Consolidated Balance Sheets

                                                                 December 31,
(In thousands, except share and per share amounts)              1997       1996
--------------------------------------------------              ----       ----
Assets
Current assets:
   Cash and cash equivalents                                $ 37,344   $ 28,530
   Short-term marketable securities                           26,600     22,037
   Accounts receivable, net of allowances for doubtful
     accounts and sales returns of $4,415 and $5,325 at
     December 31, 1997 and 1996, respectively                 61,283     75,469
   Inventories                                                 3,541      8,794
   Prepaid expenses and other current assets                   8,309      8,336
   Deferred income taxes                                       6,439      5,641
                                                               -----      -----
Total current assets                                         143,516    148,807

Property, net                                                 27,587     28,329
Long-term marketable securities                                7,826     16,705
Other assets                                                     941      1,838
                                                                 ---      -----
Total assets                                                 $179,870  $195,679
                                                             ========  ========

Liabilities and stockholders' equity
Current liabilities:
   Accounts payable                                          $ 15,003  $ 16,752
   Accrued compensation                                        14,845    10,728
   Unearned maintenance revenue                                 8,848     5,554
   Accrued royalties                                            2,743     4,531
   Other accrued liabilities                                   19,190    21,903
                                                               ------    ------
Total current liabilities                                      60,629    59,468

Deferred income taxes                                             430     3,405
Stockholders' equity:
   Preferred stock-$.10 par value, 7,000,000 shares authorized;
     none issued and outstanding
   Common stock-$.01 par value, 100,000,000 shares authorized;
     15,560,838 and 15,230,566 shares issued and outstanding
     at December 31, 1997 and 1996, respectively              130,741   127,813
Retained earnings                                               2,348     7,874
Currency translation adjustment and other                      (4,146)    1,687
                                                               ------     -----
                                                               128,943  137,374
Treasury stock at cost: 410,000 and 200,000 shares at
  December 31, 1997 and 1996, respectively                      10,132    4,568
                                                                ------    -----
Total stockholders' equity                                     118,811  132,806
Total liabilities and stockholders' equity                    $179,870 $195,679

See accompanying  Notes to Consolidated Financial Statements.


                                       25
<PAGE>

                     Consolidated Statements of Operations

                                                       Year ended December 31,
(In thousands, except per share amounts)               1997      1996      1995
----------------------------------------               ----      ----      ----
Revenue
  Software revenue                                 $132,723  $140,659  $116,052
  Service revenue                                    89,280    82,118    67,174
  Hardware revenue                                   29,422    46,136    46,152
                                                     ------    ------    ------
Total revenue                                       251,425   268,913   229,378

Costs and expenses
  Cost of software revenue                           14,768    16,464    15,146
  Cost of service revenue                            56,503    53,568    44,277
  Cost of hardware revenue                           20,330    29,633    28,800
  Research and development                           39,575    36,502    24,711
  Selling, general and administrative               125,122   117,761    96,499
  Merger, restructuring, write-off of purchased
    in-process research and development and other
    costs                                             6,000    16,011     6,393
                                                      -----    ------     -----
Total costs and expenses                            262,298   269,939   215,826
                                                    -------   -------   -------
Operating income (loss)                             (10,873)   (1,026)   13,552
Other income, net                                     3,160     2,838     2,780
                                                      -----     -----     -----
Income (loss) before income taxes                    (7,713)    1,812    16,332
Provision (benefit) for income taxes                 (2,187)    4,456     8,116
                                                     ------     -----     -----
Net income (loss)                                  $ (5,526) $ (2,644)  $ 8,216
                                                   ========  ========   =======

Basic earnings (loss) per share                    $  (0.36) $  (0.18)  $  0.57

Diluted earnings (loss) per share                  $  (0.36) $  (0.18)  $  0.52

Weighted average shares outstanding - basic          15,155    15,007    14,430

Weighted average shares outstanding - diluted        15,155    15,007    15,856

See accompanying Notes to Consolidated Financial Statements.


                                       26
<PAGE>
Consolidated Statements of Stockholders' Equity
(In thousands)
<TABLE>
<CAPTION>
                                                                                 Currency
                                 Convertible                                  Translation
                               preferred stock     Common stock     Retained   Adjustment    Treasury stock
                               Shares    Amount  Shares    Amount   earnings        Other   Shares    Amount     Total
                               ------  --------  ------  --------   --------  -----------   ------  --------  --------
<S>                             <C>    <C>       <C>     <C>         <C>          <C>       <C>     <C>      <C>
Balances at January 2, 1995     1,532  $ 19,879  11,420  $ 78,778    $ 2,302      $    47                     $101,006
Stock options exercised                             542     7,471                                                7,471
Stock option income
  tax benefits                                              3,722                                                3,722
Common stock issued under the
  Employee Qualified Stock
  Purchase Plan                                      35       814                                                  814
Exercise of Saros warrants                          195     2,235                                                2,235
Conversion of Watermark
  redeemable convertible
  preferred stock to FileNET
  common stock                                    1,062     7,699                       8                        7,707
Foreign currency translation
  adjustment                                                                          (53)                         (53)
Net income                                                             8,216                                     8,216
Other                                                                                  40                           40
                               ------  --------  ------  --------   --------  -----------   ------  --------  --------
Balances at December 31, 1995   1,532    19,879  13,254   100,719     10,518           42                      131,158
Stock options exercised                             398     3,330                                                3,330
Stock option income
  tax benefits                                              2,606                                                2,606
Common stock issued under
  the Employee Qualified
  Stock Purchase Plan                                38     1,028                                                1,028
Exercise of Saros warrants                            9       251                                                  251
Conversion of Saros
  convertible preferred
  stock to FileNET
  common stock                 (1,532)  (19,879)  1,532    19,879
Repurchase of treasury
  shares at cost                                                                              (200)  $(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                    15,231   127,813      7,874        1,687     (200)   (4,568)  132,806
Stock options exercised                             242     1,721                                                1,721
Common stock issued under the
  Employee Qualified Stock
  Purchase Plan                                      88     1,207                                                1,207
Repurchase of treasury
  shares at cost                                                                              (210)   (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                    15,561  $130,741   $  2,348      $(4,146)    (410) $(10,132) $118,811
                               ======  ========  ======  ========   ========  ============  ======= ========= ========

See accompanying Notes to Consolidated Financial Statements.
</TABLE>


                                       27
<PAGE>

                      Consolidated Statements of Cash Flows

                                                       Year ended December 31,
(In thousands)                                         1997      1996      1995
--------------                                         ----      ----      ----
Cash flows from operating activities:
Net income (loss)                                  $ (5,526) $ (2,644) $  8,216
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                 10,011    1,393
    Depreciation and amortization                    13,289     13,049   12,075
    Provision for doubtful accounts                     350      1,205      857
    Deferred income taxes                            (3,773)      (790)     196
    Changes in operating assets and liabilities,
      net of effect of business acquisition:
        Accounts receivable                           9,365    (21,921) (10,722)
        Inventories                                   5,368     (2,161)  (1,464)
        Prepaid expenses and other current assets      (539)    (1,764)  (2,497)
        Accounts payable                             (1,273)       639    4,683
        Accrued compensation                          4,380       (270)   2,689
        Unearned maintenance revenue                  3,327       (207)   1,864
        Accrued royalties                            (1,788)       959    1,125
        Other                                         1,581      2,099    6,271
                                                      -----      -----    -----
Net cash provided by (used for) operating activities 24,761     (1,795)  24,686
                                                     ------     ------   ------
Cash flows from investing activities:
   Proceeds from sale of property                       264      3,304      393
   Capital expenditures                             (14,266)   (17,866) (14,692)
   Capitalized software development costs                                (1,600)
   Payment for purchase of IFSL, net of assets
     acquired                                                  (10,011)
   Purchases of marketable securities               (30,274)   (32,092) (49,815)
   Proceeds from sales and maturities of
     marketable securities                           32,946     39,990   45,402
                                                     ------     ------   ------
Net cash used for investing activities              (11,330)   (16,675) (20,312)
                                                    -------    -------  -------
Cash flows from financing  activities:
   Debt repayments, net                                                    (163)
   Proceeds from issuance of common stock             2,928      4,609   10,520
   Common stock repurchased                          (5,564)    (4,568)
   Stock option income tax benefits                              2,606    3,722
                                                      -----      -----    -----
Net cash provided by (used for) financing activities (2,636)     2,647   14,079
                                                     ------      -----   ------
Effect of exchange rate changes on cash and cash
  equivalents                                        (1,981)       975      (25)
                                                     ------        ---      ---
Net increase (decrease) in cash and cash equivalents  8,814    (14,848)  18,428
Cash and cash equivalents, beginning of year         28,530     43,378   24,950
                                                     ------     ------   ------
Cash and cash equivalents, end of year             $ 37,344   $ 28,530 $ 43,378
                                                   ========   ======== ========
Supplemental cash flow information
   Interest paid                                   $    201   $    443 $    229
   Income taxes paid                               $  3,050   $  3,236 $  3,527

See accompanying Notes to Consolidated Financial Statements.


                                       28
<PAGE>

                   Notes to Consolidated Financial Statements

                                     Note 1
                   Summary of Significant Accounting Policies

     Nature of Operations FileNET Corporation 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 60  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
a separate component of stockholders' equity.

     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 instruments
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 13).

     Fair Value of  Financial  Instruments  The  recorded  amounts of  financial
assets and liabilities at December 31, 1997 and 1996  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 5). 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
for  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.  Translation  adjustments
resulting  from this process are  included in  stockholders'  equity.  Revenues,
costs and expenses are translated at the rates of exchange prevailing during the
year. 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 6).

     Research and  Development  The Company  expenses  research and  development
costs as incurred.  Statement of Financial  Accounting  Standards (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 and $1.8  million for the
years ended December 31, 1996 and 1995, respectively.


                                       29
<PAGE>

                   Notes to Consolidated Financial Statements

     Revenue Recognition  Software revenue is generally  recognized when product
is  delivered  to the  customer in  accordance  with the  American  Institute of
Certified Public Accountants (AICPA) Statement of Position (SOP) 91-1, "Software
Revenue  Recognition."  The  Company  recognizes  other  revenue  at the time of
product delivery and accrues any remaining costs, including insignificant vendor
obligations.   Revenue  from  service  and  post-contract  customer  support  is
recognized ratably over the term of the contract.

     Product  Warranty The Company  provides a 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 incomes  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 9).

     Earnings (Loss) Per Share Beginning in 1997, the Company computes  earnings
or loss per  share in  accordance  with  SFAS No.  128,  "Earnings  Per  Share."
Earnings  (loss) per share for all prior years have been  restated to conform to
SFAS No. 128.  Earnings (loss) per share is computed using the weighted  average
number of common shares outstanding during the reporting period. Earnings (loss)
per share  assuming  dilution is computed  using the weighted  average number of
common shares  outstanding  and the dilutive  effect of potential  common shares
out-standing (see Note 4).

     Supplier  Concentrations  Certain components for the Company's  proprietary
12-inch OSARs are available from a limited  number of sources.  Any inability to
obtain  components  in the  amounts  needed on a timely  basis  could  result in
short-term  delays in product  shipments  which  could  have a material  adverse
effect on the  Company's  operating  results.  The Company has  qualified and is
selling 5 1/4 -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 8).

     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.

     Recent  Accounting   Pronouncements  In  1997,  SFAS  No.  130,  "Reporting
Comprehensive  Income"  and SFAS No.  131,  "Disclosures  about  Segments  of an
Enterprise  and Related  Information,"  were issued and are effective for fiscal
years  beginning  after December 15, 1997. In October 1997, the AICPA issued SOP
97-2, "Software Revenue  Recognition," which supersedes SOP 91-1. The provisions
of SOP 97-2 are effective for fiscal years  beginning  after  December 15, 1997.
The Company is reviewing  the impact of these  pronouncements  on its  financial
statements.

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

                                     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 of the  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 mil-lion were expensed in the first quarter of 1996.


                                       30
<PAGE>

     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.

     Acquisition of Watermark Software Inc. In August 1995, the Company acquired
Watermark by issuing  approximately  1.3 million  shares of FileNET common stock
and  approximately  152,000 options to purchase FileNET common stock in exchange
for all of the  outstanding  Watermark  stock and options.  The  transaction was
accounted for as a pooling-of-interests  for financial reporting purposes.  Fees
and expenses  aggregating  $6.4 million  were  expensed in the third  quarter of
1995.  Included in these fees and  expenses is the  write-off of $1.4 million of
capitalized  research and development  costs for FileNET projects made redundant
by the Watermark acquisition.

                                     Note 3
                         Restructuring and Other Costs

     The $6.0 million in  restructuring  and other charge 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 head-count in certain other areas
of the Company.  The restructuring and other charges include  approximately $1.9
million for severance payments for 111 employees, $2.2 million for the write-off
of impaired assets,  $0.4 million for facility closing costs and $1.5 million of
other charges.
     At December  31,  1997,  accrued  restructuring  and other  charges of $3.0
million are included in other accrued liabilities.  The Company anticipates that
the remaining restructuring costs will be paid during 1998.

                                     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 the
then outstanding shares of Watermark's  redeemable  convertible  preferred stock
and Saros' convertible preferred stock into FileNET common stock, which occurred
upon completion of the related acquisitions (see Notes 2 and 8):

                                                 Net                Per-Share
(In thousands, except per share amounts)      Income      Shares       Amount
----------------------------------------      ------      ------       ------

Year ended December 31, 1995
   Basic earnings per share                $8,216         14,430        $0.57
   Effect of dilutive stock options                        1,426
                                            -----          -----         ----
   Diluted earnings per share              $8,216         15,856        $0.52
                                           ======         ======        =====

     The weighted  average  number of shares  outstanding  for 1997 and 1996 was
15,154,563 and  15,007,233  respectively.  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 8).

                                     Note 5
                                  Inventories

Inventories consisted of the following at December 31:

(In thousands)                                              1997         1996
--------------                                              ----         ----
Raw materials                                             $1,831       $2,606
Work-in-process                                              950        2,648
Finished goods                                               760        3,540
                                                             ---        -----
Total                                                     $3,541       $8,794
                                                          ======       ======


                                       31
<PAGE>

                   Notes to Consolidated Financial Statements

                                     Note 6
                               Property and Leases

Property consisted of the following at December 31:

(In thousands)                                              1997         1996
--------------                                              ----         ----
Machinery, equipment and software                       $ 74,981     $ 66,404
Furniture and fixtures                                     8,808        9,242
Leasehold improvements                                     5,238        5,120
                                                           -----        -----
Total                                                     89,027       80,766
Less accumulated depreciation and amortization           (61,440)     (52,437)
                                                         -------      -------
Property, net                                           $ 27,587     $ 28,329
                                                        ========     ========

     The Company  leases its  corporate  office,  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 $10.8 million,  $9.6 million, and
$9.3 million for the years ended December 31, 1997, 1996 and 1995, respectively.
The following  table  summarizes  future minimum lease  payments  required under
operating leases:

(In thousands)
--------------
1998                                                                  $11,046
1999                                                                   10,211
2000                                                                    8,518
2001                                                                    7,117
2002                                                                    6,480
Thereafter                                                              7,711
                                                                        -----
Total                                                                 $51,083
                                                                      =======

                                     Note 7
                             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, 1997.
     The Company has four additional borrowing  arrangements with foreign banks,
which expire at various  times  during 1998,  under which the Company may borrow
approximately $2 million.  Borrowings under these  arrangements bear interest at
the various banks' prime rates plus 0.75% to 1.5%. Of the $2 million  available,
approximately  $1 million  may be  borrowed  on an  unsecured  basis,  while the
remaining $1 million is collateralized by cash deposits with the bank.
     There  were no  borrowings  outstanding  under any of the  arrangements  at
December 31, 1997 and 1996.
     Interest  expense was  $263,000,  $443,000 and $288,000 for the years ended
December 31, 1997, 1996 and 1995, respectively.

                                   Note 8
                              Stockholders' Equity

     Shareholder Rights Plan In October 1988, FileNET declared a dividend of one
common stock purchase right for each  outstanding  share of common stock.  Under
certain circumstances,  a right may be exercised to purchase one share of common
stock at an exercise price of $55, subject to certain antidilution  adjustments.
The rights  become  exercisable  if and when a person (or group of affiliated or
associated persons) acquires 25% or more of FileNET's  outstanding common stock,
or announces an offer that would result in such person acquiring 30% or more


                                       32
<PAGE>

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, 1998 and may be
redeemed  by  FileNET  at one cent per  right  at any time  before a person  has
acquired 25% 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 210,000 shares at an
aggregate  cost of $5.6 million.  During the first quarter of 1998,  the Company
repurchased  $4.4  million of its common  stock,  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 200,000 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  Qualified Stock Purchase Plan In March 1988,  FileNET adopted the
1988 Employee  Qualified  Stock  Purchase Plan (the Purchase  Plan).  A total of
600,000  shares of common stock are reserved  for  purchases  under the Purchase
Plan as  amended.  Under the terms of the  Purchase  Plan,  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  Plan  covers
substantially  all domestic  employees of the Company.  Eligible  employees  may
elect to have a portion of their  salaries  withheld  for the  purpose of making
purchases under the Purchase Plan. 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  Plan.  At December  31,  1997,  $360,850 had been
withheld from employees'  salaries pursuant to the Purchase Plan for the current
offering  period,  which  expires  on March 31,  1998.  At  December  31,  1997,
approximately 126,897 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  3,250,000  shares of the  Company's  common  stock were  reserved  for
issuance to employees,  officers and directors.  Options to purchase 541,415 and
821,548  common  shares were  exercisable  at December 31, 1997 and December 31,
1996, respectively.  In May 1995, the 1986 Plan was terminated and the remaining
reserve of 70,049 shares was transferred  into the 1995 Stock Option Plan and 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
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 1,600,000
shares of the  Company's  common stock were  reserved for issuance to employees,
officers and  directors.  This reserve was added to the 70,049  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.  As of  December  31,  1997,  960,867  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, 1997, 10,186 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 487,988  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, 1997, a total of 43,250  options were
outstanding and 30,543 were exercisable.


                                       33
<PAGE>

                   Notes to Consolidated Financial Statements

     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 70,000 shares at prices  ranging from $11.50
to $32.69 per share were  granted from  December  18, 1989 to May 24,  1995.  At
December  31,  1997,  options to  purchase  23,700  shares of common  stock were
exercisable  and 23,200 have been exercised to date. This plan was terminated in
May 1995 with respect to future  option  grants.  Future  grants to  nonemployee
directors are granted under the provisions of the 1995 Plan.

     In  August  1997,  the  Company  filed a Form S-8 with the  Securities  and
Exchange  Commission,  registering a Non-Statutory Stock Option Grant of 300,000
shares,  dated May 22, 1997,  to the  Company's  President  and Chief  Operating
Officer and a Non-Statutory Stock Option Grant of 80,000 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, 1997, no options were
exercisable related to these Non-Statutory Stock Option Grants.

     On July 11, 1997, the Company approved a stock option  cancellation/regrant
program which allowed employees,  excluding nonemployee  directors,  to exchange
outstanding  options with an exercise price greater than $18.00 for new options.
Outstanding  options of 1,552,525  shares were  canceled and regranted at $18.00
per share,  the current  market value on July 11,  1997.  Under the stock option
cancellation/regrant  pro-gram,  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
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 $26.00 for new options.  Outstanding options of 530,571 shares were
canceled and regranted at $26.00 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:

                                                                     Weighted
                                                                      Average
                                                       Number of     Exercise
                                                         Options        Price
                                                         -------        -----
Balances, January 1, 1995                              2,604,174       $15.27
   Granted (Weighted average fair value of $14.68)       771,674       $30.41
   Exercised                                            (542,142)      $13.78
   Canceled                                             (130,597)      $19.51
                                                        --------       ------
Balances, December 31, 1995                            2,703,109       $19.68
   Granted (Weighted average fair value of $14.96)     1,362,418       $36.65
   Exercised                                            (398,041)      $ 8.37
   Canceled                                             (866,603)      $43.34
                                                        --------       ------
Balances, December 31, 1996                            2,800,883       $22.22
   Granted (Weighted average fair value of $8.26)      2,801,049       $18.66
   Exercised                                            (241,704)      $ 7.12
   Canceled                                           (1,965,119)      $26.96
                                                      ----------       ------
Balances, December 31, 1997                            3,395,109       $17.62
                   === ====                            =========       ======


                                       34
<PAGE>

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

                          Options Outstanding            Options Exercisable
                 ------------------------------------   ---------------------
                                  Weighted
                                   Average   Weighted                Weighted
                                 Remaining    Average                 Average
Range of              Number   Contractual   Exercise        Number  Exercise
Exercise Price   Outstanding          Life      Price   Exercisable     Price
--------------   -----------          ----      -----   -----------     -----
$ 0.93 - $15.06      987,899          7.05     $12.48       346,807    $ 9.69
$15.13 - $17.87      199,798          5.15     $16.04       149,598    $15.79
$18.00 - $18.00    1,603,512          9.51     $18.00         2,084    $18.00
$18.38 - $53.50      603,900          8.67     $26.02       107,855    $20.97
                     -------          ----     ------       -------    ------
$ 0.93 - $53.50    3,395,109          8.39     $17.62       606,344    $13.23
                   =========          ====     ======       =======    ======

     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":

                                                      Year ended December 31,
(In  thousands, except  per share  amounts)          1997      1996      1995
-------------------------------------------          ----      ----      ----
Net income (loss) - as reported                   $(5,526)  $(2,644)   $8,216
Net income (loss) - pro forma                     (12,497)   (7,320)    7,273
Diluted earnings (loss) per share - as reported     (0.36)    (0.18)     0.52
Diluted  earnings (loss) per share - pro forma      (0.82)    (0.49)     0.46

     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 1997, 1996 and 1995;  expected volatility of 60%;
risk-free  interest rates of 5.3% to 5.6% for 1997 and 5.8% to 6.9% for 1996 and
1995; and an expected life of 1 year from vest date. Pro forma compensation cost
of options granted under the Employee  Qualified Stock Purchase Plan is measured
based on the discount from market value.

                                     Note 9
                                  Income Taxes

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

                                                      Year ended December 31,
(In  thousands)                                      1997      1996      1995
---------------                                      ----      ----      ----
Current:
   Federal                                        $   785    $2,930    $4,017
   State                                              (40)       75       867
   Foreign                                            841     2,241     2,458
Deferred:
   Federal                                         (1,963)     (772)      834
   State                                           (1,168)      (18)      (60)
   Foreign                                           (642)
                                                     ----      ----      ----
Total provision (benefit) for income taxes        $(2,187)   $4,456    $8,116
                                                  =======    ======    ======

     The valuation allowance increased by $1.4 million,  $9,000 and $3.5 million
in the years ended December 31, 1997, 1996 and 1995, respectively.


                                       35
<PAGE>

                   Notes to Consolidated Financial Statements

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

                                                     Year ended December 31,
                                                     1997      1996      1995
                                                     ----      ----      ----
Income taxes (benefit) at statutory Federal  rate    (35%)      35%       35%
State taxes (benefit), net of Federal benefit         (6)        4         5
Unbenefited/utilized domestic losses                            42        21
Foreign tax rate differential/unbenefited losses      11      (130)      (14)
Non-deductible acquisition costs                               291         5
Other                                                  2         4        (2)
                                                       -         -        --
Total                                                (28%)     246%       50%
                                                     ===       ===        ==

     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, 1997 and 1996 are as
follows:

                                                         Year ended December 31,
(In thousands)                                              1997         1996
--------------                                              ----         ----
Foreign loss carryforwards                              $  2,788     $  1,445
Domestic loss carryforwards                               11,928        9,198
Tax credit carryforwards                                   3,159        1,954
Accrued expenses                                           2,954        1,745
Sales returns and allowance reserves                       1,111        1,359
Capitalized software                                        (272)        (206)
Depreciable assets                                           857          802
Residual U.S. tax on foreign earnings                     (4,027)      (3,710)
Other                                                      1,963        2,661
                                                           -----        -----
Total                                                     20,461       15,248
Valuation allowance                                      (14,452)     (13,012)
                                                         -------      -------
Net deferred tax asset                                  $  6,009     $  2,236
                                                        ========     ========

     The Company has $35.1 million of domestic net operating loss carryforwards,
which can be utilized to reduce future  taxable  income.  Any net operating loss
carryforwards  not utilized will begin  expiring in 2004. The Company has a $3.2
million  tax  credit   carryforward,   which  will  expire  beginning  in  2004.
Utilization  of $1.1  million  of the  loss  carryforward  arising  from the tax
benefit related to the exercise of  nonqualified  stock options will be recorded
to stockholders' equity when utilized.
     At December 31, 1997,  the Company had Dutch,  United  Kingdom,  French and
German  subsidiary  tax loss  carryforwards  relating to its foreign  subsidiary
operations  of $1.7  million,  $1.6  million,  $1.9  million  and $3.0  million,
respectively.  The Dutch,  United Kingdom and German tax loss carryforwards have
no expiration. French losses of $0.2 million will expire in 1998.
     The Company has not provided any residual U.S. tax on  approximately  $16.1
million of the Company's foreign  subsidiaries  undistributed  earnings,  as the
Company intends to indefinitely reinvest such earnings.


                                       36
<PAGE>

                                    Note 10
                            Geographical Information

                                                     Year ended December 31,
(In  thousands)                                      1997      1996      1995
---------------                                      ----      ----      ----
Revenue
   United States*
      Customers                                  $173,588  $174,618  $155,728
      Intercompany                                 20,690    23,355    14,597
                                                   ------    ------    ------
         Total                                    194,278   197,973   170,325
   Europe*
      Customers                                    68,247    83,786    67,916
      Intercompany                                 21,547    15,815    11,448
                                                   ------    ------    ------
         Total                                     89,794    99,601    79,364
   Other
      Customers                                     9,590    10,509     5,734
      Intercompany                                  3,479     1,794     2,086
                                                    -----     -----     -----
         Total                                     13,069    12,303     7,820
      Eliminations                                (45,716)  (40,964)  (28,131)
                                                  -------   -------   -------
Total revenue                                    $251,425  $268,913  $229,378
                                                 --------  --------  --------
Operating income (loss)
   United States**                               $ (6,730) $(18,588) $    369
   Europe**                                        (2,999)   17,680    12,589
   Other                                              669     1,691       629
   Eliminations                                    (1,813)   (1,809)      (35)
                                                   ------    ------       ---
Total operating income (loss)                    $(10,873) $ (1,026) $ 13,552
                                                 --------  --------  --------
Assets
   United States                                 $125,091  $132,781  $151,929
   Europe                                          49,822    56,971    38,993
   Other                                            5,054     6,043     2,672
   Eliminations                                       (97)     (116)   (3,912)
                                                      ---      ----    ------
Total assets                                     $179,870  $195,679  $189,682
                                                 ========  ========  ========

*U.S.  revenue includes hardware sales to third-party  international  resellers.
European revenue includes software sales to third-party international resellers.
**U.S. operating income includes $4.3 million, $16.0 million and $3.9 million in
1997, 1996 and 1995,  respectively,  for merger,  restructuring and write-off of
purchased  in-process research and development costs.  European operating income
includes $1.5 million and $2.5 million for restructuring, merger and other costs
in 1997 and 1995, respectively.  Other operating income includes $.2 million for
restructuring and other costs in 1997. For all years presented,  U.S.  operating
income  (loss)  includes  certain  corporate   expenses  such  as  research  and
development, marketing communications and corporate administration, and European
and other operating income includes international headquarters expenses.


                                       37
<PAGE>

                   Notes to Consolidated Financial Statements

                                    Note 11
                                 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
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.
     FileNET 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  FileNET's
unenforceability defense on one of the patents. 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 (the Plaintiff) 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 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 alleges 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. The complaint seeks unspecified compensatory and punitive
damages,  interest,  payment of  attorney's  fees and costs,  and  equitable  or
injunctive relief.
     On April 1, 1997,  The  Plaintiff  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  Federal
Action).  The  action  purportedly  was  filed on  behalf  of the same  class of
purchasers of the Company's  common stock as the State Action.  The  allegations
contained in the Federal Action are very similar to the allegations contained in
the State Action,  except that the Federal  Action asserts claims under Sections
10(b) and 20(a) of the  Securities  Exchange Act and Rule 10b-5.  The  complaint
seeks  unspecified  compensatory  damages,  interest,  attorneys'  fees,  expert
witness fees,  costs and equitable or injunctive  relief.  On July 2, 1997,  the
court granted  plaintiff's  motion to be appointed  "lead  plaintiff"  under the
Private Securities Litigation Reform Act.
     In the  Federal  Action,  defendants  have  filed a motion to  dismiss  the
complaint  in its  entirety.  Plaintiff  has filed a motion to stay the  Federal
Action,  in light of the parallel  State Action.  The court is scheduled to hear
both of these motions during March 1998.
     In the State Action,  defendants moved to stay the action,  in light of the
parallel  Federal Action.  The trial court granted the motion to stay the action
as to  discovery on September  8, 1997.  Defendants  also  demurred and moved to
strike the  complaint.  The trial court  overruled  the  demurrer and denied the
motion to strike on October 21, 1997. On January 14, 1998,  the court entered an
order dismissing with prejudice two of plaintiff's  three causes of action:  the
claims under Cal. Civ. Code ss.ss.  1709-1710 and Cal. Bus. & Prof.  Code ss.ss.
17200 et seq.
     On January  30,  1998,  the trial  court in the State  Action  granted  the
Plaintiff's  motion to certify a class  composed of persons  who bought  FileNET
stock in California  only between October 19, 1995 and July 2, 1996. This ruling
is subject to revision  based on the decisions to be rendered by the  California
Supreme Court in Diamond Multimedia Systems, et al. v. Superior Court (Pass) and
StorMedia,  Inc., et al. v. Superior Court  (Werczberger).  The trial court also
denied the Plaintiff's motion to lift the discovery stay.
     The  Company  believes  that  all  of  the  allegations  contained  in  the
complaints  filed in the State and Federal Actions are without merit and intends
to defend the actions vigorously.


                                       38
<PAGE>

     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 12
                           Related Party Transactions

     The Company  entered into a two-year  agreement on May 20, 1997,  to employ
its new President and Chief Operating 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 total
cost to the Company was charged to compensation expense in 1997.
     Watermark originally entered into a republishing and distribution agreement
with  a UK  company  (the  Distributor)  which  provided  the  Distributor  with
exclusive  distribution rights of Watermark's  products in defined  territories.
The Chief  Executive  Officer of the  Distributor  is the brother of Watermark's
then President and Chief Executive  Officer.  During 1995,  Watermark elected to
purchase  the  portion  of  the   Distributor's   business  related  to  selling
Watermark's  products at a negotiated  price of $2.5 million that is included in
merger and other costs in 1995.

                                    Note 13
                          Other Financial Instruments

     The following table summarizes the notional amount,  which is equivalent to
the fair market value, of the Company's foreign currency agreements entered into
on December 31, 1997 and 1996, all maturing in three months:

                                                              At December 31,
(In thousands)                                              1997         1996
--------------                                              ----         ----
Australian Dollar                                        $ 4,299      $ 5,110
British Pound                                             11,586       17,070
Canadian Dollar                                            1,014        3,409
French Franc                                               5,247        5,118
German Mark                                               14,651       19,532
Irish Punt                                                   602        6,902
Japanese Yen                                                 330          266
Netherland Guilder                                         3,689        2,152
Singapore Dollar                                             368           82
                                                             ---           --
Total                                                    $41,786      $59,641
                                                         =======      =======

                                    Note 14
                  Quarterly Financial Information (Unaudited)

(In thousands,                        First   Second   Third    Fourth   Fiscal
except per share amounts)           Quarter  Quarter  Quarter  Quarter     Year
-------------------------           -------  -------  -------  -------     ----
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      (0.63)   (0.25)    0.12     0.39    (0.36)
 Diluted earnings (loss) per share    (0.63)   (0.25)    0.12     0.36    (0.36)
Year ended December 31, 1996
 Revenue                           $ 66,744  $64,997  $64,622  $72,550 $268,913
 Income (loss) before income taxes  (10,417) * 3,351    4,575    4,303    1,812
 Net income (loss)                  (11,820) * 2,513    3,431    3,232   (2,644)
 Basic earnings (loss) per share      (0.79)    0.17     0.23     0.22    (0.18)
 Diluted earnings (loss) per share    (0.79)    0.15     0.22     0.20    (0.18)

*Includes  charges  of $6.0  million  in the  second  quarter  of 1997 and $16.0
million in the first  quarter of 1996 for merger,  restructuring,  write-off  of
purchased in-process research and development and other costs.


                                       39
<PAGE>

Independent Auditors' Report

To the Stockholders and the Board of Directors
FileNET Corporation

     We have audited the  accompanying  consolidated  balance  sheets of FileNET
Corporation  and its  subsidiaries  as of December  31,  1997 and 1996,  and the
related  consolidated  statements of operations,  stockholders'  equity and cash
flows for each of the three years in the period ended  December 31, 1997.  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,  such consolidated  financial statements present fairly, in
all material  respects,  the financial  position of FileNET  Corporation and its
subsidiaries  as of  December  31,  1997  and  1996  and the  results  of  their
operations  and their cash flows for each of the three years in the period ended
December 31, 1997 in conformity with generally accepted accounting principles.



February 3, 1998
Costa Mesa, California