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

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                                    FORM 10-K

[X]  ANNUAL REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES  EXCHANGE
     ACT OF 1934 For the fiscal year ended January 31, 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: 0-26334

                              INFERENCE CORPORATION
             (Exact name of registrant as specified in its charter)

                 DELAWARE                                     95-3436352
(State or other jurisdiction of incorporation)          (I.R.S. Employer 
                                                        Identification Number)

100 Rowland Way, Novato California                              94945
(Address of principal executive offices)                     (Zip Code)

       Registrant's telephone number, including area code: (415) 893-7200

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        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, $0.01 par value per share
                                (Title of Class)

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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 shorter  period that the registrant was required
to file such reports),  and (2) has been subject to such filing requirements for
at least the past 90 days. Yes x No ___

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

The  aggregate  market value of the voting stock held by  non-affiliates  of the
Registrant was  approximately  $20,401,000 as of April 17, 1998,  based upon the
closing sale price on the NASDAQ National Market reported for such date.  Shares
of Class A Common Stock held by each officer and director and by each person who
beneficially  owns 5% or more of the outstanding  Class A Common Stock have been
excluded in that such persons may be deemed to be affiliates.  The determination
of affiliate  status is not  necessarily  a conclusive  determination  for other
purposes.

As of April 17, 1998, there were 6,195,515 shares of the Registrant's Class A
Common Stock, $0.01 par value per share, and 1,190,332 shares of the
Registrant's Class B Common Stock, $0.01 par value per share, outstanding.


                       DOCUMENTS INCORPORATED BY REFERENCE

Part III of this Report on Form 10-K incorporates  information by reference from
the  Registrant's  definitive Proxy Statement to be used in conjunction with its
fiscal 1998 Annual Meeting of Shareholders.

                                       1
<PAGE>
 
                             INFERENCE CORPORATION

                      FISCAL 1998 FORM 10-K ANNUAL REPORT

                               TABLE OF CONTENTS

<TABLE> 
<CAPTION> 
<S>         <C>                                                                     <C> 
                                    PART I
  Item 1.   Business..............................................................  3
            
  Item 2.   Properties............................................................ 10
            
  Item 3.   Legal Proceedings..................................................... 10
            
  Item 4.   Submission of Matters to a Vote of Security Holders................... 10
            
                                    PART II
  Item 5.   Market for Registrant's Common Equity and Related
                      Stockholder Matters......................................... 10
            
  Item 6.   Selected Financial Data............................................... 11
            
  Item 7.   Management's Discussion and Analysis of Financial
                      Condition and Results of Operations......................... 13
            
  Item 8.   Financial Statements and Supplementary Data........................... 21
            
  Item 9.   Changes in and Disagreements with Accountants on Accounting
                      and Financial Disclosure.................................... 21
            
                                   PART III
  Item 10.  Directors and Executive Officers of the Registrant.................... 21
            
  Item 11.  Executive Compensation................................................ 21
            
  Item 12.  Security Ownership of Certain Beneficial Owners and Management........ 21
            
  Item 13.  Certain Relationships and Related Transactions........................ 21
            
                                    PART IV
  Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K...... 22

  SIGNATURES...................................................................... 39
</TABLE> 
---------------------

     Certain  statements  contained  hereunder  regarding  matters  that are not
historical facts are forward-looking  statements (as such term is defined in the
rules  promulgated  pursuant  to the  Securities  Act of 1933,  as amended  (the
"Securities  Act")).  Such  forward-looking  statements  are  subject to certain
risks, trends and uncertainties; thus, actual results may differ materially from
those expressed in or implied by such forward-looking  statements.  Factors that
could cause or contribute to such differences  include,  but are not limited to,
fluctuations  in quarterly  operating  results,  the size and timing of customer
orders,  rapid  technological  change and product  transitions,  and competitive
actions in the  marketplace.  These  business  factors and others are  discussed
further in the section of this Annual Report entitled  "Management's  Discussion
and  Analysis of Financial  Condition  and Results of  Operations."  The Company
undertakes  no  obligation  to release  publicly the result of any  revisions to
these  forward-looking  statements  that  may  be  made  to  reflect  events  or
circumstances   after  the  date  hereof  or  to  reflect  the   occurrence   of
unanticipated events. Readers should also carefully review the business and risk
factors  described in the documents the Company files from time to time with the
Securities and Exchange Commission, including, without limitation, the Quarterly
Reports on Form 10-Q and any Current Reports on Form 8-K filed by the Company.

                                       2
<PAGE>
 
                                    PART I


Item 1.    Business


General

     Inference Corporation ("Inference" or "the Company") develops, markets and
supports knowledge management solutions for self-service and call centers to
improve customer care. The company offers a complete line of consulting, support
and training services from offices throughout the U.S., England and Europe.
Inference's CBR Express family of products ("CBR Products") facilitates
successful dialogue with the customer to quickly identify and resolve problems
in external and internal customer support and service environments.

     The Company's primary focus to date has been on the customer support
market, which includes external customer support and internal help desks. The
customer support market is divided into two segments: problem management, where
customer calls and information are tracked; and problem identification and
resolution, where information is obtained from the customer and used to define
the problem and provide a solution. The Company provides solutions focused
primarily on the problem identification and resolution segment of the customer
support market. The Company believes its strengths are that its products offer
various access options (or universal access) to enable novice and experienced
support representatives to search a single comprehensive knowledge base via an
intuitive dialogue-based interaction so that customers, employees and call
center representatives can find answers quickly and consistently. Universal
access allows customers to find answers through the method which is most
convenient to them--through the World-Wide-Web ("WWW" or "the Web"), CD-ROM or a
call center representative. A comprehensive knowledge base takes advantage of
experiences, documents and other forms of problem-solving data. The Company's
value proposition is it applies knowledge management to deliver customer care
solutions for self-service and call centers. The Company helps its customers
dramatically improve their customers' satisfaction, significantly reduce support
costs and fuel corporate growth through increased customer loyalty.

     Self-service solutions allow customers and employees to access a single
comprehensive knowledge base directly --through a complete set of access
options. In addition, self-service solutions can help companies provide 7 by 24
support (7 days a week, 24 hours a day) -- globally, have happier customers (do
not have to wait on hold or call the support center), provide accurate and
consistent responses to customer's queries. Call center solutions allow customer
support representatives to access a central knowledge base. This helps them
increase first call resolution, decrease response time, improve consistency and
accuracy of responses, increase productivity and minimize training.

     Inference's CBR Content Navigator ("CBR CN") product family, the latest CBR
product family, offers various access options to a single comprehensive
knowledge base via an intuitive dialogue-based interaction to help customers,
employees and call center representatives find answers quickly and consistently.
Inference's CBR CN product family facilitates a successful dialogue with
customers, prospects and other employees. A typical case-based reasoning ("CBR")
session begins with a description of the problem the user is having. This is
matched to descriptions of previously solved problems. CBR products further
guide the user by posing a set of questions that is used to refine the search
until a very likely solution is presented. With CBR Express, Inference's
knowledge creation application, experienced support representatives, knowledge
engineers and experts in the relevant subject matter can dynamically capture the
expertise in a support organization into a comprehensive knowledge base, taking
advantage of experiences, documents and other forms of problem-solving data.

     Inference's CBR Products are scaleable and available on popular computing
platforms, including Microsoft Windows 95 and Windows NT, and Sun Solaris. The
CBR Products support many database management systems, including Oracle,
Informix, Sybase, Microsoft's SQL Server and IBM's DB2. The Company's CBR
Products support stand-alone, client/server, Internet and intranet environments,
providing companies with many options to deploy knowledge. The Company also
provides consulting services, technical support and training for its CBR
Products.

                                       3
<PAGE>
 
Industry Background

     Customer support has become a major focus area for companies seeking to
differentiate themselves by offering superior customer service. Customers today
have greater expectations from interactions with suppliers. In addition,
sophisticated products are increasingly being sold to broader markets of first-
time buyers. At the same time, suppliers are dealing with significant rates of
employee turnover in customer service and support operations. Organizations that
recognize the lifetime value of a customer are investing to support external
customers to improve repeat sales potential.

     In addition to the challenges of serving external customers, companies are
facing increasing demands to support internal "customers." Throughout companies,
the transition to group-oriented network computing (client/server) and the use
of hardware and software from multiple vendors greatly increase the complexity
of systems management and support. Such complexity often outpaces employees'
abilities to use and/or manage the system, thereby creating a new class of
internal customers who require support. As a result, organizations train or hire
internal support talent to protect and leverage their investment in these
distributed client/server systems. This additional investment usually takes the
form of an internal help desk that gives employees the same type of support that
hardware and software vendors provide to their external customers.

     Companies have attempted to improve responsiveness to both external and
internal customers by adding personnel. In many cases, such personnel increases
have resulted in increased costs with limited improvements in customer
satisfaction. In addition, experienced personnel with the technical knowledge
required for external customer support and internal help desk positions are in
short supply.

     In recent years, companies have turned to software automation to assist the
customer support staff in contact with external and internal customers in order
to improve and leverage those valuable interactions. Specifically, organizations
are turning to software programs to help them track the customer and identify
and resolve problems, including efficient implementation of the appropriate
solution. Initial client/server applications available to automate the customer
support and internal help desk functions focused primarily on maintaining user-
specific records and tracking reported problems. These systems, which have
improved customer support and internal help desk operations, address primarily
the problem management segment of this market. Automation of problem management
itself, however, does not reduce the required individual attention necessary to
identify and resolve problems presented to customer support personnel.

     Because the identification and resolution of problems presented to support
personnel remains a time consuming and expensive process, companies are seeking
to automate the identification and resolution of support problems. Companies
have begun to deploy self-service programs that make problem identification and
resolution technology directly available to the user through the Internet on the
World Wide Web or by embedding problem resolution tools or technologies into
their products. This capability, however, is not generally available in many
problem management software applications offered today. While problem
identification and resolution applications are available, the Company believes
that many of these applications are limited to customer support and do not fully
address the complexity, scalability, ease of implementation and use requirements
of most customer service and support operations.


The Inference Solution

     The Company believes that its proprietary implementation of case-based
reasoning technology is the core technology that differentiates the Company in
the marketplace. The Company's CBR Products incorporate this adaptable and
scaleable technology that is designed to support front office operations and
ultimately make problem identification and resolution technology directly
available to the user. CBR Products enable customer support and internal help
desk personnel to manage customer interactions effectively, identify customer
problems and provide resolutions quickly. Key elements of CBR Products include
an intuitive user interface, a query refinement capability, an easy-to-use
authoring environment, support for case base objects that reference multiple
information formats (such as documents, databases and multimedia content),
search matching algorithms and a fully interactive and dynamic information
maintenance capability. CBR Products also utilize an easy-to-use, intuitive
question-and-answer technique to match inquiries with available data
efficiently. This question-and-answer approach allows support personnel with a
wide range of experience, from novice to expert, to establish a successful
dialogue with customers and to identify and resolve their problems quickly. CBR
Products provide a uniform graphical point-and-click interface to case bases
referencing structured information in computer databases and unstructured
information such as policy manuals, free text, publications, multimedia content
and business know-how. The Company believes its basic technology has practical
applicability for a wide range of business processes, including sales
automation, telemarketing, product configuration and selection, document
management and navigation, personnel evaluation, and intelligent order entry.
The Company believes that this uniform access to case bases that reference
structured and unstructured information combined with a flexible, responsive and
easy-to-use delivery system offers a competitive advantage in the front office.

                                       4
<PAGE>
 
Strategy

     The Company's mission is to be the leading provider of customer care
solutions for self-service and call centers by applying knowledge management
technologies that facilitate a successful dialogue to solve problems and answer
questions. The following are the key elements of the Company's strategy:

     Focus on Problem Identification and Resolution. The Company's primary
objective is to establish its CBR Products as the industry standard problem
identification and resolution products for internal and external customer
support. The Company believes that it can establish this position due to the key
attributes of the CBR Products. The Company intends to continue its focus on
problem identification and resolution and to leverage existing products by
adding features and functionality to extend the Company's CBR product line
beyond customer support.

     Third-Party Integration. The open architecture of CBR Products makes it
possible to integrate it with a broad range of related technologies and products
in the computing and telephony areas. Components of the CBR Products can be
embedded in legacy applications as either call-in or call-out functions, and
they can be integrated with many popular applications, such as electronic mail,
document or media browsers, spreadsheets and document editors. The Company's
software also provides an interface to a number of third-party call tracking and
help desk automation systems.

     Build On Established International Presence. The Company currently derives
a significant portion of its revenues from its international operations and
believes that it enjoys a leading market position in the United Kingdom. The
Company also has operations in France and the Netherlands and is expanding its
international distribution base in order to expand its penetration of global
markets.

     Leverage Product Sales by Providing Professional Consulting Services. To
address the growing demand for custom applications, the Company employs a staff
of professional consultants who are experienced in the design and implementation
of problem identification and resolution applications. These individuals are
also skilled at managing the development and deployment of custom solutions
using either customer or third-party programmers. The Company intends to offer
these consulting services as a secondary yet effective and differentiating
component of its sales strategy. These services are offered at rates that the
Company believes are competitive with, but generally not lower than, other
professional consulting firms.

     Provide Multiple Platform Support. CBR Products are available on several
computing platforms, including Microsoft Windows 95, Windows NT, and Sun Solaris
for SPARC, and support many database management systems, including Oracle,
Informix, Sybase, Microsoft's SQL Server and IBM's DB2.


Products and Services

   Current Products

     CBR Content Navigator ("CBR CN"), the Company's principal product, is a
suite of client/server and Internet applications that is designed to provide
access to case bases that reference structured and unstructured information for
use in the front office. To date, CBR CN's primary use has been in external
customer support and call centers and internal help desk operations.

     CBR CN includes new features including those designed to reduce the cost of
case base creation and maintenance and increase the value of summarized
documents. CBR CN allows organizations to capture, maintain and harness
knowledge to improve customer care. CBR CN enables call center representatives
to access a single comprehensive knowledge base to increase first call
resolution and raise call quality. End users can access the knowledge base
directly, via CD-ROM or the Web, to solve their own support queries--thus
reducing customer support costs. In addition, CBR CN is designed to provide a
set of development kits based on a fully documented open architecture, enabling
its tools to be customized and embedded within third party customer interaction
applications and other systems.

     CBR CN supports Microsoft Windows 95 and Windows NT, and Sun Solaris for
SPARC and is designed to support various database management systems, including
Oracle, Informix, Sybase, Microsoft SQL Server and IBM DB2.

     The CBR Content Navigator products consist of the following unbundled
components described below:

     CBR Express. CBR Express is a client/server application that provides a
series of templates for "authoring" (developing) case histories, business
policies and information stored in documents into a format readable by the
CasePoint viewer of CBR CN.

                                       5
<PAGE>
 
     .    CBR Express Professional Author - The primary knowledge creation and
          maintenance application designed to capture and update cases quickly.
          It offers a fully object-oriented authoring environment with visual
          content management techniques.

     .    CBR Express Generator - A stand-alone application which allows users
          to automatically create a case base representation that summarizes a
          set of documents, allowing easy access to information in Microsoft
          Word, tech notes, Lotus Notes, or HTML pages among other formats.

     .    CBR Express Reports - An integrated set of tools used to manage, test
          and report on the consistency and validity of the content in a case
          base.

     .    CBR Express Harvester - A stand-alone application which supports the
          ability to capture new knowledge on an ongoing basis. It allows users
          to add knowledge dynamically into the case base, as part of the
          problem solving process, through a simple point and click interface.

     CasePoint. The CasePoint viewer is the primary end user search interface
for CBR information bases. It runs as a client under Microsoft Windows 95 and
Windows NT, IBM OS/2, HP-UX and Sun Solaris for SPARC and offers a GUI for
submitting queries and searching information bases. CasePoint is offered in the
following versions:

     .    CasePoint Standard - A powerful, easy-to-use search and retrieval
          application, available as a 16- and 32-bit product, which is ideal for
          OEM/embedded and knowledge distribution applications. It can be
          deployed in a stand-alone, file-server or client/server environment.
          CasePoint Standard provides an intuitive dialogue-based interface that
          requests further input until the solution is located.

     .    CasePoint Professional - A more robust, fully object-oriented 32-bit
          search and retrieval application for corporate knowledge. It offers
          both the intuitive dialogue-based interface of CasePoint Standard and
          a new visual folder-based view of content for experienced users.

     CasePoint WebServer. CasePoint WebServer has added Web as a vehicle for
delivering knowledge in front office applications, using Inference's CBR
technology. CasePoint WebServer is an interactive Web application that enables
organizations to increase their level of customer service by allowing customers
to directly access troubleshooting information and product information--without
having to wait to contact a service agent. CasePoint WebServer uses standard RPC
facilities and is written to the Common Gateway Interface ("CGI") specification
and can be accessed using any Web browser.

   Services

     The Company has a worldwide customer services organization that provides
quality technical support and education services designed to ensure customer
success and build customer loyalty. The Company also has a worldwide consulting
services organization that assists in the design and deployment of customer
solutions. As of March 31, 1998, the Company's worldwide customer service
organizations consisted of 32 employees in North America and 28 employees
internationally.

     Consulting Services. Consultants assist customers with case base design,
review and audit and also provide technology transfer by working with a
customer's in-house staff to establish procedures for developing case bases from
existing problem identification and resolution information. Most consulting
engagements are designed to allow the customer's staff to carry out much of the
work involved in analyzing existing customer support and internal help desk
activities and designing the case base. Consulting services are typically priced
on an hourly basis.

     Technical Support Options. Customers can access the Company's support
centers by telephone, fax, electronic mail, an electronic bulletin board system
and the Web. The Company typically provides second line support for customers of
its VARs, systems integrators and OEMs. New customers receive an initial 30-day
period of complimentary support after which, for an annual fee, customers
receive new software releases, upgrades, maintenance releases and support.
Depending on the chosen support plan, the fee generally ranges from 10% to 30%
of the current list price of the licensed products. The Company offers three
levels of support, Basic, Gold and Platinum; each tailored to the customers'
specific requirements.

     Training and Education. Customers can choose from a wide variety of basic
and customized education and training programs, which are charged separately
from the Company's software products and are offered through the Company's in-
house classroom facilities in Novato, California. The Company also conducts
classes at the customer's place of business.

                                       6
<PAGE>
 
   Pricing

     The CBR CN products are offered either on a per CPU, per concurrent user or
per server license basis. The current U.S. list price for an entry-level ten-
user client/server system is approximately $25,000 and varies depending on the
number of modules purchased. Discounts from the Company's list prices may be
made available for volume purchasers, or for competitive or strategic reasons.

     The Company believes that its products and services are currently priced
competitively, yet the market for products of the type developed by the Company
is highly competitive. As a result, the Company anticipates increased pricing
pressure from current and future competitors. Any substantial downward
adjustment in the price of the Company's products or services without a
corresponding increase in unit sales would adversely affect the Company's gross
margins and could have a negative impact on the Company's business, operating
results and financial condition.


Competition

     The market for customer support software is highly competitive, and there
are certain competitors with substantially greater sales, marketing, development
and financial resources than the Company. Among the Company's major competitors
in the problem identification and resolution segment of the market are Clarify,
Inc. and Software Artistry, Inc. (a business unit of Tivoli Systems, Inc., a
subsidiary of IBM Corporation) and other smaller privately held companies.
Furthermore, many potential customers implement low-end text retrieval solutions
or develop internal applications that eliminate the need to acquire software and
services from third-party vendors such as the Company.

     The Company believes that the competitive factors affecting the market for
the Company's products and services include vendor and product reputation;
product quality, performance and price; product functionality and features;
product scalability; product integration with other enterprise applications; the
availability of products on multiple platforms; product ease-of-use; and the
quality of customer support services, documentation and training. The relative
importance of each of these factors depends upon the specific customer involved.
There can be no assurance that the Company will be able to compete effectively
with respect to any of these factors.

     The Company's present or future competitors may be able to develop products
comparable or superior to those offered by the Company or adapt more quickly
than the Company to new technologies or evolving customer requirements. In order
to be successful in the future, the Company must respond to technological
change, customer requirements and competitors' current products and innovations.
In particular, while the Company is currently developing additional product
enhancements that the Company believes address customer requirements, there can
be no assurance that the Company will successfully complete the development or
introduction of these additional product enhancements on a timely basis or that
these product enhancements will achieve market acceptance. Accordingly, there
can be no assurance that the Company will be able to continue to compete
effectively in its market, that competition will not intensify or that future
competition will not have a material adverse effect on the Company's business,
operating results or financial condition.


Customers

     The Company estimates that it has granted licenses for its products to over
500 customers for use by more than 500,000 end users. In fiscal 1996, AT&T Corp.
accounted for 11% of total revenues. In fiscal 1998 and 1997, no customer
accounted for more than 10% of the Company's total revenues.


Selling and Marketing

     The Company markets and sells its software and services in North America
through its direct sales organization, VARs, systems integrators and OEMs. The
domestic sales staff is based at the Company's corporate headquarters in Novato,
California, and in the Company's field sales offices in Atlanta, Chicago,
Dallas, Denver, Houston, Philadelphia, Seattle, and New Jersey. As of March 31,
1998, the Americas sales and marketing staff consisted of 33 employees.

     The Company maintains subsidiaries in England, France, and the Netherlands,
which are responsible for the Company's activities throughout Europe, Africa and
the Middle East. As of March 31, 1998, the international sales and marketing
staff consisted of 22 employees.

                                       7
<PAGE>
 
     The Company typically sells CBR Products and related services through a
sales representative who is assisted on an as-needed basis by a systems
engineer. To assist the sales force, the Company utilizes a multi-tiered
marketing program comprising periodic customer communications, user conferences,
advertising, public relations activities, seminars and trade show participation.

     VARs, distributors, systems integrators and OEMs complement the Company's
marketing and sales organization. These entities license certain CBR Products at
a re-licensing discount and may provide end users with a range of services
including training and customer service/support.


Product Development

     The Company believes that strong development capabilities are essential to
its future performance and the maintenance of its competitive position. Since
its formation, the Company has primarily developed its technology and products
internally. The Company intends to extend its CBR product line to support
additional hardware platforms and operating systems and to develop new
facilities for authors and end users of those products. This development is
expected to include the creation of third-party applications and database
interfaces to facilitate the integration of CBR technology into customers'
environments.

     Although the Company has a number of ongoing development projects, its
primary product development effort is focused on enhancing the CBR CN product
line. The CBR CN enhancements will continue to add functionality to the
Company's current product line. However, there can be no assurance that the
development of these enhancements will be completed successfully or on a timely
basis or that the product will include the features required to achieve market
acceptance. The Company's future operations will be substantially dependent on
the CBR CN product line, and failure to achieve market acceptance of this family
of products would have a material adverse effect on the Company's business,
operating results and financial condition.

     The Company has in the past experienced delays in software development, and
there can be no assurance that the Company will not experience further delays in
connection with its current product development or future development
activities. Software products as complex as those offered by the Company may
contain undetected errors when first introduced or as new versions are released.
There can be no assurance that errors will not be found in the Company's new or
enhanced products after commencement of commercial shipments or that
modifications to such products will not be required to satisfy customer
requirements, resulting in loss of or delay in market acceptance. Delays or
difficulties associated with new product introductions or product enhancements
could have a material adverse effect on the Company's business, operating
results and financial condition.

     The Company began commercially shipping its CasePoint WebServer product in
March 1996, which provides an Internet compatible, Web server with a Mosaic-
compatible browser and intuitive CasePoint interface. CasePoint WebServer is
designed to allow the users of the WWW to be clients of any CBR-compatible case
base or document base. By providing the WWW access to CBR knowledge bases,
companies could implement call avoidance strategies, allowing their customers,
prospects and vendors to directly submit problems, questions and requests;
receive appropriate responses; or, if appropriate, download entire case bases to
a local computer.

     The Company's development organization is arranged in five groups: the
Research group, which designs and develops future technologies; the Knowledge
Creation Tools group, which specifies, produces and maintains the graphical user
interfaces required to build effective knowledge bases for customer care
systems; the System Components group, which is responsible for creating the
Company's core technology kernels and components; the Customer Care Solutions
group, which designs and builds system integration solutions; and the Quality
Assurance group, which verifies that products meet their specifications and the
Company's quality standard. These groups are designed to ensure that there is an
efficient separation between technology development and the time-sensitive
demands of product delivery.

     The market for the Company's products is characterized by rapid
technological developments, evolving industry standards, swift changes in
customer requirements and frequent new product introductions and enhancements.
As a result, the Company's success depends upon its ability to continue to
enhance its existing products, respond to customer requirements, and to develop
and introduce, in a timely manner, new products incorporating technological
advances. To the extent one or more of the Company's competitors introduce
products that more fully address customer requirements, there could be a
material adverse effect on the Company's business, operating results and
financial condition. There can be no assurance that the Company will be
successful in developing and marketing new products or enhancements to its
existing products on a timely basis or that any new or enhanced products will
adequately address the changing needs of the marketplace.

                                       8
<PAGE>
 
     If the Company is unable to develop and introduce new products or
enhancements to existing 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. From
time to time, the Company or its competitors may announce new products,
capabilities or technologies that have the potential to replace or shorten the
life cycles of the Company's existing products. There can be no assurance that
announcements of currently planned or other new products will not cause
customers to delay their purchasing decisions in anticipation of such products,
which could have a material adverse effect on the Company's business, operating
results and financial condition.

     As of March 31, 1998, there were 29 employees on the Company's product
development and quality assurance staff. The total product development
expenditures for the Company's products for fiscal 1998 were $4.7 million.
Product development expense during fiscal 1997 and 1996 was $3.5 million and
$2.0 million, respectively. The Company expects to continue to allocate
significant resources to future research and development.

Intellectual Property and Other Proprietary Rights

     The Company's success depends in part upon its proprietary technology.
Although case-based reasoning technology is available in the public domain, the
Company believes its implementation of the CBR technology is proprietary. The
Company relies on a combination of copyright, trademark and trade secret laws,
confidentiality procedures and licensing arrangements to establish and protect
its proprietary rights (See Item 3. "Legal Proceedings."). The Company was
awarded two patents for its CBR technology in December 1996, and a third patent
was awarded in January 1998. The Company's CBR technology is embedded in its CBR
family of products. Despite the precautions the Company has taken, it may be
possible for an unauthorized third party to copy or otherwise obtain and use the
Company's products, technology or other information that the Company regards as
proprietary or to develop similar products or technology independently. In
addition, effective trademark, copyright and trade secret protection may be
unavailable or limited in certain foreign countries where the Company operates.

     The Company generally provides its products to end-users under signed
license agreements. These agreements are negotiated with and signed by the
licensee. The Company occasionally publishes articles regarding its technical
developments in industry publications that may prevent the Company from
obtaining patent protection for ideas contained in such publications, thus
increasing the availability to third parties of fundamental aspects of the
Company's technology.

     The Company is not aware that any of its products infringe upon the
proprietary rights of third parties. There can be no assurance, however, that
third parties will not claim such infringement by the Company with respect to
current or future products. The Company expects that it will increasingly be
subject to such claims as the number of products and competitors in the customer
support software market grows and the functionality of such products overlaps
with other industry segments. Any such claims, whether or not they are
meritorious, could result in costly litigation or require the Company to enter
into royalty or licensing agreements. Such royalty or license agreements, if
required, may not be available on terms acceptable to the Company or at all. If
the Company were found to have infringed upon the proprietary rights of third
parties, it could be required to pay damages, cease sales of the infringing
products and redesign or discontinue such products, any of which could have a
material adverse effect on the Company's business, operating results and
financial condition.


Employees

     As of March 31, 1998, the Company had a total of 174 employees, of which
107 were based in the United States, 60 in the United Kingdom, 1 in Germany, 5
in France, and 1 in the Netherlands. Of the total, 55 were engaged in sales and
marketing, 16 were in customer support, 44 were in consulting services, 29 were
in product development, and 30 were in administration and finance. The Company's
employees are not represented by any labor unions. The Company considers its
relations with its employees to be good, and there has never been an
interruption in business activities due to labor unrest. However, the Company's
future performance is contingent upon the uninterrupted service of key
technological and executive management staff and upon the maintenance of
conditions that can help attract and retain capable technicians and managers.
There is significant competition for talented and qualified employees, and there
can be no assurance that the Company will be able to retain its most strategic
employees or that it can attract and retain comparably qualified personnel in
the future.

                                       9
<PAGE>
 
Item 2.    Properties

     The Company's headquarters in Novato, California house product development,
sales, marketing, technical support and administrative operations in
approximately 37,000 square feet of space. The facility is under lease through
February 2005. The Company's European headquarters in Slough, England house
product development, sales, marketing, technical support and administrative
operations in approximately 14,500 square feet. This facility is under lease
through August 2002. The Company also leases additional space in its various
sales offices throughout North America and in Europe.


Item 3.    Legal Proceedings

     In September 1997, the Company filed a complaint (the "Complaint") in the
United States District Court - Northern District of California in San Jose (case
number C97-03414) charging ServiceSoft Corporation ("ServiceSoft") with patent
infringement, copyright infringement, breach of contract, intentional
interference with prospective business interest and unfair competition. In
October 1997, ServiceSoft filed its answer to the Complaint and denied the
charges made in the Complaint, and ServiceSoft also filed a counterclaim (the
"Counterclaim") charging the Company with intentional interference with
prospective business advantage, trade defamation and unfair competition. The
Counterclaim seeks unspecified damages, costs and non-monetary relief,
including, among other things, a declaration of non-infringement and a
declaration of invalidity and unenforceability of a patent with respect to the
Company's CBR technology. In November 1997, the Company answered the
Counterclaim and denied all of the claims made by ServiceSoft in the
Counterclaim. The Company believes that the Counterclaim is without merit. The
Company intends to vigorously prosecute the Complaint and defend the
Counterclaim, and believes that the ultimate outcome of this matter will not
have a material adverse impact on the Company's financial position, results of
operations or cash flows.


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

     Not applicable.

                                    PART II


Item 5.    Market for the Registrant's Common Equity and Related Stockholder
           Matters

     The Company's Class A Common Stock is traded on the NASDAQ National Market
under the symbol of "INFR". The following table sets forth for the quarterly
period indicated the range of high and low closing sales prices for the
Company's Class A Common Stock, as reported by the NASDAQ National Market
System, for the two most recent fiscal years.


-----------------------------------------------------------------
    Fiscal 1998               High                   Low
-----------------------------------------------------------------
First Quarter                 $8.88                 $4.63
Second Quarter                 5.75                  4.00
Third Quarter                  7.44                  4.31
Fourth Quarter                 5.56                  3.50
-----------------------------------------------------------------

-----------------------------------------------------------------
    Fiscal 1997               High                   Low
-----------------------------------------------------------------
First Quarter                $19.75                $16.75
Second Quarter                25.25                 16.25
Third Quarter                 20.50                 12.25
Fourth Quarter                 8.25                  5.88
-----------------------------------------------------------------


     The Company currently does not anticipate paying any cash dividends in the
foreseeable future.

     As of March 31, 1998, there were approximately 181 shareholders of record
of the Company's Class A and 1 shareholder of Class B Common Stock.

                                       10
<PAGE>
 
Item 6.    Selected Financial Data:


Consolidated Statements of Operations Data:
<TABLE> 
<CAPTION> 
                                                       Fiscal Year Ended January 31,
                                        ------------------------------------------------------------
                                             1998         1997        1996        1995        1994
                                        ------------    ---------    --------   --------   ---------
                                                   (In thousands, except per share data)
<S>                                     <C>             <C>          <C>        <C>        <C> 
Revenues:
  Products--CBR.........................   $  13,129    $  20,402    $ 16,479   $   9,790  $   6,662
  Products--Tools.......................          --           --         399       2,230      3,581
  Services..............................      15,094       15,588      12,517      16,479     17,084
                                        ------------    ---------    --------   ---------  ---------
    Total...............................      28,223       35,990      29,395      28,499     27,327
Operating costs and expenses:              
  Product...............................         982        1,248       1,710       1,611      1,575
  Services..............................       7,952        9,237       7,667      12,292     13,111
  Product development...................       4,666        3,492       1,959       2,753      3,731
  Selling and marketing.................      15,421       16,909      12,758       9,414      8,554
  General and administrative............       3,796        3,492       1,845       1,420      1,587
  Non-recurring.........................          --          --          --          774         --
                                        ------------    ---------    --------   ---------  ---------
    Total...............................      32,817       34,378      25,939      28,264     28,558
                                        ------------    ---------    --------   ---------  ---------
Income (loss) from operations...........      (4,594)       1,612       3,456         235     (1,231)
Gain on sale of investment..............       3,824          --          --          --         --
Costs of attempted secondary offering...         --          (241)        --          --         --
Non-employee option expenses............         --          (215)        --          --         --
Loss from divested Tools Business.......         --           --         (210)        --         --
Interest income.........................       1,428        1,327         803         109        --
Other income and (expense), net.........         (31)        (141)        (81)        (25)      (58)
Benefit (provision) for income taxes....          --           90        (195)       (110)       --
                                        ------------    ---------    --------   ---------  ---------
Net income (loss).......................   $     627   $    2,432   $   3,773   $     209   $ (1,289)
                                        ============    =========    ========   =========  =========
                                           
Net income (loss) per common share (1):
  Basic.................................   $    0.08   $     0.30   $    0.59   $    0.28   $  (1.77)
                                        ============    =========    ========   =========  =========
  Diluted...............................   $    0.08   $     0.28   $    0.51   $    0.04   $  (0.27)
                                        ============    =========    ========   =========  =========
Shares used in computing net 
  income (loss) per common share (1):
  Basic.................................       7,894        8,078       6,344         757        727
                                        ============    =========    ========   =========  =========
  Diluted...............................       8,110        8,702       7,393       5,089      4,759
                                        ============    =========    ========   =========  =========
</TABLE> 

Consolidated Balance Sheet Data:
<TABLE> 
<CAPTION> 
                                                                January 31,
                                        -----------------------------------------------------------
                                             1998         1997        1996       1995        1994
                                        ------------   ---------    --------   --------   ---------
                                                              (In thousands)
<S>                                     <C>            <C>          <C>        <C>        <C> 
Cash and cash equivalents...............  $  28,010    $  28,620    $ 18,619   $  3,023   $   2,642
Short-term investments..................        --           987       7,314        --        1,097
Working capital.........................     26,657       29,963      26,222      4,683       4,774
Total assets............................     36,996       42,241      36,895     12,940      11,870
Total shareholders' equity..............     28,938       32,111      27,963      7,042       6,823
</TABLE> 
----------------------
(1) Net income (loss) per share in fiscal 1994, 1995, 1996 and 1997 has been
    restated in accordance with the requirements of Statement of Financial
    Accounting Standards No. 128, "Earnings Per Share" and SEC Staff Accounting
    Bulletin No. 98. See Note 1 of Notes to Consolidated Financial Statements
    for additional information and an explanation of the determination of shares
    used in computing net income (loss) per share.

                                       11
<PAGE>
 
Selected Consolidated Quarterly Financial Data (unaudited):

Fiscal 1998 Summary by Quarter:
<TABLE> 
<CAPTION> 
                                                                         October      January
                                                 April 30,    July 31,      31,          31,
                                                    1997        1997       1997         1998
                                                 --------    --------    --------     --------
                                                     (In thousands, except per share data)
<S>                                              <C>         <C>         <C>          <C> 
     Revenues:
       Products..............................    $  3,218    $  2,709    $  3,236     $  3,966
       Services..............................       3,876       4,011       3,785        3,422
                                                 --------    --------    --------     --------
         Total...............................       7,094       6,720       7,021        7,388
     Operating costs and expenses:
       Product...............................         243         246         243          250
       Services..............................       2,207       2,097       1,886        1,762
       Product development...................       1,045       1,141       1,222        1,258
       Selling and marketing.................       3,960       3,484       4,600        3,377
       General and administrative............         923         983         950          940
                                                 --------    --------    --------     --------
         Total...............................       8,378       7,951       8,901        7,587
                                                 --------    --------    --------     --------
     Income (loss) from operations...........      (1,284)     (1,231)     (1,880)        (199)
     Other income and (expense), net.........         341         325       4,243          312 
     Benefit (provision) for income taxes....          --          --          --           --
                                                 --------    --------    --------     --------
     Net income (loss).......................   $    (943)  $    (906)  $   2,363   $      113
                                                 ========    ========    ========     ========
     Net income (loss) per common share (1):
       Basic.................................   $   (0.12)  $   (0.11)  $    0.30   $     0.01
                                                 ========    ========    ========     ========
       Diluted...............................   $   (0.12)  $   (0.11)  $    0.29   $     0.01
                                                 ========    ========    ========     ========
     Shares used in computing net
       income (loss) per common share (1):
       Basic.................................       8,111       7,915       7,838        7,720
                                                 ========    ========    ========     ========
       Diluted...............................       8,111       7,915       8,055        7,902
                                                 ========    ========    ========     ========
</TABLE> 

Fiscal 1997 Summary by Quarter:
<TABLE> 
<CAPTION> 
                                                                         October      January
                                                 April 30,    July 31,      31,          31,
                                                    1996        1996       1996         1997
                                                 --------    --------    --------     --------
                                                     (In thousands, except per share data)
<S>                                              <C>         <C>         <C>          <C> 
     Revenues:
       Products..............................    $  4,978    $  5,503    $  3,454     $  6,467
       Services..............................       4,149       3,870       4,015        3,554
                                                 --------    --------    --------     --------
         Total...............................       9,127       9,373       7,469       10,021
     Operating costs and expenses:
       Product...............................         346         371         318          213
       Services..............................       2,432       2,311       2,338        2,156
       Product development...................         711         834         962          985
       Selling and marketing.................       4,188       4,130       4,227        4,364
       General and administrative............         749         875         898          970
                                                 --------    --------    --------     --------
         Total...............................       8,426       8,521       8,743        8,688
                                                 --------    --------    --------     --------
     Income (loss) from operations...........         701         852      (1,274)       1,333
     Other income and (expense), net.........          77          12         431          210 
     Benefit (provision) for income taxes....         (25)        --          --           115 
                                                 --------    --------    --------     --------
     Net income (loss).......................   $     753   $     864   $    (843)    $  1,658
                                                 ========    ========    ========     ========
     Net income (loss) per common share (1):
       Basic.................................   $    0.10   $    0.11   $   (0.10)   $    0.20
                                                 ========    ========    ========     ========
       Diluted...............................   $    0.09   $    0.10   $   (0.10)   $    0.19
                                                 ========    ========    ========     ========
     Shares used in computing net
       income (loss) per common share (1):
       Basic.................................       7,809       8,091       8,176        8,229
                                                 ========    ========    ========     ========
       Diluted...............................       8,640       8,780       8,176        8,525
                                                 ========    ========    ========     ========
</TABLE> 
---------------------
   (1) Net income (loss) per share for each of the quarters disclosed above
       (except for the January 31, 1998 quarter) has been restated in accordance
       with the requirements of Statement of Financial Accounting Standards No.
       128, "Earnings Per Share" and SEC Staff Accounting Bulletin No. 98. See
       Note 1 of Notes to Consolidated Financial Statements for additional
       information and an explanation of the determination of shares used in
       computing net income (loss) per share.

                                       12
<PAGE>
 
Item 7.


                     MANAGEMENT'S DISCUSSION AND ANALYSIS
               OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


     Certain statements contained hereunder regarding matters that are not
historical facts are forward-looking statements (as such term is defined in the
rules promulgated pursuant to the Securities Act of 1933, as amended (the
"Securities Act")). Such forward-looking statements are subject to certain
risks, trends and uncertainties; thus, actual results may differ materially from
those expressed in or implied by such forward-looking statements. Factors that
could cause or contribute to such differences include, but are not limited to,
fluctuations in quarterly operating results, the size and timing of customer
orders, rapid technological change and product transitions, and competitive
actions in the marketplace. The Company undertakes no obligation to release
publicly the result of any revisions to these forward-looking statements that
may be made to reflect events or circumstances after the date hereof or to
reflect the occurrence of unanticipated events. Readers should also carefully
review the business and risk factors described in the documents the Company
files from time to time with the Securities and Exchange Commission, including,
without limitation, the Quarterly Reports on Form 10-Q and any Current Reports
on Form 8-K filed by the Company.

     The following discussion should be read in conjunction with the
consolidated financial statements and notes thereto. All information is based on
the Company's fiscal year end, January 31.


Background

     The Company was founded in 1979 to provide consulting services. In 1985,
the Company made its first commercial shipment of a software application
development tool ("ART"). From 1985 until May 1991, revenues of the Company were
primarily derived from the sale of ART products and related consulting services.
In May 1991, the Company commercially shipped its first CBR Product.

     From May 1991 through April 30, 1995, the Company's revenues were derived
from two separate product lines: (i) the customer support product line,
consisting of CBR Products and associated services (the "CBR Business"); and
(ii) the application development and solutions product line, which included the
Company's products: ART, ART-IM and ART*Enterprise ("Tools") and associated
services (the "Tools Business"). In the fourth quarter of fiscal 1995, the
Company made a strategic decision to focus on the CBR Business and to divest the
Tools Business. Effective May 1, 1995, the Company transferred certain assets
and liabilities of the Tools Business to a wholly owned subsidiary
("Brightware") of the Company and distributed all of the shares of such
subsidiary to the Company's stockholders (the "Spin-Off"). As part of the Spin-
Off, the Company entered into an agreement with Brightware to provide certain
services to the new entity including operational and systems support, facilities
and administrative support and certain technical and customer support. This
agreement expired on January 31, 1996. The amount received for these services
was $760,000.


Results of Operations


Fiscal 1998 Overview

     For the year ended January 31, 1998, the Company did not achieve its
planned operating objectives, resulting principally from a decline in product
revenues, both in North America and internationally. The Company attributes this
decline in product revenues to several factors, including, but not limited to:
a) lower productivity by the sales representatives in all geographic areas; b)
the significant turnover in sales personnel early in the year, especially in the
Americas operations, which has resulted in a sales force that lacks experience
in selling the Company's products; and c) the increased competitive environment
in which the Company operates. The Company has attempted to respond to these
issues by the hiring of a new sales team in the Americas and by focusing on a
sales strategy that leverages the Company's Internet self-service problem
resolution product, CasePoint Webserver. The Company believes that CasePoint
Webserver is a technological leader in self-service over the Internet, and with
it and the Company's client-server call center products, the Company will be
able to exploit the emerging self-service and knowledge management solutions
markets. However, the Internet self-service and knowledge management markets are
both emerging, and there can be no assurances that the Company will achieve or
maintain a leading position in those markets.

                                       13
<PAGE>
 
     The following  table sets forth the percentages  that certain  statement of
operations  items are to total  revenues  for the years ended  January 31, 1998,
1997 and 1996:


                                                           Fiscal Year
                                                ----------------------------
                                                  1998        1997     1996
                                                ----------------------------
     Revenues:                                                        
       Products.............................         47%      57%      57%
       Services.............................         53%      43%      43%
                                                   ----     ----     ----   
         Total..............................        100%     100%     100%
     Operating costs and expenses:                                    
       Products.............................          3%       3%       6%
       Services.............................         28%      26%      26%
       Product development..................         17%      10%       7%
       Selling and marketing................         55%      47%      43%
       General and administrative...........         13%      10%       6%
                                                   ----     ----     ----   
         Total..............................        116%      96%      88%
                                                   ----     ----     ----   
     Income (loss) from operations..........        (16%)      4%      12%
                                                   ====     ====     ====   

Years Ended January 31, 1998, January 31, 1997 and January 31, 1996

   Revenues

     The Company's revenues are derived principally from two sources: (i) fees
for licenses of the Company's software products and technology and (ii) fees for
consulting services, maintenance (technical support and upgrades of software
products) and training. Product revenues result principally from non-cancelable
license agreements that provide customers the non-exclusive right to use the
products for a fixed term or on a perpetual basis. Such revenues are recognized
upon: (i) execution of a binding agreement; (ii) shipment of the product to the
customer; (iii) when the license fee is fixed or determinable; and (iv) when
collectability is reasonably assured. Revenues from consulting and training are
recognized as the related services are performed, and maintenance revenues are
deferred and recognized over the term of the Company's maintenance contracts,
typically one year.

     Total revenues decreased 22% to $28,223,000 in fiscal 1998 from $35,990,000
in fiscal 1997, and increased 22% in fiscal 1997 from $29,395,000 in fiscal
1996. The decrease in fiscal 1998 is due to the various factors discussed
previously in Fiscal 1998 Overview.

     North American revenues amounted to $16,682,000, $21,408,000, and
$15,845,000 for fiscal 1998, 1997, and 1996, respectively. The decrease in
fiscal 1998 is due to the various factors discussed previously in Fiscal 1998
Overview.

     International revenues amounted to $11,541,000, $14,582,000, and
$13,550,000 for fiscal 1998, 1997, and 1996, respectively, representing 41%,
41%, and 46% of total revenues for such periods, respectively. The decrease in
fiscal 1998 is due to the various factors discussed previously in Fiscal 1998
Overview. In addition, during fiscal 1998, the Company made the decision to
discontinue the direct product sales organizations in Germany and the
Netherlands, and to reduce the investment in the direct product sales
organization in France. The Company currently has subsidiaries in the United
Kingdom, France and the Netherlands, offering licenses and consulting services,
and has relationships with over 15 distributors worldwide, serving Europe, the
Middle East and Africa, and Asia and the Pacific Rim. International operations,
however, are subject to various risks, including unexpected changes in
regulatory requirements, tariffs and other trade barriers; costs and risks of
localizing products for foreign countries; longer accounts receivable payment
cycles; potentially adverse tax consequences; repatriation of earnings; exchange
rate fluctuations; and the burdens of complying with a wide variety of foreign
laws. There can be no assurance that such factors will not have an adverse
effect on the revenues from the Company's future international operations and,
consequently, the Company's results of operations and financial condition.

   Product Revenues

     Product revenues decreased 36% to $13,129,000 in fiscal 1998 from
$20,402,000 in fiscal 1997, and increased 21% in fiscal 1997 from $16,878,000 in
fiscal 1996. Product revenues represented 47%, 57%, and 57% of total revenues
for fiscal years 1998, 1997, and 1996, respectively. Product revenues have
principally been derived from direct licenses of the Company's software products
to end-users. Substantially all of the growth in product revenues was due to
higher unit sales volumes; the prices of the Company's products have remained
relatively constant.

                                       14
<PAGE>
 
     North American product revenues decreased 37% to $7,663,000 in fiscal 1998
from $12,070,000 in fiscal 1997, and increased 19% in fiscal 1997 from
$10,119,000 in fiscal 1996.

     International product revenues decreased 34% to $5,466,000 in fiscal 1998
from $8,332,000 in fiscal 1997, and increased 23% in fiscal 1997 from $6,759,000
in fiscal 1996. International product revenues represented 42%, 41%, and 40% of
total product revenues for fiscal 1998, 1997 and 1996, respectively.

     The Company attributes the decline in product revenues in fiscal 1998 to
several factors, including, but not limited to: a) lower productivity by the
sales representatives in all geographic areas; b) the significant turnover in
sales personnel during the year, especially in the Americas operations, which
has resulted in a sales force that lacks experience in selling the Company's
products; and c) the increased competitive environment in which the Company
operates. See also Fiscal 1998 Overview above.

     Service Revenues

     Service revenues decreased 3% to $15,094,000 in fiscal 1998 from
$15,588,000 in fiscal 1997, and increased 25% in fiscal 1997 from $12,517,000 in
fiscal 1996. Service revenues represented 53%, 43%, and 43% of total revenues
for fiscal 1998, 1997, and 1996, respectively.

     North American service revenues decreased 3% to $9,019,000 in fiscal 1998
from $9,338,000 in fiscal 1997, and increased 63% in fiscal 1997 from $5,726,000
in fiscal 1996.

     International service revenues decreased 3% to $6,075,000 in fiscal 1998
from $6,250,000 in fiscal 1997, and decreased 8% in fiscal 1997 from $6,791,000
in fiscal 1996. International service revenues represented 40%, 40%, and 54% of
total service revenues for fiscal 1998, 1997 and 1996, respectively. During
fiscal 1997 and 1996, one customer accounted for 7% and 23% of international
service revenues, respectively. This customer terminated its contract with the
Company in fiscal 1997. In addition to the termination of this major customer's
contract, the decrease in services revenues in fiscal 1997 from fiscal 1996, was
also the result of a transition in the international consulting business, away
from the Tools Business (which was spun-off in May 1995) to a consulting
business based on the Company's CBR product line.

     Cost of Product Revenues

     Cost of product revenues, consisting primarily of the costs of product
media and duplication, manuals, packaging materials, personnel-related costs,
shipping expenses and royalties paid to third-party vendors, decreased 21% to
$982,000 in fiscal 1998 from $1,248,000 in fiscal 1997, and decreased 27% in
fiscal 1997 from $1,710,000 in fiscal 1996. The gross margin on product revenues
was 93%, 94%, and 90% in fiscal 1998, 1997, and 1996, respectively. The improved
product gross margins in fiscal 1997 was primarily the result of a significant
decrease in royalties paid to third parties.

     Cost of Service Revenues

     Cost of service revenues, consisting principally of personnel-related costs
for consulting, training and technical support, decreased 14% to $7,952,000 in
fiscal 1998 from $9,237,000 in fiscal 1997, and increased 20% in fiscal 1997
from $7,667,000 in fiscal 1996. The gross margin on service revenues was 47%,
41%, and 39% in fiscal 1998, 1997, and 1996, respectively. The gross margin on
service revenues for fiscal 1998 was significantly higher than usual as a result
of the high utilization of professional services personnel, in both the Americas
and internationally, as well as a greater percentage of the services business
coming from the Company's maintenance support business, which earns a much
higher gross margin than the professional services business. It is expected that
this higher than usual gross margin on service revenues will not continue.

     Product Development

     Product development expense consists primarily of employee-related costs,
including salaries, benefits, equipment and facility costs, incurred in the
research, design, development and enhancement of the Company's products. Product
development expense increased 34% to $4,666,000 in fiscal 1998 from $3,492,000
in fiscal 1997, and increased 78% in fiscal 1997 from $1,959,000 in fiscal 1996.
Product development expense as a percentage of total revenues was 17%, 10%, and
7% for fiscal 1998, 1997, and 1996, respectively. The significant increases in
fiscal 1998 and 1997 were primarily the result of the investment in the CBR
Content Navigator product releases.

     The Company believes that continued commitment to product development will
be required for the Company's CBR Products to obtain a competitive advantage.
Accordingly, the Company intends to allocate increasing resources to product
research and development, but such expenses may continue to vary as a percentage
of total revenues.

                                       15
<PAGE>
 
     Selling and Marketing

     Selling and marketing expense consists primarily of salaries, benefits and
commissions of sales and marketing personnel, trade shows and promotional
expenses, and non-chargeable customer field service and sales support. Selling
and marketing expense decreased 9% to $15,421,000 in fiscal 1998 from
$16,909,000 in fiscal 1997, and increased 33% in fiscal 1997 from $12,758,000 in
fiscal 1996. The decrease in fiscal 1998 was a result of extensive turnover in
the sales forces, both in the Americas and internationally, as well as a
decrease in commission expense resulting from lower product sales. The fiscal
1997 increase was the result of the expansion of the Company's direct sales
force and related marketing efforts, both in North America and internationally.
Selling and marketing expense as a percentage of total revenues was 55%, 47%,
and 43% in fiscal 1998, 1997, and 1996, respectively.

     General and Administrative

     General and administrative expense consists of the personnel costs for
finance and accounting, human resources, information systems and general
management of the Company. General and administrative expense increased 9% to
$3,796,000 in fiscal 1998 from $3,492,000 in fiscal 1997, and increased 89% in
fiscal 1997 from $1,845,000 in fiscal 1996. The increase in general and
administrative expenses in fiscal 1998 was primarily the result of the continued
investment in the Company's administrative infrastructure, and increased legal
fees associated with on-going litigation matters. The increase in fiscal 1997
compared to fiscal 1996 was primarily attributable to increased staffing and
associated expenses necessary to manage and support the Company's anticipated
growth, both domestically and internationally. In addition, the Company received
funds (which were accounted for as an offset to general and administrative
expenses) during fiscal 1996 from an administrative agreement with the Tools
Business, as previously discussed. General and administrative expense as a
percentage of total revenues was 13%, 10%, and 6% in fiscal 1998, 1997, and
1996, respectively.

     Gain on Sale of Investment

     In July 1996, the Company agreed to sell its minority investment in Limbex
Corporation to Quarterdeck Corp-oration ("Quarterdeck") for approximately
$3,400,000 in common stock of Quarterdeck, pursuant to Quarterdeck's acquisition
of the outstanding shares of Limbex. In the quarter ended October 31, 1997, the
Company received and sold its Quarterdeck shares, and recorded, in aggregate, a
gain of $3,824,000 related to this transaction.

     Interest Income

     Interest income increased 8% to $1,428,000 in fiscal 1998 from $1,327,000
in fiscal 1997, and increased 65% in fiscal 1997 from $803,000 in fiscal 1996.
These increases were primarily attributable to the interest earned on the
working capital proceeds of the Company's initial public offering, completed
during fiscal 1996.

     Income Taxes

     Federal and state taxes for fiscal 1998 and 1997 were not provided as a
result of the utilization of net operating loss carryforwards and other tax
credits. The income tax benefit in fiscal 1997 was primarily the result of
refunds of foreign taxes. The Company's provision for income taxes in fiscal
1996 represented the accrual of foreign taxes, federal alternative minimum taxes
and certain state taxes; the resulting effective tax rate was approximately 5%.
The Company's net operating loss carryforwards of $20,000,000 for federal
purposes, $5,200,000 for state purposes and certain general business credits of
$1,100,000, expire in various years through 2011. Based on the Internal Revenue
Code, the future use of these carryforwards would be subject to an annual
limitation should a 50% change in ownership of the Company's stock occur within
any three-year period.

Recent Developments

     In March 1998, the Company appointed Charles W. Jepson to succeed Peter R.
Tierney as president and chief executive officer. Jepson's appointment closely
follows the promotion of Ralph Barletta to senior vice president of Research and
Development. Jepson and Barletta joined Glen Vondrick and Philip Padfield, both
appointed to their respective positions in the last 12 months as senior vice
president, Americas and Far East Operations and vice president, Sales and
Marketing, Europe, Middle East and Africa, respectively.

     In February 1998, the Company announced a reduction of headcount of
approximately 12 percent. This action was taken to better align operating
expenses with the recent revenue trends and, ultimately, to return the Company
to showing income from operations. The Company anticipates that it will incur a
restructuring charge, primarily related to severance costs, during the April 30,
1998 quarter in the range of $1.3 to $1.6 million. Additionally, the Company
anticipates first quarter revenues to be down from the prior year's first
quarter. As a result of this and the restructuring charge, the Company
anticipates that it will report a significant loss from operations during the
first quarter ending April 30, 1998.

                                       16
<PAGE>
 
New Accounting Pronouncements

     The Financial Accounting Standards Board ("FASB") approved the new American
Institute of Certified Public Accountants Statement of Position, "Software
Revenue Recognition" ("SOP 97-2"), which provides guidance on applying generally
accepted accounting principles in recognizing revenue on software transactions.

     Based upon management's interpretation of SOP 97-2, the Company does not
believe that its implementation will have a material adverse affect on expected
revenues or earnings. However, detailed implementation guidelines for this
standard have not yet been issued. Once issued, such detailed guidance could
lead to unanticipated changes in the Company's current revenue accounting
practices and material adverse changes in the Company's reported revenues and
earnings. In the event implementation guidance is contrary to the Company's
revenue accounting practices, the Company believes it can change its current
business practices to comply with this guidance and avoid any material adverse
effect on reported revenues and earnings. However, there can be no assurance
this will be the case. SOP 97-2 will be effective for the Company beginning in
the first quarter ending April 30, 1998.

     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130") and Statement of Financial Accounting Standards No. 131, "Disclosures
About Segments of An Enterprise and Related Information" ("SFAS 131"). SFAS 130
establishes rules for reporting and displaying comprehensive income. SFAS 131
will require the Company to use the "management approach" in disclosing segment
information. Both statements will be effective for the Company's fiscal year
ending January 31, 1999. The Company does not believe that the adoption of
either SFAS 130 or SFAS 131 will have a material impact on the Company's results
of operations, cash flows, or financial position.


Liquidity and Capital Resources

     Cash and cash equivalents and short-term investments at January 31, 1998
were $28,010,000, a decrease of $1,597,000 since January 31, 1997. Working
capital at January 31, 1998 was $26,657,000, a decrease of $3,306,000 since
January 31, 1997.

     Net cash used by operating activities amounted to $516,000 during the year
ended January 31, 1998. Net cash provided by operating activities amounted to
$3,169,000 in fiscal 1997 and $5,762,000 in fiscal 1996. The primary source of
cash from operating activities during fiscal 1998 was the collection of accounts
receivable.

     Investing activities for the year ended January 31, 1998 included
$1,105,000 for purchases of property and equipment. Cash provided from investing
activities included the proceeds from the sale of investment of $3,824,000. The
Company currently has no significant capital commitments as of January 31, 1998.

     Cash provided by financing activities in the year ended January 31, 1998
included $517,000 from the exercise of options and warrants to purchase common
stock, as well as shares issued in connection with the Employee Stock Purchase
Plan. Cash used in financing activities during fiscal 1998 included $4,317,000
for the repurchase of 854,000 shares of the Company's Class A common stock,
representing approximately 12% of the outstanding Class A common shares at
January 31, 1997.

     The Company's international operations are principally transacted in
British pounds. Translation into the Company's reporting currency, the U.S.
dollar, has not historically had a material impact on the Company's financial
position. Additionally, the Company's net assets denominated in currencies other
than the functional currency has not exposed the Company to material risk
associated with fluctuations in currency rates. Given this and the relatively
stable nature of the exchange rates, historically, between the British pound and
the U.S. dollar, the Company has not considered it necessary to use foreign
currency contracts or other derivative instruments to manage changes in currency
rates. However, future changes in the exchange rates between the foreign
currencies and the U.S. dollar could have an adverse effect on the Company's
financial position.

     The Company believes that existing cash balances, together with anticipated
cash flow from operations, will be sufficient to meet its working capital and
capital expenditure requirements for at least the next twelve months.

                                       17
<PAGE>
 
Additional Factors That May Affect Future Results

     Fluctuations in Quarterly Operating Results. The Company has experienced
significant quarterly fluctuations in operating results and anticipates such
fluctuations will continue in the future. Typically, revenues, operating income
and net income for the Company's fourth quarter are higher than those for the
first quarter of the following year. In addition, the Company has historically
recognized a substantial portion of its license revenues in the last month of
the quarter, typically in the last week. The Company generally ships orders as
they are received and as a result has little or no backlog. Quarterly revenues
and operating results therefore depend on the volume and timing of orders
received during the quarter, which are difficult to forecast. In addition,
consulting service revenues tend to fluctuate as projects, which may continue
over several quarters, are undertaken or completed. Operating results may also
fluctuate due to factors such as the demand for the Company's products; the size
and timing of customer orders; the introduction of new products and product
enhancements by the Company or its competitors; the budgeting cycles of
customers; changes in the proportion of revenues attributable to licenses and
service fees; changes in the level of operating expenses; and competitive
conditions in the industry. The value of individual licenses as a percentage of
quarterly revenues can be substantial, and particular licenses may generate a
substantial portion of the operating profits for the quarter in which they are
signed. The sales cycle typically ranges from three to nine months, and license
signing may be delayed for a number of reasons outside of the control of the
Company. Because the Company's staffing and other operating expenses are based
on anticipated revenues, a substantial portion of which is not typically
generated until the end of each quarter, delays in the receipt of orders can
cause significant variations in operating results from quarter to quarter. The
Company also may choose to reduce prices or to increase spending in response to
competition or to pursue new market opportunities, which may adversely affect
the Company's operating results. Accordingly, the Company believes that period-
to-period comparisons of its results of operations may not be meaningful and
should not be relied upon as an indication of future performance.

     Due to all of the foregoing factors, it is likely that in some future
quarters the Company's operating results will be below the expectations of
investors. Regardless of the general outlook for the Company's business, the
announcement of quarterly operating results below investor expectations is
likely to result in a decline in the trading price of the Company's Class A
Common Stock.

     Rapid Technological Change; Product Transitions. The market for the
Company's products is characterized by rapid technological developments,
evolving industry standards, swift changes in customer requirements and frequent
new product introductions and enhancements. As a result, the Company's success
depends upon its ability to continue to enhance its existing products, respond
to customer requirements, and to develop and introduce, in a timely manner, new
products incorporating technological advances. To the extent one or more of the
Company's competitors introduce products that more fully address customer
requirements, the Company's business, operating results and financial condition
could be adversely affected. There can be no assurance that the Company will be
successful in developing and marketing new products or enhancements to its
existing products on a timely basis or that any new or enhanced products will
adequately address the changing needs of the marketplace.

     If the Company is unable to develop and introduce new products or
enhancements to existing 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. From
time to time, the Company or its competitors may announce new products,
capabilities or technologies that have the potential to replace or shorten the
life cycles of the Company's existing products. There can be no assurance that
announcements of currently planned or other new products will not cause
customers to delay their purchasing decisions in anticipation of such products,
which could have a material adverse effect on the Company's business, operating
results and financial condition.

     Competition. The market for customer support software is highly
competitive, and there are certain competitors with substantially greater sales,
marketing, development and financial resources than the Company. Among the
Company's major competitors in the problem identification and resolution segment
of the market are Clarify, Inc. and Software Artistry, Inc. (a business unit of
Tivoli Systems, Inc., a subsidiary of IBM Corporation) and other smaller
privately held companies. Furthermore, many potential customers implement low-
end text retrieval solutions or develop internal applications that eliminate the
need to acquire software and services from third-party vendors such as the
Company.

     The Company believes that the competitive factors affecting the market for
the Company's products and services include vendor and product reputation;
product quality, performance and price; product functionality and features;
product scaleability; product integration with other enterprise applications;
the availability of products on multiple platforms; product ease-of-use; and the
quality of customer support services, documentation and training. The relative
importance of each of these factors depends upon the specific customer involved.
There can be no assurance that the Company will be able to compete effectively
with respect to any of these factors.

                                       18
<PAGE>
 
     The Company's present or future competitors may be able to develop products
comparable or superior to those offered by the Company or adapt more quickly
than the Company to new technologies or evolving customer requirements. In order
to be successful in the future, the Company must respond to technological
change, customer requirements and competitors' current products and innovations.
In particular, while the Company is currently developing additional product
enhancements that the Company believes address customer requirements, there can
be no assurance that the Company will successfully complete the development or
introduction of these additional product enhancements on a timely basis or that
these product enhancements will achieve market acceptance. Accordingly, there
can be no assurance that the Company will be able to continue to compete
effectively in its market, that competition will not intensify or that future
competition will not have a material adverse effect on the Company's business,
operating results and financial condition.

     Pricing. The Company believes that its products are competitively priced
with other products in the customer support market. However, the market for the
Company's products is highly competitive, and the Company expects that it will
face increased pricing pressures from its current competitors and new market
entrants. Any material reduction in the price of the Company's products would
negatively affect gross margins and could materially adversely affect the
Company's business, operating results and financial condition if the Company
were unable to increase unit sales. In addition, the Company expects increased
competition and intends to invest significantly in its business.

     Product Concentration. The Company currently derives substantially all of
its revenues from licenses of CBR products and associated services. Broad market
acceptance of CBR products is critical to the Company's future success. As a
result, a decline in demand for or failure to achieve broad market acceptance of
CBR products as a result of competition, technological change or otherwise would
have a material adverse effect on the business, operating results and financial
condition of the Company.

     Possible Volatility of Stock Price. The trading price of the Company's
Class A Common Stock has been and is subject to wide fluctuations in response to
quarterly variations in operating results, announcements of technological
innovations or new products by the Company or its competitors, changes in
financial estimates or recommendations by securities analysts and other events
or factors. In addition, the stock market has experienced volatility that has
particularly affected the market prices of equity securities of many technology
companies and that often has been unrelated to the operating performance of such
companies. These broad market fluctuations may adversely affect the trading
price of the Company's Class A Common Stock.

     Dependence on Key Personnel; New Members of the Executive Management Team.
The Company has recently experienced significant changes to its executive
management team. Those who have recently joined or have been appointed to the
executive management team include Charles Jepson, President and Chief Executive
Officer; Ralph Barletta, Senior Vice President of Product Development; Glen
Vondrick, Senior Vice President of Americas; and Philip Padfield, Vice President
of International Sales and Marketing, all who have been in their respective jobs
less than a year. There can be no assurance that the new members of the
Company's management team will work effectively together or with the rest of the
Company's management.

     The Company's future performance depends in significant part upon the
continued service of its key technical, sales and senior management personnel.
The loss of the services of one or more of these key employees could have a
material adverse effect on the Company's business, operating results and
financial condition. The Company's future success also depends on its ability to
attract and retain highly qualified technical, sales and managerial personnel.
Competition for such personnel is intense, and there can be no assurance that
the Company can retain its key employees or that it can attract, assimilate or
retain other highly qualified personnel in the future. In addition, the Company
has recently hired, and plans to continue to hire, a significant number of
development engineers to design and implement improvements to the Company's
technologies.

     Uncertainty of Proprietary Rights. The Company's success depends in part
upon its proprietary technology. Although case-based reasoning technology is
available in the public domain, the Company believes its implementation of the
CBR technology is proprietary. The Company relies on a combination of copyright,
trademark and trade secret laws, confidentiality procedures and licensing
arrangements to establish and protect its proprietary rights. The Company was
awarded two patents for its Case-Based Reasoning technology in December 1996,
and a third patent was awarded in January 1998. The Company's CBR technology is
embedded in its CBR family of products. Despite the precautions the Company has
taken, it may be possible for an unauthorized third party to copy or otherwise
obtain and use the Company's products, technology or other information that the
Company regards as proprietary or to develop similar products or technology
independently. In addition, effective trademark, copyright and trade secret
protection may be unavailable or limited in certain foreign countries where the
Company operates.

                                       19
<PAGE>
 
     The Company generally provides its products to end-users under signed
license agreements. These agreements are negotiated with and signed by the
licensee. The Company occasionally publishes articles regarding its technical
developments in industry publications that may prevent the Company from
obtaining patent protection for ideas contained in such publications, thus
increasing the availability to third parties of fundamental aspects of the
Company's technology.

     The Company is not aware that any of its products infringe upon the
proprietary rights of third parties. There can be no assurance, however, that
third parties will not claim such infringement by the Company with respect to
current or future products. The Company expects that it will increasingly be
subject to such claims as the number of products and competitors in the customer
support software market grows and the functionality of such products overlaps
with other industry segments. Any such claims, whether or not they are
meritorious, could result in costly litigation or require the Company to enter
into royalty or licensing agreements. Such royalty or license agreements, if
required, may not be available on terms acceptable to the Company or at all. If
the Company was found to have infringed upon the proprietary rights of third
parties, it could be required to pay damages, cease sales of the infringing
products and redesign or discontinue such products, any of which could have a
material adverse effect on the Company's business, operating results and
financial condition.

Year 2000 Compliance. The Company is aware of the issues associated with the
programming code in existing computer systems as the year 2000 approaches. The
"year 2000 problem" is pervasive and complex, as virtually every computer
operation will be affected in some way by the rollover of the two-digit year
value to 00. The issue is whether computer systems will properly recognize date
sensitive information when the year changes to 2000. Systems that do not
properly recognize such information could generate erroneous data or cause a
system to fail. Management does not currently anticipate that the Company will
incur significant operating expenses or be required to invest heavily in
computer systems improvements to be year 2000 compliant. However, significant
uncertainty exists concerning the potential costs and effects associated with
any year 2000 compliance. Any year 2000 compliance problems of either the
Company or its vendors could materially adversely affect the Company's business,
results of operations and financial condition.

     Inference Corporation is firmly committed to ensure its commercially
available CBR software products are "Year 2000 Ready." All Company products are
capable of correctly identifying, manipulating, and performing calculations on
dates later than December 31, 1999, where operations based on dates held in 2
digit format are affected due to re-sequencing from 99 to 00. The Company
institutes, within its product design specifications, the requirement that
internal date representations are held in full format and manipulations are not
performed on short formats. This assumes the software is used in accordance with
its associated documentation and provided that when the software is linked up to
other components, such components factor in the calendar date on the same
conditions as the Company's products.


     Risks Associated with Potential Acquisitions. As part of its business
strategy, the Company may in the future review acquisition prospects that would
complement its existing product offerings, augment its market coverage or
enhance its technological capabilities, or that may otherwise offer growth
opportunities. Such acquisitions by the Company could result in potentially
dilutive issuances of equity securities, the incurrence of debt and contingent
liabilities or amortization expenses related to goodwill and other intangible
assets, any of which could materially adversely affect the Company's operating
results. Acquisitions entail numerous risks, including difficulties in the
assimilation of acquired operations, technologies and products, diversion of
management's attention to other business concerns, risks of entering markets
which the Company has no or limited prior experience and potential loss of key
employees of acquired organizations. No assurance can be given as to the ability
of the Company to successfully integrate any businesses, products, technologies
or personnel that might be acquired in the future, and the failure of the
Company to do so could have a material adverse effect on the business, operating
results and financial condition of the Company

     Earthquake Danger. The Company's corporate headquarters, including its
research and development, sales and marketing, and administrative activities are
located near major earthquake fault lines. The Company could be materially
adversely affected in the event of a major earthquake.

     Litigation. The Company is subject to legal proceedings and claims that
arise in the ordinary course of business. Management currently believes that the
ultimate amount of liability, if any, with respect to any pending actions,
either individually or in the aggregate, will not materially affect the
financial position, results of operations or liquidity of the Company. However,
the ultimate outcome of any litigation is uncertain. If an unfavorable outcome
were to occur, the impact could be material. Furthermore, any litigation,
regardless of the outcome, can have an adverse impact on the Company's results
of operations as a result of defense costs, diversion of management resources,
and other factors. See Item 3. "Legal Proceedings."

                                       20
<PAGE>
 
Item 8.    Financial Statements and Supplementary Data

     See  "Index to  Consolidated  Financial  Statements"  for a listing  of the
consolidated financial statements filed with this report.


Item 9.    Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

     Not applicable.


                                   PART III


Item 10.   Directors and Executive Officers of the Registrant

     The information required by this item will be included in the Company's
Proxy Statement with respect to its 1998 Annual Meeting of Shareholders to be
filed with the Commission within 120 days of January 31, 1998 under the captions
"Election of Directors" and "Executive Officers," and is incorporated herein by
this reference as if set forth in full herein.


Item 11.   Executive Compensation

     The information required by this item will be included in the Company's
Proxy Statement with respect to its 1998 Annual Meeting of Shareholders to be
filed with the Commission within 120 days of January 31, 1998 under the captions
"Executive Compensation and Other Information," "Election of Directors,"
"Compensation Report," and "Company Stock Price Performance," and is
incorporated herein by this reference as if set forth in full herein.


Item 12.   Security Ownership of Certain Beneficial Owners and Management

     The information required by this item will be included in the Company's
Proxy Statement with respect to its 1998 Annual Meeting of Shareholders to be
filed with the Commission within 120 days of January 31, 1998 under the caption
"Common Stock Ownership of Certain Beneficial Owners and Management," and is
incorporated herein by this reference as if set forth in full herein.


Item 13.   Certain Relationships and Related Transactions

     The information required by this item will be included in the Company's
Proxy Statement with respect to its 1998 Annual Meeting of Shareholders to be
filed with the Commission within 120 days of January 31, 1998 under the caption
"Certain Transactions," and is incorporated herein by this reference as if set
forth in full herein.

                                       21
<PAGE>
 
                                    PART IV

Item 14.   Exhibits, Financial Statement Schedule and Reports on Form 8-K

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

         (1)  Consolidated Financial Statements - See "Index to Consolidated
    Financial Statements"

         (2)  Consolidated Financial Statement Schedules:

                  All schedules for which provision is made in the applicable
                  accounting regulation of the Securities and Exchange
                  Commission are not required under the related instructions or
                  are inapplicable and therefore have been omitted.

         (3) Exhibits - See "Exhibit Index"

    (b) Reports on Form 8-K:

         Not applicable.

                                       22
<PAGE>
 
                              INFERENCE CORPORATION

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                Page
<S>                                                                             <C>
REPORT OF ERNST & YOUNG LLP,  INDEPENDENT AUDITORS ..........................   F-2

CONSOLIDATED FINANCIAL STATEMENTS

   Consolidated Balance Sheets at January 31, 1998 and 1997 .................   F-3

   Consolidated Statements of Income for the years ended January 31, 1998,
       1997 and 1996 ........................................................   F-4

   Consolidated Statements of Cash Flows for the years ended January 31,1998,
       1997 and 1996 ........................................................   F-5

   Consolidated Statements of Shareholders' Equity for the years ended
         January 31, 1998, 1997 and 1996 ....................................   F-6

   Notes to Consolidated Financial Statements ...............................   F-7
</TABLE>

                                      F-1
<PAGE>
 
                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS



The Board of Directors and Shareholders
Inference Corporation

     We have audited the accompanying consolidated balance sheets of Inference
Corporation as of January 31, 1998 and 1997, and the related consolidated
statements of income, cash flows and shareholders' equity for each of the three
years in the period ended January 31, 1998. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

     In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Inference
Corporation at January 31, 1998 and 1997, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
January 31, 1998, in conformity with generally accepted accounting principles.


                                                               ERNST & YOUNG LLP

Sacramento, California
February 20, 1998

                                      F-2
<PAGE>
 
                              INFERENCE CORPORATION

                           CONSOLIDATED BALANCE SHEETS

                                 (in thousands)
<TABLE>
<CAPTION>

                                                                                            January 31,
                                                                                       --------------------
                                                                                          1998       1997
ASSETS                                                                                 --------    --------
<S>                                                                                    <C>         <C>
Current assets:
   Cash and cash equivalents .......................................................   $ 28,010    $ 28,620
   Short-term investments ..........................................................         --         987
   Accounts receivable, net ........................................................      5,770       9,794
   Other current assets ............................................................        935         692
                                                                                       --------    --------
          Total current assets .....................................................     34,715      40,093
Property and equipment, net ........................................................      2,114       2,055
Other assets .......................................................................        167          93
                                                                                       --------    --------           
                                                                                         36,996     $42,241
                                                                                       ========    ========

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
   Accounts payable ................................................................   $    623    $  1,113
   Accrued salaries and related items ..............................................      1,301       1,539
   Other accrued liabilities .......................................................      1,670       2,082
   Deferred revenue ................................................................      4,464       5,396
                                                                                       --------    --------
          Total current liabilities ................................................      8,058      10,130

Commitments

Shareholders' equity:
   Preferred stock, $0.01 par value;
     Authorized shares-- 2,000 at January 31, 1998 and 1997;
     Issued and outstanding shares--none ............................................        --          --
   Common  stock,  $0.01 par  value;  Authorized  shares -- 27,000 and 17,000 at
     January 31, 1998 and 1997,  respectively;  Issued and outstanding shares --
     7,505 and 8,205 at
     January 31, 1998 and 1997, respectively ........................................        75          82
   Additional paid-in capital .......................................................    48,255      52,048
   Accumulated deficit...............................................................   (19,392)    (20,019)
                                                                                       --------    --------
          Total shareholders' equity.................................................    28,938      32,111
                                                                                       --------    --------
                                                                                        $36,996     $42,241
                                                                                       ========    ========

</TABLE>
                            See accompanying notes.

                                      F-3
<PAGE>
 
                              INFERENCE CORPORATION

                        CONSOLIDATED STATEMENTS OF INCOME

                  (in thousands, except per share information)
<TABLE> 
<CAPTION> 
                                                           Year Ended January 31,
                                                      -------------------------------
                                                        1998        1997        1996
                                                      -------     -------     -------
<S>                                                   <C>         <C>         <C> 
Revenues:
     Products.....................................    $13,129     $20,402     $16,878
     Services.....................................     15,094      15,588      12,517
                                                      -------     -------     -------
               Total revenues.....................     28,223      35,990      29,395
Operating costs and expenses:
     Products.....................................        982       1,248       1,710
     Services.....................................      7,952       9,237       7,667
     Product development..........................      4,666       3,492       1,959
     Selling and marketing........................     15,421      16,909      12,758
     General and administrative...................      3,796       3,492       1,845
                                                      -------     -------     -------
          Total operating costs and expenses......     32,817      34,378      25,939
                                                      -------     -------     -------
Income (loss) from operations.....................     (4,594)      1,612       3,456
                                                       
Gain on sale of investment........................      3,824          --          --
Costs of attempted secondary offering.............         --        (241)         --
Non-employee option expenses......................         --        (215)         --
Loss from divested business.......................         --          --        (210)
Interest income...................................      1,428       1,327         803 
Other income and (expense), net...................        (31)       (141)        (81)
                                                      -------     -------     -------
Income before income taxes........................        627       2,342       3,968
Benefit (provision) for income taxes..............         --          90        (195)
                                                      -------     -------     -------
Net income........................................    $   627       2,432       3,773
                                                      =======     =======     =======
Per share information:

Net income per common share:
   Basic .........................................    $  0.08        0.30        0.59
                                                      =======     =======     =======
   Diluted .......................................    $  0.08        0.28        0.51
                                                      =======     =======     =======

Shares used in computing net income per share:
   Basic .........................................      7,894       8,078       6,344
                                                      =======     =======     =======
   Diluted .......................................      8,110       8,702       7,393
                                                      =======     =======     =======
</TABLE> 

                            See accompanying notes.

                                      F-4
<PAGE>
 
                              INFERENCE CORPORATION

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                                 (in thousands)

<TABLE> 
<CAPTION> 
                                                              Year Ended January 31,
                                                          -------------------------------
                                                           1998        1997        1996
                                                          -------     -------     -------
<S>                                                       <C>         <C>         <C> 
Cash flows from operating activities:
   Net income .......................................     $   627       2,432       3,773
   Adjustments  to  reconcile  net  income  to net
     cash  provided  by  operating activities:
        Gain on sale of investment ...................     (3,824)         --          --
        Depreciation and amortization ................      1,046         771       1,091
        Changes in operating assets and liabilities:
          Accounts receivable ........................      4,024      (1,292)     (2,386)
          Other current assets .......................       (243)         27        (559)
          Other assets ...............................        (74)         33         (14)
          Accounts payable ...........................       (490)       (395)        587
          Accrued salaries and related items .........       (238)        (49)        482
          Other accrued liabilities ..................       (412)       (210)        894
          Deferred revenue ...........................       (932)      1,852       1,894
                                                          -------     -------     -------
Net cash provided (used) by operating activities .....       (516)      3,169       5,762
Cash flows from investing activities:
   Maturity of short-term investments ................        987       7,314          --
   Purchases of short-term investments ...............         --        (987)     (7,314)
   Net proceeds from sale of investment ..............      3,824          --          --
   Cash contributed to divested business .............         --          --      (1,684)
   Purchases of property and equipment ...............     (1,105)     (1,211)     (1,417)
   Software development costs capitalized.............         --          --         (50)
                                                          -------     -------     -------
Net cash provided (used) by investing activities .....      3,706       5,116     (10,465)
Cash flows from financing activities:
   Payment of dividends on convertible preferred 
     stock............................................         --          --        (114)
   Net proceeds from issuance of common stock ........        517       2,104      20,413
   Repurchase of common stock ........................     (4,317)       (388)       --
                                                          -------     -------     -------
Net cash provided (used) by financing activities .....     (3,800)      1,716      20,299
                                                          -------     -------     -------
Net increase in cash and cash equivalents ............       (610)     10,001      15,596
Cash and cash equivalents at beginning of year .......     28,620      18,619       3,023
                                                          -------     -------     -------
Cash and cash equivalents at end of year .............   $ 28,010    $ 28,620    $ 18,619
                                                          =======     =======     =======
Supplemental disclosure of cash flow information:
   Interest paid during the period...................$         15          26          45
   Income taxes paid during the period ...............        173         165         181
   Conversion of convertible preferred stock into
     common stock ....................................         --          --      28,816
</TABLE> 
                            See accompanying notes.

                                      F-5
<PAGE>
 
                             INFERENCE CORPORATION

                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                            (in thousands)
<S>                              <C>          <C>      <C>      <C>       <C>               <C>
 
                                Convertible          Common Stock          Additional                        Total 
                                 Preferred         Shares                   Paid-in       Accumulated     Shareholders' 
                                   Stock        Outstanding     Amount      Capital         Deficit          Equity 
                                -----------     -----------    -------     ----------     -----------     -------------
<S>                             <C>             <C>            <C>         <C>            <C>             <C> 
Balances at January 31, 1995.   $  28,816           757        $ 1,185     $       --     $   (22,959)    $   7,042
     Divestiture of tools
       business ...............        --            --             --             --          (3,151)       (3,151)
     Conversion of preferred 
       stock into common stock.   (28,816)         4,286        28,816             --              --            --
     Issuance of common stock .        --          2,437        20,413             --              --        20,413 
     Dividend on Class H
       preferred stock ........        --             --            --             --            (114)         (114)
     Net income ...............        --             --            --             --           3,773         3,773
                                -----------     -----------    -------     ----------     -----------     -------------
Balances at January 31, 1996  .        --          7,480        50,414             --         (22,451)       27,963
     Reincorporation  in the
       state of Delaware.......        --             --       (50,338)        50,338              --            --
     Issuance of common          
       stock...................        --            779             7          2,097              --         2,104 
      Repurchase of common 
       stock ..................        --            (54)         (1)            (387)             --          (388)
     Net income ...............        --             --          --              --            2,432         2,432
                                -----------     -----------    -------     ----------     -----------     -------------
Balances at January 31, 1997  .        --          8,205          82           52,048         (20,019)       32,111
     Issuance of common       
       stock...................        --            154           2              515              --           517 
     Repurchase of common    
       stock...................        --           (854)         (9)          (4,308)             --        (4,317) 
     Net income ...............        --             --          --               --             627           627
                                -----------     -----------    -------     ----------     -----------     -------------
Balances at January 31, 1998... $      --          7,505       $  75       $   48,255     $   (19,392)    $  28,938
                                ===========     ===========    =======     ==========     ===========     =============
</TABLE> 
                            See accompanying notes.

                                      F-6
<PAGE>
 
                              INFERENCE CORPORATION

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                January 31, 1998


1.   Organization and Significant Accounting Policies

   Organization

     Inference Corporation (the "Company") is engaged in the design, development
and marketing of software products for the customer support and service market.
The Company offers maintenance, training and consulting services in support of
its software.

   Consolidation

     The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.

   Foreign Currency Translation

     Assets and liabilities of the Company's wholly owned foreign subsidiaries
are translated at period-end exchange rates, and revenues and expenses are
translated at the weighted average monthly exchange rates. Foreign exchange
transaction gains and losses and translation adjustments are not material in the
periods presented.

   Use of Estimates

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make certain estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.

   Cash equivalents and short-term investments

     The Company considers investments that are highly liquid, readily
convertible to cash and that mature within three months from the date of
purchase as cash equivalents. Short-term investments generally mature between
three months and one year from the purchase date. All cash and short-term
investments are classified as held-to-maturity as the Company intends and has
the ability to hold the securities to maturity. Held-to-maturity securities are
stated at amortized cost, adjusted for amortization of premiums and accretion of
discounts to maturity. Such amortization is included in interest income. The
carrying values for cash and short-term investments approximate their respective
fair values at January 31, 1998 and 1997.

   Property and Equipment

     Property and equipment are recorded at cost and are depreciated using the
straight-line method over the estimated useful lives of the related assets,
ranging from one to five years, except for leasehold improvements which are
amortized over the remaining lease term.

     Property and equipment at January 31, 1998 and 1997 is as follows (in
thousands):

                                                              1998        1997
                                                              -----       -----
             Computer equipment............................  $3,090      $2,130
             Furniture & leasehold improvements............   1,821       1,676
                                                              -----       -----
                  Total....................................   4,911       3,806
             Accumulated depreciation......................  (2,797)     (1,751)
                                                              -----       -----
                  Property and equipment, net..............  $2,114      $2,055
                                                              =====       =====

   Software Development Costs

     Software development costs incurred subsequent to the determination of the
software product's technological feasibility and prior to the product's general
release to customers are not material to the Company's financial position or
results of operations for fiscal years 1998, 1997 and 1996, and have been
charged to product development expenses in the accompanying Consolidated
Statements of Income.

                                      F-7
<PAGE>
 
                              INFERENCE CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                January 31, 1998


1.   Organization and Significant Accounting Policies (Continued)

   Concentration of Credit Risk

     Financial instruments that potentially subject the Company to concentration
of credit risk consist principally of cash and cash equivalents, short-term
investments and accounts receivable. The Company places its cash, cash
equivalents, and short-term investments with high credit quality financial
institutions. Such investments are in excess of the FDIC insurance limit.
Concentration of credit risk with respect to accounts receivable are limited due
to the large number of customers comprising the Company's customer base, and
their dispersion across many different industries and geographic regions. As
such, the Company generally does not require collateral or other security to
support customer receivables. The Company routinely assesses the financial
strength of its customers and, as a consequence, believes that its accounts
receivable credit risk exposure is limited.

   Revenue Recognition

     Product revenues result principally from non-cancelable license agreements
that provide customers the non-exclusive right to use the products for a fixed
term or on a perpetual basis. Such revenues are recognized upon: (i) execution
of a binding agreement; (ii) shipment of the product to the customer; (iii) when
the license fee is fixed or determinable; and (iv) when collectability is
reasonably assured. If the Company has significant future obligations to the
customer, revenues are recognized when such obligations are satisfied.

     Service revenues result from contracts with customers for the development
and support of system applications. Service revenues are generally recognized as
the services are performed. Fixed-price service contracts are recognized on a
percentage of completion basis, based on the level of effort performed. The
Company may enter into transactions that include both product license and
service elements. As such service elements, typically, do not include
alterations to the software, the license fees are recognized upon delivery of
the product, and the service revenues are recognized as performed.

     The Company enters into maintenance and support agreements with customers
whereby the Company provides technical support and certain product updates.
Maintenance revenues received are deferred and recognized on a straight-line
basis over the maintenance support period, generally one year. If software
maintenance fees are provided for in the product license fee or at a significant
discount in a license agreement, a portion of the license fee equal to the
estimated fair value of these amounts will be allocated to deferred maintenance
revenue. Maintenance and support revenues are included in service revenues in
the accompanying Consolidated Statements of Income.

     Deferred revenues primarily relate to post-contract customer support which
has been paid by customers prior to the performance of the services.

   Non-Employee Stock Option Related Expenses

     During fiscal 1997, the Company incurred payroll-related taxes of $215,000
as a result of the exercise of non-qualified stock options held by former
Inference employees. In connection with these option exercises, the Company will
be able to take a tax deduction, if and when adequate taxable income is earned,
for the related compensation expense. However, the tax benefit will be accounted
for when utilized as an adjustment to shareholders' equity.

   Income Taxes

     Income taxes are accounted for using the liability method in accordance
with Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes" (Note 4). Under this method, deferred tax liabilities and assets are
recognized for the expected future tax consequences of temporary differences
between the carrying amounts and the tax bases of assets and liabilities.

     The Company has not provided U.S. income taxes on the undistributed income
of its foreign subsidiaries. The cumulative amount of such income was immaterial
as of January 31, 1998.

                                      F-8
<PAGE>
 
                              INFERENCE CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                January 31, 1998


1.   Organization and Significant Accounting Policies (Continued)

   Advertising Costs

     The Company accounts for advertising costs as expense in the period in
which they are incurred. Advertising expense for the fiscal years ended January
31, 1998, 1997 and 1996 was $481,000, $260,000 and $134,000, respectively.

   Accounting for Stock-Based Compensation

     Statement of Financial Accounting Standards No. 123, "Accounting for
Stock-Based Compensation" ("SFAS 123"), was issued in October 1995 and was
adopted by the Company in fiscal 1997. As permitted under SFAS 123, the Company
has elected to follow Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees", and related Interpretations ("APB 25"), in
accounting for stock-based awards to employees. Under APB 25, the Company has
generally recognized no compensation expense with respect to such awards, while
disclosures required by FAS 123 are included in Note 7.

   Product Concentration

     The Company currently derives substantially all of its revenue from the
licensing of its CBR product line and fees from related services. These products
and services are expected to account for substantially all of the Company's
revenue for the foreseeable future. Consequently, a reduction in demand for
these products and services or a decline in sales of these products and services
will adversely affect operating results.

   Net Income Per Share

     Statement of Financial Accounting Standards No. 128, "Earnings Per Share"
("SFAS 128"), was issued in February 1997 and is effective for the Company's
1998 fiscal year. SFAS 128 replaced the calculation and reporting of primary and
fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share exclude any dilutive
effect of options, warrants and convertible securities. Diluted earnings per
share are very similar to the previously reported fully diluted earnings per
share. All earnings per share amounts for all periods have been presented, and
where appropriate, restated to conform to SFAS 128.

     The following table sets forth the computation of basic and diluted net
income per common share for fiscal years ended January 31, 1998, 1997 and 1996
(in thousands, except per share information):

                                                 1998      1997       1996
                                                -------   ------     -------
Numerator:
Net income....................................  $   627   $2,432     $ 3,773
                                                =======   ======     =======
Denominator:
    Denominator for basic net income per
     common share - weighted-average shares       
     outstanding..............................    7,894    8,078       6,344

    Effect of dilutive securities:
      Stock options...........................      208      510         936
      Warrants................................        8      114         113
                                                -------   ------     -------
    Dilutive potential common shares..........      216      624       1,049
                                                -------   ------     -------

    Denominator for diluted net income per
      common share - adjusted weighted-average
      shares for assumed conversions..........    8,110    8,702       7,393
                                                =======   ======     =======
Basic net income per share....................  $  0.08   $ 0.30     $  0.59
                                                =======   ======     =======
Diluted net income per share..................  $  0.08   $ 0.28     $  0.51
                                                =======   ======     =======


                                      F-9
<PAGE>
 
                              INFERENCE CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                January 31, 1998


1.   Organization and Significant Accounting Policies (Continued)

   New Accounting Pronouncements

     The Financial Accounting Standards Board ("FASB") approved the American
Institute of Certified Public Accountants Statement of Position, "Software
Revenue Recognition" ("SOP 97-2"), which provides guidance on applying generally
accepted accounting principles in recognizing revenue on software transactions.

     Based upon management's interpretation of SOP 97-2, the Company does
not believe that its implementation will have a material adverse affect on
expected revenues or earnings. However, detailed implementation guidelines for
this standard have not yet been issued. Once issued, such detailed guidance
could lead to unanticipated changes in the Company's current revenue accounting
practices and material adverse changes in the Company's reported revenues and
earnings. In the event implementation guidance is contrary to the Company's
revenue accounting practices, the Company believes it can change its current
business practices to comply with this guidance and avoid any material adverse
effect on reported revenues and earnings. However, there can be no assurance
this will be the case. SOP 97-2 will be effective for the Company beginning in
the first quarter ending April 30, 1998.

     In June 1997, the FASB issued Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130") and Statement
of Financial Accounting Standards No. 131, "Disclosures About Segments of An
Enterprise and Related Information" ("SFAS 131"). SFAS 130 establishes rules for
reporting and displaying comprehensive income. SFAS 131 will require the Company
to use the "management approach" in disclosing segment information. Both
statements will be effective for the Company's fiscal year ending January 31,
1999. The Company does not believe that the adoption of either SFAS 130 or SFAS
131 will have a material impact on the Company's results of operations, cash
flows, or financial position.


2.   Financial Instruments

     The following table  summarizes the Company's  financial  instruments as of
January 31, 1998 and 1997 (in thousands):

                                                              1998        1997
                                                            -------     -------
     Cash and cash equivalents:
          Cash............................................. $ 4,151     $ 5,818
          Commercial paper.................................  10,201      14,523
          Money market funds...............................   7,425       8,279
          U.S. Treasury securities and obligations
               of U.S. government agencies.................   6,233          --
                                                            -------     -------
     Total cash and cash equivalents....................... $28,010     $28,620
                                                            =======     =======

     Short-term investments:
          Commercial paper.................................      --         987
                                                            -------     -------
     Total short-term investments.......................... $    --     $   987
                                                            =======     =======
     Total cash and cash equivalents and short-term        
          investments...................................... $28,010     $29,607
                                                            =======     =======

3.   Commitments

     The Company leases its facilities and certain computer equipment under
various operating leases. Total rental expense under operating leases was
approximately $2,263,000, $1,448,000 and $1,436,000 during fiscal 1998, 1997 and
1996, respectively. Future minimum obligations as of January 31, 1998 are as
follows (in thousands):

           Fiscal Year
           -----------
            1999...........................................  $    1,793
            2000...........................................       1,053
            2001...........................................       1,456
            2002...........................................       1,369
            2003...........................................         897
            Thereafter.....................................       1,908
                                                             ----------
                                            Total            $    8,476
                                                             ==========


                                      F-10
<PAGE>
 
                              INFERENCE CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                January 31, 1998


4.   Income Taxes

     The components of the benefit (provision) for income taxes for fiscal years
ended January 31, 1998, 1997 and 1996 consists of the following (in thousands):

                                                   1998       1997       1996
                                                 ---------  ---------  --------
     Current:
             Federal............................ $      --  $      --  $    (70)
             State..............................        --        (38)      (35)
             Foreign............................        --        128       (90)
                                                 ---------  ---------  --------
                  Total......................... $      --  $      90  $   (195)
                                                 =========  =========  ========


     The Company's effective tax rate differed from the statutory federal income
tax rate for fiscal years ended January 31, 1998, 1997 and 1996 as follows:

                                                  1998       1997       1996
                                               ---------  ---------   --------
Statutory federal income tax (benefit) rate..       34.0%      34.0%      34.0%
State taxes, net of federal benefit..........        0.0        1.0        0.7
Tax benefit from utilization of net
     operating loss carryforward.............      (34.0)     (48.0)     (28.0)
Effect of foreign operations.................        0.0        8.0       (4.2)
Other........................................        0.0        1.0        2.5
                                                 -------    -------     ------
Effective tax rate...........................        0.0 %     (4.0)%      5.0%
                                                 =======    =======     ======


     Significant components of deferred tax assets and related valuation 
allowance at January 31, 1998 and 1997 are as follows (in thousands):


                                                          1998         1997
                                                        --------     --------
        Deferred tax assets:
             Net operating loss carryforwards........   $  7,030     $  7,678
             General business and foreign tax credits      1,109        1,109
             Other...................................      1,827        1,712
                                                        --------     --------
             Total deferred tax assets...............      9,966       10,499
        Valuation allowance..........................     (9,966)     (10,499)
                                                        --------     --------
        Net deferred tax assets......................         --           --
                                                        --------     --------
        Net deferred taxes........................... $       --           --
                                                        ========     ========

     Due to the uncertainties surrounding the timing of realizing the benefits
of its favorable tax attributes in future tax returns, the Company has recorded
a valuation allowance against its deferred tax assets. The valuation allowance
increased by approximately $2,752,000 during fiscal year 1997 and decreased by
approximately $533,000 during fiscal year 1998. Deferred tax assets relating to
net operating loss carryforwards as of January 31, 1998 include approximately
$4,000,000 associated with stock option activity for which subsequent recognized
tax benefits, if any, will be credited directly to shareholders' equity.

     At January 31, 1998, the Company has net operating loss carryforwards for
federal income tax purposes of approximately $20,000,000 that expire in various
years through 2011 and net operating loss carryforwards for state income tax
purposes of approximately $5,200,000 which expire in various years through 2011.
The Company also has general business and foreign tax credits of approximately
$1,100,000 which expire in various years through 2009.

     Due to the "change in ownership" provisions of the Tax Reform Act of 1986,
utilization of the Company's net operating loss carryforwards and research and
development credit carryforwards may be subject to a substantial limitation if a
greater than 50% ownership change were to occur in the future.

                                      F-11
<PAGE>
 
                              INFERENCE CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                January 31, 1998


5.   Capital Structure

   Common Stock

     The Common Stock consists of two classes, Class A Common Stock and Class B
Common Stock. At January 31, 1998 and 1997, there were 6,315,000 and 7,015,000
shares of Class A Common Stock outstanding, respectively; at January 31, 1998
and 1997, there were 1,190,000 shares of Class B Common Stock outstanding.

     Class A Common Stock. The holders of the Class A Common Stock are entitled
     --------------------
to one vote per share on all matters submitted to a vote of the shareholders.
The holders of shares of Class A Common Stock do not have any preemptive rights
or rights to subscribe for additional securities of the Company. Dividends are
payable on the Class A Common Stock, when, and if, declared by the Board of
Directors out of funds legally available therefor. Each share of Common Stock,
irrespective of class, will be treated equally in respect of rights upon
liquidation of the Company and rights to dividends, except that, in the case of
dividends in the form of Common Stock, shares of any class of Common Stock will
be payable only to the holders of that class. Upon liquidation or dissolution of
the Company, the holders of the Class A Common Stock and Class B Common Stock
are entitled to share ratably in all assets available for distribution to
shareholders after payment of all prior claims.

     Class B Common Stock. The rights of the holders of the Class B Common Stock
     --------------------
are identical to those of the Class A Common Stock except with respect to voting
and conversion rights. The holders of Class B Common Stock have no right to vote
on matters submitted to a vote of shareholders, except (i) as to an amendment of
a provision of the Restated Articles of Incorporation that adversely affects the
powers, preferences or special rights of the holders of the Class B Common Stock
and (ii) as otherwise required by law. Holders may convert shares of Class B
Common Stock into Class A Common Stock, except that no holder of shares of Class
B Common Stock may convert any such shares to the extent that, as a result, the
holder and its affiliates, directly or indirectly, would own, control or have
the power to vote more than 5% of the outstanding shares of the Class A Common
Stock. A holder of Class A Common Stock also may convert its Class A Common
Stock into Class B Common Stock, subject to certain limitations. As currently
provided, each conversion will be on a one-for-one basis.

   Preferred Stock

     The Board of Directors has the authority to issue up to 2,000,000 shares of
Preferred Stock in one or more series and to fix the rights, preferences,
privileges and restrictions thereof, including dividend rights, dividend rates,
conversion rights, voting rights, terms of redemption, redemption prices,
liquidation preferences and the number of shares constituting any series or the
designation of such series, without further vote or action by the shareholders.

   Common Stock Warrants

     At January 31, 1998, there were warrants to purchase 22,000 shares of the
Company's Class A Common Stock outstanding, with an exercise price of $5.00 per
share. These warrants expire in April 1999.

   Common Stock Repurchase Program

     The Company's Board of Directors approved a program to repurchase up to
1,500,000 shares of the Company's Class A Common Stock. The purpose of this
program is to reduce the dilutive effect of common stock to be issued under the
Company's employee stock plans. In fiscal 1998 and 1997, the Company repurchased
854,000 and 54,000 shares of its common stock at a total cost of approximately
$4.3 million and $0.4 million, respectively. As of January 31, 1998,
approximately 908,000 shares had been repurchased under the plan, at a
cumulative cost of $4.7 million.

   Shareholder Rights Plan

     In November 1996, the Board of Directors adopted a Shareholder Rights Plan
(the "Rights Plan"), which authorized the distribution of one right to purchase
one one-hundredth share of Junior Participating Preferred Stock at the rate of
one Right for each share of the Company's Common Stock held by shareholders of
record as of December 10, 1996. The Rights Plan was adopted to provide
protection to shareholders in the event of an unsolicited attempt to acquire the
Company.

                                      F-12
<PAGE>
 
                              INFERENCE CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                January 31, 1998


5.    Capital Structure (Continued)

   Shareholder Rights Plan (Continued)

     Rights are not exercisable until the earlier of (i) ten business days
following a public announcement that a person or group has acquired beneficial
ownership of 20% or more of the Company's general voting power or (ii) ten
business days (or such later date as may be determined by action of the Board of
Directors) following the commencement of, or announcement of an intention to
make, a tender offer which would result in a person or group obtaining
beneficial ownership of 20% or more of the Company's general voting power,
subject to certain exceptions (the earlier of such dates being called the
"Distribution Date"). The Rights are initially exercisable for one one-hundredth
of a share of the Company's Junior Participating Preferred Stock at a price of
$40.00, subject to adjustment. However, if (i) after the Distribution Date the
Company is acquired in certain types of transactions, or (ii) any person or
group (with certain exceptions) acquires beneficial ownership of 20% of the
Company's Common Stock, then holders of Rights (other than the 20% holder) will
be entitled to receive, upon exercise of the Right, Common Stock (or common
stock equivalents) of the Company (or in the case of acquisition of the Company,
Common Stock of the acquirer) having a market value of two times the exercise
price of the Right.

     The Company is entitled to redeem the Rights, for $0.001 per Right, at the 
discretion of the Board of Directors. The Rights expire in November 2006.


6.   Employee Benefit Plans

   Employee Savings and Retirement Plans

     The Company sponsors an employee savings and retirement plan (the "401(k)
Plan") as allowed under Section 401(k) of the Internal Revenue Code. The 401(k)
Plan is available to all domestic employees who meet minimum age and service
requirements, and provides employees with tax deferred salary deductions and
alternative investment options. Employees may contribute up to 20% of their
salary, subject to certain limitations. The Company, at the discretion of the
Company's Board of Directors, may make contributions to the 401(K) Plan. The
Company has not contributed to the 401(k) Plan since its inception.

     The Company also sponsors a voluntary defined contribution retirement plan
(the "UK Plan") for employees in the United Kingdom. Employees may elect to
contribute a percentage of their annual gross compensation to the UK Plan.
Employer contributions to the UK Plan range between 5% to 12% of participating
employees' base salary, depending on the years of service with the Company.
Contributions to the plan were $366,000, $333,000, and $272,000 for the fiscal
years 1998, 1997, and 1996, respectively.


7.   Stock Based Benefit Plans

   Employee Stock Purchase Plan

     In February 1996, the Company adopted an Employee Stock Purchase Plan (the
"ESPP") and reserved 500,000 shares of Class A Common Stock for issuance
thereunder. Pursuant to the ESPP, employees meeting certain eligibility criteria
may purchase shares of the Company's Class A Common Stock, subject to certain
limitations, at not less than 85 percent of fair market value as defined in the
plan. In fiscal years 1998 and 1997, shares totaling 89,000 and 12,000 were
issued under the ESPP at weighted-average prices of $4.02 and $5.21 per share,
respectively. At January 31, 1998, a total of 399,000 shares remained available
for future issuance under the ESPP.

   Stock Option Plans

     The Company has authorized stock option plans that cover the issuance of
incentive stock options and non-statutory stock options. The plans provide for
the granting of options for the purchase of up to 2,100,000 authorized shares of
the Company's common stock. There were 50,000 shares available for future option
grants under the plans as of January 31, 1998. Under the terms of the plans,
options, which expire ten years from date of grant, may be granted to employees,
non-employee directors or consultants at prices not less than the fair value at
the date of grant. Options principally vest over periods up to four years from
the date of grant.

                                      F-13
<PAGE>
 
                             INFERENCE CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                January 31, 1998


7.    Stock Based Benefit Plans (Continued)

     On November 25, 1996 and again on December 23, 1997, the Board of Directors
approved a stock option repricing program pursuant to which employees of the
Company could elect to cancel unexercised stock options in exchange for new
stock options with an exercise price equal to the closing price of the Company's
common stock on that day, or $6.13 and $3.94, respectively. Approximately
666,000 options were repriced in November 1996, and 1,144,000 were repriced in
December 1997.

     Information relating to the outstanding stock options is as follows:

<TABLE>
<CAPTION>
                                                                              Weighted Average
                                                    Shares          Price          Price
                                                  ---------   -------------   ---------------- 
          <S>                                     <C>         <C>             <C>
           Outstanding at January 31, 1995.....   1,287,000    $2.50--$6.75          $2.56
                Options granted................     565,000   $7.00--$16.75         $13.04
                Options exercised..............     (67,000)   $2.50--$6.75          $2.92
                Options canceled...............     (81,000)  $2.50--$14.75          $4.15
                                                  ---------
            Outstanding at January 31, 1996.....  1,704,000   $2.50--$16.25          $6.31
                Options granted................   1,197,000   $6.13--$23.50         $10.27
                Options exercised..............    (753,000)  $2.50--$16.25          $2.71
                Options canceled...............    (860,000)  $2.50--$23.50         $16.17
                                                  ---------
           Outstanding at January 31, 1997.....   1,288,000   $2.50--$16.25          $5.31
                Options granted................   2,029,000    $3.94--$6.75          $4.75
                Options exercised..............     (62,000)   $2.50--$7.00          $2.51
                Options canceled...............  (1,584,000)  $2.50--$16.25          $6.26
                                                  ---------
            Outstanding at January 31, 1998.....  1,671,000   $2.50--$11.00          $3.85
                                                  =========
</TABLE>

 
     Included in the above table as of January 31, 1998 are 410,000 stock
options issued and outstanding outside the stock option plan. The options expire
at various dates from 1998 to 2007. At January 31, 1998 and 1997, options for
334,000 and 344,000 shares, respectively, were exercisable at $2.50 to $11.00
per share. The weighted average exercise price of vested options granted at
January 31, 1998 and 1997 was $2.99 and $2.98, respectively.

     The following table summarizes information concerning options outstanding
and exercisable as of January 31, 1998:

<TABLE>
<CAPTION>
                                     Options Outstanding                      Options Exercisable
                        ----------------------------------------------   ---------------------------
         Range of                   Weighted Average       Weighted                                   
         Exercise                      Remaining           Average                  Weighted Average  
          Prices         Number     Contractual Life    Exercise Price   Number      Exercise Price   
       -------------    ---------   ----------------    --------------   -------    ----------------
       <S>              <C>         <C>                 <C>              <C>        <C>
        $2.50--$3.00      312,000        5.08           $   2.50         300,000       $   2.50
        $3.01--$4.00    1,129,000        9.89           $   3.94               0       $   0.00
        $4.01--$7.50      219,000        9.05           $   4.96          28,000       $   6.50
       $7.51--$11.00       11,000        7.10           $  11.00           6,000       $  11.00
       -------------    ---------   ----------------    --------------   -------    ----------------
       $2.50--$11.00    1,671,000        8.87           $   3.85         334,000       $   2.99
</TABLE>


   Stock-Based Compensation

     As permitted under SFAS 123, the Company has elected to follow APB 25, and
related Interpretations, in accounting for stock-based awards to employees.
Under APB 25, the Company has generally recognized no compensation expense with
respect to such awards.

     Pro forma information regarding net income (loss) and net income (loss) per
share is required by SFAS 123 for awards granted after January 31, 1995 as if
the Company had accounted for its stock-based awards to employees under the fair
value method of SFAS 123. The fair value of the Company's stock-based awards to
employees was estimated using the Black-Scholes multiple option pricing model.
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options that have no vesting restrictions and are fully
transferable. In addition, the Black-Scholes model requires the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's stock-based awards to employees have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its stock based awards to employees.

                                      F-14
<PAGE>
 
                              INFERENCE CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                January 31, 1998


7.   Stock Based Benefit Plans (Continued)

     The fair value of the Company's stock-based awards to employees was
estimated assuming no expected dividends and the following weighted-average
assumptions:

<TABLE>
<CAPTION>
                                                             Options               ESPP
                                                       ------------------   ------------------
                                                          1998      1997      1998       1997
                                                       ---------  -------   ---------  -------
<S>                                                    <C>        <C>       <C>        <C>
       Expected life (years).........................      1.98      2.04      0.50      0.50
       Expected stock price volatility...............      0.85      0.85      0.85      0.85
       Risk-free interest rate.......................      5.37%     6.18%     5.81%     5.26%
</TABLE>


     The weighted average fair value of options granted in fiscal 1998, 1997 and
1996 was $3.15, $5.54 and $8.45, respectively.

     For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The Company's
pro forma information, which includes the stock option plans and the Employee
Stock Purchase Plan, for the years ended January 31, 1998 and 1997 follows (in
thousands except for basic net income (loss) per share information):


                                                         1998         1997
                                                       -------      ------- 
       Net income - actual...........................  $   627      $ 2,432
       Net loss - pro forma..........................   (3,325)        (189)

       Net income per basic share - actual...........  $  0.08      $  0.30
       Net income per diluted share - actual.........     0.08         0.28
       Net loss per basic and diluted 
          share - pro forma..........................    (0.42)       (0.02)

                                                           
     Because SFAS 123 is applicable only to options granted subsequent to
January 31, 1995, its pro forma effect will not be fully reflected until fiscal
2000. The weighted average fair value of options granted during fiscal 1998 and
1997, were $4.75 and $10.28, respectively.


8.   Reorganization and Divestiture of Business Unit

     Effective May 1, 1995, the Company transferred certain assets and
liabilities of the application development and solutions product line to a
wholly owned subsidiary of the Company and distributed all of the shares of such
subsidiary to the Company's shareholders (the "Spin-Off"). As part of the
Spin-Off, the Company entered into an agreement with the Tools Business to
provide certain services to the new entity including operational and systems
support, facilities and administrative support and certain technical and
customer support. The term of this agreement extended through January 31, 1996.
The amount received for these services was approximately $760,000 and was
accounted for as an offset against expenses. Revenues for the Tools Business
were $1,928,000 for the quarter ended April 30, 1995.


9.   Related Party Transactions

     The Company earned revenues on product sales and services from two
affiliated shareholders in the amount of $1,722,000 during fiscal 1996. These
shareholders were no longer affiliates in fiscal 1997 or fiscal 1998.

     In July 1996, the Company agreed to sell its minority investment in Limbex
Corporation ("Limbex") to Quarterdeck Corporation ("Quarterdeck") for
approximately $3,400,000 in common stock of Quarterdeck ("Investment Amount"),
pursuant to Quarterdeck's acquisition of the outstanding shares of Limbex. In
the quarter ended October 31, 1997, the Company received and sold its
Quarterdeck shares, and recorded, in aggregate, a gain of $3,824,000 related to
this transaction. Total revenues earned on one-time product sales to Limbex were
$1,011,000 in fiscal 1997.

                                      F-15
<PAGE>
 
                              INFERENCE CORPORATION

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                January 31, 1998


10.  Geographic and Significant Customer Data

     Information relating to the Company's geographic areas is as follows (in
thousands):


                                             Total     Operating   Identifiable
                                            Revenues  Income(Loss)    Assets
                                           ---------  ------------ ------------
     Year ended January 31, 1998:
             North America..............   $  16,682   $ (2,994)   $  30,657
             International..............      11,541     (1,600)       6,339
                                           ---------  ------------ ------------
               Total....................   $  28,223   $ (4,594)   $  36,996
                                           =========  ============ ============
     Year ended January 31, 1997:                      
             North America..............   $  21,408   $  1,974    $  34,172
             International..............      14,582       (362)       8,069
                                           ---------  ------------ ------------
               Total....................   $  35,990   $  1,612    $  42,241
                                           =========  ============ ============
     Year ended January 31, 1996:                      
             North America..............   $  15,845   $  1,826    $  30,381
             International..............      13,550      1,630        6,514
                                           ---------  ------------ ------------
               Total....................   $  29,395   $  3,456    $  36,895
                                           =========  ============ ============

                                                    
     In fiscal 1996, the Company earned revenue from one customer in the amount
of $3,217,000, which represented 11% of total revenues. No customer accounted
for more than 10% of revenues in fiscal 1998 or fiscal 1997.


11.   Litigation

     In September 1997, the Company filed a complaint (the "Complaint") in the
United States District Court - Northern District of California in San Jose (case
number C97-03414) charging ServiceSoft Corporation ("ServiceSoft") with patent
infringement, copyright infringement, breach of contract, intentional
interference with prospective business interest and unfair competition. In
October 1997, ServiceSoft filed its answer to the Complaint and denied the
charges made in the Complaint, and ServiceSoft also filed a counterclaim (the
"Counterclaim") charging the Company with intentional interference with
prospective business advantage, trade defamation and unfair competition. The
Counterclaim seeks unspecified damages, costs and non-monetary relief,
including, among other things, a declaration of non-infringement and a
declaration of invalidity and unenforceability of a patent with respect to the
Company's CBR technology. In November 1997, the Company answered the
Counterclaim and denied all of the claims made by ServiceSoft in the
Counterclaim. The Company believes that the Counterclaim is without merit. The
Company intends to vigorously prosecute the Complaint and defend the
Counterclaim, and believe that the ultimate outcome of this matter will not have
a material adverse impact on the Company's financial position, results of
operations or cash flows. However, the ultimate outcome of any litigation is
uncertain. If an unfavorable outcome were to occur, the impact could be
material. Furthermore, any litigation regardless of the outcome, can have an
adverse impact on the Company's results of operations as a result of defense
costs, diversion of mangagement resources, and other factors.

                                      F-16
<PAGE>
 
                                  SIGNATURES

        Pursuant to the requirements of Section 13 or 15(d) if the Securities 
Exchange Act of 1934, the Registrant had duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.




                                        INFERENCE CORPORATION

    Date:  April 27, 1998               By:  /s/ William D. Griffin
                                        ----------------------
                                        William D. Griffin
                                        Chief Financial Officer
                                        and Senior Vice President


POWER OF ATTORNEY

        KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Charles W. Jepson and William D. Griffin,
and each of them, his attorneys-in fact and agents, each with the power of
substitution, for him in any and all capacities, to sign any and all amendments
to this Report on Form 10-K, and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and Exchanges
Commission, hereby ratifying and confirming all that each of said attorneys-in
fact, or substitutes may do or cause to be done by virtue hereof.

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

<TABLE> 
<S>                                     <C>                                           <C> 
    /s/ Charles W. Jepson               Chief Executive Officer (Principal            April 27, 1998
    -----------------------------       Executive Officer), President and Director 
        (Charles W. Jepson)            

    /s/ William D. Griffin              Chief Financial Officer (Principal            April 27, 1998
    -----------------------------       Financial and Accounting Officer),
        (William D. Griffin)            Senior Vice President and Director 
                                        
    /s/ Peter R. Tierney                Director                                      April 27, 1998
    -----------------------------
        (Peter R. Tierney)

    /s/ Dean O. Allen                   Director                                      April 27, 1998
    -----------------------------
        (Dean O. Allen)

    /s/ Thomas Davenport                Director                                      April 27, 1998
    -----------------------------
        (Thomas Davenport)

    /s/ C. Scott Gibson                 Director                                      April 27, 1998
    -----------------------------
        (C. Scott Gibson)

    /s/ Anthony Sun                     Director                                      April 27, 1998
    -----------------------------
        (Anthony Sun)
</TABLE> 
<PAGE>
 
                                                             EXHIBIT INDEX
<TABLE> 
<CAPTION> 
                                                                                                  Sequential
                                                                                                     Page
Exhibit                                                                                             Number
No.             Description 
<C>             <S>                                                                               <C>  
 2.1            Agreement of Merger dated as of July 5, 1996 by and between the
                Registrant and its predecessor (merger agreement effectuating
                the reincorporation of the Registrant into Delaware). (3)

 3.1            Certificate of Incorporation of the Registrant. (3)

 3.2            Bylaws of the Registrant. (3)

 4.1            Reference is made to Exhibits 3.1. and 3.2.

 4.2            Master Registration Rights Agreement, dated as of December 5,
                1984, by and among the Registrant and the investors named
                therein, as amended and supplemented. (1)

 4.3            Second Amended and Restated Demand Registration Rights
                Agreement, dated as of April 19, 1993, by and among the
                Registrant and the investors named therein. (1)

 4.4            Rights Agreement, dated as of November 25, 1996, between
                Registrant and Harris Trust Company of California (incorporated
                by reference to Exhibit 2 to Registrant's Registration Statement
                on Form 8-A dated November 27, 1996 on file with the Securities
                and Exchange Commission ("Form 8-A")).

 4.5            Form of Certificate of Designations of Junior Participating
                Preferred Stock (incorporated by reference to Exhibit 4 to the
                Form 8-A).

10.1*           The Amended and Restated Inference Corporation 1993 Stock Option
                Plan and forms of agreement thereunder. (1)

10.2*           The Registrant's Fourth Amended and Restated Incentive Stock
                Option Plan and Nonqualified Stock Option Plan and forms of
                agreements thereunder. (1)

10.3*           The Registrant's Employee Stock Purchase Plan (incorporated by
                reference to Exhibit 10.1 to Registrant's Current Report on Form
                8-K dated July 8, 1996 on file with the Securities and Exchange
                Commission ("July 8, 1996 Form 8-K")).

10.4            Master Contribution and Spin-Off Agreement dated as of May 1,
                1995 between the Registrant and Brightware. (1)

10.5            Assumption Agreement executed by Brightware dated as of May 1,
                1995. (1)

10.6            Distributorship and Licensing Agreement dated as of May 1, 1995
                between Brightware as Owner and the Registrant as Distributor.
                (1)

10.7            Distributorship and Licensing Agreement dated as of May 1, 1995
                between Brightware as Owner and Inference Ltd. as Distributor.
                (1)

10.8            Distributorship and Licensing Agreement dated as of May 1, 1995
                between the Registrant as Owner and Brightware as Distributor.
                (1)

10.9            Not used

10.10           Technology Transfer and License Agreement dated as of May 1,
                1995 between the Registrant and Brightware. (1)

10.11*          Executive Employment Agreement effective as of February 1, 1997
                between the Registrant and William D. Griffin. (4)

10.12*          Executive Employment Agreement effective as of March 4, 1998
                between the Registrant and Charles W. Jepson. (5)

10.13*          Amendment No. 1 to Registrant's Amended and Restated 1993 Stock
                Option Plan dated February 14, 1996 (incorporated by reference
                to Exhibit 10.2 to the July 8, 1996 Form 8-K).

10.14*          Amendment No. 2 to Registrant's Amended and Restated 1993 Stock
                Option Plan dated March 28, 1996 (incorporated by reference to
                Exhibit 10.3 to the July 8, 1996 Form 8-K).

10.15*          Consulting Agreement effective as of April 1, 1998 between the
                Registrant and Peter R. Tierney, as amended by the First
                Amendment to Consulting Agreement dated April 24, 1998. (5)

10.16           Not used.

10.17           Knowledge-Pak Reseller License Agreement dated May 1, 1994
                between the Registrant and ServiceWare, Inc. (1)

10.18-10.20     Not used

10.21           Distributorship and Licensing Agreement dated June 20, 1988
                between the Registrant and Nichimen Corporation, and Adenda
                thereto. (1)

10.22           Not used

10.23           Golden Gate Plaza Full Service Lease dated October 14, 1994
                between Novato Gateway Associates and the Registrant. (1)

10.24-10.25     Not used
</TABLE> 
<PAGE>
 
<TABLE> 
<CAPTION> 
                                                                                                  Sequential
                                                                                                     Page
Exhibit                                                                                             Number
No.             Description 
<C>             <S>                                                                               <C>  
10.26           License Agreement for Distribution of Third Party Components
                with Microsoft Products dated April 30, 1993 between the
                Registrant and Microsoft Corporation. (1)

10.27           Agreement and Plan of Reorganization dated August 13, 1996 among
                Quarterdeck Corporation, Limbex Corporation, the Registrant and
                the other shareholders of Limbex Corporation named therein. (2)

10.28           License Agreement dated January 31, 1994 between the Registrant
                and International Business Machines Corporation, together with
                amendments thereto. (1)

10.29           Software License, Customization and Maintenance Agreement dated
                April 28, 1995 between the Registrant and Bank of America
                National Trust and Savings Association. (1)

10.30           Not used

10.31           Agreement G 16187 D for the Procurement of License and
                Maintenance of Software and Software Development dated February
                1, 1991 between the Registrant and American Telephone and
                Telegraph Company, together with amendments and related order
                agreements thereto. (2)

10.32           Agreement for Underleases dated March 1, 1995 between the
                Registrant and Digital Equipment Co. Limited (lease for the
                facility in the United Kingdom). (1)

10.33           Technology License Agreement dated May 9, 1995 between the
                Registrant and Limbex Corporation. (1)

10.34           Software License and Maintenance Agreement dated September
                22,1995 between the Registrant and ICL Sorbus UK Limited. (2)

10.35           License and Consulting Agreements dated March 30, 1995 between
                the Registrant and Gateway 2000. (2)

10.36-10.37     Not used

10.38*          Indemnification Agreement dated March 13, 1998 between the
                Registrant and Mark A. Wolf. (5)

10.39*          Indemnification Agreement dated March 13, 1998 between the
                Registrant and Philip Padfield. (5)

10.40*          Indemnification Agreement dated August 21, 1995 between the
                Registrant and William D. Griffin. (2)

10.41*          Indemnification Agreement dated August 21, 1995 between the
                Registrant and Peter R. Tierney. (2)

10.42*          Indemnification Agreement dated March 13, 1998 between the
                Registrant and Charles W. Jepson. (5)

10.43*          Indemnification Agreement dated March 13, 1998 between the
                Registrant and Ralph Barletta. (5)

10.44*          Indemnification Agreement dated February 7, 1997 between the
                Registrant and Glen D. Vondrick. (4)

10.45*          Indemnification Agreement dated August 21, 1995 between the
                Registrant and Dean O. Allen. (2)

10.46*          Indemnification Agreement dated February 7, 1997 between the
                Registrant and Thomas Davenport. (4)

10.47*          Indemnification Agreement dated August 21, 1995 between the
                Registrant and Scott Gibson. (2)

10.48*          Indemnification Agreement dated August 21, 1995 between the
                Registrant and Anthony Sun. (2)

21.1            Subsidiaries of the Registrant. (4)

23.1            Consent of Independent Auditors. (5)

27.1            Financial Data Schedule. (5)

27.2            Restated Financial Data Schedule for the period ended April 30,
                1996. (5)

27.3            Restated Financial Data Schedule for the period ended July 31,
                1996. (5)

27.4            Restated Financial Data Schedule for the period ended October
                31, 1996. (5)

27.5            Restated Financial Data Schedule for the period ended January
                31, 1997. (5)
</TABLE> 
-------------------------------------------------------------------------------

 *    Denotes a compensation plan or other agreement under which directors or
      executive officers may participate.

(1)   Incorporated by reference to Exhibit of same number to the Registrant's
      Registration Statement on Form S-1, as amended (file no. 33-92386) on file
      with the Securities and Exchange Commission.
(2)   Incorporated by reference to Exhibit of same number to the Registrant's
      Annual Report on Form 10-K for the fiscal year ended January 31, 1996.
(3)   Incorporated by reference to Exhibit of same number to the Registrant's
      Current Report on Form 8-K dated November 25, 1996.
(4)   Incorporated by reference to Exhibit of same number to the Registrant's
      Annual Report on Form 10-K for the fiscal year ended January 31, 1997.
(5)   Filed herewith.