CONSOLIDATED BALANCE SHEET

(dollars in thousands except share amounts)
December 31,                                               1998            1997
--------------------------------------------------------------------------------
Assets
Current assets:
    Cash and cash equivalents                         $  55,820       $  37,344
    Short-term marketable securities                     15,484          26,600
    Accounts receivable, net of allowances
       for doubtful accounts and sales
       returns of $4,382 and $4,415 at 
       December 31, 1998 and 1997, respectively          61,636          61,283
    Inventories, net                                      2,419           3,541
    Prepaid expenses and other current assets             8,865           8,309
    Deferred income taxes                                     0           2,643
                                                       ---------      ----------
    Total current assets                                144,224         139,720
    Property, net                                        44,177          27,587
    Long-term marketable securities                      10,885           7,826
    Deferred income taxes                                 6,385           3,366
    Other assets                                          1,151             941
                                                      ----------      ----------
         Total assets                                 $ 206,822       $ 179,440
                                                      ==========      ==========
Liabilities and Stockholders' Equity
  Current liabilities:
    Accounts payable                                  $  21,022       $  15,003
    Accrued compensation and benefits                    22,165          17,159
    Unearned maintenance revenue                         11,238           8,848
    Accrued royalties                                     1,459           2,743
    Deferred income taxes                                   942               0
    Other accrued liabilities                            19,676          16,876
                                                      ----------      ----------
Total current liabilities                                76,502          60,629

Stockholders' equity:
    Preferred stock--$.10 par value, 7,000,000 
         shares authorized;
         none issued and outstanding                          0               0
    Common stock--$.01 par value, 100,000,000 shares
         authorized; 32,924,950 and 31,121,676 shares
         issued and outstanding at December 31, 1998
         and 1997, respectively                         144,242         130,741
    Retained earnings                                     3,304           2,348
    Accumulated other comprehensive operations           (2,659)         (4,146)

                                                        144,887         128,943
    Treasury stock at cost; 1,098,000 and 820,000
         shares at December 31, 1998 and 1997, 
         respectively                                   (14,567)        (10,132)
                                                      ----------      ----------
Total stockholders' equity                              130,320         118,811
                                                      ----------      ----------
         Total liabilities and stockholders' equity   $ 206,822       $ 179,440
                                                      ==========      ==========

See accompanying Notes to Consolidated Financial Statements.

                                       27
<PAGE>



                      CONSOLIDATED STATEMENTS OF OPERATIONS


(dollars in thousands except share amounts)
Year Ended December 31,                            1998        1997        1996
--------------------------------------------------------------------------------
Revenue:
    Software                                  $ 171,153   $ 132,723   $ 140,659
    Service                                     115,501      89,280      82,118
    Hardware                                     23,579      29,422      46,136
                                              ---------   ----------  ----------
    Total revenue                               310,233     251,425     268,913
                                              ---------   ----------  ----------
Costs and expenses:
    Cost of software revenue                     16,814      13,416      15,389
    Cost of service revenue                      73,786      56,503      53,568
    Cost of hardware revenue                     13,181      20,330      29,633
    Research and development                     50,132      40,927      37,577
    Selling, general and administrative         156,813     125,122     117,761
    Restructuring, merger, write-off of
      purchased in-process research and
        development and other costs               2,000       6,000      16,011
                                              ---------   ----------  ----------
    Total costs and expenses                    312,726     262,298     269,939
                                              ---------   ---------- ----------
Operating loss                                   (2,493)    (10,873)     (1,026)
Other income, net                                 3,840       3,160       2,838
Incom (loss) before income taxes                  1,347      (7,713)      1,812
Provision (benefit) for income taxes                391      (2,187)      4,456
                                              ---------   ----------   ---------
Net income (loss)                             $     956   $  (5,526)   $ (2,644)
                                              =========   ==========   =========
Earnings (loss) per share:
    Basic                                     $    0.03   $   (0.18)  $   (0.09)
    Diluted                                   $    0.03   $   (0.18)  $   (0.09)
Weighted average shares outstanding--basic       31,083      30,310      30,014
                                              ---------   ----------  ----------
Weighted average shares outstanding--diluted     33,367      30,310      30,014
                                              =========   ==========  ==========

See accompanying Notes to Consolidated Financial Statements.

                                       28
<PAGE>



               CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS


(dollars in thousands)
Year Ended December 31,                            1998        1997        1996
--------------------------------------------------------------------------------
Net income (loss)                               $   956   $  (5,526)   $ (2,644)

Other comprehensive income (loss):
  Foreign currency translation adjustments, 
     net of tax                                   1,455      (5,809)      1,671
   Unrealized holding gains (losses) on 
     available for sale securities, net of tax       32         (24)        (26)
                                                --------  ----------------------
     Other comprehensive income (loss)            1,487      (5,833)      1,645
                                                --------  ----------------------
Comprehensive income (loss)                     $ 2,443   $ (11,359)   $   (999)
                                                ========  ======================

See accompaniying Notes to Consolidated Financial Statements.

                                       29
<PAGE>

                                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(dollars in thousands except per share amounts)
<TABLE>
<CAPTION>

                                  Convertible                                          Accumulated
                                  Preferred Stock      Common Stock       Retained     Other Comp    Treasury Stock
                                  ---------------      ---------------    Earnings     Operations    ----------------     Total
                                  Shares   Amount      Shares    Amount                              Shares    Amount
<S>                                <C>     <C>         <C>       <C>        <C>          <C>        <C>       <C>        <C>

Balances at January 1, 1996        3,064   $ 19,879    26,508    $100,719   $ 10,518     $    42         0    $      0   $131,158
Stock options exercised                                   796       3,330                                                   3,330
Stock option income tax benefits                                    2,606                                                   2,606
Common stock issued under the
    Employee Qualified Stock
      Purchase Plan                                        76       1,028                                                   1,028
Exercise of Saros warrants                                 18         251                                                     251
Conversion of Saros convertible
     preferred stock to FileNET
        common stock              (3,064)   (19,879)    3,064      19,879
Repurchase of treasury
     shares at cost                                                                                   (400)     (4,568)    (4,568)
Foreign currency
     translation adjustment                                                                1,671                            1,671
Net loss                                                                      (2,644)                                      (2,644)
Other                                                                                        (26)                             (26)
                                  ------------------------------------------------------------------------------------------------
Balances at December 31, 1996                          30,462     127,813      7,874       1,687      (400)     (4,568)   132,806
Stock options exercised                                   484       1,721                                                   1,721
Common stock issued under the
     Employee Qualified Stock
        Purchase Plan                                     176       1,207                                                   1,207
Repurchase of treasury
     shares at cost                                                                                   (420)     (5,564)    (5,564)
Foreign currency
     translation adjustment                                                               (5,809)                          (5,809)
Net loss                                                                      (5,526)                                      (5,526)
Other                                                                                        (24)                             (24)
                                  ------------------------------------------------------------------------------------------------
Balances at December 31, 1997                          31,122     130,741      2,348      (4,146)     (820)    (10,132)   118,811
Stock options exercised                                 1,642      12,078                                                  12,078
Common stock issued under the
     Employee Qualified Stock
        Purchase Plan                                     161       1,423                                                   1,423
Repurchase of treasury
        shares at cost                                                                                (278)     (4,435)     (4,435)
Foreign currency
        translation adjustment                                                             1,455                            1,455
Net income                                                                       956                                          956
Other                                                                                         32                               32
                                  ------------------------------------------------------------------------------------------------
Balances at December 31, 1998                          32,925    $144,242    $ 3,304     $(2,659)   (1,098)   $(14,567)  $130,320
                                  ================================================================================================

See accompanying Notes to Consolidated Financial Statements.

</TABLE>
                                       30
<PAGE>

                              CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
(dollars in thousands)
Year Ended December 31,                                        1998          1997           1996
<S>                                                        <C>           <C>            <C>

Cash flows from operating activities:
Net income (loss)                                          $    956      $ (5,526)      $ (2,644)
Adjustments to reconcile net income (loss) to net cash
  provided by (used for) operating activities:
   Write-off of capitalized and purchased in-process
     research and development costs                               0             0         10,011
   Depreciation and amortization                             15,360        13,193         13,136
   Provision for doubtful accounts                            1,041           350          1,205
   Deferred income taxes                                        566        (3,773)          (790)
   Changes in operating assets and  liabilities,  
     net of effect of business acquisition:
        Accounts receivable                                    (573)        9,365        (21,921)
        Inventories                                           1,121         5,368         (2,161)
        Prepaid expenses and other current assets              (609)         (539)        (1,764)
             Accounts payable                                 5,905        (1,273)           639
        Accrued compensation and benefits                     4,820         4,721            688
             Unearned maintenance revenue                     2,408         3,327           (207)
             Accrued royalties                               (1,284)       (1,788)           959
             Other                                            3,547         1,240          1,141
                                                          ---------     -------------------------
Net cash provided by (used for) operating activities         33,258        24,665         (1,708)
                                                          ---------     -------------------------
Cash flows from investing activities:
Capital expenditures                                        (32,474)      (14,266)       (17,866)
Proceeds from sale of property                                  478           264          3,304
Payment for purchase of IFSL, net of assets acquired              0             0        (10,011)
Purchases of marketable securities                          (34,536)      (30,274)       (32,092)
Proceeds from sales and maturities of marketable 
   securities                                                42,843        32,946         39,990
                                                          ----------    -------------------------
Net cash used for investing activities                      (23,689)      (11,330)       (16,675)
                                                          ----------    -------------------------
Cash flows from financing activities:
Proceeds from issuance of common stock                       13,501         2,928          4,609
Common stock repurchased                                     (4,435)       (5,564)        (4,568)
Stock option income tax benefits                                  0             0          2,606
                                                          ----------    -------------------------
Net cash provided by (used for) financing activities          9,066        (2,636)         2,647
                                                          ----------    -------------------------
Effect of exchange rate changes on cash and cash 
   equivalents                                                 (159)       (1,885)           888
                                                          ----------    -------------------------
Net increase (decrease) in cash and cash equivalents         18,476         8,814        (14,848)
Cash and cash equivalents, beginning of year                 37,344        28,530         43,378
                                                          ----------    -------------------------
Cash and cash equivalents, end of year                     $ 55,820      $ 37,344       $ 28,530
                                                          ==========    =========================
Supplemental cash flow information:
Interest paid                                              $     25      $    201       $    443
Income taxes paid (refunded)                               $ (2,119)     $  3,050       $  3,236

See accompanying Notes to Consolidated Financial Statements.
</TABLE>
                                       31
<PAGE>
Note 1.  Summary of Significant Accounting Policies

Nature of Operations: FileNET Corporation ("FileNET" or "the Company") develops,
markets and services an open, integrated, client/server-based family of document
management  software  products  designed for managing  information and enhancing
enterprise productivity. Additionally, the Company manufactures and sells a line
of 12-inch optical storage and retrieval libraries (OSARs).  The Company markets
its products to a broad range of industries in more than 70 countries  through a
global sales, services and support organization,  including its ValueNET partner
program of resellers, system integrators and application developers.

Principles of Consolidation:  The consolidated financial statements  include the
accounts of FileNET and its wholly-owned subsidiaries. All intercompany balances
and  transactions  have been  eliminated.

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

Investments:   The  Company's   investments  in  marketable  securities  consist
primarily of high-grade  corporate and government  securities with maturities of
less than three years.  Investments purchased with an original maturity of three
months or less are considered to be cash equivalents. The Company classifies all
of its  investments  as  available-for-sale.  Available-for-sale  securities are
carried at fair value, with unrealized gains and losses, net of tax, reported in
other comprehensive operations.

Other Financial Instruments:  The Company enters into forward  foreign  exchange
contracts as a hedge against the effects of fluctuating  currency exchange rates
on monetary  assets and  liabilities  denominated  in currencies  other than the
functional  currency of the  relevant  entity.  The Company is exposed to market
risk on the  forward  exchange  contracts  as a result  of  changes  in  foreign
exchange  rates;  however,  the market  risk  should be offset by changes in the
valuation  of the  underlying  exposures.  Gains and losses on these  contracts,
which equal the difference  between the forward contract rate and the prevailing
market spot rate at the time of valuation,  are  recognized in the  consolidated
statements  of  operations.  The  counterparties  to these  contracts  are major
financial institutions.  The Company uses commercial rating agencies to evaluate
the credit quality of the counterparties. The Company does not anticipate a loss
resulting from credit risk related to any of these institutions (see Note 14).

Fair Value of Financial Instruments:  The  recorded  amounts of financial assets
and liabilities at December 31, 1998 and 1997  approximate fair value due to the
relatively short period of time between origination of the instruments and their
expected realization.

Inventories:  Inventories are stated at the lower of first-in, first-out cost or
market (see Note 6). The Company  regularly  monitors  inventories for excess or
obsolete items and makes any necessary adjustments at each balance sheet date.

Foreign Currency:  Translation The Company  measures the financial statements of
the Company's  foreign  subsidiaries  using the local currency as the functional
currency.  Assets and  liabilities of these  subsidiaries  are translated at the
exchange  rate on the  balance  sheet date.  Revenues,  costs and  expenses  are
translated  at the rates of  exchange  prevailing  during the year.  Translation
adjustments  resulting  from this  process are  included in other  comprehensive
operations,  net of tax. Gains and losses from foreign currency transactions are
included in other income.

Property Property:  is  stated  at cost.  Depreciation  is  computed  using  the
straight-line  method over the  estimated  useful  lives of the related  assets,
generally  three to five years.  Leasehold  improvements  are amortized over the
shorter of the  estimated  useful lives of the  improvements  or the term of the
related lease (see Note 7).

Research and Development: The Company expenses research and development costs as
incurred.  SFAS No. 86,  "Accounting  for the Costs of  Computer  Software to be
Sold, Leased, or Otherwise Marketed" does not materially affect the Company. The
Company did capitalize  certain software  development  costs up to and including
the second  quarter of 1995.  The Company  amortized the  remaining  capitalized
software  development costs during 1996.  Amortization  expense was $1.2 million
for the year ended December 31, 1996. 
                                       32
<PAGE>
Revenue Recognition:  Software  revenue is  recognized  in  accordance  with the
American Institute of Certified Public Accountants (AICPA) Statement of Position
(SOP) 97-2,  "Software  Revenue  Recognition."  Pursuant  to SOP 97-2,  software
revenue is recognized on sales  contracts  when all of the following  conditions
are met: a signed contract is obtained,  delivery has occurred,  the total sales
price  is  fixed  and  determinable,   collectibility   is  probable,   and  any
uncertainties with regard to customer  acceptance are  insignificant.  For those
contracts  that include a combination  of software,  hardware  and/or  services,
revenue is allocated  among the  different  elements  based on  Company-specific
evidence  of fair value of each  element.  Revenue  allocated  to  software  and
hardware is  recognized  as the above  criteria  are met.  Revenue  allocated to
services is  recognized  as services are  performed and accepted by the customer
or, for maintenance agreements, ratably over the life of the related contract.

Product  Warranty:  The  Company  provides a 90-day  warranty  for its  products
against defects in materials and workmanship. A provision for estimated warranty
costs is  recorded  at the time of sale and  periodically  adjusted  to  reflect
actual experience.

Income Taxes:  The provision for income taxes is determined  in accordance  with
SFAS No. 109, "Accounting for Income Taxes." Deferred tax assets and liabilities
arise from temporary differences between the tax bases of assets and liabilities
and their reported  amounts in the consolidated  financial  statements that will
result in taxable or deductible amounts in future years (see Note 10).

Earnings (Loss) Per Share: Basic earnings (loss) per share is computed using the
weighted  average  number of common  shares  outstanding  during  the  reporting
period. Diluted earnings (loss) per share is computed using the weighted average
number of common shares  outstanding and the dilutive effect of potential common
shares outstanding (see Note 4).

Supplier  Concentrations:  Certain  components  for  the  Company's  proprietary
12-inch OSARs are available only from a single  source.  Any inability to obtain
components  in the amounts  needed on a timely  basis could  result in delays in
product  shipments  which could have a material  adverse effect on the Company's
operating  results.  The Company has qualified and is selling  51/4-inch optical
storage and retrieval devices from an alternative source which could be utilized
by the Company's  customers in the event of any interruptions in the delivery of
components for the Company's own OSAR product.

Stock-based  Compensation:  The  Company  accounts  for  stock-based  awards  to
employees  using the  intrinsic  value  method  in  accordance  with  Accounting
Principles  Board  Opinion  (APB)  No.  25,  "Accounting  for  Stock  Issued  to
Employees" (see Note 9).

Long-Lived Assets:  The Company accounts for the impairment  and  disposition of
long-lived  assets  in  accordance  with  SFAS  No.  121,  "Accounting  for  the
Impairment of Long-lived Assets and for Long-lived Assets to Be Disposed Of." In
accordance  with SFAS No. 121,  long-lived  assets to be held are  reviewed  for
events or changes in  circumstances  that indicate that their carrying value may
not be  recoverable.  The Company  periodically  reviews the  carrying  value of
long-lived  assets to determine  whether or not an  impairment to such value has
occurred  by  assessing   their  net   realizable   values  based  on  estimated
undiscounted  cash flows over their  remaining  useful lives.  Based on its most
recent analysis,  the Company believes that no impairment exists at December 31,
1998.

Recent Accounting  Pronouncements:   In  June  1998,  the  Financial  Accounting
Standards  Board  (FASB)  issued  SFAS  No.  133,   "Accounting  for  Derivative
Instruments  and Hedging  Activities,"  which is effective for fiscal year 2000,
but earlier  adoption is permitted.  SFAS 133 will require the Company to record
all  derivatives on the balance sheet at fair value.  For  derivatives  that are
hedges,  changes in the fair value of derivatives  will be offset by the changes
in the fair value of the hedged  assets,  liabilities or firm  commitments.  The
Company  believes the impact of adopting  this  standard will not be material to
its results of operations or equity.

Stock Split: In June 1998, the Company effected a two-for-one stock split of its
common stock. All references in the consolidated  financial statements and notes
thereto to number of shares,  number of stock options and per share amounts have
been restated to reflect the split.

Reclassifications:  Certain reclassifications  have  been  made to  prior-years'
balances to conform to the current year's presentation.

                                       33
<PAGE>

Note 2.  Acquisitions

Acquisition of Saros:  Corporation  In March 1996, the Company acquired Saros by
issuing   approximately   1.9  million   shares  of  FileNET  common  stock  and
approximately  337,000 options to purchase  FileNET common stock in exchange for
all outstanding Saros stock and options.  The transaction was accounted for as a
pooling-of-interests   for  financial  reporting  purposes.  Fees  and  expenses
aggregating $4.2 million were expensed in the first quarter of 1996.  Subsequent
to December 31, 1998, the former  shareholders have filed a demand for mandatory
arbitration  to release  approximately  0.2  million  shares  which were held in
escrow pursuant to the Agreement and Plan of Merger and for damages. The Company
believes that it has meritorious  reasons for not releasing the shares and other
defenses to the claims; however, the ultimate outcome or any resulting potential
loss cannot be presently determined.

Acquisition  of  International  Financial  Systems Ltd.:  In January  1996,  the
Company purchased for cash all of the outstanding  shares of IFSL, the developer
of a  computer  output to laser  disk  (COLD)  software  product  for  archiving
documents.  The  acquisition  was  accounted  for as a  purchase  for  financial
reporting  purposes.  The  purchase  price was  allocated  to net assets of $1.7
million  and  purchased  in-process  research  and  development  costs  of $10.0
million.  The purchased  in-process  research and development costs were written
off at the time of acquisition.

Note 3.  Restructuring and Other Costs

The $2.0 million in  restructuring  and other costs in 1998 represents the costs
of a reduction in headcount  related to a  restructuring  of the Company's sales
and marketing organization,  as well as costs of consolidating  facilities.  The
restructuring  and other costs are comprised of  approximately  $1.1 million for
severance payments for 54 employees, $0.7 million for facility closing costs and
$0.2 million of other charges.

The $6.0 million in restructuring and other charges in 1997 represents the costs
of  consolidating  the  Watermark  business  unit's  Burlington,   Massachusetts
engineering  and  marketing  functions  with  those  at  FileNET's  Costa  Mesa,
California location,  as well as a reduction in headcount in certain other areas
of the Company.  The restructuring and other charges include  approximately $2.2
million for severance payments for 111 employees, $2.2 million for the write-off
of assets  impaired by the  decision to  restructure,  $0.4 million for facility
closing costs, $0.4 million for equipment lease cancellations,  $0.3 million for
cancellation of third party development  contracts,  $0.2 million related to the
withdrawal  of  certain  products  from the  market  and $0.3  million  of other
charges.

The $16.0 million  merger,  restructuring  and write-off of purchase  in-process
research  and  development  costs in 1996  consisted  of $10.0  million  for the
write-off of purchased  in-process research and development costs related to the
acquisition of  International  Financial  Systems Ltd.  (IFSL),  $4.2 million in
merger costs related to the Saros acquisition, and $1.8 million in restructuring
costs related to the Saros and Watermark acquisitions. The restructuring charges
represented  the  costs  of  consolidating  the  various  companies'  sales  and
administrative  functions and include $1.4 million for severance payments for 30
employees and $0.4 million for the write-off of certain contractual  obligations
and other costs.

At December 31, 1998,  accrued  restructuring  and other charges of $1.7 million
are included in other  accrued  liabilities.  The Company  anticipates  that the
remaining restructuring costs will be paid during 1999.

                                       34
<PAGE>


Note 4.  Earnings (Loss) Per Share

The following table is a  reconciliation  of the earnings and share amounts used
in the  calculation  of basic  earnings  (loss) per share and  diluted  earnings
(loss) per share.  Such  calculations  include the effect of the  conversion  of
Saros'  convertible  preferred  stock into FileNET common stock,  which occurred
upon completion of the related acquisition (see Notes 2 and 9):

(dollars in thousands, except per share amounts)

                                      Net Income                      Per Share
                                          (Loss)        Shares           Amount
Year ended December 31, 1996
Basic (loss) per share              $    (2,644)        30,014       $   (0.09)
Effect of dilutive stock options                             0               0
                                    --------------------------------------------
Diluted (loss) per share            $    (2,644)        30,014       $   (0.09)
                                    ============================================
Year ended December 31, 1997
Basic (loss) per share              $    (5,526)        30,310       $   (0.18)
Effect of dilutive stock options                             0               0
                                    --------------------------------------------
Diluted (loss) per share            $    (5,526)        30,310       $   (0.18)
                                    ============================================
Year ended December 31, 1998
Basic earnings per share            $        956        31,083       $    0.03
Effect of dilutive stock options                         2,284               0
                                    --------------------------------------------
Diluted earnings per share          $        956        33,367       $    0.03
                                    ============================================

Options to  purchase  shares of common  stock in 1997 and 1996 were  outstanding
during the year but were not  included in the  computation  of diluted  loss per
share as their effect was antidilutive (see Note 9).


Note 5.  Other Comprehensive Operations

Accumulated  other  comprehensive  operations for each of the three years in the
period ended December 31, 1998 is comprised of the following:

(dollars in thousands)
                                  Foreign                          Accumulated
                                  Currency       Unrealized        Other
                                  Translation    Holding           Comprehensive
                                  Adjustment     Gains (Losses)    Operations

Balance, January 1, 1996          $      3       $     39          $     42
 Current period changes
  (Net of tax of $1,114 and 
    $(17) prospectively)             1,671            (26)            1,645
                                 ----------------------------------------------
Balance, December 31, 1996           1,674             13             1,687
 Current period changes
  (Net of tax of $(3,873) and 
    $(16) prospectively)            (5,809)           (24)           (5,833)
                                 ----------------------------------------------
Balance, December 31, 1997          (4,135)           (11)           (4,146)
 Current period changes
  (Net of tax of $970 and 
    $21 prospectively)               1,455             32             1,487
                                 ----------------------------------------------
Balance, December 31, 1998        $ (2,680)      $     21          $ (2,659)
                                 ==============================================

                                       35
<PAGE>


Note 6.  Inventories

Inventories, net of reserve for slow moving and obsolete inventory, consisted of
the following at December 31:

(dollars in thousands)
                                             1998                       1997

Raw materials                           $   1,676                  $   1,831
Work-in-process                               580                        950
Finished goods                                163                        760
                                        ----------                 -----------
Inventories, net                        $   2,419                  $    3,541
                                        ==========                 ===========

Note 7.  Property and Leases

Property consisted of the following at December 31:

(dollars in thousands)

                                             1998                       1997

Machinery, equipment and software       $  95,793                  $  74,981
Furniture and fixtures                     12,376                      8,808
Leasehold improvements                     11,796                      5,238
                                        -----------               ------------
                                          119,965                     89,027
Less accumulated depreciation and 
  amortization                            (75,788)                   (61,440)
                                       ------------               ------------
Property, net                           $  44,177                  $  27,587
                                       ============               ============

The  Company  leases  its  corporate  offices,   sales  offices,   manufacturing
facilities,  and other equipment under  noncancelable  operating leases, some of
which have renewal  options and generally  provide for  escalation of the annual
rental amount.

Expenses related to operating leases were $11.3 million, $10.8 million, and $9.6
million for the years ended December 31, 1998, 1997 and 1996, respectively.  The
following  table  summarizes   future  minimum  lease  payments  required  under
operating leases:

(dollars in thousands)

1999                                                                $  13,245
2000                                                                   10,601
2001                                                                    8,992
2002                                                                    7,613
2003                                                                    5,314
Thereafter                                                              6,461
                                                                    -----------
                                                                    $  52,226
                                                                    ===========

Note 8.  Borrowing Arrangements

The  Company  has a $20 million  commercial  line of credit that  expires in May
1999.  Borrowings  under the  arrangement are unsecured and bear interest at the
bank's prime rate. The Company is restricted  from paying  dividends  during the
term of the  arrangement  and, under the  arrangement,  must comply with certain
covenants,  including quarterly and annual profitability  covenants. The Company
was  in  compliance   with  such   covenants  as  of  December  31,  1998  after
consideration  of waivers received related to the purchase of capital assets and

                                       36
<PAGE>

consecutive  quarterly losses. There were no borrowings  outstanding at December
31, 1998 and 1997. The Company expects that it will be able to renew its line of
credit with  comparable  terms.  Interest  expense was  $119,000,  $263,000  and
$443,000 for the years ended December 31, 1998, 1997 and 1996, respectively.

Note 9.  Stockholder' Equity

Shareholder Rights Plan:  In October  1988,  FileNET  declared a dividend of one
common stock  purchase  right for each  outstanding  share of common  stock.  As
amended in July and  November of 1998, a right may be  exercised  under  certain
circumstances  to purchase  one share of common  stock at an  exercise  price of
$87.50,  subject  to  certain  antidilution   adjustments.   The  rights  become
exercisable if and when a person (or group of affiliated or associated  persons)
acquires  15% or more of FileNET's  outstanding  common  stock,  or announces an
offer that would result in such person acquiring 15% or more of FileNET's common
stock. After the rights become  exercisable,  each right will entitle its holder
to buy a number of shares of  FileNET's  common  stock  having a market value of
twice the exercise price of the rights. After the rights become exercisable,  if
FileNET is a party to certain  merger or business  combination  transactions  or
transfers 50% or more of its assets or earnings  power (as defined),  each right
will  entitle  its  holder to buy a number  of  shares  of  common  stock of the
acquiring or surviving  entity having a market value of twice the exercise price
of the right. The rights expire November 17, 2008 and may be redeemed by FileNET
at one cent per right at any time up to ten days  after a person  has  announced
that they have acquired 15% or more of FileNET's common stock.

Treasury Stock:  In 1997, the Board of Directors authorized,  subject to certain
business  and  market  conditions,  the  purchase  of up to $10  million  of the
Company's outstanding common stock. During the year ended December 31, 1997, the
number of shares  purchased  under this  authorization  was 420,000 shares at an
aggregate  cost of $5.6 million.  During the first quarter of 1998,  the Company
repurchased  278,000  shares of its common  stock at an  aggregate  cost of $4.4
million,  thereby completing the stock repurchase program. In 1996, the Board of
Directors  authorized,  subject to certain business and market  conditions,  the
purchase of up to 400,000  shares of the Company's  common stock.  The purchases
under this authorization were completed during 1996 at an aggregate cost of $4.6
million.

Employee Stock Purchase  Plans:  In May 1998,  FileNET adopted the 1998 Employee
Stock  Purchase Plan and the  International  Employee  Stock  Purchase Plan (the
Purchase  Plans).  A total of 300,000 shares were  authorized to be added to the
remaining  share reserve under the  predecessor  1988 Employee  Qualified  Stock
Purchase Plan so that the total share reserve for the Purchase Plans would be no
more than 400,000 shares.  Under the terms of the Purchase  Plans,  common stock
may be offered in successive six-month offering periods to eligible employees of
the Company at 85% of the market price of the common  stock at the  beginning or
end of the  offering  period,  whichever  is lower.  The  Purchase  Plans  cover
substantially all employees of the Company. Eligible employees may elect to have
a portion of their salary withheld for the purpose of making purchases under the
Purchase Plans.  Each participant is limited in any plan year to the acquisition
of that number of shares that have an  aggregate  fair market  value of not more
than $25,000.  There are no charges or credits to income in connection  with the
Purchase  Plans.  At  December  31,  1998,  $1,394,000  had been  withheld  from
employees'  salaries  pursuant to the  Purchase  Plans for the current  offering
period,  which  expires on April 30, 1999.  At December 31, 1998,  approximately
392,278 shares remained available for future issuance.

Stock Option Plans:  In April 1986,  the  Company  adopted the 1986 Stock Option
Plan (the 1986  Plan).  Under the  amended  terms of the 1986  Plan,  options to
purchase  6,500,000  shares of the  Company's  common  stock were  reserved  for
issuance to employees,  officers and directors.  Options to purchase 463,422 and
1,082,830  common  shares were  exercisable  under the 1986 Plan at December 31,
1998 and 1997,  respectively.  In May 1995, the 1986 Plan was terminated and the
remaining  reserve of 140,098 shares was transferred  into the 1995 Stock Option
Plan. No common  shares remain  available for future grants under the 1986 Plan.
Options  granted  were either  incentive  stock  options or  nonqualified  stock
options. Options granted become exercisable in 20% annual installments beginning
one year after the date of grant,  as determined by the Board of Directors,  and
expire no later than ten years plus one day from the date of grant. The exercise
price of

                                       37
<PAGE>

the incentive  stock options and  nonqualified  options were not to be less than
100% and 85%,  respectively,  of the fair market value of the  Company's  common
stock at the date of grant.

In May 1995,  the Company  adopted  the 1995 Stock  Option Plan (the 1995 Plan).
Under the amended terms of the 1995 Plan,  options to purchase  4,400,000 shares
of the Company's common stock were reserved for issuance to employees,  officers
and  directors.  This  reserve was added to the 140,098  shares of common  stock
transferred  from the 1986 Plan.  Outstanding  options  under the 1986 Plan will
continue to be governed by the  provisions of the  agreements  evidencing  those
grants. To the extent any of those outstanding options terminate or expire prior
to exercise,  the shares subject to those unexercised  options will be available
for subsequent option grant pursuant to the provisions of the 1995 Plan. Through
December 31, 1998,  1,942,152  options of the 1986 Plan had been  terminated and
were made available  under the 1995 Plan.  Options granted under the 1995 Plan's
Discretionary  Option Grant Program for employees and the Automatic Option Grant
Program  for  directors  have an  exercise  price  per share of 100% of the fair
market  value per share on the grant date and become  exercisable  in 25% annual
installments beginning one year from the date of grant. As of December 31, 1998,
1,160,997 options were exercisable under the 1995 Plan.

Prior to their merger into FileNET, Saros and Watermark had adopted stock option
plans.  These plans were  assumed by the Company and  outstanding  options  were
converted  into options to purchase an  aggregate  of 975,976  shares of FileNET
common stock.  Outstanding  options under the plans will continue to be governed
by the provisions of the agreements  evidencing those grants.  To the extent any
of those outstanding  options terminate or expire prior to exercise,  the shares
subject to those unexercised options will not be available for subsequent option
grant.  At December  31, 1998, a total of 50,400  options were  outstanding  and
41,312 were exercisable under these plans.

In  December  1989,  the  Company   adopted  the  1989  Stock  Option  Plan  for
Non-Employee  Directors (the Directors' Plan). Under the terms of the Directors'
Plan,  as  amended,   each  FileNET   director  who  was  not  an  employee  was
automatically  granted an initial option to purchase  10,000 shares of FileNET's
common  stock at its fair  market  value on the date of grant and was granted an
additional  option to purchase  3,500  shares every year  following  the initial
grant,  provided  such person  continued to be a director at such time.  Options
granted  under the plan  vested at the rate of 20% per year from the grant date.
Options to purchase an aggregate of 140,000  shares at prices ranging from $5.75
to $16.35 per share were  granted from  December  18, 1989 to May 24,  1995.  At
December  31,  1998,  options to  purchase  23,600  shares of common  stock were
exercisable.  This plan was terminated in May 1995 with respect to future option
grants.  Future  grants to  non-employee  directors  are to be granted under the
provisions of the 1995 Plan.

In August 1997,  the Company  registered a  Non-Statutory  Stock Option Grant of
600,000 shares, dated May 22, 1997, to the Company's current President and Chief
Executive  Officer and a  Non-Statutory  Stock Option  Grant of 160,000  shares,
dated June 18, 1997, to the Company's  Senior Vice President,  Worldwide  Sales.
Such grants were in accordance  with employment  agreements  entered into by the
Company and the grantees.  Options  granted have an exercise  price per share of
100% of the  fair  market  value  per  share on the  date of  grant  and  become
exercisable  in 25%  installments  beginning one year from the date of grant and
will expire no later than ten years from the date of grant.  As of December  31,
1998,  40,000  options were  exercisable  related to these  Non-Statutory  Stock
Option Grants and 150,000 had been exercised to date.

On July 11,  1997,  the  Company  approved a stock  option  cancellation/regrant
program which allowed  employees,  but not non-employee  directors,  to exchange
outstanding  options with an exercise  price greater than $9.00 for new options.
Outstanding  options to purchase 3,105,050 shares were canceled and regranted at
$9.00 per share,  the current  market  value on July 11,  1997.  Under the stock
option  cancellation/regrant  program,  the  regranted  options  are  considered
granted on July 11, 1997. The regranted options retained the exercisable  status
of the canceled options with the following exceptions. The exercise date for the
regranted  options related to canceled  options that would have been exercisable
as of July 11,  1997 was  extended  six  months to  January  11,  1998.  For the

                                       38
<PAGE>

reporting  officers as defined in Section 16 of the  Securities  Exchange Act of
1934, as amended (the Act),  the exercise date of regranted  options  related to
canceled options which would have been exercisable on July 11, 1997 was extended
twelve months to July 11, 1998. The prospective exercise dates for the remaining
regranted  options  related to canceled  options that were not exercisable as of
July 11, 1997, were extended six months from the original exercise date.

On August 8, 1996,  the  Company  approved a stock  option  cancellation/regrant
program which allowed employees,  excluding all directors and reporting officers
as defined in Section 16 of the Act, to exchange  options with an exercise price
greater than $13.00 for new options.  Outstanding  options to purchase 1,061,142
shares were canceled and regranted at $13.00 per share, the current market value
on August 8, 1996.  Under the stock  option  cancellation/regrant  program,  the
regranted options were considered  granted on August 8, 1996 and are exercisable
prospectively  in accordance  with the provisions of the  agreements  evidencing
those grants.

Information regarding the stock option plans, after giving retroactive effect to
the conversions of the Watermark and Saros stock options on their original grant
dates, is as follows:


                                           Number of           Weighted Average
                                           Options             Exercise Price
                                          -----------         ----------------
Balances, January 1, 1996                  5,406,218               $   9.84
         Granted (weighted average 
          fair value of $7.48)             2,724,836               $  18.32
         Exercised                          (796,082)              $   4.19
         Canceled                         (1,733,206)              $  21.67
                                          -----------            -------------
Balances, December 31, 1996                5,601,766               $  11.11
         Granted (weighted average 
          fair value of $4.13)             5,602,098               $   9.33
         Exercised                          (483,408)              $   3.56
         Canceled                         (3,930,238)              $  13.48
                                          -----------            -------------
Balances December 31, 1997                 6,790,218               $   8.81
         Granted (weighted average 
          fair value of $7.41)             2,166,520               $  13.43
         Exercised                        (1,641,758)              $   7.51
         Canceled                           (597,838)              $  10.86
                                          ------------           -------------
Balances, December 31, 1998                6,717,142               $  10.47
                                          ============           =============


The following table summarizes  information concerning currently outstanding and
exercisable options:

                       Options Outstanding               Options Exercisable
                 ---------------------------------     -------------------------
                                 Weighted
                                  Average
Range of              Number    Remaining  Weighted         Number    Weighted
Exercise Price   Outstanding  Contractual   Average    Exercisable     Average
Exercise Price                       Life

$ 0.71-$ 6.53        740,891        7.37    $  5.42        299,109     $  5.23
$ 6.81-$ 8.94      1,692,664        8.49    $  7.33        253,184     $  7.61
$ 9.00             2,216,027        8.52    $  9.00        858,652     $  9.00
$ 9.17-$16.35      1,493,399        8.75    $ 12.53        307,725     $ 12.39
$23.88-$29.00        574,161        9.35    $ 26.60         10,661     $ 26.73
                   ---------                             ---------     
$0.71-$29.00       6,717,142        8.51    $ 10.47      1,729,331     $  8.86
                   =========                             =========     

                                       39
<PAGE>

The Company accounts for its stock-based  compensation  plans in accordance with
APB Opinion No. 25,  "Accounting  for Stock  Issued to  Employees",  and related
interpretations. No compensation expense has been recognized for its stock-based
compensation  plans.  The following  table  summarizes  the Company's net income
(loss) and net income  (loss)  per share on a pro forma  basis had  compensation
cost for the Company's  stock-based  compensation plans been determined based on
the provisions of SFAS 123, "Accounting for Stock-Based Compensation":

(dollars In thousands, except per share amounts)

                                    1998              1997             1996
                                ---------------------------------------------
Net income (loss)--as reported  $    956        $  (5,526)      $   (2,644)
Net income (loss)--proforma       (6,915)         (12,497)          (7,320)
Diluted earnings (loss) per 
  share--as reported                0.03            (0.18)           (0.09)
Diluted earnings (loss) per 
  share--proforma                  (0.21)           (0.41)           (0.24)

The fair value of each option grant was estimated on the date of grant using the
Black-Scholes   option-pricing   model  with  the  following   weighted  average
assumptions used for grants in 1998, 1997 and 1996;  expected  volatility of 75%
for 1998 and 60% for 1997 and 1996; risk-free interest rates of 5.4% to 5.5% for
1998 and 5.3% to 5.6% for 1997 and 5.8% to 6.9% for 1996;  and an expected  life
of 1 year from vest date. Pro forma compensation cost of shares issued under the
Employee  Qualified  Stock Purchase Plans is measured based on the discount from
market value.

Note 10.  Income Taxes

         The provision (benefit) for income taxes consists of the following:

(dollars in thousands)
------------------------
Years ended December 31,                1998             1997              1996
                                   ---------------------------------------------
Current:
     Federal                       $   (405)         $   785           $ 2,930
     State                               32              (40)               75
     Foreign                            198              841             2,241

Deferred:
     Federal                            (20)          (1,963)             (772)
     State                               40           (1,168)              (18)
     Foreign                            546             (642)                0
                                   ---------          -------          ---------
Total provision                    $    391           (2,187)          $ 4,456
                                   =========          =======          =========

The valuation allowance increased by $9.9 million,  $1.4 million,  and $9,000 in
the years ended December 31, 1998, 1997 and 1996, respectively.

A reconciliation of the Company's  effective tax rate (benefit)  compared to the
statutory Federal tax rate is as follows:


Years ended December 31,                           1998        1997       1996
                                                   -----------------------------
Income taxes (benefit) at statutory Federal rate     35%        (35%)      35%
State taxes (benefit), net of Federal benefit         5          (6)         4
Unbenefited/utilized domestic losses                153           0         42
Foreign tax rate differential/unbenefited losses   (163)         11       (130)
Non-deductible acquisition costs                      0           0        291
Other                                                (1)          2          4
                                                   -----       ------     ------
Total                                                29%        (28%)       246%
                                                   =====       ======     ======

                                       40
<PAGE>

The Company  provides  deferred income taxes for temporary  differences  between
assets  and  liabilities  recognized  for  financial  reporting  and  income tax
purposes.  The income tax effects of these  temporary  differences  representing
significant  portions of the deferred  taxes at December 31, 1998,  and December
31, 1997 are as follows:

(dollars in thousands)
------------------------
December 31,                                     1998               1997
                                           ----------------------------------
Deferred taxes:
  Foreign loss carryforwards                $   1,768          $   2,788
  Domestic loss carryforwards                  22,540             11,928
  Tax credit carryforwards                      6,934              3,159
  Accrued expenses                              1,874              2,954
  Sales returns and allowance reserves            982              1,111
  Capitalized software                           (319)              (272)
  Depreciable assets                            1,070                857
  Residual U.S. tax on foreign earnings        (4,504)            (4,027)
  Other                                          (528)             1,963
                                            ----------         -----------
Total                                          29,817             20,461
Valuation allowance                           (24,374)           (14,452)
                                            ----------         -----------
Net deferred tax asset                      $   5,443          $   6,009
                                            ==========         ===========

The Company has $66.3 million in domestic net operating loss carryforwards which
can be utilized to reduce future  taxable  income.  Any unutilized net operating
loss  carryforward  will begin  expiring in 2004. The Company has a $6.9 million
tax credit  carryforward  which will expire  beginning in 2002.  Utilization  of
$14.9 million of the loss carryforward will be recorded to stockholders'  equity
when utilized.

At December 31, 1998,  the Company had Dutch,  French and German  subsidiary tax
loss  carryforwards  relating  to its  foreign  subsidiary  operations  of  $0.6
million, $1.9 million and $2.5 million,  respectively.  The Dutch and German tax
loss carryforwards  have no expiration.  French losses of $61,000 will expire in
2000. The Company has not provided any residual U.S. tax on approximately  $16.4
million  of a  portion  of  the  Company's  foreign  subsidiaries  undistributed
earnings as the Company intends to indefinitely reinvest such earnings.

Note 11. Operating Segment and Geographic Information

         Operating  segments are defined as components  of an  enterprise  about
which separate financial information is available that is evaluated regularly by
the Company's  chief  operating  decision  maker,  or decision  making group, in
deciding how to allocate resources and in assessing  performance.  The Company's
chief  operating  decision maker is its Chief Executive  Officer.  The operating
segments of the Company are managed separately because each segment represents a
strategic business unit that offers different products or services.

The Company's reportable operating segments include Software, Hardware, Customer
Support, and Professional  Services. The Software operating segment develops and
markets the  Company's  line of integrated  document  management  software.  The
Hardware  operating segment  manufactures and markets the Company's line of OSAR
libraries.  The Customer  Support segment provides  after-sale  support for both
software and hardware products as well as providing  software upgrades under the
Company's upgrade assurance program. The Professional  Services segment provides
fee-based  implementation  and  technical  services  related  to  the  Company's
products.

The  accounting  policies of the  Company's  operating  segments are the same as
those  described in Note 1--Summary of Significant  Accounting  Policies--except
that the disaggregated  financial results of the segments reflect  allocation of
certain functional expense  categories  consistent with its internal  reporting.
The Company evaluates performance based on stand-alone segment operating income.
Because the Company does not evaluate  performance  based on return on assets at
the operating segment level,  certain Company assets are not tracked  internally
by segment. Therefore, segment asset information is not presented.

                                       41
<PAGE>

Operating segment data for each of the three years in the period ending December
31, 1998 was as follows:

<TABLE>
<CAPTION>
(in thousands)                                             Customer  Professional  Education
---------------                    Software    Hardware     Support     Services   and Other  Consolidated
Year Ended December 31, 1998
<S>                                <C>          <C>         <C>         <C>         <C>       <C>
Revenue                            $171,153    $ 23,579    $ 73,524    $ 26,383    $ 15,594   $310,233
Depreciation and amortization         9,061         652       3,906       1,047         694     15,360
Operating income (loss) before
      other income                  (17,023)      1,807      12,023        (649)      1,349     (2,493)
Assets                                                                                         206,822
Capital expenditures                 19,383       1,118       8,341       2,510       1,122     32,474

Year Ended December 31, 1997
Revenue                            $132,723     $ 29,422   $ 54,417    $ 18,996    $ 15,867   $251,425
Depreciation and amortization         7,582          971      2,926         898         816     13,193
Operating income (loss) before
     other income                   (19,779)         107      7,035          22       1,742    (10,873)
Assets                                                                                         179,440
Capital expenditures                  8,462          864      3,155       1,063         722     14,266

Year Ended December 31, 1996
Revenue                            $140,659     $ 46,136   $ 44,136    $ 20,317    $ 17,665   $268,913
Depreciation and amortization         7,939        1,194      2,791         509         703     13,136
Operating income (loss) before
     other income                    (7,917)      (1,651)     5,335        (308)      3,515     (1,026)
Assets                                                                                         192,274
Capital expenditures                 11,771        1,750      2,840         781         724     17,866
</TABLE>

Revenue is attributed to geographic areas based on the location of the entity to
which the products or services were sold. The operation in Ireland  functions as
a  manufacturing  and  service  center  for  non-United  States  customers.   An
allocation  of its assets  among the  geographic  segments is not  prepared  for
management reporting. Information concerning principal geographic areas in which
the Company operates was as follows:
<TABLE>
<CAPTION>
(in thousands)
-----------------------
Year ended December 31,             1998                     1997                     1996
                             ------------------       ------------------       ------------------
                             Revenue     Assets       Revenue     Assets       Revenue     Assets
<S>                         <C>        <C>           <C>        <C>           <C>        <C>
North America:
     United States          $205,797   $142,471      $170,116   $123,681      $173,436   $128,375
     Canada                    6,669      1,869         8,027      2,263         3,889      2,491
                            -------------------      -------------------      -------------------
     Total North America     212,466    144,340       178,143    125,944       177,325    130,866
Europe:
     France                    7,516      5,562         6,961      2,481         5,616      3,049
     Germany                  30,675     14,450        21,665      9,100        35,431     10,991
     United Kingdom           20,882      9,800        16,838      8,007        19,437      9,242
     Ireland                       0     23,551             0     29,411             0     32,349
     Other Europe             19,373      4,172         9,358        961        10,507      1,736
                            -------------------      -------------------      -------------------
     Total Europe             78,446     57,535        54,822     49,960        70,991     57,367
Asia Pacific                  10,058      4,782        13,892      3,494        14,642      4,055
All other international        9,263        165         4,568         42         5,955        (14)
                            -------------------      -------------------      -------------------
Totals                      $310,233   $206,822      $251,425   $179,440      $268,913   $192,274
                            ===================      ===================      ===================
</TABLE>

Note 12.  Contingencies

In October 1994, Wang Laboratories,  Inc. (Wang) filed a complaint in the United
States  District  Court for the  District  of  Massachusetts  alleging  that the
Company is infringing  five patents held by Wang (the FileNET Case). On June 23,
1995,  Wang amended its complaint to include an additional  related  patent.  On

                                       42
<PAGE>
July 2, 1996,  Wang filed a complaint in the same court alleging that Watermark,
formerly  a  wholly-owned  subsidiary  that  was  merged  into the  Company,  is
infringing  three of the same  patents  asserted in the initial  complaint  (the
Watermark Case). On October 9, 1996, Wang withdrew its claim in the FileNET Case
that one of the patents it  initially  asserted is  infringed  by the  Company's
products that were  commercialized  before the initial complaint was filed. Wang
reserved  the  right to  assert  that  patent  against  the  Company's  products
commercialized after that date in a separate lawsuit.

In March 1997, Eastman Kodak Company (Kodak) purchased the Wang imaging business
unit that has responsibility  for this litigation.  The patents in the suit have
been  transferred to a Kodak  subsidiary,  Kodak Limited of England,  which,  in
turn,  has  exclusively  licensed  them to  another  Kodak  subsidiary,  Eastman
Software,  Inc. in the United  States  (Eastman).  On July 30,  1997,  the Court
permitted  Eastman  and  Kodak  Limited  of  England  to be  substituted  in the
litigation in place of Wang.

The Company has moved for summary judgement on noninfringement as to each of the
five patents in the suit,  and for summary  judgment of  invalidity as to one of
the  patents.   Eastman   moved  for  summary   judgment  as  to  the  Company's
unenforceability  defense on one of the patents.  In July 1998,  the  Magistrate
Judge  assigned to the case,  heard oral  arguments on the Company's  motion for
summary  judgement that U.S.  Patent  4,918,588 is not infringed and is invalid.
The  Magistrate  Judge has not yet decided these motions.  The Company  believes
that after he has ruled on these  motions,  he will hear oral  arguments  in the
remaining motions in the sequence in which they were filed. A trial date has not
been set.

If it should be determined that the patents at issue in the litigation are valid
and  are  infringed  by any  of  the  Company's  products,  including  Watermark
products,  the Company will,  depending on the product,  redesign the infringing
products  or seek to obtain a license  to market the  products.  There can be no
assurance  that the Company will be able to obtain such a license on  acceptable
terms.  Based on the  Company's  analysis  of these  Eastman  patents  and their
respective file histories, the Company believes that it has meritorious defenses
to Eastman's claims;  however,  the ultimate outcome or any resulting  potential
loss cannot be determined at this time.

On  December  20,  1996,  plaintiff  Michael  I.  Goldman  filed a class  action
complaint  against the Company and certain of its officers and  directors in the
Superior Court of California,  County of Orange (the Goldman State Action).  The
action was purportedly filed on behalf of a class of purchasers of the Company's
common  stock  during the period  October 19,  1995  through  July 2, 1996.  The
plaintiff alleged that the Company and other defendants violated Cal. Corp. Code
ss.ss.  25400 and 25500,  Cal. Civ. Code ss.ss.  1709-1710 and Cal. Bus. & Prof.
Code ss.ss.  17200 et seq. in connection with various public  statements made by
the Company and certain of its officers and directors  during the putative class
period. On September 30, 1998, the Court entered an order dismissing this action
in its entirety without prejudice.

On April 1, 1997,  plaintiff  Michael I.  Goldman  filed  another  class  action
complaint  against the Company and certain of its officers and  directors in the
United States District Court for the Central District of California (the Goldman
Federal Action). The action purportedly was filed on behalf of the same class of
purchasers  of the  Company's  common  stock as the Goldman  State  Action.  The
allegations  contained  in the Goldman  Federal  Action were very similar to the
allegations  contained  in the  Goldman  State  Action,  except that the Goldman
Federal  Action  asserts claims under Sections 10(b) and 20(a) of the Securities
Exchange Act and Rule 10b-5.  On September 23, 1998,  the Court entered an order
dismissing this action in its entirety without prejudice.

On October 23, 1998, plaintiff Avram Gart filed a class action complaint against
the Company and certain of its officers and  directors in the Superior  Court of
California, County of Orange (the Gart State Action). The action was purportedly
filed on behalf of a class of purchasers  of the  Company's  common stock during
the period January 13, 1998 through October 7, 1998. The plaintiff  alleges that
the Company and the other defendants  violated Cal. Corp. Code ss.ss.  25400 and
25500 in  connection  with  various  public  statements  made by the Company and
certain of its  officers and  directors  during the putative  class  period.  On
November  5, 1998,  the court  entered an order  dismissing  this  action in its
entirety  without  prejudice.

On October 27, 1998,  plaintiff Thomas P. Nyquist filed a class action complaint
against  the Company and certain of its  officers  and  directors  in the United

                                       43
<PAGE>

States  District  Court for the Central  District  of  California  (the  Nyquist
Federal  Action).  The  action  was  purportedly  filed on  behalf of a class of
purchasers  of the  Company's  common  stock  during the period  April 16,  1998
through  October 7, 1998. The plaintiff  alleges claims under Sections 10(b) and
20(a) of the Securities  Exchange Act and Rule 10b-5 in connection  with various
public  statements made by the Company and certain of its officers and directors
during the putative class period.  The complaint seeks unspecified  compensatory
damages, interest, attorneys' fees, expert witness fees and costs. Plaintiff has
filed a motion for the appointment of lead plaintiffs and  consolidation  of any
future related actions.  Defendants have not yet responded to the complaint. The
Company  believes that all of the  allegations  contained in the Nyquist Federal
Action are without merit and intends to defend the actions vigorously.

The Company, in the normal course of business, is subject to various other legal
matters.  While the results of litigation  and claims  cannot be predicted  with
certainty,  the Company  believes  that the final outcome of these other matters
will not have a materially adverse effect on the Company's  consolidated results
of operations or financial condition.

Note 13.  Related Party Transactions

The Company  entered into a two-year  agreement  on May 20, 1997,  to employ its
current President and Chief Executive Officer. Under the terms of the agreement,
the Company  agreed to  reimburse  the  officer  for legal costs in  defending a
lawsuit from the officer's former employer. The case was settled and the cost to
the Company was charged to compensation expense in 1997.

Note 14.  Other Financial Instruments

The following table summarizes the notional amounts, which are equivalent to the
fair market value, of the Company's foreign currency  agreements entered into on
December 31, 1998 and 1997, all maturing in three months:
<TABLE>
<CAPTION>

At December 31,                         1998                                     1997
                          ---------------------------------      ----------------------------------
                          Notional Amount   Notional Amount      Notional Amount   Notional Amount
(in thousands)                  Purchased              Sold           Purchased               Sold
                          ---------------------------------      ----------------------------------
<S>                             <C>              <C>                  <C>                <C>
European currencies             $  11,238        $   (8,488)          $  31,261          $  35,775
Australian dollar                                    (2,938)                                (4,299)
Asian currencies                      929                                                     (698)
Canadian dollar                                        (522)                                (1,014)
                          ----------------------------------     ----------------------------------
         Total                  $  12,167        $  (11,948)          $  31,261          $  29,764
                          ==================================     ==================================
</TABLE>

                                       44
<PAGE>

Note 15.  Quarterly Financial Information (Unaudited)
<TABLE>
<CAPTION>

(Dollars in thousands, except per share amounts)
--------------------------------------------------
                                            First        Second       Third       Fourth      Fiscal
                                          Quarter       Quarter     Quarter      Quarter        Year
<S>                                     <C>          <C>          <C>         <C>          <C>
Year ended December 31, 1998
     Revenue                            $  73,609    $  80,372    $  71,152   $  85,100    $ 310,233
     Income (loss) before income taxes      3,555        6,528       (8,143)       (593)*      1,347
     Net income (loss)                      2,524        4,635       (5,779)       (424)         956
     Basic earnings (loss) per share         0.08         0.15        (0.18)      (0.01)        0.03
     Diluted earnings (loss) per share       0.08         0.14        (0.18)      (0.01)        0.03

Year ended December 31, 1997
     Revenue                            $  47,562    $  62,450    $  65,011   $  76,402    $ 251,425
     Income (loss) before income taxes    (13,082)      (5,353)*      2,627       8,095       (7,713)
     Net income (loss)                     (9,420)      (3,854)       1,891       5,857       (5,526)
     Basic earnings (loss) per share        (0.31)       (0.13)        0.06        0.19        (0.18)
     Diluted earnings (loss) per share      (0.31)       (0.13)        0.06        0.18        (0.18)

*Includes pre-tax charges of $2.0 million in the fourth quarter of 1998 and $6.0
million in the second quarter of 1997 for restructuring and other costs.
</TABLE>
                                       45
<PAGE>
To the Stockholders and the Board of Directors
FileNET Corporation

         We have audited the accompanying consolidated balance sheets of FileNET
Corporation and its subsidiaries (the Company) as of December 31, 1998 and 1997,
and the related consolidated statements of operations, comprehensive operations,
stockholders'  equity and cash  flows for each of the three  years in the period
ended December 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  assurances  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 presentation. We
believe that our audits provide a reasonable basis for our opinion.

         In our opinion, such consolidated  financial statements present fairly,
in all material respects,  the financial position of FileNET Corporation and its
subsidiaries  as of  December  31,  1998  and  1997  and the  results  of  their
operations  and their cash flows for each of the three years in the period ended
December 31, 1998 in conformity with generally accepted accounting principles.


/s/ Deloitte & Touche LLP


January 26, 1999
(March 10, 1999 as to Note 8)
Costa Mesa, California

                                       46