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

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

                                   FORM 10-Q
                                        
(Mark One)
[X]  Quarterly Report Pursuant to Section 13 or 15(d) of the
     Securities Exchange Act of 1934 for the quarter ended July 4, 1998 or

[_]  Transition Report Pursuant to Section 13 or 15(d) of the
     Securities Exchange Act of 1934 for the transition period from 
     __________ to __________

COMMISSION FILE NUMBER 0-18623

                                ---------------
                                        
                               IKOS SYSTEMS, INC.
             (Exact name of registrant as specified in its charter)

                                        
               DELAWARE                                      77-0100318
   (State or other jurisdiction of                        (I.R.S. Employer
    incorporation or organization)                       Identification No.)


     19050 PRUNERIDGE AVE., CUPERTINO, CA                        95014
   (Address of principal executive offices)                    (zip code)


              REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
                                 (408) 255-4567
                                        
   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 the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.

       COMMON STOCK $.01 PAR VALUE                    8,313,000
       ---------------------------            
              (Title of Class)              (Outstanding as of July 4, 1998)

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<PAGE>
 
                               IKOS SYSTEMS, INC.
                                   FORM 10-Q
                           QUARTER ENDED JULY 4, 1998


                                     INDEX
                                     -----


                                        
Part I:  Financial Information

         Item 1:  Financial Statements
                                                                          PAGE
                  Consolidated Balance Sheets at
                    July 4, 1998 and September 27, 1997...............       3
 
                  Consolidated Statements of Income
                    for the three and nine months ended
                    July 4, 1998 and June 28, 1997....................       4
 
                  Consolidated Statements of Cash Flows
                    for the nine months ended July 4, 1998
                    and June 28, 1997.................................       5
 
                  Notes to Consolidated Financial Statements..........       6
 
         Item 2:  Management's Discussion and Analysis
                    of Financial Condition and Results of Operations..       8
 

Part II:  Other Information

         Item 6:  Exhibits and Reports on Form 8-K....................      15

         Signatures...................................................      18

                                       2
<PAGE>
                        PART I. FINANCIAL INFORMATION

ITEM 1 FINANCIAL STATEMENTS

                              IKOS SYSTEMS, INC. 
                          CONSOLIDATED BALANCE SHEETS
                   (in thousands, except per share amounts)
<TABLE>
<CAPTION>
                                                                 July 4,            September 27,
                                                                  1998                   1997
                                                                --------               --------
                                                               (Unaudited)
<S>                                                             <C>                  <C>   
                         ASSETS
Current assets:
     Cash and cash equivalents..............................      $5,544                 $9,486
     Short-term investments.................................       9,320                 15,329
     Accounts receivable (net of allowances for
         doubtful accounts of $776 and $501,
         respectively)......................................       9,638                 12,228
     Inventories............................................       4,197                  4,804
     Deferred taxes.........................................       3,450                  3,450
     Prepaid expenses and other assets......................         499                    659
                                                                --------               --------
            Total current assets............................      32,648                 45,956

     Equipment and leasehold improvements
         Office and evaluation equipment....................       4,416                  3,684
         Machinery and equipment............................       8,869                  7,328
         Leasehold improvements.............................         479                    337
                                                                --------               --------
                                                                  13,764                 11,349
           Less allowances for depreciation and
             amortization...................................      (8,808)                (7,080)
                                                                --------               --------
                                                                   4,956                  4,269
     Intangible assets (net of amortization of
         $2,649 and $1,681, respectively)...................       5,091                  4,626
     Deferred taxes.........................................       1,127                  1,127
     Other assets...........................................         379                    572
                                                                --------               --------
                                                                 $44,201                $56,550
                                                                ========               ========
              LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
     Accounts payable.......................................      $3,923                 $3,073
     Accrued payroll and related expenses...................       2,339                  2,437
     Accrued commissions....................................         421                    742
     Income taxes payable...................................       1,319                  1,072
     Other accrued liabilities..............................       4,051                  1,551
     Deferred revenues......................................       6,100                  5,123
     Current portion of long-term debt......................          --                    350
                                                                --------               --------
            Total current liabilities.......................      18,153                 14,348

Accrued rent................................................         172                    212
Commitments
Stockholders' equity:
     Preferred stock, $.01 par value; 10,000 shares
         authorized, none issued and outstanding............          --                     --
     Common stock, $.01 par value; 50,000 shares
         authorized, 8,313 and 8,579 shares
         issued and outstanding, respectively...............          83                     85
     Additional paid-in capital.............................      55,042                 57,442
     Accumulated deficit....................................     (29,249)               (15,537)
                                                                --------               --------
                                                                  25,876                 41,990
                                                                --------               --------
            Total stockholders' equity......................     $44,201                $56,550
                                                                ========               ========
</TABLE>
                See notes to consolidated financial statements.

                                       3
<PAGE>
 
                               IKOS SYSTEMS INC.
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                   (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                            Three Months Ended                         Nine Months Ended
                                                      ------------------------------               ------------------------
                                                       July 4,              June 28,               July 4,         June 28,
                                                        1998                 1997                   1998            1997
                                                      --------             --------               --------        --------
<S>                                                   <C>                  <C>                    <C>             <C>
Net revenues
   Product                                              $5,090              $12,308                $23,334         $36,182
   Maintenance                                           3,334                2,121                  9,474           6,911
                                                      --------             --------               --------        --------
      Total net revenues                                 8,424               14,429                 32,808          43,093

Cost of revenues
   Product                                               4,473                2,771                  9,651           8,141
   Maintenance                                             420                  492                  1,428           1,379
                                                      --------             --------               --------        --------
      Total cost of revenues                             4,893                3,263                 11,079           9,520
                                                      --------             --------               --------        --------
      Gross profit                                       3,531               11,166                 21,729          33,573

Operating expenses:
   Research and development                              4,485                2,648                 10,533           7,508
   Sales and marketing                                   4,924                4,470                 13,704          12,428
   General and administration                            1,131                  832                  3,003           2,935
   Acquired in-process research and
      development and special charges                    7,600                7,002                  7,600           7,002
   Amortization of intangibles                             434                  315                  1,147             945
                                                      --------             --------               --------        --------
      Total operating expenses                          18,574               15,267                 35,987          30,818
                                                      --------             --------               --------        --------
Income (loss) from operations                          (15,043)              (4,101)               (14,258)          2,755

Other income (expense):
   Interest income                                         230                  344                    846             906
   Interest expense                                         --                   --                     --              --
   Other                                                    --                    6                     --              71
                                                      --------             --------               --------        --------
      Total other income                                   230                  350                    846             977
                                                      --------             --------               --------        --------

Income (loss) before provision for income taxes        (14,813)              (3,751)               (13,412)          3,732
Provision (benefit) or income taxes                       (230)              (1,407)                   300           1,386
                                                      --------             --------               --------        --------
      Net income (loss)                               ($14,583)             ($2,344)              ($13,712)         $2,346
                                                      ========             ========               ========        ========

Basic net income (loss) per share                       ($1.74)              ($0.28)                ($1.62)          $0.28
                                                      ========             ========               ========        ========
Common and common equivalent shares used
   in computing basic per share amounts                  8,392                8,457                  8,443           8,359
                                                      ========             ========               ========        ========

Dilutive net income (loss) per share                    ($1.74)              ($0.28)                ($1.62)          $0.26
                                                      ========             ========               ========        ========
Common and common equivalent shares used
   in computing dilutive per share amounts               8,392                8,457                  8,443           8,940
                                                      ========             ========               ========        ========

</TABLE>
                See notes to consolidated financial statements.

                                       4
<PAGE>
 
                              IKOS SYSTEMS, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
         Increase (decrease) in cash and cash equivalents in thousands
                                  (Unaudited)
<TABLE>
<CAPTION>
                                                                                    Nine Months Ended
                                                                               ----------------------------
                                                                                July 4,            June 28,
                                                                                 1998               1997
                                                                               --------           --------
<S>                                                                            <C>                <C>
Operating activities:
   Net income (loss)......................................................     ($13,712)            $2,346
   Adjustments to reconcile net income to net
     cash provided by operating activities:
     Depreciation and amortization........................................        3,123              2,036
     Acquired in-process research and
         development and special charges..................................        7,600              7,002
     Gain on retirement of equipment......................................           --                  4
     Deferred taxes.......................................................           --                735
     Deferred rent........................................................          (40)               (17)

   Changes in operating assets and liabilities:
     Accounts receivable..................................................        2,590             (2,335)
     Inventories..........................................................          607             (1,170)
     Prepaid expenses and other current assets............................          160                (98)
     Other assets.........................................................          193               (295)
     Accounts payable.....................................................          850             (1,731)
     Accrued payroll and other expenses...................................          (98)              (212)
     Accrued commissions..................................................         (321)              (157)
     Income taxes payable.................................................          247                378
     Other accrued liabilities............................................          (50)               (33)
     Deferred revenues....................................................          977               (528)
                                                                               --------           --------
       Net cash provided by operating activities..........................        2,126              5,925

Investing activities:
   Purchases of equipment and leasehold improvements......................       (2,335)            (1,631)
   Acquisiton of Deerbrook Systems, Inc...................................         (500)                --
   Acquistion of Interra, Inc. technology.................................       (6,490)                --
   Purchase of Zycad Lightspeed technology................................           --             (4,500)
   Purchase of short-term investments.....................................      (11,623)           (22,078)
   Maturities of short-term investments...................................       17,632             22,931
                                                                               --------           --------
       Net cash used in investment activities.............................       (3,316)            (5,278)

Financing activities:
   Principal payments on long-term borrowings.............................         (350)              (750)
   Net sale (repurchase) of common stock..................................       (2,402)             1,885
                                                                               --------           --------
       Net cash provided by (used in) financing activities................       (2,752)             1,135
                                                                               --------           --------
Increase (decrease) in cash and cash equivalents..........................       (3,942)             1,782
Cash and cash equivalents at beginning of period..........................        9,486             10,590
                                                                               --------           --------
Cash and cash equivalents at end of period................................       $5,544            $12,372
                                                                               ========           ========
</TABLE>

                See notes to consolidated financial statements.

                                       5
<PAGE>
 
                               IKOS SYSTEMS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1.   BASIS OF PRESENTATION

     The accompanying consolidated financial statements at July 4, 1998 and for
     the three and nine month periods ended July 4, 1998 and June 28, 1997, have
     been prepared in conformity with generally accepted accounting principles,
     consistent with those applied in, and should be read in conjunction with,
     the audited consolidated financial statements for the year ended September
     27, 1997 included in the Form 10-K as filed with the Securities and
     Exchange Commission on December 19, 1997.  The unaudited interim financial
     information reflects all normal recurring adjustments which are, in the
     opinion of management, necessary for a fair statement of results for the
     interim periods presented.  The results for the three and nine month
     periods ended July 4, 1998 are not necessarily indicative of results
     expected for the full year.


2.   FISCAL YEAR

     The Company is on a 52-53 week fiscal year.  Fiscal year 1998 is a 53-week
     year and the three-month period ending January 3, 1998 included the
     additional week for the fiscal year.


3.   INVENTORIES

     Inventories are stated at the lower of cost (first-in, first-out) or market
     and consisted of (in thousands):

                                                        
                                          July 4,      September 27,
                                           1998            1997
                                     ----------------  ------------
     Raw materials                        $1,261          $1,979
     Work-in-process                       1,380           1,385
     Finished goods                        1,556           1,440
                                          ------          ------
                                          $4,197          $4,804
                                          ======          ======

                                       6
<PAGE>
 
                               IKOS SYSTEMS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
                                        

4.   NET INCOME PER SHARE

     The following table sets forth the computation of basic and diluted
     earnings per share:


 
<TABLE> 
<CAPTION> 
                                                                 Three Months Ended            Nine Months Ended
                                                              ----------------------------------------------------
                                                               July 4,        June 28,       July 4,      June 28,
                                                                1998            1997          1998          1997
                                                              --------       --------      --------       --------  
<S>                                                          <C>              <C>            <C>           <C> 
BASIC EARNINGS PER SHARE:
Net income                                                    ($14,583)       ($2,344)     ($13,712)        $2,346
                                                              ========       ========      ========       ======== 

Weighted average common shares outstanding                       8,392          8,457         8,443          8,359
                                                              ========       ========      ========       ======== 
Basic net income per share                                      ($1.74)        ($0.28)       ($1.62)         $0.28
                                                              ========       ========      ========       ======== 
DILUTIVE EARNINGS PER SHARE:
Net income                                                    ($14,583)       ($2,344)     ($13,712)        $2,346
                                                              ========       ========      ========       ======== 
Number of shares used in computing per share amounts:
    Weighted average common shares outstanding                   8,392          8,457         8,443          8,359
    Common equivalent shares attributable to stock
      options (treasury stock method)                               --             --            --            581
                                                              --------       --------      --------       --------  
Total weighted average common shares outstanding                 8,392          8,457         8,443          8,940
                                                              ========       ========      ========       ======== 
Dilutive net income per share                                   ($1.74)        ($0.28)       ($1.62)         $0.26
                                                              ========       ========      ========       ======== 
</TABLE> 


 
5.   TECHNOLOGY ACQUISITION

     In May 1998, the Company completed its acquisition of certain technology
     and research and development expertise from Interra, Inc. and its
     affiliate, Delsoft India Pvt. Limited. The purchase price paid including
     costs of the transaction was approximately $9,000,000. Through July 4,
     1998, the Company has paid approximately $6,490,000 with the remaining
     $2,550,000 to be paid in three installments through November 1999. In
     connection with the acquisition, the Company has established a research and
     development facility in India. The Company recorded a charge of
     approximately $7,600,000 related to the acquired in-process research and
     development. The evaluation of the underlying technology acquired
     considered the inherent difficulties and uncertainties in completing the
     development, and thereby achieving technological feasibility, and the risks
     related to the viability of and potential changes in future target markets.
     The underlying technology had no alternative use (in other research and
     development projects or otherwise) since the technology was acquired for
     the sole purpose of developing simulation and emulation products.


                                       7
<PAGE>
 
ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

Forward-looking statements in this Quarterly Report on Form 10-Q are made
pursuant to the safe harbor provisions of Section 21E of the Securities Exchange
Act of 1934, as amended.  In this report, the words "anticipates," "believes,"
"expects," "future," "intends'" and similar expressions identify forward-looking
statements.  Investors are cautioned that all forward-looking statements involve
risks and uncertainties, including, without limitation, those contained under
the section entitled "Factors That May Affect Future Results of Operations" and
other risks detailed from time to time in the Company's periodic reports and
other information filed with the Securities and Exchange Commission.  Actual
events and results may differ materially from the Company's current expectations
and beliefs.


NET REVENUES

Net revenues for the three and nine months ended July 4, 1998 totaled $8,424,000
and $32,808,000, respectively, representing a decrease of approximately 42% and
24%, respectively from the same periods in fiscal 1997.  The decreases were
primarily the result of the decline in the sales of the Company's Voyager
simulation product line due in part to delays in the introduction of new
simulation products and increased focus on the Company's emulation product line
and consulting services. In addition, due to the extended length of the
Company's beta program with respect to its new emulation product, emulation
revenues for the quarter decreased 67% from the previous year and 81% from the
previous quarter.  The unexpected length of the beta program prohibited the
Company from shipping additional revenue units during the quarter.  The Company
is currently completing its beta program and expects to ship commercial product
in the fourth quarter of fiscal 1998.  Consulting services increased from
approximately $448,000 and $1,690,000 during the three and nine months ended
June 28, 1997 to over $802,000 and $3,756,000, respectively, for the same
periods in 1998.  The Company's aggressive pursuit of providing value added
consulting service to new and existing customers is the main reason for the
increases.

International sales for the three and nine months ended July 4, 1998 totaled
$2,393,000 and $11,239,000, a decrease of approximately 50% and approximately
29%, respectively from the same periods in fiscal 1997.  The decrease is due in
part to the decline in sales activity in the Asian marketplace resulting from
the economic issues in that location and also as a result of the overall decline
in sales of the Company's simulation products.



GROSS PROFIT MARGINS

During the quarter, the Company recorded a charge to operations of approximately
$2,300,000 for the write-off of excess and obsolete inventory primarily related
to the Company's previous emulation products.  Prior to the charge, gross profit
margin for the three and nine month periods ended July 4, 1998 were
approximately 69% and 73% of net revenues, respectively and are lower when
compared to approximately 77% and 78%, respectively, for the same periods of
fiscal 1997.  In addition to the impact from the inventory write-off, the
decrease in margins are a result of the lower than expected revenues resulting
in less coverage of fixed manufacturing costs.  In addition, the increase in the
consulting services personnel costs which increased the level of fixed costs
charged against margins.

                                       8
<PAGE>
 
RESEARCH AND DEVELOPMENT EXPENSES

Research and development expenses for the three and nine months ended July 4,
1998 totaled $4,485,000 and $10,533,000, representing an increase of
approximately 69% and 40%, respectively, when compared to the same periods in
fiscal 1997.  The increases during the quarter and for the nine months is a
result of increased outside consulting charges, additional costs associated with
the implementation of the India research and development facility and certain
non-recurring engineering charges as well as increased depreciation expenses.
The Company expects research and development expenses to continue to increase
over the remainder of the year as the Company continues its on-going development
efforts for enhancing its current products and for new product technology
development.


SALES AND MARKETING EXPENSES

Sales and marketing expenses totaled $4,924,000 and $13,704,000 for three and
nine month periods ended July 4, 1998, representing an increase of approximately
10%, respectively, when compared to the same periods in fiscal 1997. The
increases are primarily the result of additional headcount offset by decreased
commissions as a result of lower revenue levels.  Sales and marketing expenses
are expected to continue to increase in absolute dollars over the remainder of
the year reflecting increased headcount, commission expense and marketing
expenses.


GENERAL AND ADMINISTRATIVE EXPENSES

General and administrative expenses were $1,131,000 and $3,003,000 for the three
and nine month periods ended July 4, 1998 and were higher when compared to
$832,000 and $2,935,000 for the same three and nine month periods in fiscal
1997. The increase is primarily a result of certain consulting and professional
services received during the quarter and over the course of the year.  General
and administrative expenses are expected to remain relatively flat over the
remainder of fiscal 1998.


INCOME TAXES

The Company's effective tax rate on the consolidated pretax loss for the three
and nine month periods ended July 4, 1998 is 2% and (2%), respectively, compared
to an effective tax rate of 37% on consolidated pretax income for the three and
nine month periods ended June 28, 1997. The tax benefit for the three month
period ended July 4, 1998 results from the overall loss reported for the quarter
and expected for the full fiscal year.  The tax provision for the nine months
ended July 4, 1998 results from taxes on income in jurisdictions despite an
overall loss.  The effective tax rate for the nine months ended June 28, 1997
differs from the statutory rate primarily due to the tax benefits associated
with its foreign sales corporation and research credits and tax costs associated
with non deductible goodwill amortization and state income taxes.


OTHER

The Company has experienced minimal gains or losses on foreign currency
translation since substantially all of its international sales to date have been
billed and collected in U.S. dollars. The Company pays the expenses of its
international operations in local currencies and to date the Company has not
engaged in hedging transactions with respect to such obligations.  The Company
has reorganized its operations at its Japan subsidiary and is engaging in
transactions in the Japanese local currency.  As such, the Company periodically
enters into foreign exchange contracts to minimize foreign exchange risk
relating to the Japanese subsidiary's sales which are denominated in yen.  A
forward exchange contract obligates the Company to exchange predetermined
amounts of a specified foreign currency at a specified exchange  rate on a
specified date or to make an equivalent US dollar payment equal to the value of
such exchange.  These contracts are accounted for as hedges of an identifiable
foreign currency commitment.  Realized gains or losses are recognized upon
maturity of the contracts and offset the underlying asset or liability. Through
July 4, 1998, such hedging arrangements have been immaterial to the Company
operations.

                                       9
<PAGE>
 
FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS

Potential Fluctuations in Quarterly Results - The Company's quarterly operating
-------------------------------------------                                    
results have in the past and may in the future vary significantly depending on
factors including the timing of customer development projects and purchase
orders, new product announcements and releases by the Company and other
companies, gain or loss of significant customers, price discounting of the
Company's products, the timing of expenditures, customer product delivery
requirements, availability and cost of components or labor and economic
conditions generally and in the electronics industry specifically. Any
unfavorable change in these or other factors could have a material adverse
effect on the Company's operating results for a particular quarter. Many of the
Company's customers order on an as-needed basis and often delay issuance of firm
purchase orders until their project commencement dates are determined. Quarterly
revenue and operating results will therefore depend on the volume and timing of
orders received during the quarter, which  are difficult  to forecast
accurately.  Moreover, a  significant portion of the Company's revenue may
result, from shipments during the last few weeks of the quarter from orders
generally received in the last month of the quarter. Any concentration of sales
at the end of the quarter may limit the Company's ability to plan or adjust
operating expenses and production and inventory levels. Therefore, if
anticipated shipments in any quarter do not occur or are delayed, expenditure
levels could be disproportionately high as a percentage of revenue, and  the
Company's  operating results  for that  quarter would be adversely affected. In
addition, sales of individual systems with high average sales prices can
constitute a significant percentage of the Company's quarterly revenue.
Operating results in any period should not be considered indicative of the
results to be expected for any future period, and there can be no assurance that
the Company's net revenues will increase or that the Company will remain
profitable in any future period.

Increased Sales and Development of the Company's Products - Substantially all of
---------------------------------------------------------                       
the Company's product revenues since fiscal 1993 have been derived from the sale
of its Voyager and Gemini simulation systems. The Company has seen a decline in
such revenues and there can be no assurance the decline in these product's
revenues will reverse. Increased sales of the Company's hardware-assisted
simulation products for the verification of IC and system designs is expected to
depend on the introduction of new simulation products and methodologies.
Furthermore, increased sales will also depend on an increasing number of complex
ICs designed for electronic systems, integration of the Company's products with
other tools for IC design and simulation, the ability of hardware-assisted
simulation systems to shorten the time of simulation of IC designs, continued
industry acceptance of mixed-level hardware-assisted simulation.  Because the
market for hardware-assisted simulation products is evolving, it is difficult to
predict with any assurance whether the market for hardware-assisted simulation
products will continue to expand. There can be no assurances that such market
will expand, or even if such market expands, that the Company's products will
achieve the market acceptance required to maintain revenue growth and continued
profitability in the future.

In addition to the Company's simulation product line the Company has focused
certain of its resources on its emulation product line.  The Company's initial
emulation product was commercially released in the first quarter of fiscal 1997.
While the Company has seen increases in its emulation revenues, there can be no
assurance that the product will adequately meet the requirements of the
marketplace.  In addition, there continues to be further development of the
emulation product.  As the Company continues to develop emulation products which
are based on a new technology concept, there can be no assurance that the
enhancement of current products or other developed products resulting from this
development will provide the necessary solutions to customer design verification
needs, be of acceptable quality or achieve further market acceptance. The
success of the Company in developing, introducing, selling and supporting
emulation products will depend on a variety of  factors including  but not
limited to the timely

                                       10
<PAGE>
 
and successful enhancement of current products, completion of product design and
development of future products, the timely and efficient implementation of
manufacturing processes, effective sales, marketing and customer service, and
the absence of performance problems or other difficulties that may require
design modifications and related expenses and may hinder or damage market
acceptance of the products. While the Company's emulation systems are designed
to provide cost and ease of use advantages intended to broaden the market for
logic emulation, there can be no assurance that its products will be able to
achieve such goals. Moreover, there can be no assurance that the market for
logic emulation will broaden beyond the current set of emulation systems users.
The adoption of any emulation products the Company has or may develop will also
depend on the continued increasing complexity of ICs designed for electronic
systems, integration of such products with other tools for IC design and
verification, importance of the time to market benefits of emulation systems and
industry acceptance of the need to close the gap between high level design and
silicon production. Because the market for emulation products is new and
evolving, it is difficult to predict with any assurance whether the market for
emulation products will continue to expand, or even if such market expands, that
the Company's products will achieve the market acceptance required to maintain
revenue growth and continued profitability.

In May 1998, the Company completed its acquisition of certain technology and
research and development expertise from Interra, Inc., and its affiliate,
Delsoft India Pvt. Limited.  While the Company expects that the technology
acquired and the resources obtained in this transaction will assist the Company
in meeting its new product introduction goals and deadlines, there can be no
assurances that such goals or deadlines will be achieved in a timely manner.
Furthermore, should such goals and deadlines for the introduction of new
products be attained, there can be no assurances that the resulting new products
will adequately meet the requirements of the marketplace.

Competition - The EDA industry is highly competitive and rapidly changing. The
-----------                                                                   
Company's products are specifically targeted at the emerging portion of the
industry relating to complex designs that the Company believes benefit from
simulation and emulation products.  The Company currently experiences
competition from traditional software verification methodologies, including
product offerings sold by Cadence, Synopsis and Mentor Graphics. The Company's
main competition for emulation systems are those sold by Quickturn. The Company
expects competition in the market for verification tools to increase as other
companies attempt to introduce new products, such as cycle-based software
simulation products and product enhancements. Moreover, the Company competes,
and expects that it will continue to compete, with established EDA companies. A
number of these companies have longer operating histories, significantly greater
financial, technical and marketing resources, greater name recognition and
larger installed customer bases than the Company. In addition, many of these
competitors and potential competitors have established relationships with
current and potential customers of the Company and offer a broader and more
comprehensive product line. Increased competition could result in price
reductions, reduced margins and loss of market share, all of which could
materially adversely affect the Company. In addition, current competitors or
other entities may develop other products that have significant advantages over
the Company's products. There can be no assurance that the Company will be able
to compete successfully against current and future competitors or that
competitive pressures faced by the Company will not materially adversely affect
its operating results.

                                       11
<PAGE>
 
New Products and Technological Change - The EDA industry is characterized by
-------------------------------------                                       
extremely rapid technological change in both hardware and software development,
frequent new product introductions, evolving industry standards and changing
customer requirements. The introduction of products embodying new technologies
and the emergence of new industry standards can render existing products
obsolete and unmarketable. The Company's future success will depend upon its
ability to enhance its current series of simulation and emulation systems and to
design, develop and support its future simulation and emulation products on a
timely basis. Those efforts require a high level of expenditures for research
and development by the Company to address the increasingly sophisticated needs
of the customers. For example, all of the Company's current products operate in,
and planned future products will operate in, the Unix operating environment, an
industry standard in the EDA market. In the event that another operating system,
such as Windows NT, becomes an industry standard, the Company may be required to
port its products to such new standard. In addition, the Company's simulation
systems generally accept designs in the broadly accepted hardware description
language, Verilog-XL, which Cadence has developed and made available to the
Company. In the event Cadence adopts a less cooperative stance toward the
Company in the future, the Company's systems may not be able to accept designs
based on Verilog-XL and the Company  may be required to develop software to
accept designs of other hardware description languages. The inability to accept
designs in Verilog-XL may materially adversely affect the Company's results of
operations. There can be no assurance that the Company will be successful in
developing and marketing product enhancements or new products that respond to
technological change or evolving industry standards or changing customer
requirements, that the Company will not experience difficulties that could delay
or prevent the successful development, introduction and marketing of these
products, or that its new products and product enhancements will adequately meet
the requirements of the marketplace, will be of acceptable quality or will
achieve market acceptance. If the Company is unable, for technological or other
reasons, to develop and introduce  products in a  timely  manner in response to
changing market conditions or customer requirements, the Company's business,
operating results and financial condition will be materially and adversely
affected. Moreover, from time to time, the Company may announce new products or
technologies that have the potential to replace the Company's existing product
offerings. There can be no assurance that the announcement of new product
offerings will not cause customers to defer purchases of existing Company
products, which could adversely affect the Company's results of operations for
any particular quarter.

Dependence on Electronics Industry - The Company is dependent upon the
----------------------------------                                    
electronics industry and, in particular, new system and IC design projects. The
electronics industry is characterized by rapid technological change, short
product life cycles, fluctuations in manufacturing capacity and pricing and
margin pressures, all of which cause it to be volatile. As a result, the
electronics industry has historically experienced sudden and unexpected
downturns, at which time the number of new system and IC design projects
decrease. Because most of the Company's sales occur upon the commencement of new
projects for system and IC products, the Company is dependent upon the rate of
commencement of new system and IC design projects. Accordingly, negative factors
affecting the electronics industry could have a material adverse effect on the
Company's results of operations.

Dependence Upon Certain Suppliers - Certain key components used in the Company's
---------------------------------                                               
products are presently available from sole or limited sources. The inability to
develop alternative sources for these sole or limited source components or to
obtain sufficient quantities of these components could result in delays or
reductions in product shipments which could adversely affect the Company's
operating results. The Company's systems use proprietary ASICs and FPGAs that
are currently manufactured solely by American Microsystems, Inc. (''AMI'') and
Xilinx, Inc. ("Xilinx"), respectively.

                                       12
<PAGE>
 
The Company generally purchases these components, including semiconductor
memories used in the Company's hardware simulators, pursuant to purchase orders
placed from time to time in the ordinary course of business and has no supply
arrangements with any of its source suppliers that require the suppliers to
provide components in guaranteed quantities or at set prices. Moreover, the
manufacture of these components can be extremely complex, and the Company's
reliance on the suppliers of these components exposes the Company to production
difficulties and quality variations that may be experienced by these suppliers.
Therefore, the Company's reliance on its sole and limited source suppliers
involves several risks, including a potential inability to obtain an adequate
supply of required components, reduced control over pricing and timely delivery
and quality of acceptable components. While the timeliness and quality of
deliveries to date from such suppliers have been acceptable, there can be no
assurance that problems will not occur in the future. Any prolonged inability to
obtain components or subassemblies in sufficient quantities or quality or on
favorable pricing or delivery terms, or any other circumstances that would
require the Company to seek alternative sources of supply, could have a material
adverse effect on the Company's operating results and could damage the Company's
relationships with its customers.

Customer Concentration - A relatively limited number of customers have
----------------------                                                
historically accounted for a substantial portion of the Company's net revenues.
During fiscal 1997 and 1996, sales to the Company's top ten customers accounted
for approximately 52% and 65%, respectively, of the Company's net revenues. The
Company expects that sales of its products to a limited number of customers will
continue to account for a high percentage of net revenues for the foreseeable
future. The loss of a major customer or any reduction in orders by such
customers, including reductions due to market or competitive conditions in the
electronics or EDA industries, would have an adverse effect on the Company's
results of operations. Moreover, the Company's ability to increase its sales
will depend in part upon its ability to obtain orders from new customers, as
well as the financial condition and success of its existing customers and the
general economy. There can be no assurance that such increases will occur.


LIQUIDITY AND CAPITAL RESOURCES

Since inception, the Company has financed its operations, including increases in
accounts receivable and inventory and capital equipment acquisitions, primarily
through private and public sales of equity securities and a loan secured by
capital equipment. The Company's cash, cash equivalents and short-term
investments decreased to $14,864,000 at July 4, 1998 from $24,815,000 at
September 27, 1997.  The decrease was a result of $2,126,000 cash provided by
operating activities offset by $9,325,000 used in investing activities and
$2,752,000 of cash used in financing activities.

Operating Activities - The Company's operating activities provided cash of
--------------------                                                      
$2,126,000 during the first nine months of fiscal 1998.  The $2,126,000 cash
provided by operations was primarily due to net loss adjusted for acquired in-
process research and development, depreciation and amortization, a decrease in
accounts receivable and inventory and increases in accounts payable, income
taxes payable and deferred revenues offset by payments on, accrued payroll,
accrued commission and other accrued balances.

Investing Activities - Net cash used in investing activities for the nine months
--------------------                                                            
ending July 4, 1998 was $3,316,000.  The primary source of cash during this
period was the net maturities of short-term investments totaling $6,009,000.
The increase in cash equivalents from these maturities was the result of the
investment in higher yielding cash equivalent securities rather than certain
short-term investments. This source of cash from investment activities was
offset by approximately $2,335,000 in capital expenditures, $500,000 related to
the acquisition of Deerbrook Systems, Inc. and $6,490,000 related to the
acquisition of technology from Interra, Inc.  For each period presented, capital
expenditures were primarily for evaluation equipment and engineering
workstations.

                                       13
<PAGE>
 
Financing Activities - Net cash used in financing activities for the nine months
--------------------                                                           
ended July 4, 1998 was primarily related to the net purchases of stock during
the nine-month period. During the nine-month period, the Company announced its
intention to repurchase up to 1,000,000 shares of its outstanding common stock
on the open market.  Through July 4, 1998, the Company had repurchased
approximately 386,500 shares at a weighted-average per share price of $6.92.  In
addition, the Company repaid its remaining principal debt obligations totaling
$350,000.

The Company's primary unused sources of funds at July 4, 1998 consisted of
$5,544,000 of cash and cash equivalents, in addition to $9,320,000 of short-term
investments. The Company believes that current cash, cash equivalents and short-
term investments, together with cash and cash equivalents generated from
operations, will be sufficient to finance its operations for at least the next
twelve months.

                                       14
<PAGE>
 
                           PART II. OTHER INFORMATION

ITEMS 1-5  Not applicable

ITEM 6     Exhibits and Reports on Form 8-K


(a) INDEX TO EXHIBITS

<TABLE> 
<CAPTION> 

Exh. No.                Documentation Description                                    Page
-------                 -------------------------                                    ----
<C>       <S>                                                                     <C>     
 2.1      Agreement and Plan of Reorganization among the Company, VMW Acquisition
          Corporation and VMW dated May 14, 1996 (Incorporated by reference to
          Exhibit 2.1 of the Company's registration statement on Form S-3
          effective June 26, 1996).

 2.2      Technology Purchase Agreement dated May 12, 1998 by and between the
          Company and Interra, Inc. (Incorporated by reference to Exhibit 2.1 of
          the Company's Current Report on Form 8-K filed May 20, 1998).

 3.1      Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 of
          the Company's registration statement on Form S-1 effective July 25,
          1990).

 3.2      Certificate of Amendment of Certificate of Incorporation filed May 5, 1994
          (Incorporated by reference to Exhibit 4.1 of the Company's
          registration statement on Form S-2 effective October 12, 1995).

 3.3      Certificate of Amendment of Certificate of Incorporation filed April 24,
          1995 (Incorporated by reference to Exhibit 4.2 of the Company's
          registration statement on Form S-2 effective October 12, 1995).

 3.4      Certificate of Amendment of Certificate of Incorporation filed February 3.
          1997 (Incorporated by reference to Exhibit 3.4 of the Company's
          quarterly report on Form 10-Q for the quarter ending March 29, 1997).

 3.5      By laws (Incorporated by reference to Exhibit 3.2 of the Company's
          registration statement on Form S-1 effective July 25, 1990).

 4.1      Rights agreement dated as of January 27, 1992 between the Company and
          Manufacturers Hanover Trust Company of California, Rights Agent.
          (Incorporated by reference to Exhibit (C)1, in the Company's report on
          Form 8-K filed February 10, 1992).

</TABLE> 

                                       15
<PAGE>
 
<TABLE> 
<CAPTION> 
Exh. No.                Documentation Description                                         Page
-------                 -------------------------                                         ----
<C>       <S>                                                                            <C>     
10.1      Lease Agreement for the Company's principal facility dated March 20, 1992,
          between Ames Avenue Associates and the Company, as amended.
          (Incorporated by reference to Exhibit 10.1 of the Company's annual
          report on 10-K for the year ending September 26, 1992).

10.2      Form of Director and Officer Indemnity Agreement.  (Incorporated by
          reference to Exhibit 10.6 of the Company's registration statement on
          Form S-1 effective July 25, 1990).

10.3      1988 Stock Option Plan.  (Incorporated by reference to Exhibit 10.14 of
          the Company's registration statement on Form S-1 effective July 25,
          1990).

10.4      Patent Cross License Agreement dated May 17, 1989 with Zycad Corporation
          (Incorporated by reference to Exhibit 10.20 of the Company's
          registration statement on Form S-1 effective July 25, 1990).

10.5      International Distributorship Agreement dated April 11, 1988, with C.
          Itoh & Co., Ltd. (Incorporated by reference to Exhibit 10.24 of the
          Company's registration statement on Form S-1 effective July 25, 1990).
          Confidential Treatment has been granted as to certain portions of this
          Exhibit.

10.6      OEM Software License Agreement between CAD Language Systems, Inc. and
          IKOS Systems, Inc. dated June 22, 1989 and amendment dated September
          1991  (Incorporated by reference to Exhibit 10.18 of the Company's
          Annual Report for the year ended September 28, 1991).

10.7      Technology Transfer and Joint Development Agreement with Racal-Redac,
          Inc. dated July 1, 1993   (Incorporated by reference to Exhibit 10.19
          of the Company's quarterly report on Form 10-Q for the quarter ended
          July 3, 1993).  Confidential Treatment has been granted as to certain
          portions of this Exhibit.

10.8      Settlement Agreement and Release dated March 31, 1994 between Racal
          Redac, Inc. and the Company (Incorporated by reference to Exhibit
          10.13 of the Company's registration statement on Form S-2 effective
          October 12, 1995).

10.9      Software License Agreement with Compass Design Automation dated December
          31, 1993  (Incorporated by reference to Exhibit 10.17 of the Company's
          quarterly report on Form 10-Q for the quarter ended January 1, 1994).

10.10     Agreement dated June 2, 1994, by and between the Company and Gerald S.
          Casilli (Incorporated by reference to Exhibit 10.18 of the Company's
          quarterly report on Form 10-Q for the quarter ended July 2, 1994).
</TABLE> 

                                       16
<PAGE>
 
<TABLE> 
<CAPTION> 
Exh. No.                Documentation Description                                         Page
-------                 -------------------------                                         ----
<C>       <S>                                                                            <C>     

10.11     Agreement dated June 2, 1994, by and between the Company and Daniel R.
          Hafeman (Incorporated by reference to Exhibit 10.18 of the Company's
          quarterly report on Form 10-Q for the quarter ended July 2, 1994).

10.12     Agreement dated June 2, 1994, by and between the Company and Stephen
          McLaughlin. (Incorporated by reference to Exhibit 10.18 of the
          Company's quarterly report on Form 10-Q for the quarter ended July 2,
          1994).

10.13     Agreement dated June 2, 1994, by and between the Company and Larry A.
          Melling (Incorporated by reference to Exhibit 10.18 of the Company's
          quarterly report on Form 10-Q for the quarter ended July 2, 1994).

10.14     Agreement dated June 2, 1994, by and between the Company and Ramon A.
          Nunez (Incorporated by reference to Exhibit 10.18 of the Company's
          quarterly report on Form 10-Q for the quarter ended July 2, 1994).

10.15     Agreement dated June 2, 1994, by and between the Company and Joseph W.
          Rockom (Incorporated by reference to Exhibit 10.18 of the Company's
          quarterly report on Form 10-Q for the quarter ended July 2, 1994).

10.16     The Company's 1995 Outside Directors Stock Option Plan (Incorporated by
          reference to Exhibit 10.22 of the Company's registration statement on
          Form S-2 effective October 12, 1995).

10.17     Development and OEM Agreement for Verilog/IKOS Co-simulation Interface
          dated August 26, 1994 by and between the Company and Precedence
          Incorporated (Incorporated by reference to Exhibit 10.24 of the
          Company's registration statement on Form S-2 effective October 12,
          1995).

10.18     Amendment to OEM Agreement for the acquisition of certain software
          technology, by and between Compass Design Automation, Inc. and the
          Company dated December 27, 1995  (Incorporated by reference to Exhibit
          10.20 of the Company's quarterly report on Form 10-Q  for the  quarter
          ended  December 30, 1995).

10.19     Amended and Restated Employment Agreement dated August 1, 1995 by and
          between the Company and Ramon Nunez  (Incorporated by reference to
          Exhibit 10.21 of the Company's quarterly report on Form 10-Q for the
          quarter ended December 30, 1995).
</TABLE> 

                                       17
<PAGE>
 
<TABLE> 
<CAPTION> 
Exh. No.                Documentation Description                                         Page
-------                 -------------------------                                         ----
<C>       <S>                                                                            <C>     
10.20     Patent License Agreement dated December 22, 1993 between Massachusetts
          Institute of Technology and the Company (Incorporated by reference to
          Exhibit 10.20 of the Company's quarterly report on Form 10-Q for the
          quarter ended June 29, 1996). Confidential treatment has be granted as
          to certain portions of this Exhibit.

10.21     The Company's 1995 Stock Option Plan, as amended (Incorporated by
          reference to Exhibit 10.21 of the Company's Quarterly Report on Form
          10-Q for the quarter ended April 4, 1998).

10.22     The Company's 1996 Employee Stock Purchase Plan, as amended (Incorporated 
          by reference to Exhibit 10.22 of the Company's quarterly report on Form 
          10-Q for the quarter ended April 4, 1998).

27.1      Financial Data Schedule
</TABLE> 

(b) REPORTS ON FORM 8-K

          The Company filed a report on Form 8-K on May 20, 1998, relating to
the Technology Purchase Agreement by and between the Company and Interra, Inc.
and the Consulting Assignment and Technology Use Restriction Agreement by and
between the Company and the Principals of Interra. The Company described the
acquisition under Item 2 of the report -- Acquisition or Disposition of Assets.



                                  SIGNATURES

Pursuant to the requirements 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.



                                      IKOS SYSTEMS, INC.
                                      ------------------
                                      Registrant



Date: August 14, 1998                 /s/ Joseph W. Rockom
                                      ---------------------        
                                      (JOSEPH W. ROCKOM CFO)
                                      Principal Financial Officer,
                                      Duly Authorized Officer

                                       18