material. At the same time that inputs
for new plastics have become more expensive,  government regulations in the U.S.
and abroad have begun to require  consumers  and  producers  to  recycle.  As of
December 31, 1995,  ten states had enacted  legislation  requiring  recycling of
plastics and many others have legislation pending. ARC believes that most of the
states will eventually enact some type of recycling  regulations.  Many European
and other  countries  have also enacted  recycling  laws which require up to 40%
post-consumer material in plastic bottles.

     Because  different  types  of  plastics  used  in  consumer  products  have
different  characteristics,  they  must be  separated  prior to use in  recycled
products.  ARC's proprietary  lighting and camera technologies take advantage of
different  reflective  properties  of these  plastics  to  enable  producers  of
recycled plastics to accurately separate valuable materials that could otherwise
be wasted.  Plastics used in recycled plastic  products,  include PET (polyethyl
teraphthalate)  used for transparent  soda bottles,  NHDPE (natural high density
polyethylene)  used for  translucent  milk and other fluid bottles,  and colored
HDPE used for a variety of opaque, colored bottles, such as those used for motor
oil  and  dishwashing  detergent.   Another  type  of  plastic,  PVC  (polyvinyl
chloride),  has  melting  characteristics  different  from PET or HDPE.  ARC has
developed  technologies  that (i) separate  plastics by melting point,  which is
necessary  to ensure  purity of the  recycled  material  and to  prevent  costly
shutdowns of equipment  used by recyclers in the  processes,  and (ii)  separate
plastics by color,  which is vital to the remarketing of the recycled  material.
Customers in the plastics  recycling  market  include Union  Carbide,  Inc., and
Wellman Industries.


Technology, Engineering, Research and Development
=================================================


Technology
==========

     Lighting:
     ---------
     ARC has  developed  a number  of  proprietary  technologies  that  form the
foundation  of its vision  systems,  particularly  in the areas of lighting  and
cameras.  The performance of machine vision systems is analogous to human vision
insofar as the ability to see is only as good as the lighting and optics permit.
However,  machine  vision  performance  can  be  optimized  through  the  use of
specialized  lighting to improve the contrast  between one part of an object and
another part of the same object, with the two parts having differing  reflection
properties.  ARC has developed  proprietary  lighting  technology to enhance the
contrast discrimination for objects that have nearly identical visual properties
in the visible light range. ARC's proprietary  lighting systems are manufactured
in-house.

     Optimizing  the   performance  of  a  machine  vision  system  requires  an
understanding of the spectral characteristics of the object being analyzed. This
means that the reflective  properties of the object must be  characterized  as a
function of the varying color of light (i.e. wavelength of light) by which it is
illuminated.  This process of  characterizing  the reflection of the object as a
function of the wavelength of light is called spectral analysis or spectroscopy.

     ARC's  spectroscopy  laboratory is fully equipped to measure the reflective
properties of customer  products with lighting that ranges from ultraviolet (UV)
to infrared (IR). This ability to determine the spectral  characteristics  of an
object allows ARC to eliminate trial and error approaches to lighting and camera
configurations and, therefore,  ensures optimal visual discrimination capability
of ARC vision  systems.  To better  serve its  customers,  ARC has  developed  a
portable  spectrometer  that can be taken into the field for applications  where
measurements  must be made on location due to the mutability or perishability of
the customer's product.

     Cameras:
     --------
     Machine  vision  systems  that have full color  perception  capability  are
limited by the camera's  ability to represent true color.  True color means that
the color seen by both the human observer and the machine vision system's camera
must result in the same  interpretation.  The  Company's  full color cameras use
three   fundamental   colors:   red,  green  and  blue  (RGB).  The  best  color
representation  can be  achieved  when  each of the R, G, and B sensor  elements
(i.e. pixels) are optically  coincident.  This means that when the RGB camera is
looking at a specific point on an object, all three (RGB) sensor arrays (charged
couple devices,  or "CCD's") have  corresponding  R, G & B pixels looking at the
same spot. Color accuracy and, therefore,  performance depends on the ability of
its  camera to  accurately  align the RGB CCD's.  SRC has a  patented  alignment
process for building its commercial full color line-scan cameras.

     Processing:
     -----------
     An accurate  interpretation  of images  created using  lighting and cameras
depends on the image  processing  capabilities of the rest of the machine vision
system.  Real-time image  processing is  accomplished  by high speed  electronic
signal processors  (hardware) and detection  algorithms  (software).  Successive
generations  of ARC vision  systems  have  grown  from  pan-chromatic/gray-scale
systems to full color vision.  The current  generation product under development
makes  extensive  use  of  DSP  (digital  signal  processor)  chips  that  allow
commonality within the machine with very high throughput  performance and highly
flexible functional expansion capability.

    Software:
    ---------
     High speed vision requires efficient software  algorithms.  ARC maintains a
software group that develops  specialized  proprietary  detection  algorithms to
achieve  real-time  signal   processing.   Multiple   generations  of  detection
algorithms have resulted in continual refinement of image processing capability.
This  in-house  software  resource  is  also  responsible  for the  creation  of
user-friendly  Graphics  User  Interfaces  (GUI) that make ARC products  easy to
learn, use and maintain. This enables workers in a customer's production process
to achieve the benefits of ARC's systems  without  extensive and time  consuming
training.


Research and Development
========================

     The Company anticipates research and development expenditures will continue
to increase in the future. Some of the more significant research and development
projects   undertaken   in   recent   years   were   the   development   of   an
application-specific  tobacco machine vision system for sorting,  and processing
enhancements  for  existing and new systems.  Further  research and  development
efforts are expected to flow from these activities.

     ARC's  research and  development  group  conducts new product  research and
development,  provides  support  engineering  for released  products and project
engineering for custom systems.  The R&D group includes  electronic,  mechanical
and software engineers,  mathematicians and technical support personnel. Ongoing
development  activities include improvements to current products and development
of new products. The Company provides engineering support for products in all of
its locations.

     ARC's research and development expenses have been as follows:

     Fiscal year ended December 31, 1994............................  1,476,000
     Fiscal year ended December 31, 1995............................  1,987,000
     Fiscal year ended December 31, 1996............................  4,038,000


Marketing and Sales
===================

     A principal ARC marketing  strategy is to determine  which new niche market
or application to pursue,  and to form a strategic  relationship  with a leading
company in that market.  ARC's  objective in such an alliance is (i) to interest
the leader in purchasing ARC's machine vision systems, which may lead to further
sales to other companies in the field that follow industry  trends,  and (ii) to
obtain the benefit of direct customer input and participation during the product
design  phase of adapting the ARC system to the new market or  application.  ARC
has identified  new niche market  opportunities  for  application of its machine
vision technology initially in pulp wood, tobacco and plastics for recycling.

     Focused Customer Strategy:
     --------------------------
     In recent  years,  the  Company has  established  certain  contractual  and
non-contractual  relationships  with existing  customers,  potential  customers,
distributors  and others.  The purpose of this focused  customer  strategy is to
access such customers'  knowledge and contacts within the applicable  industries
to identify  customer needs and expand sales.  Relationships  entered into since
1994 include the following:

<TABLE>
<CAPTION>
Name and/or                            Potential
Type of Company        Industry       Application         Description of Relationship
---------------        --------       -----------         ---------------------------
<S>                    <C>            <C>                 <C>
1. Union Carbide       Plastics       Recycling whole     Processing of post-consumer colored
                       recycling      bottles and         HDPE (high density polyethylene, used
                                      plastic             flakes for translucent milk and other
                                                          fluid bottles) to create PRISMA(TM)standard
                                                          plastics (PRISMA(TM) is a set of color
                                                          standards that allows for manufacture of
                                                          consistently colored HDPE containers which
                                                          require certain portions of post-consumer
                                                          material).

2. Excel               Food           Meat sorter         Non-exclusive relationship with a large
   (meat processor)                                       U. S. meat processor resulting in a
                                                          USDA-approved meat sorting system.

3. COMAS, S.p.A.       Tobacco        Tobacco sorting     COMAS contributes market access as well
   (manufacturer                                          as extensive product handling experience
   of tobacco                                             for improving ARC sorter designs to
   processing                                             accelerate market penetration with better
   equipment)                                             performing machines.

4. VTT (agency of      Pulp wood      Wood chip sorting   Exclusive arrangement with VTT on the Massahake
   the government                                         wood chip upgrading process. The Massahake
   of Finland)                                            process allows for efficient utilization of
                                                          trees that are taken from the forest.

5. CAE Machinery,      Pulp wood      Wood chip sorting   ARC seeks to capitalize on the reputation
   Ltd. (major                                            CAE in the technologically conservative
   supplier to the                                        forest products industry in North America
   North American                                         to speed the adoption of machine vision
   wood products                                          sorting technology in that industry.
   industry)

6. Columbia Forest     Wood veneer    Further automation   Agreement to mutually expore further
   Products                           of veneer            automation of hardwood plywood manufacturing
                                      processing           processes.
</TABLE>


     The Company  believes that adapting  current ARC machine vision systems for
new applications  through strategic  relationships such as these will contribute
to base business growth and accelerate entry into new niche markets.

     Sales and Distribution:
     -----------------------
     ARC has a direct sales force of 12 employees.  It also markets its products
through  representatives  pursuant  to  various  agreements  covering  different
geographical  areas.  Prior to September 30, 1996,  ARC offered its products for
sale outside the United States and Canada through Ham & Hak Engineering b.v. and
its Foodectronics  subsidiary.  Sales to Foodectronics amounted to approximately
2.9%,  6.4% and 20.1% of ARC total sales in the twelve months ended December 31,
1996,  1995 and 1994,  respectively.  On September  30, 1996,  SRC and Ham & Hak
terminated their ten-year exclusive  distribution contract. The Company will now
sell and service its machine vision systems through its  Pulsarr-based  European
office and contract sales and service engineers.

     Marketing Through Trial Units:
     ------------------------------
     ARC occasionally enters into Site Lease Agreements with potential customers
which  provide for a trial  period  (generally  from two to four months) for the
customer to test a system.  The potential customer pays a monthly rental fee for
the trial units,  which is then  credited  against the  purchase  price when the
customer  purchases  the  system.  Due to the  success  rate in  customer  sales
resulting  from the use of these trial units as a  marketing  tool,  the Company
intends  to seek to  increase  the  placement  of trial  units in new  potential
customer sites.

     International Sales:
     --------------------
     International  sales (i.e.  sales outside the United  States) for the years
ended  December 31, 1996,  1995 and 1994  accounted  for 53%, 26% and 22% of net
sales, respectively.  International sales increased as a percentage of net sales
in 1996  because  of the  acquisition  of  Pulsarr  in 1996.  Foreign  sales are
denominated  in U. S.  dollars,  or,  in the case of  Pulsarr,  primarily  Dutch
guilders.


Backlog
=======

     ARC's backlog for its products was approximately $7,578,000 at December 31,
1996,  as  compared to  $2,307,000  at December  31,  1995.  Shipment of all the
backlog orders is scheduled to take place within nine months.  Backlog  includes
only those orders for which a purchase  order has been  received and for which a
delivery  schedule  has been  established  by ARC.  However,  such orders can be
subject  to  cancellation  by the  customer.  Because  of the  timing of orders,
customer changes in delivery  schedule,  cancellation of orders and trial period
programs which are not included in backlog,  backlog as of any  particular  date
may not be  representative  of ARC's  actual  sales  for any  succeeding  fiscal
period.


Manufacturing and Supplies
==========================

     The  Company  manufactures,  assembles,  and  ships its  products  from its
facilities in Medford and Eugene,  Oregon and Eindhoven,  Holland. The Company's
Medford facility has a vertically integrated  manufacturing  process,  beginning
with  sheets and bars of  stainless  steel  which are cut and  configured,  then
welded,  to the Company's  specifications  for its components and machines.  The
Medford  operation  also  manufactures  or assembles  many of the components and
subassemblies  used  in its  machines,  such  as the  processing  unit,  air jet
expulsion component, frames and related systems.  Additionally,  all proprietary
components are manufactured by ARC in Medford, such as its RGB Cyclops(TM) color
cameras  used for optical  scanning in the  KROMA-SORT(R)  systems,  and various
lights and lamps  developed  by the  Company  for  certain of the  systems.  The
Company's Ventek (Eugene) and Pulsarr (Eindhoven)  operations integrate hardware
components  manufactured  by outside  suppliers.  The Company's  machine  vision
systems  incorporate  its  proprietary  software  and  algorithms.  Basic system
assembly  is  relatively   consistent   among  product  models  using  similarly
fabricated  parts for the machine  structure.  Most systems are customized as to
number of cameras, lighting configurations and certain other features.

     The Company has a computerized manufacturing inventory control system which
integrates  and monitors  purchasing,  inventory  control and  production.  Each
vision system is tested prior to delivery to a customer.  The Company's  quality
control   process   tests  for   reliability   and   conformance   with  product
specifications.

     The Company is dependent on outside unaffiliated  suppliers for some of the
components and parts used in its vision automation systems. Most major parts and
components are available from multiple sources;  however, the prisms required in
RGB Cyclops color cameras are obtained from a single source  supplier.  Although
such  supplier has not indicated any intention to limit or reduce sales of parts
to the  Company,  if it  were  to do so,  the  Company's  business,  results  of
operations and financial condition could be adversely affected.  The Company has
a  supply  contract  with  Pulsarr's   product  handling   machinery   supplier.
Historically, ARC has generally been able to obtain parts and components for its
systems,  as needed,  either  from its  then-current  suppliers  or  replacement
vendors.  ARC  believes  that it will  continue  to be able to  obtain  required
components and parts from various suppliers,  although there can be no assurance
that it will be able to do so.


Warranty and Customer Service
=============================

     ARC generally  provides a one-year limited warranty on its products.  Since
1993,  there  have  not  been any  claims  under  ARC's  warranty  program  that
materially  affected  ARC's  operations.  ARC also provides  telephone  customer
support services and offers annual service agreements.

     In addition, for certain custom-designed  systems, the Company contracts to
meet certain performance  specifications for specific applications.  The Company
has incurred higher  warranty  expenses  related to new products,  especially on
products  that  have not yet been  proven  to be  commercially  viable  (such as
Pulsarr's water-jet cutting  developmental  products),  than it typically incurs
with established  products.  There can be no assurance that the Company will not
incur  substantial  warranty  expenses in the future  related to new products as
well as established products, which may have an adverse effect on its results of
operations and customer relationships.


Competition
===========

     The vision  automation  system industry is subject to intense  competition.
Some of  ARC's  major  competitors  are  substantially  larger  in size and have
greater  financial  resources  than ARC. Some of its  competitors  sell machines
which are less expensive than ARC's. In some instances, a potential customer may
select the less  expensive  alternative  even  though  the ARC  system  provides
greater sorting capability.  Currently,  Key Technology,  Elbicon, Sortex, Allen
International, Morvue Electronics and Coe International are believed to be ARC's
direct  competitors.  There may be other  competitors  of ARC in addition to the
ones listed above.  ARC competes with its  competitors  on the basis of quality,
technology, systems solutions and price. There can be no assurance that ARC will
continue  to  successfully   differentiate   its  products  from  those  of  its
competitors.


Patents and Trademarks
======================

     ARC has been issued or assigned approximately 22 United States patents, and
has applied  for two other  United  States  patents  relating  to its  products,
including various inspection and detection systems and a cutter knife system. In
addition,  ARC has obtained or has applied for patent  protection for certain of
these  systems in selected  foreign  countries.  ARC believes  that two of these
patents, a system for stabilizing  articles on a conveyor and an RGB camera, are
important to its business.  These two patents expire in March 2011 and September
2008,  respectively.  Other  than  the two  patents  described  in the  previous
sentence,  ARC does not consider any of the present  patents  significant to its
current operations. These patents expire at various times over a six year period
commencing in April 2005. Additionally, SRC has seven registered trademarks: VHS
OPTISORT(TM),  KROMA-SORT(R),  SPECTRA-SORT(TM), Length and Defect Analyzer(TM),
Pulpwood Sorter, Quadra-View(R) and ODSS II(TM).

     The  Company  also   attempts  to  protect  its  trade  secrets  and  other
proprietary   information  through  proprietary   information   agreements  with
employees and consultants and other security measures. There can be no assurance
that these measures will be successful in protecting  the Company's  proprietary
rights. The laws of certain countries in which the Company's products are or may
be manufactured or sold may not protect the Company's  products and intellectual
property rights to the same extent as the laws of the United States.

     There can be no assurance  that third parties will not assert  infringement
of other claims against the Company with respect to existing or future  products
or that licenses will be available on reasonable  terms, or at all, with respect
to  Company  patents  or  any  third-party  technology.  Litigation  to  prevent
infringement  of Company patents or to determine the validity of any third-party
claims could result in significant expense to the Company and divert the efforts
of the  Company's  technical  and  management  personnel,  whether  or not  such
litigation is  determined  in favor of the Company.  The Company is not aware of
any threatened or pending patent actions.

     As a result of the 1992  settlement of a lawsuit  alleging  certain  patent
infringements, SRC entered into a royalty agreement pursuant to which SRC agreed
to pay  royalties of 7% of certain  vision  system sales  through the earlier of
June  30,  2003,  and  the  date  at  which  aggregate  royalty  payments  equal
$1,600,000. The final royalty payment was made in July 1996.


Employees
=========

     At December 31, 1996, the Company had 184 full-time employees, including 52
in manufacturing, 47 in engineering,  research and development, 38 in marketing,
sales and service,  and 26 in general  administration  and finance.  None of the
Company's  employees is represented by a labor union. The Company  considers its
employee relations to be excellent.


--------------------------------------------------------------------------------

ITEM 2.  PROPERTIES

--------------------------------------------------------------------------------

     The principal  executive  office of ARC and the principal  executive office
and  manufacturing  facilities  of SRC (a total of  approximately  82,000 square
feet) are  located  on an  approximately  6.4 acre  parcel  of land in  Medford,
Oregon.  SRC owns the land and building,  subject to a deed of trust securing an
approximately  $2.7  million  loan made by Western Bank (the Western Bank Loan).
The  Western  Bank Loan bears  interest at Western  Bank's  prime rate plus 3.5%
(9.5% as of December 31, 1996). The loan is due February 15, 2003.

     The Company's Pulsarr  manufacturing and research and development  facility
is in a 45,000 square foot building  located on a three-acre  site in Eindhoven,
Holland.  This facility,  built to Pulsarr's  specifications,  was completed and
occupied in July 1996. Pulsarr owns the land and improvements  subject to a deed
of trust securing two loans of approximately  $2.0 million made by V.S.B.  Bank.
The loans bear interest at 4.25%-7.85%  and are due in equal  installments  over
the next 13-26 years.

     Ventek  occupies  12,000  square  feet of a building  which  also  houses a
principal supplier of mechanical components for its vision systems. The space is
leased  through May 1997.  The Company  presently  intends to extend the current
lease past its expiration date.


--------------------------------------------------------------------------------

ITEM 3.  LEGAL PROCEEDINGS

--------------------------------------------------------------------------------

Liviakis Financial Communications, Inc.
=======================================

     Effective  December  31,  1993,  the Company  retained  Liviakis  Financial
Communications,   Inc.   ("Liviakis   Financial"),   a  California   corporation
wholly-owned   by  John   Liviakis   and  his  spouse,   to  provide   financial
communications  and other  consulting  services to the Company for a  three-year
period. As consideration for these services, Liviakis Financial received 790,000
shares of Class A Common Stock as a commencement  bonus as of December 31, 1993,
and was to receive an additional 2,400 shares of Class A Common Stock each month
for the term of the agreement.  The value of the shares issued as a commencement
bonus aggregated $964,000 and was recorded as an expense prior to fiscal 1994.

     On May 9, 1994,  ARC's  Board of  Directors  authorized  management  of the
Company to terminate the consulting  agreement  between the Company and Liviakis
Financial because of what the Company believed to have been material breaches of
the agreement by Liviakis Financial.  On May 20, 1994, the Company filed a claim
with the  American  Arbitration  Association  seeking a  determination  that the
contract  had been  breached  by Liviakis  Financial,  the return of the 790,000
shares of Class A Common Stock delivered to date to Liviakis  Financial pursuant
to the  contract,  a  determination  that the Company had no obligation to issue
additional  shares to Liviakis  Financial  under the contract,  plus  attorney's
fees.

     Arbitration on the Company's claims against Liviakis Financial and Liviakis
Financial's  counter-claims  occurred in  December  1994 and  January  1995.  On
February 15, 1995, the  arbitrator  issued an Interim Award  requiring  Liviakis
Financial to return  668,278 shares of Class A Common Stock to ARC, which shares
were returned in March 1995.  Additionally,  the Interim Award provided that ARC
was  entitled  to recover  all of its  reasonable  expenses  including,  but not
limited to,  attorney's  fees and costs.  The arbitrator also concluded that all
cross complaints by Liviakis Financial were without merit.

     A gain of $732,000  was  recorded in  February  1995  related to the shares
recovered.  In July 1995, ARC received  $100,000 in full  settlement of all fees
and expenses.


Ford & Cohn
===========

     In March  1993,  Wilson  Ford,  Robert  Paul  and  Maxwell  Cohn  (together
"Claimants") brought various claims against ARC and William Patridge, Asif Ahmad
and Nagaraj Murthy,  past or current  directors or employees of ARC, in lawsuits
in the Superior Courts for Los Angeles County and Orange County, California. The
lawsuits were  consolidated  in February,  1994,  and were litigated in Superior
Court for Los Angeles County in September and October, 1995.

     Ford, a  consultant  to ARC,  claims that ARC  breached an agreement  dated
September 17, 1987, and subsequently amended on August 16, 1988, by which he was
to receive 25,000 shares of stock of CNVS, Inc.,  predecessor to ARC, at no cost
and an option to  purchase  25,000  additional  shares  in the  future  upon the
occurrence of specified  events.  Ford claims he was promised that this total of
50,000 shares in the Company would amount to 5% of the outstanding  shares. Ford
also claims ARC owes him  royalties  under a royalty  agreement  for certain low
light video camera  technology.  ARC contends that Ford was never  promised that
his interest would amount to 5% of the outstanding  shares,  that Ford failed to
fulfill his obligations under the royalty agreement,  and that Ford's claims are
barred under  various  legal  theories.  Based on these  allegations,  Ford made
claims for breach of contract  and breach of the covenant of good faith and fair
dealing.

     The Claimants contend that statements allegedly made by William Patridge to
United States Alcohol Testing of America,  Inc.  ("USAT") caused USAT to rescind
an Asset Purchase  Agreement with the Claimants.  The Claimants  allege that the
statements  concerning  outstanding  lawsuits and  disputes  between ARC and the
Claimants  were false and meant to disrupt  the  business  relationship  between
Prime Lasertech and USAT. The Claimants  allegedly would have benefited from the
Asset  Purchase  Agreement  as  shareholders  and/or  licensees.  Based on these
allegations,   the  Claimants   made  claims  for   intentional   and  negligent
interference with prospective advantage, intentional and negligent infliction of
emotional distress, and civil conspiracy.

     On  October  2, 1995,  a jury  awarded  $375,000  to the  Claimants,  which
included  $281,000 of punitive  damages  for the breach of contract  claim.  The
Company has filed  motions with the court to eliminate  the punitive  portion of
the award.  ARC believes such damages are improper because (i) the claimants did
not ask for punitive damages in the contract claim, and (ii) such damages cannot
be awarded  for breach of contract  under  applicable  state  laws.  ARC is also
attempting to overturn the balance of the breach of contract  award based on the
fact that the claim was made after the statute of limitations  had expired.  ARC
has made an appeal to overturn  the verdict  based on these  factors and certain
other irregularities that occurred during the trial, which ARC believes unfairly
affected the jury's  decision.  Due to the fact that a verdict was  rendered,  a
$93,000 loss on the breach of contract  claim was recorded as a liability in the
fourth quarter of 1995.


Credit Suisse, Max Khan and Konrad Meyer
========================================

     On January 9, 1997,  the  Company  sued  Credit  Suisse in Jackson  County,
Oregon,  seeking  $1,600,000  in  fulfillment  of  Credit  Suisse's  contractual
obligation  to fund a Private  Placement  Subscription  Agreement  dated May 14,
1996. The Company claims that Credit Suisse's  failure to fund has limited ARC's
ability to finance its business plan for Pulsarr and other  operations and, as a
result,  will adversely  impact ARC's  credibility  with investors and financial
analysts.  Any  erosion  of  credibility  or,  alternatively,  the  dilution  of
shareholder value caused by alternate  financing may, in turn,  adversely impact
the Company's ability to raise debt and equity financing.

     The suit also  claims  that  Messrs.  Khan and  Meyer,  who had  previously
provided  investment  banking services to ARC, persuaded Credit Suisse to breach
the Subscription Agreement.


Other
=====

     ARC is a party  to  several  other  suits  in the  ordinary  course  of its
business.  Several of these  actions  have been  brought in Europe  against  the
Company's  Pulsarr  subsidiary.  ARC  believes  that  the  outcome  of all  such
proceedings,  even if determined adversely to Pulsarr,  will not have a material
adverse  effect upon its financial  statements  since the Company is indemnified
for any losses arising from such suits by Pulsarr's former owner.


--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

     None.




<PAGE>





                                     PART II


--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

     The Company's Class A Common Stock, Class A Warrants,  and Class B Warrants
are  quoted on the  NASDAQ  system  under the  symbols  ARCCA,  ARCCW and ARCCZ,
respectively.  The high and low  closing  prices  for the Class A Common  Stock,
Class A Warrants  and Class B Warrants  as  reported  by NASDAQ for the last two
fiscal years are indicated below.  Such prices are  inter-dealer  prices without
retail  markups,  markdowns or commissions,  and may not  necessarily  represent
actual  transactions.  There is no  established  public  trading  market for the
Company's Class B Common Stock.

<TABLE>
<CAPTION>
                                         Class A
                                       Common Stock   Class A Warrants  Class B Warrants
                                       ------------   ----------------  ----------------
                                       Low     High     Low     High     Low      High
                                       ---     ----     ---     ----     ---      ----
<S>                                    <C>     <C>      <C>     <C>      <C>      <C>
Year Ended December 31, 1995
----------------------------
First Quarter (January-March)           0.69   1.25     0.25    0.44     0.09     0.19
Second Quarter (April-June)             0.88   1.56     0.31    0.59     0.13     0.38
Third Quarter (July-September)          1.19   3.69     0.25    1.94     0.19     0.72
Fourth Quarter (October-December)       1.88   3.38     0.94    1.81     0.31     0.63

Year Ended December 31, 1996
----------------------------
First Quarter (January-March)           1.50   2.50     0.69    1.09     0.31     0.41
Second Quarter (April-June)             1.56   2.50     0.72    1.19     0.25     0.47
Third Quarter (July-September)          1.50   2.19     0.59    0.88     0.28     0.44
Fourth Quarter (October-December)       1.56   2.38     0.63    0.80     0.22     0.38

   Closing price on March 10, 1997          1.56            0.41              0.13

</TABLE>


     On December 31, 1996,  there were 110 and 25 record owners of the Company's
Class A and Class B Common  Stock,  respectively.  The  majority of  outstanding
shares of Class A Common Stock are held of record by a nominee  holder on behalf
of an unknown number of ultimate  beneficial  owners.  The Company believes that
the total number of  beneficial  owners of its common  shares was  approximately
2,300.

     ARC has not declared or paid any cash dividends upon its Common Stock since
its  inception.  ARC does  not  anticipate  paying  any  cash  dividends  in the
foreseeable  future.  It is  anticipated  that  earnings,  if any,  which may be
generated from operations will be used to finance the operations of ARC.


--------------------------------------------------------------------------------

ITEM 6.  SELECTED FINANCIAL DATA

--------------------------------------------------------------------------------

     The selected financial data for the Company presented below is derived from
and is qualified by the Company's  financial  statements  included  elsewhere in
this report,  which have been audited,  and should be read in  conjunction  with
such financial  statements and the related notes thereto.  Until early 1990, the
Company was principally  engaged in research and development and  organizational
activities  relating to its laser operations.  In October 1995, the Company sold
its laser  operations,  which  accounted  for all sales and related  expenses in
fiscal  years  1992,  1993,  all sales and a portion of  expenses  for the three
months  ended  December  31,  1993,  and a portion  of 1994  sales  and  related
expenses.  The laser operations have been treated as a discontinued  business in
the selected financial data and in the financial  statements  included elsewhere
in this Form 10-K.  All costs  incurred by the Company  prior to October 1, 1993
related to its laser operations and are netted against sales and included in the
loss from discontinued operations line. Around October 1, 1993, ARC conceived of
a new business  strategy whereby ARC would  restructure its  organizational  and
capital structure to become a parent company of various  operating  subsidiaries
(i.e., the platform company  concept).  Expenses  incurred after October 1, 1993
relating to the platform  Company  activities  are included in their  applicable
line items in the  Selected  Financial  Data below as they relate to  continuing
operations.

     In February 1994, the Company  acquired SRC. In March and July of 1996, the
Company acquired Pulsarr and Ventek, respectively;  their operations account for
a large  portion of the  fluctuation  in amounts  between  fiscal years 1996 and
1995. In May 1994, the Company  changed its fiscal year end from September 30 to
December 31. The quarter  ended  December 31,  1993,  is excluded  from any full
fiscal year and is shown  separately  below.  Selected  financial data should be
read in light of these facts and in conjunction  with the Financial  Statements,
notes to financial statements and other financial information included herein.

<TABLE>
<CAPTION>

                                                                              Three
                                         Year Ended December 31,              Months          Year Ended September 30,
                             -------------------------------------------      Ended         ----------------------------
                                  1996           1995            1994        12/31/93           1993            1992
                             ------------   ------------    ------------   ------------     ------------    ------------
<S>                          <C>            <C>             <C>            <C>              <C>             <C>
Net sales                    $ 29,938,000   $ 19,394,000    $ 11,922,000   $         --     $         --    $         --
Cost of sales                  15,794,000     11,194,000       8,537,000             --               --              --
Gross profit                   14,144,000      8,200,000       3,385,000             --               --              --
Operating expenses             12,882,000      7,546,000       8,897,000        241,000               --              --
Charge for acquired in-process
   technology                   4,915,000             --              --             --               --              --
Charge for royalty expense        647,000             --              --             --               --              --
Interest and other (expense)
   - net                         (960,000)       461,000         (37,000)      (964,000)              --              --
Income (loss) from continuing
   operations                  (5,260,000)     1,115,000      (5,549,000)    (1,205,000)              --              --
(Loss) from discontinued
   operations                          --       (173,000)     (2,248,000)      (326,000)      (3,461,000)     (2,446,000)
Net income (loss)              (5,260,000)       942,000      (7,797,000)    (1,531,000)      (3,461,000)     (2,446,000)
Earnings (loss) per share:
   Continuing operations            (0.46)          0.12           (0.57)         (0.20)              --              --
   Discontinued operations             --          (0.02)          (0.23)         (0.05)           (0.91)          (0.99)
      Total                         (0.46)          0.10           (0.80)         (0.25)           (0.91)          (0.99)
Weighted average number of
   common stock outstanding    11,486,000      9,451,000       9,703,000      6,114,000        3,793,000       2,459,000

Balance Sheet Data:

Current assets                 15,411,000     10,391,000       7,766,000      6,787,000               --              --
Current liabilities             9,498,000      3,501,000       3,181,000        810,000               --              --
Working capital surplus         5,913,000      6,890,000       4,585,000      5,977,000               --              --
Net assets relating to
   discontinued operations             --             --         393,000      1,036,000        3,445,000       2,911,000
Total assets                   30,938,000     17,628,000      14,876,000      6,815,000        3,445,000       2,911,000
Long term debt                 14,940,000      4,875,000       2,737,000             --               --              --
Total shareholders' equity
   (deficit)                    6,500,000      9,252,000       8,958,000      5,996,000        3,445,000       2,911,000

</TABLE>


--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------


Introduction
============

     Before the February  1994  acquisition  of SRC,  ARC's sole  operation  was
Applied Laser Systems,  Inc. of Oregon  ("ALSO"),  a manufacturer of laser diode
devices. The laser operation was sold in October 1995. Consequently, the results
of  operations  of ALSO have been  reported  as a  discontinued  business in the
accompanying financial statements and in the discussion below.

     The Company  acquired SRC,  Pulsarr and Ventek in February 1994, March 1996
and July  1996,  respectively.  The  operations  of the  acquired  entities  are
included in the financial statements from their respective acquisition dates.

     The following table sets forth the results of operations for the last three
years (amounts in thousands):

<TABLE>
<CAPTION>

                                                                      Year Ended December 31,
                                           -----------------------------------------------------------------------
                                                     1996                      1995                     1994
                                           ---------------------     ---------------------    --------------------
                                             Amounts        %         Amounts         %         Amounts        %
                                           ---------      ------     ---------      ------    ----------    ------
<S>                                        <C>            <C>         <C>           <C>        <C>          <C>
Sales                                      $  29,938      100.0%      $ 19,394      100.0%     $  11,922    100.0%
Cost of sales                                 15,794       52.8%        11,194       57.7%         8,537     71.6%
                                           ---------    --------      --------     -------     ---------   -------
   Gross profit                               14,144       47.2%         8,200       42.3%         3,385     28.4%
                                           ---------    --------      --------     -------     ---------   -------
Operating expenses:
   Selling & marketing                         4,662       15.6%         3,255       16.8%         2,636     22.1%
   Research & development                      4,038       13.5%         1,987       10.2%         1,476     12.4%
   General & administrative                    3,549       11.8%         1,933       10.0%         4,438     37.2%
   Goodwill expense                              633        2.1%           371        1.9%           347      2.9%
   Charge for acquired in-process
     technology                                4,915       16.4%            --          --            --        --
   Charge for royalty expense                    647        2.2%            --          --            --        --
                                           ---------    --------      --------     --------     --------   -------
                                              18,444       61.6%         7,546        38.9%        8,897     74.6%
                                           ---------    --------      --------     --------     --------   -------
Income (loss) from continuing
   operations before other income
   and expense                                (4,300)     (14.4)%          654        3.4%        (5,512)   (46.2)%
Gain on rescission of stock
   compensation - net                             --          --           732        3.8%            --        --
Other income (expense) - net                     190          .6%          212        1.1%           211       1.8%
Interest expense                              (1,150)      (3.8)%         (483)      (2.5)%         (248)    (2.1)%
                                           ----------   ---------     --------     --------     --------   --------
Income (loss) from continuing
   operations before income
   taxes                                      (5,260)     (17.6)%        1,115        5.8%        (5,549)   (46.5)%
Provision for income taxes                        --          --            --          --            --        --
Income (loss) from continuing
   operations                                 (5,260)     (17.6)%        1,115        5.8%        (5,549)   (46.5)%
Loss from discontinued
   operations                                     --          --          (173)      (0.9)%       (2,248)   (18.9)%
                                           ---------    ---------     --------     --------    ---------   --------
   Net income (loss)                       $  (5,260)     (17.6)%     $    942        4.9%     $  (7,797)   (65.4)%
                                           =========    =========     ========     =======     =========   ========
</TABLE>


Fiscal 1996 Compared to Fiscal 1995
===================================

     Sales for 1996 were $29,938,000,  up 54% when compared to sales for 1995 of
$19,394,000.  The increase is due to the inclusion of  $11,234,000  of Pulsarr's
and Ventek's sales.  Sales of non-food  machine vision systems  increased 36% or
$4,118,000 to $15,524,000. Sales of food machine vision systems increased 80% or
$6,426,000 to $14,414,000. Total machine vision systems sold in 1996 were 127 as
compared to 67 in 1995.

     Cost of sales was 52.8% of sales in 1996 and 57.7% in 1995.

     Gross profit  increased by 72.5% to  $14,144,000  in 1996 when  compared to
$8,200,000 of gross profit in 1995. In 1996, gross profit was 47.2%, as compared
to 42.3% in 1995.  The  increase  in gross  profit as a  percentage  of sales is
primarily related to the higher margin Ventek products included in 1996, as well
as a change in product mix at SRC to higher margin non-food industry systems.

     Selling and marketing  expense  increased  43.2% in 1996 to $4,662,000 when
compared to 1995 due principally to the addition of Pulsarr and Ventek.  Selling
and marketing  expenses amounted to 13.5% of sales in 1996.  Similar expenses in
1995 were $3,255,000 or 16.8% of sales.

     Research and  development  expenses were  $4,038,000 and $1,987,000 in 1996
and 1995,  or 13.5% and 10.2% of sales,  respectively.  The larger  research and
development  level in 1996 was due principally to the continuing  development of
SRC's  Advanced  Vision  Processor  and  projects in non-food  industry  sorting
applications and $885,000 for Pulsarr and Ventek.

     General and administrative  expenses increased  $1,616,000 to $3,549,000 in
1996 from  $1,933,000  in 1995.  The  increase  in  general  and  administrative
expenses is due to the  addition of Pulsarr and Ventek as well as an increase in
personnel costs and legal fees at SRC and ARC.

     The increase in Goodwill amortization is due to the acquisitions of Pulsarr
and Ventek.

     As discussed in the Notes to the  Financial  Statements,  on March 1, 1996,
the Company acquired Pulsarr for approximately $7.8 million.  Approximately $4.9
million of the purchase price was allocated to in-process technology,  which was
charged to expense  during the quarter ended March 31, 1996.  This charge is not
deductible  for tax  purposes.  The  Company  will need to invest in  additional
development  related  to the  in-process  technology  in  order  to  make  these
technologies commercially viable. These expenditures are expected to be paid out
over the next few years and will be funded  primarily  from cash  generated from
operations.

     In the first  quarter of 1996,  the Company  wrote off $647,000 of deferred
royalty expenses  relating to certain  technologies,  as all royalties have been
earned and the Company believes that no significant  future economic life exists
relating to the royalty agreement,  as the result of changing technologies.  See
Liquidity and Capital Resources below.

     In  February  1995,  Liviakis  Financial   Communications,   Inc.  returned
approximately  668,000  previously issued and outstanding  shares of ARC Class A
Common Stock pursuant to an award in arbitration in favor of the Company. A gain
of $732,000 was recorded in February 1995 relating to the shares recovered.

     The increase in interest expense is due to the increase in debt outstanding
relating to the acquisitions of Pulsarr and Ventek.

     The net loss for 1996 was  $5,260,000 as compared to net income of $942,000
in 1995.  The  variation  is due  primarily  to the  non-recurring  charges  for
in-process  technology and royalty expense,  the increased level of research and
development expenses,  and the non-recurring gain in 1995 relating to the shares
of ARC Common Stock returned pursuant to an arbitration award.


Fiscal 1995 Compared to Fiscal 1994
===================================

     The 1995 statement of operations  includes 12 months of SRC's operations as
compared to 11 months in 1994 (i.e., since the date of the Company's acquisition
of SRC).  Sales for 1995  increased 63% or $7,472,000 to $19,394,000 as compared
to 1994. Sales of non-food  machine vision systems  increased 550% or $9,653,000
to $7,988,000.  Total machine vision systems sold in 1995 were 67 as compared to
54 systems in 1994.

     Cost of sales was 57.7% of sales in 1995 and 71.6% in 1994. The decrease is
primarily  due to a spreading of fixed  manufacturing  costs over a larger sales
base and better margins on sales of non-food industry systems.  Cost of sales in
1994 also included restructuring charges of $138,000.

     Gross profit  increased by $4,815,000 to 42.3% of sales in 1995 as compared
to 28.4% of sales in 1994 as a result of the factors discussed above.

     Selling and marketing expenses increased $619,000 or 23% from 1994 to 1995.
As a percentage  of sales,  such  expenses were 16.8% in 1995 and 22.1% in 1994.
The decrease is due to the spreading of fixed costs over a larger sales base and
a  relatively  larger  trade  show  expense  in 1994  when  compared  to  sales.
Management  accelerated marketing activities in 1994 as compared to prior years.
Selling and marketing expenses also included  restructuring  charges of $227,000
in 1994.

     Research and  development  ("R&D")  expense  increased  $511,000 in 1995 to
$1,987,000.  R&D  expenditures  were  $1,476,000 in 1994. In 1994, such expenses
were  increased  from the  previous  year to develop  SRC's next  generation  of
digital signal processor,  which development continued in 1995. In 1994 SRC also
incurred the cost of developing the  SPECTRA-SORT(TM)  system and  restructuring
charges of $132,000.

     General and  administrative  expenses decreased by $2,505,000 to $1,933,000
for 1995 from $4,438,000 for 1994. The decrease is the result of the curtailment
of acquisition  activities and cost reductions implemented in the September 1994
restructuring. During 1994, acquisition related and restructuring costs amounted
to $1,419,000.  General and administrative expenses were 10% in 1995 as compared
to 37.2% in 1994. In 1995, general and administrative  expenses were spread over
a larger sales base.

     Goodwill  expense  increased  $24,000 in 1995 because of one extra month of
amortization in that period. Goodwill amortization began in February 1994.

     Income from continuing  operations  before other income and expense in 1995
was $654,000 compared to a loss of $5,512,000 in 1994 due to the above reasons.

     In  February  1995,  Liviakis  Financial   Communications,   Inc.  returned
approximately  668,000  previously issued and outstanding  shares of ARC Class A
Common Stock pursuant to an award in arbitration in favor of the Company.  A net
gain of $732,000 was recorded in February 1995 relating to the shares recovered.

     Interest  expense  increased to $483,000 in 1995 from $248,000 in 1994 as a
result of the additional debt outstanding.

     Income  from  continuing  operations  before  income  taxes  for  1995  was
$1,115,000 compared to a loss of $5,549,000 for 1994 due to the above reasons.

     The loss from  discontinued  operations  declined  to $173,000 in 1995 from
$2,248,000 in 1994. The 1994 loss included  restructuring charges of $1,250,000.
The remaining decrease in the loss from discontinued  operations was primarily a
result of cost reductions implemented in the September 1994 restructuring.

     Net income for 1995 was  $942,000 as compared to a loss of  $7,797,000  for
1994, a positive change of $8,739,000.


Liquidity and Capital Resources
===============================

     In March 1996, in conjunction with the acquisition of Pulsarr,  the Company
received  $2,000,000  from the sale of 1,400,000  shares of Class A Common Stock
pursuant to a private placement.  In April 1996, the Company received $3,000,000
representing the net proceeds of a private  placement of a convertible  debt. In
October 1995, the Company received approximately $1,052,000 from the sale of its
laser  diode  operations.   In  April  1995,  the  Company  received  $2,000,000
representing the net proceeds from a private  placement of convertible debt. The
cash generated from these  transactions  was used to finance the  acquisition of
Pulsarr and to provide funds for working capital purposes.

     The Company's  principal  sources of operating capital have been funds from
the above  transactions,  its overseas  Regulation S offerings in September  and
October 1993 and in 1994 and its initial public offering in March 1992.

     As of December 31, 1996, the Company had $5,913,000 in working capital.

     As a result of the  settlement in July 1992 of a lawsuit  alleging  certain
patent  infringements,  SRC entered into a royalty agreement,  pursuant to which
SRC agreed to pay  royalties of 7% of certain  vision  system sales  through the
earlier of June 30, 2003, and the date at which aggregate royalty payments equal
$1,600,000.  Until aggregate royalty payments equal  $1,600,000,  maximum annual
royalty payments were $400,000 through 1996. The final $400,000  installment was
paid on June 30,  1996.  During the quarter  ended March 31,  1996,  the Company
wrote off against income  $647,000 of deferred  royalty  expense  related to the
settlement as all royalties had been earned and no significant  future  economic
life is estimated to exist.

     The Company intends to continue to market its vision systems technology and
products,  and will  evaluate  selected  acquisition  opportunities.  Additional
investments will be required for capital  equipment,  marketing and research and
development for the Company to remain  competitive.  For example,  funds must be
expended to complete  development of the Company's next  generation of processor
to enhance the Company's ability to effectively  compete in certain markets with
Key  Technology  Inc.'s  (the  Company's  principal   competitor)  1995  product
introduction.  Furthermore,  if the Company  consummates  additional  technology
intensive  acquisitions,  additional  equipment  and R & D  investments  may  be
necessary,  perhaps  to  a  greater  extent  than  for  the  Company's  existing
operations.

     The Company's  ALSO  operation,  ARC's only business  prior to the February
1994 acquisition of SRC, had suffered losses since  inception.  ALSO was sold in
October 1995. In 1995, SRC generated  operating  profits  (before  allocation of
corporate overhead expenses). Even though SRC reached operating profitability in
four of the last six quarters and had a history of profitable  operations  prior
to  its   acquisition  by  ARC,  there  can  be  no  assurance  that  long  term
profitability  will be realized.  Pulsarr operated  profitably from 1990 through
1995,  but at a small loss in 1996 due to the push-down of  acquisition  related
costs,  including  interest on acquisition debt. Ventek has operated  profitably
since 1992. The Company operates in a highly competitive environment, and delays
and  difficulties  relating to technological  changes and turnaround  situations
often occur,  any of which would  materially and adversely  affect the Company's
cash  flow.  Furthermore,  operational  and  marketing  difficulties  may  occur
relating to the  integration of the recently  completed  acquisitions of Pulsarr
and Ventek.

     The  acquisition  of  Pulsarr  occurred  on March 1,  1996.  In  connection
therewith,  the Company has paid approximately $6.3 million to the sellers. Cash
received from the March and April 1996  placements  of stock and notes  detailed
above generated  approximately  $5,000,000.  The balance of the cash payments of
approximately $1,300,000, was paid from the Company's current cash balances.

     The  acquisition  of Ventek  occurred in July 1996.  Consideration  for the
transaction  was  approximately  $5.1 million in notes and other  securities  as
described  in Note 5 of  Notes to  Consolidated  Financial  Statements  included
elsewhere in this Form 10-K.

     Prior to 1995,  the Company had a history of negative  operating cash flow.
The Company  believes  it will  operate at a negative  cash flow during  certain
periods in the future due to payment of notes  issued in  connection  with prior
financings,  working capital requirements,  the need to fund certain development
projects,  cash required to enter new market areas,  and possible cash needed to
fully integrate  Pulsarr's and Ventek's  operations.  To fulfill its operational
goals and to repay  approximately  $1.3  million in debt due in April 1997,  the
Company will require approximately $1.3 million of additional  financing.  Other
than this financing  need,  management  believes that the Company has sufficient
cash to enable the Company to sustain its operations and to adequately  fund the
cash  flow  expected  to be used in  operating  activities  for the next  twelve
months.  Until the Company is able to consistently  generate  sustained positive
cash flow from operations, the Company must rely on debt or equity financing.

     In January 1997,  the Company sued Credit Suisse to fulfill its  obligation
to fund $1.6 million  pursuant to a Subscription  Agreement  dated May 14, 1996.
There can be no assurance  that the Company  will prevail in this suit  although
the Company believes it has a contractual right to the funding.

     In  connection  with the  acquisition  of Pulsarr,  the  Company  wrote off
approximately  $4.9  million  of  acquired  in-process  technology  in the first
quarter of 1996. This non-recurring charge contributed to a substantial reported
loss in 1996,  even  though  sales for 1996,  including  Pulsarr and Ventek from
their respective acquisition dates, increased from 1995 levels.

     The  Company  is seeking  additional  financing;  however,  there can be no
assurance the Company will be able to obtain any  additional  financing on terms
satisfactory to the Company,  if at all. The recent increases in (i) outstanding
shares of the Company's  Class A Common Stock due to private  placements and the
1997  Restricted  Stock  Plan,  (ii) the  April  1995  and  April  1996  private
placements  of  convertible  debt,  (iii) notes  issued in  connection  with the
acquisition  of Ventek,  (iv) a substantial  loss in 1996, and (v) the number of
securities issuable upon exercise of warrants and convertible debt may limit the
Company's ability to negotiate additional debt or equity financing.

Other Information
=================

     ARC did not have any  material  commitments  for  capital  expenditures  at
December 31, 1996.

<TABLE>
<CAPTION>

Cash Flow Summary*
==================

                                                                  Years Ended December 31,
                                                   -----------------------------------------------------
                                                        1996               1995                1994
                                                   -------------       -------------      --------------
<S>                                                <C>                 <C>                <C>
    Net cash provided by (used in)
       operating activities                        $    (950,000)      $     586,000      $   (6,190,000)
    Net cash provided by (used in)
       investing activities                           (7,511,000)            734,000          (8,938,000)
    Net cash provided by financing activities          6,199,000           2,061,000          10,477,000
                                                   -------------       -------------      --------------

    Net increase (decrease) in cash                $  (2,262,000)      $   3,381,000      $   (4,651,000)
                                                   =============       =============      ==============

     * This  information  was derived from the  Consolidated  Statements of Cash
       Flows which are part of the Company's financial statements.

</TABLE>

     Other than for fiscal 1995, in each of the fiscal  periods set forth in the
Cash Flow  Summary  above,  net  losses  driven by  special  charges in 1996 and
minimal revenues in 1994 were responsible for the significant cash flow deficits
from  operating  activities.  Furthermore,  in  1994  significant  amounts  were
expended  in  pursuit  of the  Company's  acquisition  strategy,  including  the
acquisition of SRC. There can be no assurance that the Company will ever sustain
long-term profitability, which could result in cash flow deficits.

     Historically, the Company has financed its cash flow deficits by borrowings
and sales of securities,  principally  with the net proceeds of its Regulation S
offerings.


Inflation
=========

     The Company has not been materially affected by general inflation.


Cautionary Statements and Risk Factors
======================================

     The Company may, from time to time,  make forward  looking  statements that
involve risks and  uncertainties.  Factors  associated  with the forward looking
statements  which could cause  actual  results to differ  materially  from those
stated appear below.  Readers should carefully consider the following cautionary
statements and risk factors.

     History of Losses; Negative Cash Flow:
     --------------------------------------
     Other than in 1995,  the Company  has had a history of losses and  negative
operating cash flow. The Company believes it may operate at a negative cash flow
in the future due to (i) the need to fund  certain  development  projects,  (ii)
cash required to enter new market areas,  (iii) interest costs  associated  with
recent financings, (iv) cash required for the repayment of debt, especially $1.5
million  due in April 1997,  and (v)  possible  cash  needed to fully  integrate
Pulsarr's  and Ventek's  operations.  Until the Company is able to  consistently
generate sustained positive cash flow from operations,  the Company must rely on
debt or equity financing.

     Although  the  Company  achieved  profitability  in 1995,  there  can be no
assurance as to the  Company's  profitability  on a quarterly or annual basis in
the future. Furthermore,  the non-recurring expenses in early 1996 resulted in a
significant loss for the 1996 year.

     Need for Additional Financing:
     ------------------------------
     The  Company  is seeking  additional  financing;  however,  there can be no
assurance the Company will be able to obtain any  additional  financing on terms
satisfactory to the Company,  if at all. The recent increases in (i) outstanding
shares of the  Company's  Class A Common  Stock due to  private  placements  and
implementation  of the 1997 Restricted Stock Plan, (ii) the April 1995 and April
1996 private  placements of convertible  debt, (iii) a substantial loss in 1996,
(iv)  debt  incurred  for the  acquisition  of  Ventek,  and (v) the  number  of
securities issuable upon exercise of warrants and convertible debt may limit the
Company's ability to negotiate additional debt or equity financing.

     Uncertain Ability to Manage Growth and Integrate Acquired Businesses:
     ---------------------------------------------------------------------
     As part of its  business  strategy,  the  Company  intends to pursue  rapid
growth.  In March and July  1996,  the  Company  acquired  Pulsarr  and  Ventek,
respectively,  which had sales in 1995 of  approximately  $11.4 million and $4.4
million,  respectively,  and would have added approximately 80% to the Company's
1995  sales  on  a  proforma  basis.  This  growth  strategy  will  require  the
integration of new entities,  such as Pulsarr and Ventek,  the  establishment of
distribution  relationships in foreign countries,  expanded customer service and
support,   increased   personnel   throughout  the  Company  and  the  continued
implementation  and  improvement  of the  Company's  operational,  financial and
management  information systems.  There is no assurance that the Company will be
able to attract  qualified  personnel or to accomplish other measures  necessary
for its successful integration of Pulsarr,  Ventek or other acquired entities or
for  internal  growth,  or that the Company  can  successfully  manage  expanded
operations.  As the  Company  expands,  it may  from  time  to  time  experience
constraints that will adversely affect its ability to satisfy customer demand in
a timely fashion.  Failure to manage growth  effectively  could adversely affect
the Company's financial condition and results of operations.

     Rapid Technological Change; Product Development:
     ------------------------------------------------
     The markets for the Company's  machine vision products are characterized by
rapidly  changing  technology,  evolving  industry  standards  and  frequent new
product  introductions and enhancements.  For example, the Company believes that
the 1995 introduction by Key Technology,  Inc. of its new line of vision sorting
equipment  adversely  affected bookings in late 1995 and 1996. Sales of products
such  as  those  offered  by the  Company  depend  in  part  on  the  continuing
development  and  deployment  of  emerging   technology  and  new  services  and
applications  based on such technology.  The Company's  success will depend to a
significant extent upon its ability to enhance its existing products and develop
new products  that gain market  acceptance.  There can be no assurance  that the
Company will be  successful  in  selecting,  developing  and  manufacturing  new
products or enhancing its existing products on a timely or cost-effective  basis
or that  products  or  technologies  developed  by others  will not  render  the
Company's  products  noncompetitive  or  obsolete.  Moreover,  the  Company  may
encounter  technical  problems in connection with its product  development  that
could   result  in  the  delayed   introduction   of  new  products  or  product
enhancements.  Failure to develop or introduce on a timely basis new products or
product  enhancements  that  achieve  market  acceptance  would  materially  and
adversely  affect  the  Company's  business,  operating  results  and  financial
condition.

     Market Acceptance of New Products:
     ----------------------------------
     The  Company's  future  operating  results  will depend upon its ability to
successfully  introduce and market,  on a timely and  cost-effective  basis, new
products and enhancements to existing  products.  There can be no assurance that
new products or enhancements, if developed and manufactured, will achieve market
acceptance.  The  Company  is  currently  in  the  initial  prototype  stage  of
development  on  a  new  high  speed  software  and  digital  signal  processing
technology designed to significantly improve system performance. There can be no
assurance that a market for this system will develop (i.e.,  that a need for the
system will exist,  that the system will be favored  over other  products on the
market,  etc.) or, if a market  does  develop,  that the  Company  will be able,
financially or operationally, to market and support the system successfully.

     Dependence on Certain Markets and Expansion Into New Markets:
     -------------------------------------------------------------
     The future success and growth of the Company is dependent  upon  continuing
sales in domestic and international food processing market as well as successful
penetration of other existing and potential  markets.  A substantial  portion of
the Company's  historical sales has been in the potato and vegetable  processing
markets.  Reductions in capital equipment expenditures by such processors due to
commodity surpluses,  product price fluctuations,  changing consumer preferences
or other  factors  could  have an  adverse  effect on the  Company's  results of
operations.  The Company also intends to expand the marketing of its  processing
systems in additional  food markets such as meat and granular food products,  as
well as nonfood  markets such as  plastics,  wood  products and tobacco,  and to
expand its sales activities in foreign markets.  In the case of Ventek, the wood
products  market  served  is  narrow,  and  saturation  of that  market  and the
potential  inability to identify and develop new markets could adversely  affect
Ventek's  growth  rate.   There  can  be  no  assurance  that  the  Company  can
successfully penetrate additional food and non-food markets or expand further in
foreign markets.

     Lengthy Sales Cycle:
     --------------------
     The sales cycle in the marketing and sale of the Company's  machine  vision
systems,  especially in new markets or in a new application,  is lengthy and can
be as long as three  years.  Even in existing  markets,  due to the  $100,000 to
$450,000  price range for each system,  the purchase of a machine  vision system
can constitute a substantial  capital  investment for a customer (which may need
more than one machine for its particular proposed application) requiring lengthy
consideration and evaluation. In particular, a potential customer must develop a
high  degree of  assurance  that the product  will meet its needs,  successfully
interface  with the  customer's  own  manufacturing,  production  or  processing
system, and have minimal warranty, safety and service problems. Accordingly, the
time lag from initiation of marketing efforts to final sales can be lengthy.

     Competition:
     ------------
     The markets for the  Company's  products  are highly  competitive.  A major
competitor of the Company has recently made a new product introduction which has
increased  the  competition  that  the  Company  faces.  Some  of the  Company's
competitors may have substantially greater financial,  technical,  marketing and
other resources than the Company. Important competitive factors in the Company's
markets include price, performance,  reliability,  customer support and service.
Although  the Company  believes  that it  currently  competes  effectively  with
respect to these  factors,  there can be no  assurance  that the Company will be
able to continue to compete effectively in the future.

     Dependence Upon Certain Suppliers:
     ----------------------------------
     Certain key components and subassemblies used in the Company's products are
currently  obtained from sole sources or a limited  group of suppliers,  and the
Company does not have any long-term supply agreements to ensure an uninterrupted
supply of these  components.  Although the Company seeks to reduce dependence on
sole or limited source  suppliers,  the inability to obtain  sufficient  sole or
limited source components as required,  or to develop alternative sources if and
as required,  could result in delays or  reductions in product  shipments  which
could  materially and adversely  affect the Company's  results of operations and
damage customer relationships. The purchase of certain of the components used in
the  Company's  products  require  an 8 to 12 week  lead time for  delivery.  An
unanticipated  shortage of such components could delay the Company's  ability to
timely manufacture units, damage customer relations, and have a material adverse
effect on the Company. In addition,  a significant  increase in the price of one
or  more of  these  components  or  subassemblies  could  adversely  affect  the
Company's results of operations.

     Dependence Upon Significant Customers and Distribution Channel:
     ---------------------------------------------------------------
     The Company sold equipment to two unaffiliated  customers  totaling 13% and
12% of sales in 1996 and to two customers totaling 19% and 16% of sales in 1995.
Sales to another  unaffiliated  customer totaled 15% of sales in 1994.  Ventek's
sales  have  been  to  a  relatively  small  number  of  multi-location  plywood
manufacturers.  The  Company  usually  receives  orders  of from one to  several
machine vision  systems,  but  occasionally  receives  larger orders.  While the
Company  strives  to  create  long-term  relationships  with its  customers  and
distributors,  there  can be no  assurance  that  they  will  continue  ordering
additional systems from the Company. The Company may continue to be dependent on
a small number of customers and distributors,  the loss of which would adversely
affect the Company's business.

     Risk of International Sales:
     ----------------------------
     Due to its export  sales (from the U.S.  in the case of SRC and Ventek,  or
from the  Netherlands  in the case of  Pulsarr),  the  Company is subject to the
risks of conducting business  internationally,  including  unexpected changes in
regulatory  requirements;  fluctuations in the value of the U.S. dollar or Dutch
guilder,  which  could  increase  the sales  prices in local  currencies  of the
Company's  products  in  international  markets;   delays  in  obtaining  export
licenses,  tariffs  and other  barriers  and  restrictions;  and the  burdens of
complying with a variety of international laws. In addition, the laws of certain
foreign countries may not protect the Company's  intellectual property rights to
the same extent as do the laws of the United States or the Netherlands.

     Fluctuations in Quarterly Operating Results; Seasonality:
     ---------------------------------------------------------
     The Company has  experienced and may in the future  experience  significant
fluctuations  in revenues  and  operating  results  from quarter to quarter as a
result of a number of  factors,  many of which are  outside  the  control of the
Company.  These factors include the timing of significant  orders and shipments,
product  mix,  delays in  shipment,  capital  spending  patterns  of  customers,
competition  and  pricing,  new  product  introductions  by the  Company  or its
competitors,  the timing of research and development expenditures,  expansion of
marketing  and support  operations,  changes in material  costs,  production  or
quality  problems,  currency  fluctuations,  disruptions  in  sources of supply,
regulatory changes and general economic conditions.  These factors are difficult
to forecast,  and these or other factors could have a material adverse effect on
the Company's  business and operating results.  Moreover,  due to the relatively
fixed nature of many of the Company's costs,  including personnel and facilities
costs,  the  Company  would  not be able  to  reduce  costs  in any  quarter  to
compensate for any unexpected shortfall in net sales, and such a shortfall would
have a proportionately greater impact on the Company's results of operations for
that quarter.  For example, a significant portion of the Company's quarterly net
sales depends upon sales of a relatively  small number of  high-priced  systems.
Thus,  changes in the number of such  high-priced  systems  shipped in any given
quarter can produce  substantial  fluctuations in net sales, gross profits,  and
net income from  quarter to quarter.  In  addition,  in the event the  Company's
machine vision systems' average selling price  increases,  of which there can be
no assurance,  the addition or  cancellation  of sales may exacerbate  quarterly
fluctuations in revenues and operating results.

     The Company's  operating  results may also be affected by certain  seasonal
trends.  The Company  typically  experiences lower sales and order levels in the
first quarter when compared with the preceding  fourth  quarter due primarily to
the  seasonality  of certain  harvested  food items.  The Company  expects these
seasonal  patterns to continue,  though their impact on revenues will decline as
the  Company  continues  to expand its  presence  in  nonagricultural  and other
markets which are less seasonal.

     Risks Associated With Possible Acquisitions:
     --------------------------------------------
     The Company may pursue strategic acquisitions or joint ventures in addition
to the acquisitions of Pulsarr and Ventek as part of its growth strategy.  While
the Company has no understandings, commitments or agreements with respect to any
further  acquisition,  the  Company  anticipates  that  one  or  more  potential
opportunities  may  become  available  in the  future.  Acquisitions  and  joint
ventures  would require  investment of operational  and financial  resources and
could  require  integration  of  dissimilar  operations,   assimilation  of  new
employees,  diversion of management resources, increases in administrative costs
and additional costs associated with debt or equity  financing.  There can be no
assurance that any  acquisition or joint venture by the Company will not have an
adverse  effect on the  Company's  results of  operations  or will not result in
dilution to existing shareholders. If additional attractive opportunities become
available,  the  Company  may decide to pursue  them  actively.  There can be no
assurance  that the  Company  will  complete  any future  acquisitions  or joint
ventures or that such a future  transaction  will not  materially  and adversely
affect the Company.

     Dependence Upon Key Personnel:
     ------------------------------
     The Company's  success depends to a significant  extent upon the continuing
contributions  of its key management,  technical,  sales and marketing and other
key personnel.  Except for William J. Young,  the Company's  President and Chief
Executive  Officer,  Alan R. Steel, the Company's Chief Financial  Officer,  Dr.
James  Ewan,  SRC's  President  and  Chief  Executive  Officer,  Jan C.  Scholt,
Pulsarr's  Managing  Director,  and the four former  stockholders of Ventek, the
Company does not have long-term employment agreements or other arrangements with
such  individuals  which would  encourage  them to remain with the Company.  The
Company's  future  success  also  depends upon its ability to attract and retain
additional  skilled  personnel.  Competition for such employees is intense.  The
loss of any  current  key  employees  or the  inability  to  attract  and retain
additional key personnel  could have a material  adverse effect on the Company's
business and operating results.  There can be no assurance that the Company will
be able to retain its  existing  personnel or attract  such  additional  skilled
employees in the future.

     Intellectual Property:
     ----------------------
     The  Company's  competitive  position  may be  affected  by its  ability to
protect its proprietary technology.  Although the Company has a number of United
States and foreign patents, there can be no assurance that any such patents will
provide  meaningful  protection  for its  product  innovations.  The Company may
experience additional intellectual property risks in international markets where
it may lack patent protection.

     Product Liability and Other Legal Claims:
     -----------------------------------------
     From time to time, the Company may be involved in litigation arising out of
the normal course of its business,  including  product liability and other legal
claims.  While  the  Company  has a general  liability  insurance  policy  which
includes  product  liability  coverage up to an aggregate amount of $10 million,
there can be no  assurance  that the Company  will be able to  maintain  product
liability  insurance  on  acceptable  terms or that its  insurance  will provide
adequate  coverage  against  potential  claims  in the  future.  There can be no
assurance  that third parties will not assert  infringement  claims  against the
Company,  that any such assertion of infringement  will not result in litigation
or that the Company would prevail in such litigation.  Furthermore,  litigation,
regardless of its outcome,  could result in substantial cost to and diversion of
effort by the Company. Any infringement claims or litigation against the Company
could materially and adversely affect the Company's business,  operating results
and financial condition. If a substantial product liability or other legal claim
against the Company  were  sustained  that was not covered by  insurance,  there
could  be  an  adverse   effect  on  the  Company's   financial   condition  and
marketability of the affected products.

     Warranty Exposure and Performance Specifications:
     -------------------------------------------------
     The Company generally provides a one-year limited warranty on its products.
In addition, for certain custom-designed  systems, the Company contracts to meet
certain performance specifications for a specific application.  In the past, the
Company has incurred  higher warranty  expenses  related to new products than it
typically  incurs  with  established  products.  For  example,  Pulsarr has sold
several  water-jet  cutting  machines,  a  technology  that has yet to be proven
commercially viable, which have required redesign and warranty-type expenditures
over the past several years. There can be no assurance that the Company will not
incur substantial  warranty expenses in the future with respect to new products,
as well as  established  products,  or with respect to its  obligations  to meet
performance  specifications,  which may have an adverse effect on its results of
operations and customer relationships.


--------------------------------------------------------------------------------

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

--------------------------------------------------------------------------------

     The financial  statements and related financial  information required to be
filed hereunder are indexed on page F-1 of this report and  incorporated  herein
by reference.


--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

     None.




<PAGE>





                                    PART III


--------------------------------------------------------------------------------

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

--------------------------------------------------------------------------------


                                   Management

     Executive Officers and Directors
     --------------------------------
     The directors and executive officers of ARC are as follows:

Name                         Age      Position
------------------------    -----     ------------------------------------------

William J. Young             54       President and Chief Executive Officer, and
                                      Chairman of the Board of Directors

James Ewan, Ph.D.            48       President and Chief Executive Officer of
                                      SRC Vision, Inc. and Director

Alan R. Steel                52       Vice President of Finance and Chief
                                      Financial Officer and Secretary

Rodger A. Van Voorhis        39       President, Ventek, Inc. and Director

Asif S. Ahmad                53       Director

Haig S. Bagerdjian           39       Director

Vikram Dutt                  55       Director

Robert M. Loeffler           74       Director

Nagaraj P. Murthy            42       Director

Jack Nelson                  46       Director


     William  J.  Young  became  President  and Chief  Executive  Officer of the
Company effective February 1, 1994, and Chairman of the Board in September 1994.
Mr. Young was the President and Chief Executive Officer of Volkswagen of America
from 1991 through  March 1993,  where he was  responsible  for all the company's
operations  in the  United  States,  which  exceeded  $2.2  billion  in  revenue
annually. As CEO of Volkswagon of America, Mr. Young also served as President of
V-Crest  Systems,  Inc., a computer  services  company serving 1,200  automobile
agencies,  and as a  Director  of VCI,  Inc.  a $2  billion  financial  services
company.  From  January  1989 through  December  1991,  Mr. Young served as Vice
President of Sales and Marketing of Volkswagen United States and its 700 dealers
operating in the North American market. From 1982 through 1988, Mr. Young headed
W.J. Young and Associates, an automotive marketing consulting company. From 1979
through May 1983, Mr. Young was the General  Manager of the Volkswagen  Division
of Volkswagen of America, where he was responsible for implementing the sale and
marketing  strategies  of  the  Volkswagen  Division  and  the  maintenance  and
financial health of the Volkswagen dealer organization of 950 dealers.  Prior to
1979, Mr. Young served in the capacity of National Sales Manager, and held other
management  positions in the Volkswagen  organization and other  companies.  Mr.
Young is a director of Lithia Motors, Inc.

     Dr.  James  Ewan  became  President  and  Chief  Executive  Officer  of the
Company's SRC Vision,  Inc. ("SRC") subsidiary in May 1994 and a Director of the
Company in 1996. Before joining SRC, Dr. Ewan was with Teledyne Corporation from
1985 to 1994 where he was President of Teledyne Microwave and General Manager of
Teledyne Monolithic Microwave.  At Teledyne Microwave,  Dr. Ewan was responsible
for restructuring the company from primarily a military  electronics  company to
one that derived half of revenues  from  commercial  applications.  Dr. Ewan led
Teledyne  Monolithic  Microwave  from its start-up phase until it was eventually
merged into Teledyne Microwave as an operating division.  Prior to Teledyne, Dr.
Ewan was Section Manager of the Gallium-Arsenide  Microelectronics Center of The
Aerospace  Corporation  from  1980 to 1985.  While at  Aerospace,  Dr.  Ewan was
responsible  for  the  development  of  a  range  of  state-of-the-art  compound
semiconductor  technology,  device and circuit processing and digital and analog
circuit design.

     Alan R. Steel became Vice President of Finance and Chief Financial  Officer
on March 14, 1994. Mr. Steel was the Vice President and Chief Financial  Officer
of DDL  Electronics,  Inc.  ("DDL"),  a New York Stock Exchange  listed company,
since 1983.  From 1980 to 1983, he served as Controller  for DDL.  While at DDL,
Mr.  Steel was  responsible  for handling  New York Stock  Exchange  compliance,
financial and SEC reporting, public and private equity offerings and shareholder
relations.  From  1975  to  1980,  he  served  as  financial  manager  for  ARCO
Transportation Company, a subsidiary of Atlantic Richfield Company. From 1974 to
1975 he was the Director of Internal Control at Atlantic Richfield Company. From
1967 to 1994, Mr. Steel was a certified public accountant with Arthur Andersen &
Company.

     Rodger Van Voorhis  joined  Ventek in 1992 as Vice  President of Operations
and became  President  in 1996,  and a director of the Company in 1996.  Mr. Van
Voorhis was  previously  an Assistant  Vice  President  of Marketing  for United
Financial Systems,  and held various management positions at Morvue Electronics,
Inc., a designer and  manufacturer  of wood veneer defect scanning  systems.  On
July 24, 1996,  Mr. Van Voorhis  entered into a five-year  employment  agreement
with Ventek  which  provides  for an annual  base salary of $150,000  and a $375
monthly automobile  allowance.  The contract provides that if Mr. Van Voorhis is
terminated  other than for cause before July 24, 1999, he shall be paid his base
salary until that date.

     Asif S. Ahmad is one of the two founders of ARC. He was the Chairman of the
Board and Chief Executive  Officer of ARC since it was incorporated in September
1987 until December 1993, and he remains a director of ARC. From July 1984 until
the present,  Mr. Ahmad has been practicing as a certified public  accountant at
his firm, Ahmad and Company, Certified Public Accountants. Mr. Ahmad is a member
of Chartered Accountants Institute,  Quebec and Ontario, Canada, and a member of
the California State Board of Accountancy.

     Haig S. Bagerdjian is currently Senior Vice President, Business Development
and  General  Counsel  for  Syncor  International   Corporation,  a  Chatsworth,
California-based operator of domestic and international nuclear pharmacy service
centers,  at which he has been employed since 1991. From 1987 to 1991, he served
in several executive level positions at Calmark Holding Corporation. He also was
General Counsel for American Adventure,  Inc., which was a subsidiary of Calmark
Holding.  Mr. Bagerdjian received a J.D. from Harvard Law School and is admitted
to the State Bar of California.

     Since 1983,  Vikram Dutt has been the President of Aaron, Dutt and Edwards,
Inc.  a  Chicago,  Illinois  consulting  firm  specializing  in  consulting  and
administration  of pension and profit sharing plans.  Mr. Dutt received a B.S.in
Chemical Engineering and an M.B.A. from the University of Illinois.

     Since 1978,  Robert  Loeffler  has been a  Director,  Chairman of the Audit
Committee and member of the Executive  Committee and  Compensation  Committee at
PaineWebber  Group, Inc. From 1987 to 1991, Mr. Loeffler was attorney of counsel
to Wyman, Bautzer, Kuchel & Silbert in Los Angeles,  California.  Prior to that,
he spent ten years as Partner and Managing Partner at Jones, Day, Reavis & Pogue
in Los Angeles prior to his  retirement  from the firm.  From 1965 to 1973,  Mr.
Loeffler  served in a variety  of  positions  at the asset  management  company,
Investors Diversified Services,  Inc. (IDS),  including Chief Legal Officer. Mr.
Loeffler  received an LL.B.,  magna cum laude from  Harvard  Law  School.  He is
admitted to the state bars of New York, California, Minnesota and Oklahoma.

     Dr.  Nagaraj P. Murthy is one of the two founders of ARC. He was  Secretary
and Treasurer  since it was  incorporated  in 1987 until  December  1993, and he
remained the Secretary of ARC until April 1994.  Dr. Murthy has been  practicing
as a dentist at his firm,  Nagaraj P. Murthy,  DDS,  Inc.  since 1979,  and is a
member of the American Dental Association and the California Dental Association.

     Jack Nelson,  Esq. has served as the Chairman of the Board, Chief Executive
Officer and  Treasurer of Advanced NMR Systems,  Inc., a public  company,  since
June 1991,  and was Vice Chairman from 1990 until June 1991.  Mr. Nelson is also
Chairman of the Board and Treasurer of Advanced  Mammography  Systems,  a public
company.  From January 1986 to December  1993, Mr. Nelson was an attorney at the
firm of Zaslowsky, Marx & Nelson.


--------------------------------------------------------------------------------

ITEM 11.   EXECUTIVE COMPENSATION

--------------------------------------------------------------------------------

     The Company  currently  compensates  directors who are not also officers or
employees of the Company ("outside"  directors) for attending Board meetings and
committee  meetings in the form of stock options.  Generally,  outside directors
will be granted  options to purchase  100,000  shares of Class A Common Stock at
the closing price  determined on the date such person becomes a director of ARC.
The options vest 25% upon  becoming a director,  with the  remaining 75% vesting
25% per year over the next  three  years,  subject  to  service  as a  director.
Members of the Stock Option, Audit, and Compensation Committees receive $400 per
meeting  not held in  conjunction  with a  regularly  scheduled  board  meeting.
William J. Young,  James Ewan and Rodger Van Voorhis  receive no compensation as
directors. All directors are reimbursed for expenses incurred in attending board
and committee meetings.


Executive Compensation
======================

     The following  table sets forth the  compensation  for the Chief  Executive
Officer  ("CEO") and each  executive  officer who received over $100,000 in cash
compensation for the fiscal year ended December 31, 1996

<TABLE>
<CAPTION>

                                                  Annual Compensation           Long-Term
                                            -------------------------------    Compensation
Name and Principal Positions     Year(3)    Salary      Bonus (4)   Other(1)    Options - #
----------------------------     ----       ------      -----       -------     -----------
<S>                              <C>      <C>            <C>      <C>             <C>
William J. Young                 1996     $  235,000     $40,000  $  30,000            --
 President & Chief Executive     1995        150,000          --         --       500,000 (2)
 Officer                         1994        137,500          --         --       250,000

James Ewan                       1996        200,000      40,000     30,000            --
 President of SRC Vision         1995        160,000          --         --       300,000 (2)
                                 1994        100,000          --         --       150,000

Alan R. Steel                    1996        135,000      20,000     15,000            --
 Vice President, Finance and     1995        120,000          --         --       250,000 (2)
 Chief Financial Officer         1994         95,000          --         --       100,000

<FN>
(1)    Amounts  represent  sign-on  bonuses.  No individual  listed in the table
       received  aggregate other  compensation  exceeding  $50,000 or 10% of the
       compensation reported in the table for such individual or group.

(2)    Includes 250,000, 150,000 and 100,000 options for Messrs. Young, Ewan and
       Steel,   respectively,   which  were  granted  in  replacement  of  those
       originally granted in 1994 after such 1994 options were canceled.

(3)    Messrs. Young, Ewan and Steel jointed the Company in February, March and
       May 1994, respectively.

(4)    Amounts  represent  80% of 1996  bonuses  which are payable in cash.  The
       remaining  20%  ($10,000 for Messrs.  Young and Ewan,  and $5,000 for Mr.
       Steel will be paid only if the Company  achieves  specified  profit goals
       for 1997.
</FN>
</TABLE>


Employment Agreements
=====================

     Effective  February 1, 1994,  William J. Young became  President  and Chief
Executive  Officer of the Company at a starting  salary of  $150,000.  Mr. Young
became  Chairman of the Board on  September 9, 1994.  Mr.  Young also  received,
during the first year of employment, a one-time payment of $25,000 to offset his
relocation  expenses and costs  associated  with the purchase of a new home. Mr.
Young was also granted (i) options to purchase  150,000 shares of Class A Common
Stock not under the  Company's  1991 or 1994 Stock Option Plans  exercisable  at
$4.62 per share,  and (ii) 100,000 shares of Class A Common Stock under the 1994
Stock Option Plan exercisable at $4.875 per share, which vested at a rate of 33%
per year.  In 1995,  these  options were canceled and replaced with new options.
Effective January 1, 1996, Mr. Young entered a new employment  contract with the
Company  which  provided for a sign-on  bonus of $30,000 and an annual salary of
$235,000. Effective January 1, 1997, Mr. Young entered a new employment contract
which provided for an annual salary of $250,000.  The new  employment  agreement
replaced the previous  agreement.  The  agreement  provides that if Mr. Young is
terminated  by the  Company at any time other than for cause,  he is entitled to
two years' salary as  severance.  Additionally,  the Company  provides Mr. Young
with the use of a car.

     Effective May 1, 1994, Dr. James Ewan became  President and Chief Executive
Officer of SRC at a  starting  salary of  $160,000.  Dr.  Ewan was also  granted
options to purchase  150,000 shares of Class A Common Stock under the 1994 Stock
Option Plan exercisable at $3.50 per share. In 1995, these options were canceled
and replaced by new options.  Effective  January 1, 1996, Dr. Ewan entered a new
employment  agreement with SRC which provided for a sign-on bonus of $30,000 and
an annual salary of $200,000.  Effective January 1, 1997, Dr. Ewan entered a new
employment  contract  which  provided for an annual salary of $225,000.  The new
employment  agreement  replaced the previous  agreement.  The agreement provides
that if Dr. Ewan is  terminated  by SRC at any time other than for cause,  he is
entitled to two years'  salary as  severance.  Furthermore,  if William J. Young
leaves the employ of the Company, Dr. Ewan may invoke the severance provision at
his option. Dr. Ewan is also provided with the use of a car.

     Effective March 14, 1994, the Company entered into an employment  agreement
with Alan R. Steel, Vice President of Finance and Chief Financial  Officer,  for
an annual  salary of $120,000 per year.  Mr.  Steel was also granted  options to
purchase 100,000 shares of Class A Common Stock under the 1994 Stock Option Plan
exercisable  at $4.875 per share.  In 1995,  these  options  were  canceled  and
replaced  with new options.  Additionally,  the Company paid certain  relocation
expenses for Mr.  Steel.  Effective  January 1, 1996,  Mr.  Steel  entered a new
employment  contract  with the Company  which  provided  for a sign-on  bonus of
$15,000 and an annual salary of $135,000.  Effective  January 1, 1997, Mr. Steel
entered  a new  employment  contract  which  provided  for an  annual  salary of
$143,000.  The new employment  agreement  replaced the previous  agreement.  The
agreement  provides  that if Mr. Steel is terminated by the Company at any time,
other  than for  cause,  he is  entitled  to two  years'  salary  as  severance.
Additionally, the Company provides Mr. Steel with the use of a car.


Limitation of Liability and Indemnification Matters
===================================================

     The Company's Restated Articles of Incorporation limit the liability of its
directors.  As permitted by amendments to the California General Corporation Law
enacted  in 1987,  directors  will not be  liable  to ARC for  monetary  damages
arising  from  a  breach  of  their  fiduciary  duty  as  directors  in  certain
circumstances.  Such  limitation  does not affect  liability for any breach of a
director's duty to ARC or its  stockholders  (i) with respect to approval by the
director of any transaction from which he derives an improper  personal benefit,
(ii) with respect to acts or omissions  involving an absence of good faith, that
he believes to be contrary to the best interest of ARC or its stockholders, that
involve intentional  misconduct or a knowing and culpable violation of law, that
constitute an unexcused  pattern or inattention that amounts to an abdication of
his duty to ARC or its stockholders,  or that show a reckless  disregard for his
duty to ARC or its stockholders in circumstances in which he was, or should have
been aware,  in the  ordinary  course of  performing  his  duties,  of a risk of
serious  injury  to ARC or its  stockholders,  or (iii)  based  on  transactions
between  ARC  and  its  directors  or  another  corporation  with  inter-related
directors or on improper  distributions,  loans or guarantees  under  applicable
sections of the California General Corporation Law. Such limitation of liability
also does not affect the  availability of equitable  remedies such as injunctive
relief  or  rescission.  ARC  has  been  informed  that  in the  opinion  of the
Securities and Exchange  Commission  indemnification  provisions,  such as those
contained in ARC's Restated  Articles of Incorporation,  are unenforceable  with
respect to claims arising under federal securities laws.

     ARC's  Amended and Restated  Bylaws  provide that ARC shall  indemnify  its
directors and officers to the full extent permitted by California law, including
circumstances  in  which   indemnification  is  otherwise   discretionary  under
California law, and ARC has entered into indemnity agreements with its directors
and officers providing such indemnity.


Stock Options
=============

     There were no stock  options  granted to the named  executive  officers  in
1996.

     The following table sets forth information concerning options exercised and
held by each of the named executive  officers,  and the value of options held at
December 31, 1996:

<TABLE>
<CAPTION>
                                                           Number of Shares
                                                        Underlying Unexercised     Value of Unexercised
                                                           Options/SARs at        In-the-Money Options at
                         Number of                        December 31, 1996        December 31, 1996(1)
                          Shares                          -----------------        --------------------
                         Acquired        Dollar
Name                    On Exercise  Value Realized   Exercisable/Unexercisable  Exercisable/Unexercisable
----                    -----------  --------------   -------------------------  -------------------------

<S>                          <C>            <C>            <C>                       <C>
William J. Young             0              0              333,333/166,667           $300,000/$115,000

James Ewan                   0              0              200,000/100,000           $138,000/$69,000

Alan R. Steel                0              0              166,667/83,000            $115,000/$57,000

<FN>
(1)   Amounts are shown as the difference between exercise price and fair market
      value (based on the closing price of $1.69 per share at fiscal year end).
</FN>
</TABLE>

     No options were exercised by any of the Company's executive officers during
the year ended December 31, 1996.


1991 and 1994 Stock Option Plans
================================

     The Company has adopted two stock option plans,  the 1991 Stock Option Plan
(the "1991 Plan") and the 1994 Stock Option Plan (the "1994 Plan") (collectively
the "Plans"), covering 1,000,000 and 2,000,000 shares, respectively,  of Class A
Common Stock, pursuant to which officers,  non-employee  directors and employees
of the Company, as well as other persons who render services to or are otherwise
associated  with  the  Company,   are  eligible  to  receive   incentive  and/or
non-qualified stock options.

     The terms of the Plans are  substantially  the same.  The 1991 Plan,  which
expires in December 2001, and the 1994 Plan, which expires in November 2004, are
administered by the Stock Option Committee of the Board of Directors,  currently
consisting of Jack Nelson and Robert M. Loeffler. The selection of participants,
allotments of shares, determination of price and other conditions of purchase of
options will be  determined  by the Board or the Stock  Option  Committee at its
sole  discretion  in order to attract  and retain  persons  instrumental  to the
success of the Company.  Incentive  stock  options  granted  under the Plans are
exercisable  for a  period  of up to ten  years  from  the  date of  grant at an
exercise  price  which is not less  than the fair  market  value of the  Class A
Common  Stock on the date of the  grant,  except  that the term of an  incentive
stock option  granted under the Plans to a  shareholder  owning more than 10% of
the voting  power of the  Company on the date of grant may not exceed five years
and its exercise price may not be less than 110% of the fair market value of the
Class A Common  Stock on the date of the grant.  Non-qualified  options  granted
under the Plans may be granted at less than the fair market value of the Class A
Common Stock on the date of grant.

     As of  December  31,  1996,  options to purchase  67,000  shares of Class A
Common Stock were available for future grant under the Plans.

     During the year ended December 31, 1996, an option covering  100,000 shares
was granted to James K.  Rifenbergh  upon his appointment to the Company's Board
of  Directors.  The options were not part of the 1991 or 1994 Stock Option Plans
and  were  granted  by  approval  of other  members  of the  Company's  Board of
Directors.  The options had an exercise price of $2.38 per share,  vested 25% on
the June 1, 1996  grant  date and an  additional  25% on each of the next  three
anniversary dates of the grant, and expired May 31, 2001. In January 1997, Mr.
Rifenbergh resigned as a director.

     Subsequent  to  December  31,  1996,  the Board of  Directors  granted  the
following options to the named, newly appointed directors:

<TABLE>
<CAPTION>

                                               Exercise or
          Name and                Options      Base Price
Relationship to Company          Granted (1)    ($/Share)     Expiration       Vesting
-----------------------------    -----------    ---------     ----------       -------

<S>                               <C>             <C>          <C>          <C>
Haig S. Bagerdjian, Director      100,000         $1.69        01/10/02     25% per year
                                                                            beginning 01/10/97

Vikram Dutt, Director             100,000         $1.69        01/10/02     25% per year
                                                                            beginning 01/10/97

Robert M. Loeffler, Director      100,000         $1.69        01/10/02     25% per year
                                                                            beginning 01/10/97

<FN>
(1)   Options granted to Messrs. Bagerdjian,  Dutt and Loeffler were not part of
      the 1991 or 1994 Stock  Option Plans and were granted by approval of other
      members of the Company's Board of Directors.
</FN>
</TABLE>


SRC Stock Option Plan
=====================

     Subsequent  to December  31,  1996,  the Board of  Directors  approved  the
adoption  of the SRC  Vision,  Inc.  1997  Stock  Option  Plan (the "SRC  Plan")
covering  396,000  shares of SRC's  common  stock,  pursuant to which  officers,
directors, employees and other persons providing significant services to SRC are
eligible to receive incentive and/or  non-qualified stock options. The SRC Plan,
which expires in August 2007, is administered  by the Stock Option  Committee of
SRC's Board of Directors.  The selection of participants,  allotments of shares,
determination  of price and other  conditions  of  purchase  of options  will be
determined by SRC's Board or the Stock Option  Committee at its sole  discretion
in order to  attract  and retain  persons  instrumental  to the  success of SRC.
Incentive  stock options granted under the SRC Plan are exercisable for a period
of up to ten years from the date of grant at an exercise price which is not less
than the fair  market  value of  SRC's  common  stock on the date of the  grant,
except that the term of an incentive  stock option granted under the SRC Plan to
a  shareholder  owning  more than 10% of the voting  power of SRC on the date of
grant may not exceed five years and its exercise price may not be less than 100%
of the fair  market  value  of the SRC  common  stock on the date of the  grant.
Non-qualified options granted under the SRC Plan may be granted at less than the
fair market value of the SRC common Stock on the date of grant.

     The SRC Plan was established in  contemplation of a possible future initial
public offering  ("IPO") of SRC common stock to raise  long-term  growth capital
for SRC.  While the  Company  has no current  specific  plans to effect  such an
offering,  the Company's  Board of Directors  determined that it would be in the
best  interest of ARC, as the only  stockholder  of SRC,  to  "incentivize"  key
directors  and  employees of SRC prior to an IPO in order to retain the services
of such individuals.  The following table sets forth information with respect to
SRC options granted to the named ARC executive  officers  subsequent to December
31, 1996:

<TABLE>
<CAPTION>
                                                    Exercise
          Name and                 Number of         Price
     Relationship to SRC        Options Granted   ($/Share)(1)    Expiration        Vesting
     -------------------        ---------------   ------------    ----------        -------
<S>                                   <C>           <C>          <C>           <C>
William J. Young,                     42,660         $1.86        01/09/07     100% on 01/10/06 (2)
   Chairman of the Board

James Ewan, President                152,300         $1.86        01/09/07     100% on 01/10/06 (2)
   and Chief Executive Officer
   and Director

Alan R. Steel, Chief Financial        25,005         $1.86        01/09/07     100% on 01/10/06 (2)
   Officer and Director

<FN>
     (1) The exercise  price  represents  fair market value on the grant date as
         determined by independent valuation.

     (2) Upon completion of an IPO, vesting will accelerate to 100% on the third
         anniversary date of the IPO.
</FN>
</TABLE>

     In  January  1997,  a total of 342,445  options  were  granted to  selected
optionees  under the SRC Plan on the same terms as indicated above for the named
executives.  Options to purchase 53,555 shares of SRC common stock are available
for future grant under the SRC Plan.


1997 Restricted Stock Plan
==========================

     In January 1997, the Board of Directors  adopted the 1997 Restricted  Stock
Plan (the "1997 Plan") to  compensate  for past  performance,  and to retain the
services  of,   selected   officers  and   directors  of  the  Company  and  its
subsidiaries.  A maximum  of  2,000,000  shares  of Class A Common  Stock may be
issued under the 1997 Plan,  which is  administered  by the Board of  Directors.
Subject  to the  provisions  of the 1997  Plan,  the  Board  may  interpret  the
provisions of, and adopt  amendments  to, the plan.  Stock awards under the 1997
Plan are subject to terms and conditions as determined by the Board.

     On January 10, 1997, the Board awarded  restricted shares of Class A Common
Stock to the following named executives of the Company:

     William J. Young            952,000 Shares
     James Ewan                  572,000 Shares
     Alan R. Steel               476,000 Shares

     As to 10% of the shares, such shares cannot be traded or transferred unless
(i) the employee remains in the employ of the Company until January 10, 2000 and
(ii) a payment of $1.80 per share is made by the  employee  to ARC. As to 90% of
the shares,  such shares cannot be traded or transferred  unless, in addition to
the conditions in the prior sentence, the market price of the stock as quoted by
Nasdaq or other  applicable  stock exchange for any 30 consecutive days prior to
the third  anniversary  date of the award is at least $20 per  share.  If any of
these conditions are not met, the shares of stock will be forfeited and returned
to the Company.


Report of the Compensation Committee on Executive Compensation
==============================================================

     During  the  fiscal  year  ended  December  31,  1996,  the  Company  had a
Compensation Committee of the Board of Directors (the "Committee") consisting of
directors Jack Nelson and Joseph A. DeRose or James Rifenbergh.  Messrs.  DeRose
and   Rifenbergh   resigned  as  directors  in  June  1996  and  January   1997,
respectively,  replaced in January 1997 by Robert M. Loeffler.  The compensation
of the  executive  officers of the  Company,  including  those of the  executive
officers named in the Executive  Compensation  table above, is determined by the
Committee.

     The Company's executive compensation programs are designed to:

     * provide  competitive  levels of base  compensation  in order to  attract,
       retain, and motivate high quality employees;

     * tie  individual  total  compensation  to individual  performance  and the
       success of the Company; and

     * align the interests of the Company's executive officers with those of its
       stockholders.

     In the last several years,  the Company has been  transformed from a single
business  entity  founded  in 1987 to a holding  company  with  three  operating
subsidiaries.  Past and  current  compensation  programs  reflect  the change in
business  organization.  In  view  of  the  relatively  brief  evolution  of the
executive  management team, the Company's executive  compensation  program has a
limited history, with focus being upon base salary and stock-based compensation,
such as grants of stock options and restricted stock.


Base Compensation
=================

     In determining base compensation for the Company's executive officers,  the
Committee  assesses the relative  contribution of each executive  officer to the
Company,  the  background  and  skills of each  individual,  and the  particular
opportunities  and problems which the individual  confronts in his position with
the  Company.  These  factors are then  assessed  in the context of  competitive
market factors,  including competitive  opportunities with other companies.  The
Committee may also supplement base compensation  through  discretionary  bonuses
and/or  grants  of  stock-based  compensation  in  the  course  of  its  ongoing
assessments of the performance of the Company's  executive  officers.  In making
its assessments of the Company's executive  officers,  other than Mr. Young, the
Committee gives  significant  consideration  to the views of Mr. Young including
with respect to awards of stock options.


Stock Options
=============

     The  Committee  believes  that  the  Company,  its  shareholders,  and  its
executive   officers  and  other   employees  are  well  served  by  stock-based
compensation.  Accordingly,  the Committee  views options granted under the 1991
and the 1994 Plans,  and the  restricted  stock grants  under the 1997 Plan,  as
important to an effective executive  compensation  policy. The same rationale is
also applicable to the Company's outside directors, pursuant to which awards are
granted to new directors meeting specified criteria.


Chairman of the Board, President and Chief Executive Officer
============================================================

     In determining the compensation of the Chairman of the Board, President and
Chief  Executive  Officer,  the  Committee  focused upon the programs  described
above.

     Mr. Young, the Company's  Chairman,  President and Chief Executive Officer,
was hired in  February  1994.  Mr.  Young  receives  a base  salary and has been
granted  stock  options  and  restricted  stock.  The  Committee  believes  that
stock-based  compensation  granted to Mr. Young closely align his interests with
those of the Company's stockholders.

     The  Committee  believes  that the  factors  described  in this  report are
significant  for  determining  the  Company's  performance,   and  consequently,
compensation of officers;  but  stockholders  should be aware that these are not
the only factors which influence Company stock value or overall performance, and
that the same factor may not be the most  significant in any succeeding  period.
Also, the  achievement  of targeted  objectives by the Company in any period may
not be solely indicative of the Company's future performance.


                                         Compensation Committee
                                         Robert M. Loeffler
                                         Jack Nelson




<PAGE>





Compensation Committee Interlocks and Insider Participation
===========================================================

     During the fiscal year ended  December 31,  1996,  ARC's Board of Directors
had a Compensation  Committee consisting of two directors--Jack  Nelson (for all
of 1996) and Joseph DeRose (from January to June of 1996) or James K. Rifenbergh
(from  July  to  December  1996).  Robert  M.  Loeffler  was  appointed  to  the
Compensation  Committee in January 1997 upon Mr.  Rifenbergh's  resignation from
the Board.  There are no  interlocks  between  the  Company  and other  entities
involving  the  Company's  executive  officers  and board  members  who serve as
executive officers or board members of other entities.


Comparative Stock Performance
=============================

     The chart below sets forth a line graph  comparing the  performance  of the
Company's  Class A Common Stock against the Nasdaq Stock Market - US Index and a
peer group index (Nasdaq  Non-Financial  Stock Index) for the period  commencing
March 10, 1992 (the date of the Company's initial public  offering),  and ending
December 31, 1996.  During the period from March 10, 1992,  through December 31,
1993,  the  Company  was  primarily  engaged  in the  design,  manufacture,  and
marketing of laser diode devices.  The Company  purchased SRC,  Pulsarr  Holding
b.v.  and  Ventek,  Inc.,   manufacturers  of  vision  systems  used  in  defect
identification  and machine  sorting and defect removal  equipment,  in 1994 and
1996.  As most of the  Company's  competitors  in these  business  segments  are
privately  held,  a  directly  comparable  peer  group  index is not  available.
Therefore,  the Nasdaq  Non-Financial Stock Index was selected as the peer group
index.

     The indices  assume that the value of the investment in ARC Capital Class A
Common Stock and each index was $100 on March 10, 1992,  and that dividends were
reinvested.  The  performance  graph is provided as required under federal proxy
rules.

[GRAPHIC OMITTED]

<TABLE>
<CAPTION>

                           03/10/92     09/30/92      09/30/93     12/31/94     12/31/95      12/31/96
                           --------     --------      --------     --------     --------      --------

<S>                        <C>          <C>            <C>        <C>           <C>           <C>
ARC Capital                $ 100.00     $ 122.66       $191.46    $   29.70     $  71.45      $  60.29
Nasdaq Stock Market-
  US Index                   100.00        93.88        122.96       122.55       173.31        213.18
Nasdaq Non-Financial
  Stocks                     100.00        88.79        115.60       114.55       159.63        193.95

</TABLE>


Resignation of Directors
========================

     In June 1996, the Company's Board of Directors  accepted the resignation of
Joseph A. DeRose. In January 1997, the Company's Board of Directors accepted the
resignation of James K. Rifenbergh.


--------------------------------------------------------------------------------

ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

--------------------------------------------------------------------------------

     The following table sets forth certain information regarding the beneficial
ownership of Class A Common  Stock as of March 10, 1997,  by (i) each person who
is known by ARC to own beneficially  more than 5% of outstanding  Class A Common
Stock; (ii) each of ARC's directors and named executive officers;  and (iii) all
executive officers and directors of ARC as a group:

                                                                Approximate
                                        Amount and Nature of    Percent of
     Name and Address                   Beneficial Ownership    Ownership(1)
     ----------------                   --------------------    ------------

     William J. Young                     1,566,300 (2) (4) (5)    10.5%
     2067 Commerce Drive
     Medford, OR 97504

     Allen & Company Incorporated           731,587 (3)             6.4%
        and Allen Holding, Inc.
     711 Fifth Avenue
     New York, NY 10022

     Dr. James Ewan                         872,000 (2) (5)         6.1%
     2067 Commerce Drive
     Medford, OR 97504

     Alan R. Steel                          726,000 (2) (5)         5.1%
     2067 Commerce Drive
     Medford, OR 97504

     Rodger A. Van Voorhis                  608,333 (6)             4.4%
     4217 West Fifth Avenue
     Eugene, OR 97402

     Nagaraj P. Murthy, DDS                 400,727 (5)             2.9%
     1601 North Long Beach Boulevard
     Compton, CA 90221

     Asif S. Ahmad                          367,394 (5)             2.7%
     249 East Ocean Boulevard
     Long Beach, CA 90802

     Jack Nelson, Esq.                       75,000 (5)                *
     c/o 2067 Commerce Drive
     Medford, OR 97504

     Vikram Dutt                             25,000 (5)                *
     150 North Wacker Drive
     Chicago, IL 60606

     Robert M. Loeffler                      25,000 (5)                *
     10701 Wilshire Boulevard #1401
     Los Angeles, CA 90024

     Haig S. Bagerdjian                      25,000 (5)                *
     20001 Prairie Street
     Chatsworth, CA 91311

     All executive officers and           2,541,121                18.9%
     directors as a group (10 persons)


 *     Less than 1%

     (1) Does not  include  any  shares of Class A Common  Stock  issuable  upon
exercise of any options other than certain options held by such shareholder.

     (2) Includes 952,000,  572,000 and 476,000 shares of restricted stock owned
by Messrs. Young, Ewan and Steel, respectively.

     (3)  Pursuant to  Schedule  13G,  filed with the  Securities  and  Exchange
Commission on February 14, 1997, this amount includes  126,904 shares of Class A
Common Stock  issuable upon  exercise of Class A Warrants and 604,683  shares of
Class A Common Stock issuable upon exercise of Class B Warrants.

     (4) Consists of (i) 500,000  shares of Class A Common Stock  issuable  upon
exercise of vested options; (ii) an aggregate of 14,000 shares of Class A Common
Stock  issuable  upon exercise of 5,000 Class A Warrants and the exercise of the
Class B Warrants underlying the Class A Warrants; (iii) 72,800 shares of Class A
Common Stock  issuable upon exercise of 52,000 Class B Warrants (of which 14,000
Class B Warrants are held by Mr. Young  jointly with his spouse and 16,000 Class
B Warrants  are held by Mr.  Young as  trustee  for his minor  child),  and (iv)
27,500 outstanding shares of Class A Common Stock.

     (5) Includes the currently vested portion of options held by Messrs.  Ahmad
(75,000 shares),  Murthy (75,000 shares),  Nelson (75,000 shares), Ewan (300,000
shares), Steel (250,000 shares), Dutt (25,000 shares),  Loeffler (25,000 shares)
and Bagerdjian (25,000 shares).

     (6) Consists of (i) 25,000 shares of Class A Common Stock owned by Whamdyne
LLC; (ii) 333,333 shares of Class A Common Stock issuable  pursuant to the terms
of a $2,250,000  convertible note to Veneer Technology,  Inc.; and (iii) 250,000
shares of Class A Common  Stock  issuable  upon  exercise of  warrants  owned by
Veneer  Technology,  Inc.  Mr. Van Voorhis is a 25% owner of  Whamdyne,  LLC and
Veneer  Technology,  Inc. and is, therefore,  deemed to be a beneficial owner of
such shares. See also "Certain Transactions."

     The  Class A Common  Stock  and  Class B  Common  Stock  are  substantially
identical  on a  share-for-share  basis.  The holders of Common  Stock vote as a
single  class on all  matters  to come  before  stockholders  for a vote and may
cumulate their votes in the election of directors upon giving notice as required
by law. Each share of Class B Common Stock is  automatically  converted into one
share of Class A Common  Stock  upon its sale or  transfer,  or the death of the
holder.


Compliance With Section 16(a) of the Securities Exchange Act of 1934
====================================================================

     Under the federal  securities  laws,  the  Company's  directors,  executive
officers,  and any person holding more than 10% of the Company's  Class A Common
Stock,  Redeemable  Class A  Warrants,  Redeemable  Class B  Warrants  or  Units
(consisting of shares of Class A Common Stock,  Redeemable  Class A Warrants and
Redeemable  Class B Warrants)  are  required to report  their  ownership  of the
Company's  securities  and any changes in that  ownership to the  Securities and
Exchange Commission. Specific due dates for these reports have been established,
and the Company is required to report in this Proxy  Statement  any  failures to
file by these dates since the Company  became public in March 1992.  The Company
knows of no  instances  of persons who have failed to file or have  delinquently
filed  Section  16(a) reports  within the most  recently  completed  fiscal year
except that one report covering beneficial ownership by Mr. Van Voorhis of Class
A Common Stock was filed late.


--------------------------------------------------------------------------------

ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

--------------------------------------------------------------------------------

     Concurrent  with  the  Company's  July  1996  acquisition  of  the  assets,
operations and name of Ventek, Inc. (the remaining business being renamed Veneer
Technology, Inc. ("Veneer")),  Rodger A. Van Voorhis was appointed a director of
the Company.  Mr. Van Voorhis remains a stockholder of Veneer, a private company
engaged in real estate and other business.

     In  connection  with the  acquisition,  ARC issued the  following  notes to
Veneer:  (i) a 6.75% $1,000,000 note due in three years; (ii) a 6.75% $2,250,000
note due in three years  convertible  into the Company's Class A Common Stock at
$2.25 per share; and (iii) a note and stock  appreciation  rights payable (a) by
issuance of up to 1,800,000  shares of Class A Common Stock or at the  Company's
option,  in cash in three  years,  or (b) solely in cash in the event ARC Common
Stock is  delisted  from the  Nasdaq  Stock  Market.  The  $2,250,000  note also
contains a provision giving Veneer the right to sell back to ARC up to 1,000,000
shares of ARC Class A Common Stock received upon  conversion  for  consideration
consisting  of SRC common  stock owned by ARC,  but only if an IPO of SRC common
stock is completed  before the maturity date of the note..  The number of shares
of SRC common stock to be paid shall be  determined by dividing the total market
value (as  defined) of the shares of ARC Class A Common  Stock to be sold by 70%
of the IPO price of SRC's common stock.

     The Company also issued a warrant to purchase  1,000,000  shares of Class A
Common Stock at $2.25 per share which vests over a four-year  period  subject to
Ventek's meeting specified sales and earnings goals.

     In 1996, the Company  authorized a 7.5%,  $100,000 loan to Dr. Ewan,  which
loan was  funded  in 1997.  The loan is  secured  by real  property.  The  loan,
including  interest thereon,  is to be forgiven at the rate of 25% per year over
four years beginnining on the first anniversary of the loan date, provided Dr.
Ewan remains an employee of the Company.




<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.

DATED:  March 11, 1997                          ARC CAPITAL

                                     By:   /s/   William J. Young
                                           ----------------------
                                           William J. Young
                                           Chief Executive Officer and President

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

<TABLE>
<CAPTION>

     Signature                                    Title                          Date
     ---------                                    -----                          ----

<S>                                 <C>                                       <C>
/s/   William J. Young              Chairman of the Board of Directors,
------------------------------      Chief Executive Officer and President
William J. Young                                                              March 11, 1997

/s/   Alan R. Steel                 Chief Financial Officer, Principal
------------------------------      Financial and Accounting Officer
Alan R. Steel                                                                 March 11, 1997

                                    Director                                  March __, 1997
------------------------------
Asif S. Ahmad

/s/   Haig S. Bagerdjian            Director                                  March 11, 1997
------------------------------
Haig S. Bagerdjian

/s/   Vikram Dutt                   Director                                  March 14, 1997
------------------------------
Vikram Dutt

/s/   James Ewan                    Director                                  March 11, 1997
------------------------------
James Ewan

/s/   Robert M. Loeffler            Director                                  March 10, 1997
------------------------------
Robert M. Loeffler

/s/   Nagaraj P. Murthy             Director                                  March 28, 1997
------------------------------
Nagaraj P. Murthy

                                    Director                                  March __, 1997
------------------------------
Jack Nelson

                                    Director                                  March __, 1997
------------------------------
Rodger A. Van Voorhis

</TABLE>




<PAGE>





                                     PART IV


--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

(a)  The following documents are filed as part of this report:

    1,2.   Financial Statements and Schedules.

           The financial  statements  and schedules of the Company are set forth
           in  the  "Index  to  Financial  Statements  and  Financial  Statement
           Schedules" on page F-1.

    3.     Exhibits. The following exhibits are filed as a part of this report:

Exhibit
Number     Description
------     -----------

    3.1    Restated Articles of Incorporation of the Company as amended to
           date.(7)

    3.2    Restated and Amended By-Laws of the Company. (7)

    4.1    Form of Warrant Agreement (including forms of Class A and Class B
           Warrant Certificates). (1)

    4.2    Form of Underwriter's Unit Purchase Option. (1)

    4.3    Form of Class C Warrant Agreement (including form of Class C Warrant
           Certificate). (1)

    4.4    Form of Class D Warrant Agreement. (1)

    4.5    Form of Class F Warrant Agreement. (7)

    4.6    Form of Class G Warrant Agreement. (8)

    4.7    Form of Class H Warrant Agreement. (9)

    4.8    Form of Class I Warrant Agreement. (11)

    4.9    Form of Laidlaw Warrant Agreement. (7)

    4.10   Form of stock option agreement. (10)

    4.11   Form of 1997 Restricted Stock Plan and restricted stock agreement.
           (12)

   10.1    Stock Option Plan and form of option agreements. (1)

   10.2    Form of Indemnity Agreement between the Company and each of its
           officers and directors. (1)

   10.3    Settlement Agreement and License Agreement dated July 27, 1992,
           between Key Technology, Inc. and SRC Vision. (2)

   10.4    Employment Agreement between Alan R. Steel and the Company dated
           January 1, 1997.

   10.5    Employment Agreement between William J. Young and the Company dated
           January 1, 1997.

   10.6    Employment Agreement between William J. Young and SRC Vision, Inc.
           dated January 1, 1997.

   10.7    Employment Agreement between James Ewan and the Company dated January
           1, 1997.

   10.8    Confidential Separation Agreement dated September 9, 1994, between
           the Company and William C. Patridge. (3)

   10.9    Convertible Subordinated Secured Note dated April 13, 1995, between
           ARC and Ilverton International, Ltd. (4)

   10.10   Form of Pledge and Security Agreement dated April 13, 1995, among
           ARC, Ilverton International, Ltd. and pledge holder. (4)

   10.11   Plan of Merger between ALS and ARC to effect an amendment to the
           Company's Articles of Incorporation to change the Company's name
           from Applied Laser Systems to ARC Capital. (5)

   10.12   Asset Purchase Agreement between Applied Laser Systems, Inc. and
           Coherent, Inc. dated September 22, 1995. (5)

   10.13   Stock Purchase Agreement dated March 1, 1996, (without exhibits)
           between Meijn Beheer b.v. and ARC Netherlands b.v., a wholly-owned
           subsidiary of the Company. (6)

   10.14   Stock Purchase Agreement dated March 1, 1996, between J. C. Scholt
           and ARC Netherlands b.v., a wholly-owned subsidiary of the Company.
           (6)

   10.15   Convertible Note dated March 1, 1996,  issued in connection with that
           certain Stock Purchase Agreement dated March 1, 1996, between
           J. C. Scholt and ARC Netherlands b.v. (6)

   10.16   Subscription Agreement dated January 18, 1996, between the Company
           and Swiss American Securities, Inc. as agent for Credit Suisse
           related to the private placement of 1,400,000 shares of the Company's
           Class A Common Stock. (6)

   10.17   Subscription  Agreement dated April 9, 1996,  between the Company and
           Swiss American Securities,  Inc., as agent for Credit Suisse, related
           to the private placement of $3,000,000 of convertible secured notes.
           (8)

   10.18   Convertible Secured Note dated April 17, 1996, between the Company
           and Ilverton International, Inc. (13)

   10.19   Asset Purchase Agreement dated July 24, 1996, by and among ARC,
           Ventek and the shareholders of Ventek. (11)

   10.20   $1,000,000 Note dated July 24, 1996, between ARC and Ventek. (11)

   10.21   $2,250,000 Convertible Note dated July 24, 1996, between ARC and
           Ventek. (11)

   10.22   $1,125,000 Note dated July 24, 1996, between ARC and Ventek. (11)

   10.23   Stock Appreciation Rights Agreement dated July 24, 1996 between ARC
           and Ventek. (11)

   10.24   Form of Employment Agreement dated July 24, 1996 between each of the
           four stockholders of Ventek and ARC. (11)

   10.25   Pledge and Security Agreement dated July 24, 1996, by and among ARC,
           ARC Subsidiary, Inc., Ventek and Solin and Associates, P.C. (11)

   10.26   Subscription  Agreement  dated May 14, 1996,  between the Company and
           Swiss American Securities,  Inc., as agent for Credit Suisse, related
           to the private placement of $1,600,000 of convertible secured notes.

   10.27   1997 SRC Vision, Inc. Stock Option Plan and forms of stock option
           agreements.

   23      Consent of Independent Public Accountants

   27      Financial Data Schedule

----------------------------------

  (1)      Previously filed as an exhibit to Form S-1 (File No. 33-45126).

  (2)      Filed with the SEC on May 18, 1994, as an exhibit to the Company's
           Post Effective Amendment No. 5 to Form S-1 (File No. 33-45126).

  (3)      Previously filed with the SEC on September 15, 1994, as an exhibit to
           ARC's current report on Form 8-K dated September 9, 1994.

  (4)      Filed with the SEC on April 13, 1995, as an exhibit to the Company's
           Form 10-K.

  (5)      Filed with the SEC on October 5, 1995, as an exhibit to the Company's
           Form 8-K dated October 2, 1995.

  (6)      Filed with the SEC on March 6, 1996,  as an Exhibit to the  Company's
           Form 8-K dated March 1, 1996.

  (7)      Previously filed as an exhibit to Form S-3 (File No. 333-10847).

  (8)      Filed with the SEC on April 14, 1996,  as an exhibit to the Company's
           Form 10-K for the year ended December 31, 1995.

  (9)      Filed with the SEC on May 14,  1996,  as an exhibit to the  Company's
           Form 10-Q for the quarter ended March 31, 1996.

  (10)     Filed with the SEC as an exhibit to form S-1 (File No. 33-45126).

  (11)     Filed with the SEC on July 30, 1996,  as an exhibit to the  Company's
           Form 8-K dated July 24, 1996.

  (12)     Filed  with  the  SEC on  January  22,  1997,  as an  exhibit  to the
           Company's Form 8-K dated January 9, 1997.

  (13)     Filed with the SEC on May 14,  1996,  as an exhibit to the  Company's
           Form 10-Q for the quarter ended March 31, 1996.


(b)  Reports on Form 8-K:

           On October 7, 1996, a Form 8-K was filed regarding the acquisition of
           Ventek  to  include  audited  financial  statements  of the  business
           acquired and related proforma financial information.

           On January 22, 1997, a Form 8-K was filed  regarding the  resignation
           of a director, the appointment of four new directors, and adoption of
           the 1997 Restricted Stock Plan.



<PAGE>







                                   ARC Capital

         Index to Financial Statements and Financial Statement Schedules

                                                                        Page
                                                                        ----

Financial Statements
--------------------

     Report of Independent Accountants                                  F-2

     Consolidated Balance Sheets -
      December 31, 1996 and 1995                                        F-3

     Consolidated Statements of Operations -
      Fiscal Years Ended December 31, 1996, 1995 and 1994               F-4

     Statements of Shareholders' Equity -
      Fiscal Years Ended December 31, 1996, 1995 and 1994               F-5

     Consolidated Statements of Cash Flows -
      Fiscal Years Ended December 31, 1996, 1995 and 1994               F-6

     Notes to Consolidated Financial Statements                         F-7

Financial Statement Schedules
-----------------------------

     Schedule VIII - Valuation and Qualifying Accounts                  F-25






                                       F-1


<PAGE>






                            Price Waterhouse Opinion
                        Report of Independent Accountants

To the Board of Directors and Shareholders of ARC Capital:

In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material  respects,  the financial  position of ARC
Capital and its  subsidiaries  at December 31, 1996 and 1995, and the results of
their  operations and their cash flows for each of the three years in the period
ended  December 31, 1996,  in  conformity  with  generally  accepted  accounting
principles.  These financial  statements are the responsibility of the Company's
management;  our  responsibility  is to express  an  opinion on these  financial
statements  based on our audits.  We conducted our audits of these statements in
accordance with generally accepted auditing standards which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement.  An audit includes examining, on a
test basis,  evidence  supporting  the amounts and  disclosures in the financial
statements,  assessing the accounting  principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for the opinion  expressed
above.

PRICE WATERHOUSE LLP

Portland, Oregon
March 18, 1997






                                       F-2


<PAGE>



<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------
ARC Capital

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

                                                                                          December 31,
                                                                                --------------------------------
                                                                                     1996               1995
                                                                                -------------      -------------
                                                      ASSETS
                                                      ------
<S>                                                                             <C>                <C>
Current assets:
     Cash and cash equivalents (Note 1)                                         $   1,909,000      $   4,171,000
     Accounts receivable, net of allowance for doubtful
        accounts of $280,000 and $165,000 at
        December 31, 1996 and 1995, respectively (Note 1)                           4,979,000          1,904,000
     Inventories (Notes 1 and 3)                                                    8,132,000          3,810,000
     Prepaid expenses                                                                 391,000            506,000
                                                                                -------------      -------------

              Total current assets                                                 15,411,000         10,391,000
Property, plant and equipment, net (Notes 1, 4 and 7)                               6,488,000          4,693,000
Intangible assets, net (Note 5)                                                     7,876,000          1,885,000
Other assets                                                                        1,163,000            659,000
                                                                                -------------      -------------
                                                                                $  30,938,000      $  17,628,000
                                                                                =============      =============

                                       LIABILITIES AND SHAREHOLDERS' EQUITY
                                       ------------------------------------

Current liabilities:
     Accounts payable                                                           $   1,897,000      $     769,000
     Short-term borrowings (Note 7)                                                   947,000                 --
     Accrued liabilities (Notes 6 and 10)                                           1,299,000            845,000
     Customer deposits (Note 1)                                                     2,463,000          1,083,000
     Accrued payroll                                                                  707,000            374,000
     Warranty reserve                                                                 479,000            408,000
     Current portion of notes payable (Note 7)                                      1,706,000             22,000
                                                                                -------------      -------------
              Total current liabilities                                             9,498,000          3,501,000
                                                                                -------------      -------------
Notes payable, less current portion (Note 7)                                       14,940,000          4,875,000
                                                                                -------------      -------------
Commitments and contingencies  (Note 10)

Shareholders' equity (Notes 9, 10 and 11): Common stock:
         Class A - no par value, one vote per share: 60,000,000
              shares authorized, 11,140,000 and 8,718,000 shares
              issued and outstanding at December 31, 1996 and
              1995, respectively                                                   25,648,000         22,966,000
         Class B - no par value, one vote per share:  3,000,000 shares
              authorized, 110,000 and 705,000 shares issued and
              outstanding at December 31, 1996 and 1995, respectively                  72,000            458,000
         Class E - no par value, one vote per share: 3,000,000 shares
              authorized, 0 and 497,000 shares issued and outstanding
              at December 31, 1996 and 1995 (subject to forfeiture)                        --            326,000
     Common stock warrants                                                          2,403,000          3,112,000
     Additional paid in capital                                                     2,797,000          1,500,000
     Accumulated deficit                                                          (24,370,000)       (19,110,000)
     Cumulative translation adjustment (Note 1)                                       (50,000)                --
                                                                                -------------      -------------
              Total shareholders' equity                                            6,500,000          9,252,000
                                                                                -------------      -------------
                                                                                $  30,938,000      $  17,628,000
                                                                                =============      =============

</TABLE>



                   See Accompanying Notes to Consolidated Financial Statements.

                                             F-3


<PAGE>



<TABLE>
<CAPTION>

-------------------------------------------------------------------------------------------------------------
ARC Capital

Consolidated Statements of Operations
-------------------------------------------------------------------------------------------------------------


                                                                          Year Ended December 31,
                                                              -----------------------------------------------
                                                                   1996             1995              1994
                                                                   ----             ----              ----
<S>                                                           <C>               <C>              <C>
Net sales (Note 1)                                            $ 29,938,000      $ 19,394,000     $ 11,922,000
Cost of sales                                                   15,794,000        11,194,000        8,537,000
                                                              ------------      ------------     ------------

Gross profit                                                    14,144,000         8,200,000        3,385,000
                                                              ------------      ------------     ------------

Operating expenses:
     Selling and marketing                                       4,662,000         3,255,000        2,636,000
     Research and development (Note 1)                           4,038,000         1,987,000        1,476,000
     General and administrative                                  3,549,000         1,933,000        4,438,000
     Goodwill amortization                                         633,000           371,000          347,000
     Charge for acquired in-process technology                   4,915,000                --               --
     Charge for royalty expense                                    647,000                --               --
                                                              ------------      ------------     ------------

                                                                18,444,000         7,546,000        8,897,000
                                                              ------------      ------------     ------------

Income (loss) from continuing operations
   before other income and expense                              (4,300,000)          654,000       (5,512,000)
Other income and expense:
     Gain on rescission of stock
         compensation - net (Note 10)                                   --           732,000               --
     Investment and other income                                   190,000           212,000          211,000
     Interest expense                                           (1,150,000)         (483,000)        (248,000)
                                                              ------------      ------------     ------------
Income (loss) from continuing operations
   before income taxes                                          (5,260,000)        1,115,000       (5,549,000)

Provision for income taxes (Note 8)                                     --                --               --
                                                              ------------      ------------     ------------

Income (loss) from continuing operations                        (5,260,000)        1,115,000       (5,549,000)

Loss from discontinued operations (Notes 1 and 12)                      --          (173,000)      (2,248,000)
                                                              ------------      ------------     ------------

Net income (loss)                                             $ (5,260,000)     $    942,000     $ (7,797,000)
                                                              =============     ============     ============
Earnings (loss) per share (Notes 1 and 11):
     Continuing operations                                    $       (0.46)    $       0.12     $      (0.57)
     Discontinued operations                                           0.00            (0.02)           (0.23)
                                                              -------------     ------------     ------------

         Total                                                $       (0.46)    $       0.10     $      (0.80)
                                                              =============     ============     ============

Weighted average shares outstanding (Notes 1 and 11)             11,486,000         9,451,000       9,703,000
                                                              =============     =============    ============

</TABLE>



                    See Accompanying Notes to Consolidated Financial Statements.

                                              F-4


<PAGE>



<TABLE>
<CAPTION>

------------------------------------------------------------------------------------------------------------------------------------
ARC Capital

Consolidated Statements of Shareholders' Equity (Deficit)
------------------------------------------------------------------------------------------------------------------------------------

                             Class A                Class B             Class E
                          Common Stock           Common Stock        Common Stock      Common    Additional               Cumulative
                          ------------           ------------        ------------       Stock     Paid in   Accumulated  Translation
                      Shares      Amount     Shares     Amount    Shares    Amount    Warrants    Capital     Deficit    Adjustments
                      ------      ------     ------     ------    ------    ------    --------    -------     -------    -----------
<S>                 <C>        <C>           <C>      <C>        <C>      <C>        <C>         <C>         <C>           <C>
Balance,
 December 31, 1993  6,000,000  $12,719,000   971,000  $ 630,000  497,000  $ 326,000  $3,076,000  $1,500,000  $(12,255,000) $     --
Stock compensation     12,000       15,000        --         --       --         --          --          --            --        --
Common stock issued
 through Regulation
 S offering         3,000,000   10,793,000        --         --       --         --          --          --            --        --
Repurchase of Class
 A Common Stock       (40,000)    (104,000)       --         --       --         --          --          --            --        --
Conversion of Class
 B to Class A
 Common Stock         253,000      164,000  (253,000)  (164,000)      --         --          --          --            --        --
Exercise of  warrants   8,000       34,000        --         --       --         --      (5,000)         --            --        --
Issuance of warrants       --           --        --         --       --         --      26,000          --            --        --
Net loss                   --           --        --         --       --         --          --          --    (7,797,000)       --
                    ---------  -----------  --------  ---------  -------  ---------  ----------  ----------  ------------  --------

Balance,
 December 31, 1994  9,233,000   23,621,000   718,000    466,000  497,000    326,000   3,097,000   1,500,000   (20,052,000)       --
Rescission of stock
 compensation, net   (612,000)    (747,000)       --         --       --         --          --          --            --        --
Issuance of Class
 F Warrants in
 connection with
 debt issuance             --           --        --         --       --         --      15,000          --            --        --
Conversion of Class
 B to Class A
 Common Stock          13,000        8,000   (13,000)    (8,000)      --         --          --          --            --        --
Exercise of options    84,000       84,000        --         --       --         --          --          --            --        --
Net income                 --           --        --         --       --         --          --          --       942,000        --
                    ---------  -----------  --------  ---------  -------  ---------  ----------  ----------  ------------  --------

Balance,
 December 31, 1995  8,718,000   22,966,000   705,000    458,000  497,000    326,000   3,112,000   1,500,000   (19,110,000)       --
Redemption of Class
 E Common Stock            --           --        --         -- (497,000)  (326,000)         --     326,000            --        --
Expiration of Class
 E Warrants                --           --        --         --       --         --    (971,000)    971,000            --        --
Issuance of Class G,
 H, I and J Warrants       --           --        --         --       --         --     262,000          --            --        --
Conversion of Class
 B to Class A
 Common Stock         595,000      386,000  (595,000)  (386,000)      --         --          --          --            --        --
Common Stock issued
 through Regulation
 S Offering         1,400,000    1,571,000        --         --       --         --          --          --            --        --
Exercise of options    83,000       80,000        --         --       --         --          --          --            --        --
Partial conversion
 of Note Payable      344,000      645,000        --         --       --         --          --          --            --        --
Translation adjustment     --           --        --         --       --         --          --          --            --   (50,000)
Net loss                   --           --        --         --       --         --          --          --    (5,260,000)       --
                    ---------  -----------  --------  ---------  -------  ---------  ----------  ----------  ------------  --------
Balance,
 December 31, 1996 11,140,000  $25,648,000   110,000  $  72,000       --  $      --  $2,403,000  $2,797,000  $(24,370,000) $(50,000)
                    =========  ===========  ========  =========  =======  =========  ========== ===========  ============  ========

</TABLE>


                    See Accompanying Notes to Consolidated Financial Statements.

                                              F-5


<PAGE>



<TABLE>
<CAPTION>

----------------------------------------------------------------------------------------------------------------
ARC Capital

Consolidated Statements of Cash Flows
----------------------------------------------------------------------------------------------------------------

                                                                             Year Ended December 31,
                                                                  ----------------------------------------------
                                                                       1996            1995             1994
                                                                  ------------     ------------     ------------
<S>                                                               <C>              <C>              <C>
Cash flows from operating activities:
   Net (loss) income                                              $ (5,260,000)    $    942,000     $ (7,797,000)
   Loss from discontinued operations                                        --          173,000        2,248,000
                                                                  ------------     ------------     ------------

   (Loss) income from continuing operations                         (5,260,000)       1,115,000       (5,549,000)
   Adjustments to reconcile net income (loss) to net cash
     used in operating activities:
     Charge for acquired in-process technology                       4,915,000               --               --
     Charge for royalty expense                                        247,000               --               --
     Cash outflows related to discontinued operations                       --         (728,000)      (1,606,000)
     Provision for restructuring adjustments                                --               --          930,000
     Depreciation and amortization                                   1,263,000          831,000          744,000
     Stock compensation                                                     --         (732,000)              --
     Changes  in  assets  and   liabilities
       (net of amounts purchased in acquisition):
       Accounts receivable                                          (1,741,000)        (122,000)        (776,000)
       Inventories                                                    (581,000)         402,000         (175,000)
       Prepaid expenses and other assets                               156,000         (399,000)        (189,000)
       Accounts payable, short-term borrowings,
         accrued liabilities, customer deposits,
         accrued payroll, and warranty reserve                          51,000          219,000          431,000
                                                                  ------------     ------------     ------------

         Net cash (used in) provided by operating activities          (950,000)         586,000       (6,190,000)
                                                                  ------------     ------------     ------------

Cash (used in) provided by investing activities:
   Proceeds from sale of ALSO                                               --        1,052,000               --
   Acquisition of SRC Vision                                                --               --       (8,100,000)
   Acquisition of Pulsarr/Ventek - net                              (5,984,000)              --               --
   Purchases of property and equipment                              (1,527,000)        (598,000)        (468,000)
   Collection (issuance) of notes receivable - net                          --          280,000         (370,000)
                                                                  ------------     ------------     ------------

         Net cash provided by (used in) investing activities        (7,511,000)         734,000       (8,938,000)
                                                                  ------------     ------------     ------------

Cash (used in) provided by financing activities:
   Notes payable to related parties, net                                    --               --         (202,000)
   Notes payable to bank and others, net                             4,621,000        2,137,000          (39,000)
   Proceeds from common stock issuances                              1,896,000               --       10,793,000
   Proceeds from exercise of stock options                              82,000           84,000               --
   Proceeds from exercise of warrants                                       --               --           29,000
   Repurchase of Class A Common Stock                                       --               --         (104,000)
   Debt issuance costs                                                (400,000)        (160,000)              --
                                                                  ------------     ------------     ------------

         Net cash provided by financing activities                   6,199,000        2,061,000       10,477,000
                                                                  ------------     ------------     ------------

Net (decrease) increase in cash                                     (2,262,000)       3,381,000       (4,651,000)

Cash and cash equivalents, beginning of the period                   4,171,000          790,000        5,441,000
                                                                  ------------     ------------     ------------

Cash and cash equivalents, end of the period                      $  1,909,000     $  4,171,000     $    790,000
                                                                  ============     ============     ============
Supplemental cash flow information:
   Cash paid for:
     Interest                                                     $    809,000     $    372,000     $    251,000
                                                                  ============     ============     ============


</TABLE>






                    See Accompanying Notes to Consolidated Financial Statements.

                                              F-6


<PAGE>





                          ARC CAPITAL AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

--------------------------------------------------------------------------------

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

--------------------------------------------------------------------------------

     Basis of Presentation:
     ----------------------
     The consolidated  financial  statements include the accounts of ARC Capital
("ARC" or the "Company")  and its four  wholly-owned  subsidiaries,  SRC Vision,
Inc. ("SRC");  Ventek, Inc. ("Ventek");  ARC Netherlands B.V. and its respective
wholly-owned  subsidiary,  Pulsarr Holding B.V.  ("Pulsarr");  and Applied Laser
Systems, Inc. of Oregon ("ALSO").

     ALSO designed,  developed,  manufactured  and marketed laser diode devices,
incorporating  its  visible  laser  module,  and  "no-light"  products  based on
technology for  illumination  with infrared laser systems.  In October 1995, the
Company sold the operations of ALSO to Coherent, Inc. for cash (see Note 12).

     In February  1994, the Company  acquired all of the issued and  outstanding
capital stock of SRC for $8,100,000 in cash. In March 1996, the Company acquired
all of the issued and outstanding  stock of Pulsarr for $7.8 million in cash and
a note. In July 1996,  the Company  acquired the business and certain  assets of
Ventek,  subject  to  certain  liabilities,  for  $5.1  million  in  notes.  The
operations  of  each  of  the  three  acquired  entities  are  included  in  the
consolidated financial results since their respective acquisition dates. Through
these subsidiaries, the Company designs, manufactures and markets computer-aided
vision defect  detection and sorting and defect  removal  equipment for use in a
variety of industries,  including food processing,  wood products and recycling.
The Company's  systems  combine optical and mechanical  systems  technologies to
perform diverse scanning, analytical sensing, measuring and sorting applications
on a variety of products such as food,  wood and plastic.  The Company sells its
products throughout the world (see Note 13).

     Use of Estimates:
     -----------------
     The  preparation  of financial  statements  in  conformity  with  generally
accepted  accounting  principles  requires  management  to  make  estimates  and
assumptions  that  affect the  reported  amounts of assets and  liabilities  and
disclosure of  contingent  assets and  liabilities  at the date of the financial
statements  and the  reported  amounts  of  revenues  and  expenses  during  the
reporting period. Actual results could differ from those estimates.

     Accounting Period:
     ------------------
     The Company  utilizes a 52-53 week fiscal year ending on the Sunday closest
to the end of the fiscal  period.  Fiscal periods shown ended December 29, 1996,
December 31, 1995 and January 1, 1995. In these financial statements, the fiscal
periods are shown as December 31, 1996, December 31, 1995 and December 31, 1994,
for clarity of presentation.

     Cash Equivalents:
     -----------------
     A For financial reporting  purposes,  cash equivalents consist primarily of
money market  instruments  and bank  certificates  of deposit that have original
maturities of three months or less.

                                      F-7


<PAGE>

     Concentrations of Credit Risk:
     ------------------------------
     Financial   instruments   that   potentially   subject   the   Company   to
concentrations  of credit risk consist  principally of money market  instruments
and trade  receivables.  The Company  invests  its excess  cash in money  market
instruments  and  certificates  of deposit  with high credit  quality  financial
institutions,  and by policy,  limits the amount of credit  exposure  to any one
issuer.  Concentrations  of credit risk with respect to trade  receivables exist
because the Company's  subsidiaries rely heavily on a relatively small number of
customers (see Note 13). The Company performs ongoing credit  evaluations of its
customers  and  generally  does not require  collateral.  The Company  maintains
reserves for potential credit losses and such losses,  to date, have been within
management's expectations.

     Inventories:
     ------------
     Manufacturing inventories are stated at the lower of cost or net realizable
value,  with  cost  determined  principally  by use of the  first-in,  first-out
method.

     Property, Plant, and Equipment:
     -------------------------------
     Property,  plant  and  equipment  are  stated  at  cost.  Depreciation  and
amortization are computed by either the  straight-line or an accelerated  method
over the estimated  useful lives of the assets,  which range from 3 to 30 years.
When  assets  are  retired  or  otherwise  disposed  of,  the cost  and  related
accumulated depreciation are removed from the accounts and any resulting gain or
loss is recognized in operations  for the period.  The cost of  maintenance  and
repairs is charged to expense as incurred;  significant renewals and betterments
are capitalized.

     Intangible Assets:
     ------------------
     Intangible  assets primarily  represent the excess of the purchase price of
acquisitions over the fair value of net assets acquired ("goodwill"). Intangible
assets  also  represent  costs  allocated  to  existing  technologies  and other
specifically identifiable assets arising from business acquisitions.  Intangible
assets  are being  amortized  on the  straight-line  basis over seven to fifteen
years (see Note 5). The Company  assesses the  recoverability  of its intangible
assets as described under Long-Lived Assets below.

     Long-Lived  Assets:
     ------------------
     In  March  1995,  the  Financial  Accounting  Standards  Board  issued  the
Statement of Financial  Accounting  Standard No. 121 (FAS 121),  "Accounting for
the  Impairment of Long-Lived  Assets and For  Long-Lived  Assets to Be Disposed
Of." FAS 121 requires that long-lived assets and certain identifiable intangible
assets to be held and used by a company  be  reviewed  for  impairment  whenever
events or changes in  circumstances  indicate  that  expected  future cash flows
(undiscounted and without interest charges) for individual  subsidiaries may not
be sufficient to support the recorded assets. If undiscounted cash flows are not
sufficient to support the recorded assets, an impairment is recognized to reduce
the carrying value of the assets based on expected  discounted cash flows of the
subsidiary.  The Company  adopted the  statement  in fiscal 1996;  however,  the
adoption did not have a material impact on the Company's financial statements.

     Revenue Recognition:
     --------------------
     The  Company  recognizes  revenue  upon  shipment  of  products or upon the
customer's acceptance of the product, as contractually agreed. Customer deposits
represent monies received in advance of shipment of products.

     Research and Development Costs:
     -------------------------------
     Research  and  development  costs are  expensed as  incurred.  Research and
development  expense is related to  developing  new  products  and to  improving
existing products or processes.

     Earnings (Loss) Per Share:
     --------------------------
     Earnings  (loss) per share has been computed based on the weighted  average
number of common shares and dilutive common equivalent shares outstanding during
the period.  Class E shares have been excluded from the net earnings  (loss) per
share  calculation  as  they  were  considered  to be  "contingent  shares"  and
anti-dilutive  for  purposes  of the  calculation.  Class  B  shares  have  been
considered  outstanding  on an  "as  if  converted"  basis  from  the  date  the
underlying stock was issued (see Note 11).

     Changes in Classification:
     --------------------------
     Certain  reclassifications  have  been  made to the  fiscal  1995  and 1994
financial  statements to conform with the financial  statement  presentation for
fiscal 1996. Such  reclassifications  had no effect on the Company's net loss or
shareholders' equity.

     Income Taxes:
     -------------
     The Company  accounts  for income  taxes in  accordance  with  Statement of
Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes."
FAS 109 requires the  recognition of deferred tax assets and liabilities for the
expected tax effects from  differences  between the financial  reporting and tax
bases of assets and  liabilities.  In  estimating  future tax  effects,  FAS 109
generally  considers all expected future events other than enactments of changes
in tax law or statutorily imposed rates.

     Stock-Based Compensation:
     -------------------------
     The Company uses the  intrinsic  value based method in  accounting  for its
stock option plans as prescribed by  Accounting  Principles  Board (APB) Opinion
No. 25, "Accounting for Stock Issued to Employees" (see Note 9).

     Fair Value of Financial Assets and Liabilities:
     -----------------------------------------------
     Statement of Financial  Accounting  Standards No. 107,  "Disclosures  About
Fair Value of Financial  Instruments,"  requires disclosure of the fair value of
certain  financial assets and liabilities.  The Company estimates the fair value
of its monetary  assets and liabilities  based upon the existing  interest rates
related to such  assets and  liabilities  compared  to current  market  rates of
interest for similar nature and degree of risk.  The Company  estimates that the
carrying value of all of its monetary assets and liabilities  approximates  fair
value as of December 31, 1996.

     Foreign Currency Translation:
     -----------------------------
     All assets and liabilities of foreign subsidiaries are translated into U.S.
dollars  at  fiscal  year-end  exchange  rates.  Income  and  expense  items are
translated at average  exchange  rates  prevailing  during the fiscal year.  The
resulting  translation  adjustments are recorded as a component of shareholders'
equity.


--------------------------------------------------------------------------------

NOTE 2 - ACQUISITION STRATEGY AND RESTRUCTURING

--------------------------------------------------------------------------------

     In 1993, the Company  established a long-term  growth  through  acquisition
strategy. In connection with its strategy, the Company adjusted its organization
and  capital  structure  at the end of  1993  and the  beginning  of 1994  which
transformed  the Company  into a "platform"  company,  with each of its business
units operating as a separate  subsidiary.  ARC intended to use, and has used, a
portion of the approximately $17,692,000 raised in 1993 and 1994 in Regulation S
offerings  and/or its securities to acquire other  companies with certain key or
proprietary technology, know-how, licenses or other assets which, in the opinion
of  management,  had potential to  contribute to the long-term  growth of ARC in
either its current or new businesses.

     In February  1994, ARC acquired all of the issued and  outstanding  capital
stock of SRC for $8.1 million in cash (see Note 5).  Between March and September
1994,  new  management  of the Company  terminated  discussions  with five other
acquisition  candidates  after  performing due diligence  procedures.  The costs
associated  with  these  terminated  acquisitions  aggregated  $648,000  and are
included in general and administrative expenses.

     Restructuring:
     --------------
     In September  1994, the Company  adjusted its platform and ALSO  operations
due to the winding  down of the  acquisition  activities  described  above and a
change in product line direction,  respectively. William C. Patridge resigned as
Chairman of the Board.  Including Mr. Patridge's  resignation,  the platform was
reduced from eleven to five employees.  At ALSO, the high-powered  laser project
was canceled due to the perceived lack of market for the product and to redirect
available  resources to remaining  product lines. The employee count at ALSO was
reduced  by  approximately  29%.  Restructuring  adjustments  recorded  in  1994
included write-downs for idled assets and excess inventories, employee severance
costs,  legal and settlement costs associated with due diligence and terminating
acquisitions,  specifically  identified warranty issues and related items. These
adjustments  were reflected as increased cost of sales  ($138,000) and operating
expenses  ($1,130,000),  or if related to ALSO,  they are  included in loss from
discontinued operations ($1,250,000).


--------------------------------------------------------------------------------

NOTE 3 - INVENTORIES

--------------------------------------------------------------------------------

     Inventories consist of the following:

                                                         December 31,
                                                -------------------------------
                                                     1996              1995
                                                -------------     -------------

     Raw materials                              $   2,662,000     $   1,242,000
     Work-in-process                                2,234,000           889,000
     Finished goods                                 3,236,000         1,679,000
                                                -------------     -------------

                                                $   8,132,000     $   3,810,000
                                                =============     =============


     The increase is due principally to the acquisition of Pulsarr and Ventek in
the current year (see Note 5).


--------------------------------------------------------------------------------

NOTE 4 - PROPERTY, PLANT AND EQUIPMENT

--------------------------------------------------------------------------------

     Property, plant and equipment consists of the following:

                                                         December 31,
                                                 ------------------------------
                                                    1996             1995
                                                 -------------    -------------

     Land                                        $   1,339,000    $     879,000
     Buildings                                       4,780,000        3,449,000
     Machinery and equipment                           799,000          342,000
     Furniture, fixtures and office equipment          988,000          820,000
                                                 -------------    -------------

                                                     7,906,000        5,490,000
     Less:  accumulated depreciation                (1,418,000)        (797,000)
                                                 -------------    -------------

                                                 $   6,488,000    $   4,693,000
                                                 =============    =============


     Substantially  all of the  property,  plant and  equipment  is  secured  by
various  mortgage notes payable (see Note 7).  Depreciation  expense  aggregated
$630,000, $460,000 and $397,000, respectively, for 1996, 1995 and 1994.


--------------------------------------------------------------------------------

NOTE 5 - ACQUISITIONS

--------------------------------------------------------------------------------

     SRC:
     ----
     On February 2, 1994, the Company purchased all of the outstanding shares of
stock  of SRC for  $8,100,000  in  cash.  The  Company  has  accounted  for this
acquisition using the purchase method. The cost of the acquisition was allocated
to the assets acquired and liabilities assumed on the basis of their fair values
at  the  date  of  acquisition.  Goodwill  of  $2,632,000  was  recorded  as the
difference  between  the  acquisition  cost and the fair  values  of the  assets
acquired and liabilities  assumed. The Company is amortizing goodwill over seven
years using the straight-line  method.  Goodwill amortization for 1996, 1995 and
1994 was $371,000, $371,000 and $347,000, respectively.

     Pulsarr:
     --------
     On March 1, 1996, the Company acquired all of the outstanding capital stock
of Pulsarr for cash of $6.5 million and notes payable  aggregating  $1.3 million
(see Note 7). The  acquisition  is accounted  for under the  purchase  method of
accounting.  The $7.8 million  purchase  price was  allocated  based on the fair
values of the identifiable assets of Pulsarr as follows: $1.1 million represents
the fair values of net  tangible  assets of  Pulsarr,  $4.9  million  represents
acquired  in-process  technology  which was charged to operations in the quarter
ended March 31, 1996,  and the  remainder of $1.8  million  represents  existing
technologies and goodwill to be amortized over 15 years. Existing technology and
goodwill  amortization  for the year ended  December 31, 1996 was $100,000.  The
fair values of the acquired  in-process  technologies and existing  technologies
and  goodwill  were  determined  from  independent  appraisals  received  by the
Company.

     Ventek:
     -------
     On July 24, 1996, the Company  acquired  certain assets and the business of
Ventek,  subject to certain  liabilities.  The purchase price was  approximately
$5.1 million in notes and other  securities:  (i) a 6.75% $1,000,000 note due in
three years;  (ii) a 6.75%  $2,250,000 note due in three years  convertible into
the  Company's  Class A Common  Stock at $2.25 per  share;  and (iii) a note and
stock  appreciation  rights payable (a) by issuance of up to 1,800,000 shares of
Class A Common Stock or at the Company's  option, in cash in three years, or (b)
solely in cash in the event ARC Common  Stock is delisted  from the Nasdaq Stock
Market.  The Company also issued a warrant to purchase 1,000,000 shares of Class
A Common  Stock which vests over a four year  period  subject to Ventek  meeting
specified sales and earnings  goals.  The acquisition is accounted for under the
purchase  method of  accounting.  The $5.1 million  purchase price was allocated
based on the fair values of the identifiable  assets of Ventek as follows:  $0.2
million  represents  the fair values of net tangible  assets of Ventek,  and the
remainder of $4.9  million  represents  goodwill to be amortized  over 15 years.
Goodwill amortization for the year ended December 31, 1996 was $162,000.

     The  consolidated  results of  operations  for the Company  include  SRC's,
Pulsarr's and Ventek's results of operations from their  respective  acquisition
dates.

     Unaudited Proforma Statements of Operations:
     --------------------------------------------
     The unaudited proforma condensed combined  statements of operations,  shown
below as  supplemental  information,  assumes  the  acquisitions  of Pulsarr and
Ventek  occurred as of the  beginning  of 1996 and 1995.  However,  the proforma
combined  balances are not  necessarily  indicative of balances which would have
resulted  had  the  acquisitions  occurred  as of the  beginning  of  the  years
presented.  Unaudited proforma  condensed combined  statements of operations for
1996 and 1995 are as follows:

                                                      Proforma (unaudited)
                                                 ------------------------------
                                                     1996              1995
                                                 -------------    -------------

     Sales                                       $  34,945,000    $  35,422,000
                                                 =============    =============
     Gross profit                                $  17,803,000    $  19,729,000
                                                 =============    =============
     Net income                                  $   1,796,000    $   2,823,000
                                                 =============    =============
     Earnings per share                          $        0.15    $        0.22
                                                 =============    =============


     The $4.9 million  charge for in-process  technologies  is excluded from the
above proforma information.

     Supplemental Cash Flow Disclosures Relating to Acquisitions:
     ------------------------------------------------------------
     In 1996, the Company paid $5,984,000 in cash, net of cash acquired, as part
of the cost to acquire Pulsarr and Ventek as follows:

     Fair value of tangible assets acquired                       $   6,997,000
     Acquired existing and in-process technologies                    6,653,000
     Goodwill and other intangible assets                             4,987,000
     Liabilities assumed                                             (6,368,000)
     Issuance of acquisition notes and warrants                      (6,285,000)
                                                                  -------------

     Cash paid                                                    $   5,984,000
                                                                  =============


--------------------------------------------------------------------------------

NOTE 6 - ACCRUED LIABILITIES

--------------------------------------------------------------------------------

     Accrued liabilities consist of the following:

                                                         December 31,
                                                -------------------------------
                                                    1996               1995
                                                -------------     -------------

     Commissions and royalties                  $     192,000     $     530,000
     Legal claims and fees                            431,000           185,000
     Interest                                         220,000            48,000
     Other                                            456,000            82,000
                                                -------------     -------------

                                                $   1,299,000     $     845,000
                                                =============     =============


--------------------------------------------------------------------------------

NOTE 7 - FINANCING ARRANGEMENTS

--------------------------------------------------------------------------------

     Short-term borrowings represent Pulsarr's  outstanding  borrowings pursuant
to its  operational  line of  credit.  As of  December  31,  1996,  Pulsarr  had
borrowings under this line of credit totaling  $947,000.  The maximum  borrowing
capacity under this line is approximately $1,145,000 (2,000,000 Dutch Guilders).
The line of credit is secured by receivables and  inventories of Pulsarr.  As of
December 31, 1996, the interest rate was 4.375%.

     Long-term debt consists of the following:

                                                          December 31,
                                                -------------------------------
                                                    1996               1995
                                                -------------     -------------

     Mortgage note (SRC)                        $   2,715,000     $   2,737,000
     Mortgage notes (Pulsarr)                       1,962,000                --
     10.25% convertible note                        1,515,000         2,160,000
     6.75% convertible note                         3,400,000                --
     Pulsarr acquisition note                         316,000                --
     6% convertible note                              927,000                --
     6.75% note (Ventek)                            1,000,000                --
     6.75% convertible note (Ventek)                2,250,000                --
     Ventek note                                    1,529,000                --
     Technical development grant                    1,032,000                --
                                                -------------     -------------

                                                   16,646,000         4,897,000
     Less:  current maturities                     (1,706,000)          (22,000)
                                                -------------     -------------

                                                $  14,940,000     $   4,875,000
                                                =============     =============


     The SRC  mortgage  note is  payable to a bank in  monthly  installments  of
$23,000  including  interest at 9.5%,  with the remaining  unpaid balance due on
February 15, 2003.  In February  1996,  and every three years  thereafter  until
maturity,  the note  provides  that the  interest  rate will be adjusted to 3.5%
above the  prime  rate.  While a normal  February  1996  adjustment  would  have
resulted in a rate of 12%, the holder of the note has agreed to fix the interest
rate at 9.5% until February 1999. The note is secured by all of SRC's  property,
plant  and  equipment.   The  loan  agreement  contains  certain  covenants  and
restrictions  including  limitations  on  incurrence  of  debt  and  payment  of
dividends.

     The  Pulsarr  mortgage  notes  are  payable  to a bank and  consist  of the
following: (i) a note for $552,000 payable in equal monthly installments over 13
years,  bearing  interest at 4.25% as of  December  31, 1996 and (ii) a note for
$1,410,000 payable in equal monthly installments over 26 years, bearing interest
at 7.85% as of December 31, 1996. The interest rate for the 13-year note changes
monthly based on the Amsterdam  Inter-Bank  Offering Rate (AIBOR).  The interest
rate on the 26-year note is based on the bank's  long-term rates and is fixed at
7.85% through  2001.  The notes are secured by Pulsarr's  land and building,  as
well as a  restricted  cash  deposit of $285,000 as of December  31,  1996.  The
deposit  earns  interest at a variable rate and will be reduced as Pulsarr makes
principal  payments  when due.  The deposit is  included in Other  assets in the
accompanying Consolidated Balance Sheets.

     On  April  13,  1995,  the  Company  borrowed   $2,160,000  pursuant  to  a
convertible  subordinated  secured  note.  Interest on the note is 10.25% and is
payable twice yearly.  The  principal  amount is due in April 1997.  The note is
secured  by the  issued  and  outstanding  capital  stock of ARC's  wholly-owned
subsidiary, SRC. The note is convertible into the Company's Class A Common Stock
at $1.875 per share.  In  connection  with the  borrowing,  the  Company  paid a
finders fee of $160,000 and issued  300,000  warrants to purchase Class A Common
Stock at $1.875 per share. In October 1996 and March 1997, $645,000 and $250,000
of principal of the note were converted into 344,000 and 133,333 shares of Class
A Common Stock, respectively.

     In April 1996, in connection with the  acquisition of Pulsarr,  the Company
raised a net of $3,000,000 in a private  placement of $3,400,000 of  convertible
secured notes. The notes bear interest at 6.75% payable quarterly.  The interest
rate may be adjusted upward on each  anniversary date of the notes if the market
price of the Company's Class A Common Stock fails to reach certain  levels.  The
maximum  possible  coupon  interest  rate is 11.25% if none of the market  price
thresholds  are met. The principal  amount will be due in April 2001.  The notes
are  secured  by 54% of  the  stock  of ARC  Netherlands  B.V.,  a  wholly-owned
subsidiary  of the  Company  established  to  purchase  Pulsarr.  The  notes are
convertible  into the  Company's  Class A Common  Stock at $2.125 per share.  In
connection  with the borrowing,  the Company paid a finder's fee of $400,000 and
issued 340,000 warrants to purchase Class A Common Stock at $2.125 per share.

     The  Pulsarr  acquisition  note  and 6%  convertible  note  arose  from the
Company's  purchase  of 20% of  Pulsarr's  stock  from J. C.  Scholt,  Pulsarr's
managing director.  The Pulsarr acquisition note is payable in five equal annual
installments  beginning March 1, 1997. The 6% convertible note bears interest at
6% payable  annually;  is due in one  installment on the earlier of (i) February
28, 2001, (ii) upon termination of Mr. Scholt's employment  agreement other than
for cause,  or (iii) upon Mr.  Scholt's death to his heirs; is secured by 20% of
the stock of Pulsarr;  and is convertible into ARC Class A Common Stock at $2.22
per share.

     ARC  issued the  following  notes in  connection  with the  acquisition  of
Ventek: (i) the 6.75% $1,000,000 note due July 23, 1999; (ii) a 6.75% $2,250,000
note due July 23, 1999  convertible  into the Company's  Class A Common Stock at
$2.25 per  share;  and (iii) a  $1,125,000  note and stock  appreciation  rights
payable (a) by issuance of up to 1,800,000  shares of Class A Common Stock or at
the  Company's  option,  in cash on July 23, 1999,  or (b) solely in cash in the
event ARC Common Stock is delisted from the Nasdaq Stock Market.  The $1,125,000
note and stock  appreciation  rights  payable  was valued at  $1,529,000  on the
acquisition  date based upon an independent  appraisal  received by the Company.
All three  notes are  secured  by all of the issued  and  outstanding  shares of
Ventek. The three notes are payable to Veneer  Technology,  Inc. a company owned
by the four former  stockholders of Ventek, all of whom are current employees of
the Company.  The 6.75%  $2,250,000 note also contains a provision that, upon an
initial  public  offering  ("IPO") of the common stock of one or more of, or any
combination of, SRC, Pulsarr and Ventek  (together,  "Subsidiary"),  but only if
such IPO occurs during the term of the note, the noteholder shall have the right
to sell back to ARC up to 1,000,000  shares of ARC Class A Common Stock received
upon conversion for consideration consisting of Subsidiary common stock owned by
ARC.  The  number of  shares  of  Subsidiary  common  stock to be paid  shall be
determined  by dividing the total market value (as defined) of the shares of ARC
Class A Common Stock to be sold by 70% of the IPO price of  Subsidiary's  common
stock.

     Pulsarr has a conditional  obligation to repay a technical development loan
received  from the  government  of the  Netherlands  should the  development  of
certain  technologies prove to be commercially  successful.  If the technologies
are commercially successful,  the technical development loan must be repaid at a
rate of 11% of net sales of the products including such technologies,  and bears
interest  at a rate of 8% per  annum  from  the  date  the  technologies  become
commercially  successful.  If the technologies are not commercially  successful,
there is no  obligation to repay the loan.  The Company is currently  developing
these  technologies  and expects  that such  technologies  will be  commercially
successful. If the Company should discontinue development of these technologies,
the Company will recognize a gain on the forgiveness of this liability.

     As of December 31, 1996,  the  aggregate  amount of minimum  maturities  of
long-term    debt   are   as    follows:    1997--$1,706,000;    1998--$193,000;
1999--$4,975,000; 2000--$198,000; 2001--$4,528,000; and thereafter $5,046,000.


--------------------------------------------------------------------------------

NOTE 8 - INCOME TAXES

--------------------------------------------------------------------------------

     Income (loss) from continuing operations before income taxes is composed of
the following:

                                   1996             1995              1994
                              -------------     -------------     -------------

     Domestic                 $      75,000     $   1,115,000     $  (5,549,000)
     Foreign                     (5,335,000)               --                --
                              -------------     -------------     -------------

                              $  (5,260,000)    $   1,115,000     $  (5,549,000)
                              =============     =============     =============


     The components of the provision for income taxes are as follows:


                                   1996             1995              1994
                              -------------     -------------     -------------

     Federal:
       Current                $         --      $         --      $          --
       Deferred                   (124,000)          386,000         (2,582,000)
                              ------------      ------------      -------------

         Total Federal            (124,000)          386,000         (2,582,000)
                              ------------      ------------      -------------

     State:
       Current                          --                --                 --
       Deferred                    (14,000)           45,000           (304,000)
                              ------------      ------------      -------------

         Total State               (14,000)           45,000           (304,000)
                              ------------      ------------      -------------

     Increase (decrease) in
       valuation allowance         138,000          (431,000)         2,886,000
                              ------------      ------------      -------------

         Total provision      $         --      $         --      $          --
                              ============      ============      =============


     The tax effect of temporary differences between financial reporting and the
tax bases of assets and liabilities relate to the following:

                                                         December 31,
                                                -------------------------------
                                                    1996               1995
                                                -------------     -------------

Deferred tax asset:
     Loss carry-forwards                        $   6,181,000     $   6,403,000
     Reserves and accruals                            454,000           346,000
     Research and development costs                   167,000           226,000
     Property basis differences                       520,000           341,000
                                                -------------     -------------

                                                    7,322,000         7,316,000
Deferred tax liability:
     Royalty                                               --          (132,000)
                                                -------------     -------------

Net deferred tax asset before
  valuation allowance                               7,322,000         7,184,000

Deferred tax asset valuation allowance             (7,322,000)       (7,184,000)
                                                -------------     -------------

                                                $          --     $          --
                                                =============     =============


     The deferred tax asset has been fully  reserved in accordance  with FAS 109
because the  Company  cannot  anticipate  future  taxable  income to realize the
potential benefits of the gross deferred tax asset.

     The  provision  for  (benefit  from)  income  taxes  differs from an amount
computed using the statutory federal income tax rate as follows:

<TABLE>
<CAPTION>
                                                                             Year Ended December 31,
                                                                  ----------------------------------------------
                                                                       1996            1995             1994
                                                                  ------------     ------------     ------------
<S>                                                               <C>              <C>              <C>
     Provision for (benefit from) income taxes
        at federal statutory rate                                 $ (1,788,000)    $    320,000    $  (2,651,000)
     State taxes (benefit)                                            (259,000)          38,000         (312,000)
     Non-deductible in-process technology charge                     1,671,000               --               --
     Realized benefit from utilizing net operating
        loss carry-forward                                             191,000               --               --
     Deferred tax valuation allowance                                  138,000         (431,000)       2,886,000
     Nondeductible expenses                                             47,000           73,000           77,000
                                                                  ------------     ------------     ------------
                                                                  $         --     $         --     $         --
                                                                  =============    ============     ============
</TABLE>

     The  Company  has  net  operating  loss   carry-forwards  of  approximately
$16,200,000.  Such  carry-forwards may be used to offset taxable income, if any,
in  future  years  through  their  expiration  in  2003-2010.   Because  of  the
substantial change in the Company's  ownership which occurred as a result of the
initial public offering in March 1992 and subsequent  issuances of common stock,
the annual  amount of tax loss  carry-forward  which can be utilized is limited.
Utilization of approximately  $9,300,000 of the above  carry-forwards is limited
to  approximately  $1,800,000  per year.  Such  limitation  could  result in the
expiration of a part of the carry-forwards before their utilization.


--------------------------------------------------------------------------------

NOTE 9 - EMPLOYEE BENEFIT AND STOCK OPTION PLANS

--------------------------------------------------------------------------------

     The  Company   sponsors  a  defined   contribution   401(k)  plan  covering
substantially  all employees.  Pursuant to the provisions of the plan,  eligible
participants  may  elect to  contribute  up to 15% of their  base  compensation,
subject to certain  limitations,  and the  Company  may,  at its  option,  match
employee  contributions  up to a certain  percentage.  No Company  matching  has
occurred under the plan.

     The Company maintains several stock option plans under which  non-qualified
and incentive  stock  options for the  Company's  Class A Common Stock have been
granted to directors,  officers, and other employees. The plans are administered
by the Stock  Option  Committee  of the Board of  Directors  (the  "Committee").
Additionally,   the  Company  has  occasionally   granted  non-plan  options  to
directors,  officers or consultants on terms similar to plan options.  The stock
option price per share for options granted is determined by the Committee and is
based on market  price of the  Company's  common  stock on the date of grant and
each option is exercisable within the period and in the increments as determined
by the  Committee,  except that no option can be  exercised  later than 10 years
from the date it was granted.  The stock options generally vest over one to four
years.  The  terms of  non-plan  options  are  determined  by the full  Board of
Directors or the Compensation Committee of the Board.

     The  following  table  sets  forth  the  options  granted,  forfeited,  and
exercised  during the three years ended December 31, 1996, and their  respective
weighted average exercise price per share:

                                                                    Weighted
                                                   Shares           Average
                                                Under Option     Price Per Share
                                                ------------     ---------------

     Balance at December 31, 1993                  1,102,000         $ 3.58
         Granted                                   1,007,000           4.67
         Exercised                                        --             --
         Canceled                                   (370,000)          4.42
                                                    --------         ------

     Balance at December 31, 1994                  1,789,000         $ 4.02
         Granted                                   1,957,000           1.00
         Exercised                                   (84,000)          1.00
         Canceled                                 (1,012,000)          3.89
                                                  ----------         ------

     Balance at December 31, 1995                  2,650,000         $ 1.94
         Granted                                     698,000           1.93
         Exercised                                   (83,000)          1.00
         Canceled                                   (138,000)          1.21
                                                 -----------         ------

     Balance at December 31, 1996                  3,127,000         $ 2.00
                                                 ===========         ======


     The following table sets forth information about stock options  outstanding
at December 31, 1996:

<TABLE>
<CAPTION>
                       Options Outstanding                      Options Exercisable
------------------------------------------------------------  -----------------------
                                     Weighted       Weighted                 Weighted
                                      Average        Average                  Average
   Range of         Number           Remaining      Exercise     Number      Exercise
Exercise Price    Outstanding    Contractual Life     Price    Exercisable     Price
--------------    -----------    ----------------     -----    -----------     -----

<S>                 <C>                <C>            <C>        <C>           <C>
  1.00              1,674,000          8 years        1.00       1,094,000     1.00
  1.63-2.38           653,000          9 years        1.95          81,000     1.63
  3.00-4.94           800,000          7 years        4.01         800,000     4.01
                  -----------                                  -----------

                    3,127,000                                    1,975,000
                  ===========                                  ===========
</TABLE>

     There are 67,000 shares available for future grants.

     In January 1997, the Company established an SRC stock option plan (the "SRC
Plan") under which  incentive and  non-qualified  stock options for SRC's common
stock may be granted to  directors,  officers and other  employees.  The plan is
administered by the Stock Option Committee of the Board of Directors of SRC (the
"SRC Committee"). The stock option price per share for options granted under the
SRC Plan is  determined  by the SRC  Committee  and is based on the fair  market
value of the  Company's  common  stock on the date of grant,  and each option is
exercisable  within the period and in the  increments  as  determined by the SRC
Committee,  except that no option may be exercised before the ninth  anniversary
date of grant  unless there shall have been an IPO of SRC's  common  stock,  and
except that no option can be exercised later than ten years from the date it was
granted.

     In January 1997, SRC granted a total of 342,445  options under the SRC Plan
to purchase SRC common stock at $1.86 per share. The options become  exercisable
on January  10,  2006 and  expire one year  thereafter.  Upon  completion  of an
initial public offering of SRC's common stock,  the vesting of such options will
accelerate so that 100% will be exercisable on the third anniversary date of the
IPO.

     Statement of Financial  Accounting  Standards  No. 123 ("FAS 123"):  During
1995, the Financial  Accounting  Standards Board issued FAS 123, "Accounting for
Stock Based Compensation," which defines a fair value based method of accounting
for an employee  stock option or similar  equity  instrument  and encourages all
entities  to adopt that method of  accounting  for all of their  employee  stock
compensation  plans.  However,  it also  allows an entity to continue to measure
compensation  cost for those plans using the method of accounting  prescribed by
the Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock
Issued to Employees."  Entities electing to remain with the accounting in APB 25
must make proforma  disclosures of net income and earnings per share,  as if the
fair  value  based  method of  accounting  defined  in this  Statement  has been
applied.

     The Company has elected to account for its stock-based  compensation  plans
under APB 25; however, the Company has computed for proforma disclosure purposes
the value of all options  granted  during 1996 and 1995 using the  Black-Scholes
option pricing model as prescribed by FAS 123 and the following weighted average
assumptions used for grants:  risk-free interest rate--6.77%;  expected dividend
yield--0%;  expected lives--5 Years; expected  volatility--67%.  Adjustments are
made for options forfeited prior to vesting.  The total value of options granted
was computed to be the following  approximate amounts,  which would be amortized
over the vesting period of the options:

     Year ended December 31, 1996                    $     789,000
     Year ended December 31, 1995                    $     817,000

     If the Company had accounted  for these plans in  accordance  with FAS 123,
the  Company's  net income (loss) and proforma net income (loss) per share would
have been reported as follows:

                                                         December 31,
                                                -------------------------------
                                                    1996               1995
                                                -------------     -------------
     Net income (loss):
         As reported                            $  (5,260,000)    $     942,000
         Proforma                               $  (5,797,000)    $     397,000
     Proforma earnings (loss) per share:
         As reported                            $       (0.46)    $        0.10
         Proforma                               $       (0.51)    $        0.04


     The weighted average fair value of options granted during 1996 and 1995 was
$1.13 and $0.42, respectively.


--------------------------------------------------------------------------------

NOTE 10 - COMMITMENTS, CONTINGENCIES AND SPECIAL ITEMS

--------------------------------------------------------------------------------

     Royalty Commitments:
     --------------------
     In connection with the settlement of a patent infringement lawsuit in 1992,
SRC entered into a royalty  agreement  whereby SRC agreed to pay royalties of 7%
of  certain  vision  system  sales  through  June 30,  2003,  up to a maximum of
$400,000 per year and $1,600,000 in the aggregate.  Royalty  expense  aggregated
$214,000 and $199,000 in 1995 and 1994,  respectively,  and is included in costs
of sales. The final $400,000 payment under the settlement was made in July 1996.
In 1996, the Company wrote off $647,000 of remaining  deferred  royalty  expense
because  all  royalties  have been  earned,  and the  Company  believes  that no
significant  future economic life exists relating to the royalty  agreement as a
result of changing technologies.

     Liviakis Financial Communications, Inc.:
     ----------------------------------------
     Effective  December  31,  1993,  the Company  retained  Liviakis  Financial
Communications,   Inc.   ("Liviakis   Financial"),   a  California   corporation
wholly-owned   by  John   Liviakis   and  his  spouse,   to  provide   financial
communications  and other  consulting  services to the Company for a  three-year
period. As consideration for these services, Liviakis Financial received 790,000
shares of Class A Common Stock as a commencement  bonus as of December 31, 1993,
and was to receive an additional 2,400 shares of Class A Common Stock each month
for the term of the agreement.  The value of the shares issued as a commencement
bonus aggregated $964,000 and was recorded as an expense prior to fiscal 1994.

     On May 9, 1994,  ARC's  Board of  Directors  authorized  management  of the
Company to terminate the consulting  agreement  between the Company and Liviakis
Financial because of what the Company believed to have been material breaches of
the agreement by Liviakis Financial.  On May 20, 1994, the Company filed a claim
with the  American  Arbitration  Association  seeking a  determination  that the
contract  had been  breached  by Liviakis  Financial,  the return of the 790,000
shares of Class A Common Stock delivered to date to Liviakis  Financial pursuant
to the  contract,  a  determination  that the Company had no obligation to issue
additional  shares to Liviakis  Financial  under the contract,  plus  attorney's
fees.

     Arbitration on the Company's claims against Liviakis Financial and Liviakis
Financial's  counter-claims  occurred in  December  1994 and  January  1995.  On
February 15, 1995, the  arbitrator  issued an Interim Award  requiring  Liviakis
Financial to return  668,278 shares of Class A Common Stock to ARC, which shares
were returned in March 1995.  Additionally,  the Interim Award provided that ARC
was  entitled  to recover  all of its  reasonable  expenses  including,  but not
limited to,  attorney's  fees and cost. The  arbitrator  also concluded that all
cross complaints by Liviakis Financial were without merit.

     A gain of $732,000  was  recorded in  February  1995  related to the shares
recovered.  In July 1995, ARC received  $100,000 in full  settlement of all fees
and expenses.

     Ford & Cohn:
     ------------
     In March  1993,  Wilson  Ford,  Robert  Paul  and  Maxwell  Cohn  (together
"Claimants") brought various claims against ARC and William Patridge, Asif Ahmad
and Nagaraj Murthy,  past or current  directors or employees of ARC, in lawsuits
in the Superior Courts for Los Angeles County and Orange County, California. The
lawsuits were  consolidated  in February  1994,  and were  litigated in Superior
Court for Los Angeles County in September and October, 1995.

     Ford, a  consultant  to ARC,  claims that ARC  breached an agreement  dated
September 17, 1987, and subsequently amended on August 16, 1988, by which he was
to receive 25,000 shares of stock of CNVS, Inc.,  predecessor to ARC, at no cost
and an option to  purchase  25,000  additional  shares  in the  future  upon the
occurrence of specified  events.  Ford claims he was promised that this total of
50,000 shares in the Company would amount to 5% of the outstanding  shares. Ford
also claims ARC owes him  royalties  under a royalty  agreement  for certain low
light video camera technology. Based on these allegations,  Ford made claims for
breach of contract  and breach of the  covenant of good faith and fair  dealing.
ARC contends that Ford was never  promised that his interest  would amount to 5%
of the outstanding shares, that Ford failed to fulfill his obligations under the
royalty  agreement,  and that  Ford's  claims are  barred  under  various  legal
theories.

     The Claimants contend that statements allegedly made by William Patridge to
United States Alcohol Testing of America,  Inc.  ("USAT") caused USAT to rescind
an Asset Purchase  Agreement with the Claimants.  The Claimants  allege that the
statements  concerning  outstanding  lawsuits and  disputes  between ARC and the
Claimants  were false and meant to disrupt  the  business  relationship  between
Prime Lasertech and USAT. The Claimants  allegedly would have benefited from the
Asset  Purchase  Agreement  as  shareholders  and/or  licensees.  Based on these
allegations,  the  Claimants  have made  claims for  intentional  and  negligent
interference with prospective advantage, intentional and negligent infliction of
emotional distress, and civil conspiracy.

     On  October  2, 1995,  a jury  awarded  $375,000  to the  Claimants,  which
included  $281,000 of punitive  damages  for the breach of contract  claim.  The
Company has filed  motions with the court to eliminate  the punitive  portion of
the award.  ARC believes such damages are improper because (i) the claimants did
not ask for punitive damages in the contract claim, and (ii) such damages cannot
be awarded  for breach of contract  under  applicable  state  laws.  ARC is also
attempting to overturn the balance of the breach of contract  award based on the
fact that the claim was made after the statute of limitations  had expired.  ARC
has made an appeal to overturn  the verdict  based on these  factors and certain
other irregularities that occurred during the trial, which ARC believes unfairly
affected the jury's  decision.  Due to the fact that a verdict was  rendered,  a
$93,000 loss on the breach of contract  claim was recorded as a liability in the
fourth  quarter of 1995.  As of  December  31,  1996,  the  Company had posted a
$375,000 appeal bond secured by restricted cash in an equal amount. The bond and
restricted  cash was increased by $206,000 in January 1997. The restricted  cash
deposit is included in Other  assets in the  accompanying  Consolidated  Balance
Sheets.

     Credit Suisse, Max Khan and Konrad Meyer:
     -----------------------------------------
     On January 9, 1997,  the  Company  sued  Credit  Suisse in Jackson  County,
Oregon,  seeking  $1,600,000  in  fulfillment  of  Credit  Suisse's  contractual
obligation  to fund a private  placement  Subscription  Agreement  dated May 14,
1996. The Company claims that Credit Suisse's  failure to fund has limited ARC's
ability  to  finance  its  business  plan for  Pulsarr  and,  as a result,  will
adversely impact ARC's  credibility with investors and financial  analysts.  Any
erosion of credibility  or,  alternatively,  the dilution of  shareholder  value
caused by alternate  financing  will,  in turn,  adversely  impact the Company's
ability to raise debt and equity financing.

     The suit also  claims  that  Messrs.  Khan and  Meyer,  who had  previously
provided  investment  banking services to ARC, persuaded Credit Suisse to breach
the Subscription Agreement.

     Other:
     ------
     ARC is a party  to  several  other  suits  in the  ordinary  course  of its
business.  Several of these  actions  have been  brought in Europe  against  the
Company's  Pulsarr  subsidiary.  ARC  believes  that  the  outcome  of all  such
proceedings,  even if determined adversely to Pulsarr,  will not have a material
effect upon its business since the Company is indemnified for any losses arising
from such suits by Pulsarr's former owner.


--------------------------------------------------------------------------------

NOTE 11 - SHAREHOLDERS' EQUITY AND EARNINGS (LOSS) PER SHARE

--------------------------------------------------------------------------------

     Common Stock and Recapitalization:
     ----------------------------------
     On February 25, 1992,  the Company  completed a  six-for-one  reverse stock
split, reconstituted all outstanding shares as Class A Common Stock and effected
a share  exchange of one share of Class B Common Stock and two shares of Class E
Common  Stock for each  share of Class A Common  Stock  outstanding.  The common
stock  amounts and loss per share  amounts for all periods  presented  have been
adjusted  to  reflect  the effect of these  actions  (see Note 1 and below for a
description of shares utilized in the calculation of earnings (loss) per share).

     Each share of Class B stock is  automatically  converted  into one share of
Class A stock upon its sale or transfer or the death of the holder.  The Class E
shares  were  automatically  convertible  into  Class B  shares  if the  Company
attained  certain  earnings  levels or if the Class A shares  traded at  certain
dollar  amounts.  Since earnings and market value levels were not achieved,  the
Class E shares  were  redeemed  by the  Company  for  nominal  consideration  on
February 15, 1996. All of the common  shareholders are entitled to share equally
in the assets available for distribution.

     Initial Public Offering:
     ------------------------
     In March  1992,  the  Company  completed  an  underwritten  initial  public
offering of 1,200,000 units.  These units consist of 2,400,000 shares of Class A
Common Stock,  2,400,000  redeemable Class A Warrants (each  exercisable for one
share of Class A Common Stock and one redeemable  Class B Warrant) and 1,200,000
redeemable  Class B Warrants (each  exercisable  for one share of Class A Common
Stock). In addition,  the over-allotment  option provided to the underwriter was
exercised in April 1992,  resulting in the sale of an additional  180,000 units.
These units,  which expired  unexercised on March 9, 1997,  consisted of 360,000
shares of Class A Common Stock,  360,000 redeemable Class A Warrants and 180,000
redeemable Class B Warrants.  The offering resulted in proceeds of approximately
$6.7 million, net of issuance costs of approximately $1.6 million.  (See further
discussion of the attributes of the warrants below.)

     Regulation S Offerings - Sales of Common Stock:
     -----------------------------------------------
     In  September  and October  1993 and  February  1994,  the Company  sold an
aggregate of 5,360,000 shares of its Class A Common Stock in private  Regulation
S offerings to foreign investors at substantial  discounts from the then trading
price of the  Class A  Common  Stock in the  over-the-counter  market.  Of these
shares,  2,360,000  were sold for $3.25 per share and 3,000,000 were sold for an
average  price  of  $4.08  per  share.  In  March  1996 in  connection  with the
acquisition  of Pulsarr,  the Company  sold  1,400,000  shares of Class A Common
Stock in a private Regulation S offering at the then market price of the stock.

     Preferred Stock, Exchange Agreement and Lock-Up and Contribution Agreement:
     ---------------------------------------------------------------------------
     Effective September 30, 1991, the Company issued 1,500,000 shares of Series
A Preferred Stock in settlement of advances from  shareholders.  The shares were
issued in fiscal  1992.  The  Series A  Preferred  Stock was  nonvoting,  had no
dividend rights, and had a liquidation preference of $1.00 per share. The shares
also had certain redemption provisions.

     In December  1993,  the Company  and three of its  principal  shareholders,
including its president at that time,  entered into an exchange  agreement and a
lock-up and contribution  agreement effective December 31, 1993. The lock-up and
contribution agreement provided that the three principal shareholders agreed not
to sell their stock for two years,  and further  provided that the two principal
shareholders (excluding the Company's president) contribute all 1,500,000 shares
of their Series A Preferred Stock to the capital of the Company.

     Pursuant to the exchange  agreement,  the same two  principal  shareholders
exchanged  all of their  1,502,906  shares of Class E Common Stock for 3,002,906
Class E Warrants to purchase one share of Class A Common Stock each at $5.50 per
share.  The Class E Warrants were held in escrow by the Company and were subject
to the  same  conditions  as the  Class E  Common  Stock.  Since  the  financial
conditions set forth for Class E Common Stock were not met within the time frame
specified, the Class E Warrants ceased to exist on February 15, 1996.

     Class E Common Stock and Class E Warrants:
     ------------------------------------------
     On February 15, 1996, the Company  redeemed all 497,094 shares of its Class
E Common Stock for nominal consideration. Also on that date, the 3,002,906 Class
E Warrants to  purchase  Class A Common  Stock  ceased to exist  because  escrow
conditions related to the warrants were not met.

     Schedule  of  Outstanding  Stock,  Warrants,  Units,  Convertible  Debt and
     Potential Dilution:
     ---------------------------------------------------------------------------
     The following table summarizes, as of December 31, 1996, outstanding common
stock,  potential  dilution to the  outstanding  common  stock upon  exercise of
warrants and UPO Units and conversion of convertible debt, and proforma proceeds
from the  exercise  of  warrants  and UPO  Units.  The table also sets forth the
exercise or conversion prices and warrant expiration and debt due dates.

<TABLE>
<CAPTION>
                                                                                         Exercise     Proforma

                                   Number or Principal                Class A Common        or        Proceeds
                                   Amount Outstanding    Conversion     Stock After     Conversion     or Debt
          Security                at December 31, 1996     Factor       Conversion         Price      Reduction
          -----------------------------------------------------------------------------------------------------
<S>         <C>  <C>                     <C>                 <C>         <C>             <C>       <C>
         Common Stock:
          Class A (D)                   11,139,857                      11,139,857
          Class B                          110,168                         110,168
                                                                     -------------

         Total currently outstanding                                    11,250,025

         Warrants (expiration date):
          A (3/9/98)                     2,941,963           1.4         4,118,748       $  2.84   $    11,697,000
          B (3/9/98)                     4,354,863 (A)       1.4         6,096,808          4.17        25,424,000
          C (3/9/98)                       846,250           1.4         1,184,750          2.21         2,618,000
          D (6/30/98-7/31/98)              275,000            1            275,000          2.75           756,000
          F (4/12/98)                      300,000            1            300,000          1.88           564,000
          G (2/28/99)                      240,000            1            240,000          2.00           480,000
          H (4/16/01)                      340,000            1            340,000          2.13           724,000
          I (7/23/01)                    1,000,000 (B)        1          1,000,000          2.25         2,250,000
          J (9/30/99)                      300,000            1            300,000          2.03           608,000
          Gerinda (8/97)                   300,000            1            300,000          5.00         1,500,000
          Laidlaw (4/1/97)                 135,000            1            135,000          2.25           304,000
                                                                     -------------                 ---------------

                                                                        14,290,306                      46,925,000
                                                                     -------------                 ---------------
         Unit Purchase Options
         (3/9/97): (C)                     188,400                                          6.38         1,202,000
          Class A Common                   376,800            1            376,800
          A Warrants                       376,800           1.4           527,520          2.84         1,498,000
          B Warrants                       565,200           1.4           791,280          4.17         3,300,000
                                                                     -------------                 ---------------

                                                                         1,695,600                       6,000,000
                                                                     -------------                 ---------------
         Convertible Debt (due date):
          10.25% Notes (4/13/97)       $ 1,515,000 (E)                     808,000          1.88         1,515,000
          6.75% Notes (4/16/01)          3,400,000                       1,600,000          2.13         3,400,000
          6.75% Ventek Note (7/23/99)    2,250,000                       1,000,000          2.25         2,250,000
          6% Note (2/28/01)                980,000                         441,486          2.22           980,000
          Ventek Note (7/23/99)          1,529,000 (B)                   1,800,000                       1,529,000
                                                                     -------------                 ---------------

                                                                         5,649,486                       9,674,000
                                                                     -------------                 ---------------
        Potentially outstanding shares and proforma proceeds
          and reduction of debt                                         32,885,417                 $    62,599,000
                                                                     =============                 ===============

</TABLE>

     (A)  Includes 1,412,900 outstanding plus 2,941,963 assuming exercise of the
          Class A Warrants.

     (B) The  Company  issued  the  $1,529,000  note  and  Class  I  Warrant  in
         connection  with the  Ventek  acquisition  (see  Note  5).  The note is
         payable,  (a) at the Company's  option, in cash or by delivery of up to
         1,800,000 shares of Class A Common Stock on the third  anniversary date
         of the note;  or (b)  solely in cash in the event ARC  Common  Stock is
         delisted from the Nasdaq Stock Market. The Warrant vests 25% in each of
         the next four years if sales and earnings objectives are achieved.

     (C) The Unit Purchase  Options  expired March 8, 1997  unexercised  thereby
         reducing the potentially  outstanding  shares and proforma  proceeds by
         1,695,000 and $6,000,000, respectively.

     (D) Subsequent to December 31, 1996,  the Company issued  2,000,000  shares
         pursuant to the 1997 Restricted Stock Plan described below.

     (E)  Subsequent  to December 31,  1996,  $250,000  principal  amount of the
          10.25% Note was converted into 133,333 shares of Class A Common Stock.


     The proforma amounts above are for illustrative  purposes only.  Unless the
market  price of ARC's  Class A  Common  Stock  rises  significantly  above  the
exercise  or  conversion  prices,  it is  unlikely  that  any  warrants  will be
exercised or that the debt will be converted.

     The  Company  has the right to redeem the Class A and Class B Warrants at a
price of $.05 per warrant, subject to certain conditions regarding the bid price
of the Class A Common Stock.  All classes of warrants  provide for adjustment of
the  exercise  price and for a change in the  number  of  shares  issuable  upon
exercise to protect holders  against  dilution in the event of a stock dividend,
stock split,  combination or  reclassification  of the Class A Common Stock. The
Class A, B, C and D Warrants also provide for such an  adjustment  upon issuance
of shares of Class A Common  Stock at prices lower than the market price then in
effect  other than  issuances  upon  exercise of options  granted to  employees,
directors and  consultants  to ARC, or options to be granted under any ARC stock
option plan.

     In addition,  on December 31, 1996, ARC had outstanding options to purchase
3,127,000 shares of Class A Common Stock, 2,766,000 of which are under its stock
option plans (see Note 9).

     The existence of these outstanding warrants, options, and convertible debt,
including  those  granted or to be granted  under  ARC's Stock  Option  Plans or
otherwise,  and potentially issuable shares pursuant to antidilution  provisions
of warrant  agreements  could  adversely  affect ARC's  ability to obtain future
financing.  The price which ARC may receive for the Class A Common  Stock issued
upon exercise of options and warrants, or amount of debt forgiven in the case of
conversion of debt, may be less than the market price of Class A Common Stock at
the time such options and warrants are exercised or debt is  converted.  For the
life of the warrants,  options and  convertible  debt, the holders are given, at
little or no cost, the  opportunity to profit from a rise in the market price of
their Class A Common Stock without assuming the risk of ownership. Moreover, the
holders of the options and warrants might be expected to exercise them at a time
when ARC would,  in all  likelihood,  be able to obtain needed  capital by a new
offering of its  securities on terms more  favorable  than those provided for by
the options and warrants.

     1997 Restricted Stock Plan:
     ---------------------------
     The 1997 Restricted  Stock Plan ("1997 Plan") was established to retain the
services  of  selected  employees,  officers  and  directors  of the Company and
provide them with strong  incentives to enhance the  Company's  growth and stock
price.  The total  number of shares of Class A Common Stock  issuable  under the
1997 Plan shall not exceed 2,000,000.

     In January 1997, the Company's Board of Directors  awarded 2,000,000 shares
of restricted Class A Common Stock to three key employees of the Company.  As to
10% of the stock,  such shares  cannot be traded or  transferred  unless (i) the
employee  remains in the employ of the Company until January 10, 2000 and (ii) a
payment  of $1.80 per  share is made by the  employee  to ARC.  As to 90% of the
stock,  such stock cannot be traded or  transferred  unless,  in addition to the
conditions  in the prior  sentence,  the market  price of the stock as quoted by
Nasdaq or other  applicable  stock exchange for any 30 consecutive days prior to
the third  anniversary  date of the award is at least $20 per  share.  If any of
these  conditions are not met, the related shares of stock will be forfeited and
returned to the Company.

     Earnings (Loss) Per Share:
     --------------------------
     Earnings (loss) per share is computed based on the weighted  average number
of common shares and dilutive common  equivalent shares  outstanding  during the
period.  Dilutive common  equivalent  shares consist of the shares relating to a
note and stock appreciation right agreement, options and warrants.

     As ARC has outstanding options and warrants which, in the aggregate, exceed
20% of the common  stock  currently  outstanding,  ARC is required to follow the
provisions of Accounting Principles Board (APB) Opinion No. 15, paragraph 38, in
calculating  earnings  (loss) per share,  if  dilutive.  APB 15,  paragraph  38,
assumes the exercise of all options and warrants and certain other computations.
If earnings (loss) per share so computed resulted in a lower earnings or greater
loss per share when compared to earnings  (loss) per share excluding such items,
such amount would be reported in the financial statements. The APB 15, paragraph
38 calculation  was not dilutive for the full years ending  December 31, 1996 or
1995 even though dilution did occur during 1996 for the quarters ended September
30 and December 31, 1996 standing alone.


--------------------------------------------------------------------------------

NOTE 12 - DISCONTINUED OPERATIONS

--------------------------------------------------------------------------------

     In October  1995,  the Company sold the ALSO laser  operations to Coherent,
Inc. for approximately  $1,052,000 in cash, which represented the net book value
of the operation.  Operating  results for the above  discontinued  business have
been  excluded  from  the  Consolidated  Statements  of  Operations  to  present
separately  the  results of  continuing  operations.  Net sales for ALSO for the
years ended 1995 and 1994 were $2,279,000 and $3,272,000, respectively.


--------------------------------------------------------------------------------

NOTE 13 - BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION

--------------------------------------------------------------------------------

     The Company is engaged in one principal activity--designing,  manufacturing
and marketing of  computer-aided  vision defect detection and sorting and defect
removal equipment. The Company has subsidiaries located in the United States and
the  Netherlands.   Revenue  transfers  between   geographic  areas,  and  other
intergeographical  eliminations  are not material.  Net sales, net income (loss)
and identifiable assets by geographic areas are as follows:

                                 1996             1995              1994
                           --------------    --------------   --------------
Net sales:
     United States         $   21,506,000    $   19,394,000   $  11,922,000
     Europe                     8,432,000                --              --
                           --------------    --------------   -------------

                           $   29,938,000    $   19,394,000   $  11,922,000
                           ==============    ==============   =============

Net income (loss):
     United States         $       75,000 (A)$      942,000   $  (7,797,000)
     Europe                    (5,335,000)(B)            --              --
                           --------------    --------------   -------------

                           $   (5,260,000)   $      942,000   $  (7,797,000)
                           ==============    ==============   =============

Identifiable assets:
     United States         $   20,784,000    $   17,628,000   $  14,876,000
     Europe                    10,154,000                --              --
                           --------------    --------------   -------------

                           $   30,938,000    $   17,628,000   $  14,876,000
                           ==============    ==============   =============


     (A)  Includes  charges of $647,000 for the  write-off  of deferred  royalty
          expense.

     (B)  Includes  a  charge  of  $4,915,000  for  the  write-off  of  acquired
          in-process technology.

     Included in United  States  sales are export sales of  $7,504,000  in 1996,
$5,117,000 in 1995 and $2,650,000 in 1994.

     The Company sold equipment to two different unaffiliated customers totaling
13% and 12% of sales in 1996 and to two customers  totaling 19% and 16% of sales
in 1995. Sales to a third unaffiliated customer totaled 15% of sales in 1994.


--------------------------------------------------------------------------------

NOTE 14 - QUARTERLY FINANCIAL DATA (UNAUDITED)

--------------------------------------------------------------------------------
<TABLE>
<CAPTION>

Quarters Ended                        March 31         June 30     September 30      December 31        Total
-------------------------------------------------------------------------------------------------------------

Fiscal 1996
-----------
<S>                              <C>               <C>            <C>               <C>            <C>
Sales                            $    3,613,000    $   6,419,000  $   10,097,000    $   9,809,000  $  29,938,000
Gross profit                          1,479,000        2,598,000       5,094,000        4,973,000     14,144,000
Net income (loss)                    (6,797,000)(A)     (900,000)        985,000        1,452,000     (5,260,000)
Earnings (loss) per share:                (0.68)           (0.08)           0.07             0.08          (0.46)

Fiscal 1995
-----------
Sales                                 2,726,000        4,976,000       6,550,000        5,142,000     19,394,000
Gross profit                            831,000        2,030,000       2,886,000        2,453,000      8,200,000
Income (loss):
     Continuing operations               97,000          201,000         617,000          200,000      1,115,000
     Discontinued operations            (26,000)          57,000         (53,000)        (151,000)      (173,000)
                                 --------------    -------------  --------------    -------------  -------------

              Net income (loss)  $       71,000    $     258,000  $      564,000    $      49,000  $     942,000
                                 ==============    =============  ==============    =============  =============
Earnings (loss) per share:
     Continuing operations       $         0.01    $        0.01  $         0.07    $        0.03  $        0.12
     Discontinued operations                 --             0.01           (0.01)           (0.02)         (0.02)
                                 --------------    -------------  --------------     ------------  -------------

              Total              $         0.01    $        0.02  $        0.06     $        0.01  $        0.10
                                 ==============    =============  =============     =============  =============

</TABLE>

(A)  Includes  charges of $4,915,000  and $647,000 for the write-off of acquired
     in-process  technology  and deferred  royalty  expense,  respectively.  The
     Company  previously  reported a net loss of $7,970,000 on its Form 10-Q for
     the quarter ended March 31, 1996. The  $1,173,000  reduction of the loss as
     previously  reported  was solely  related to a reduction  in the charge for
     acquired  in-process  technologies.  During the fourth  quarter of 1996, an
     independent  valuation  of  Pulsarr's  in-process  technologies,   existing
     technologies  and  business  and  other  intangible  assets  was  completed
     resulting  in a reduction in the  $6,088,000  charge  previously  taken for
     acquired in-process technology to $4,915,000.



<PAGE>





--------------------------------------------------------------------------------

ARC Capital

Schedule VIII - Valuation and  Qualifying  Accounts For the Years Ended December
31, 1994, 1995 and 1996

--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                                 Additions
                                                       ---------------------------
                                          Balance at    Charged to        Charged                    Balance
                                           beginning     cost and        to other                    at end
                                           of period     expenses        accounts     Deductions    of period
                                           ---------     --------        --------     ----------    ---------
<S>                                    <C>             <C>            <C>           <C>           <C>
Year ended December 31, 1994:
    Allowance for doubtful accounts    $           --  $      64,000  $    101,000  $        --   $   165,000
                                       ==============  =============  ============  ===========   ===========

Year ended December 31, 1995:
    Allowance for excess and
    obsolete inventory                 $           --  $     305,000  $         --  $        --   $   305,000
                                       ==============  =============  ============  ===========   ===========
    Allowance for doubtful accounts    $      165,000  $          --  $         --  $        --   $   165,000
                                       ==============  =============  ============  ===========   ===========

Year ended December 31, 1996:
    Allowance for excess and
    obsolete inventory                 $      305,000  $     131,000  $         --  $        --   $   436,000
                                       ==============  =============  ============  ===========   ===========
    Allowance for doubtful accounts    $      165,000  $      21,000  $    120,000  $   (26,000)  $   280,000
                                       ==============  =============  ============  ===========   ===========

</TABLE>

                                      F-25