Management's  Discussion  and Analysis of Results of  Operations  and  Financial
Condition

     Results  of  Operations  The  following   discussion   should  be  read  in
conjunction  with the  Consolidated  Financial  Statements and Notes thereto for
FileNet Corporation ("FileNet" or the "Company") contained elsewhere herein.

     On March 1, 1996, the Company acquired all the outstanding  shares of Saros
Corporation  ("Saros").  The merger was accounted for as a  pooling-of-interests
for financial reporting purposes.  The historical  financial  statements for the
periods  prior to the  merger are  restated  as though  the  companies  had been
combined.  The Saros  stockholders  received an aggregate of  approximately  2.2
million  shares and options to purchase the  Company's  common stock in exchange
for all of  their  Saros  common  stock  and  options  (see  Note 2 to  Notes to
Consolidated Financial Statements for information related to the acquisition).

     Factors That May Affect Future  Operating  Results and Financial  Condition
The market for the Company's  products is characterized  by rapid  technological
developments,  evolving industry standards, changes in customer requirements and
frequent new product  introductions  and enhancements.  The Company's  continued
success will be  dependent  upon its ability to continue to enhance its existing
products,  develop and introduce, in a timely manner, new products incorporating
technological advances and respond to customer  requirements.  To the extent one
or more of the Company's  competitors introduce products that more fully address
customer requirements, the Company's business could be adversely affected. There
can be no  assurance  that the Company  will be  successful  in  developing  and
marketing  enhancements  to its  existing  products or new  products on a timely
basis or that any new or enhanced products will adequately  address the changing
needs of the marketplace.  If the Company is unable to develop and introduce new
products or enhancements to existing  products in a timely manner in response to
changing market conditions or customer requirements,  the Company's business and
operating results could be adversely affected. From time to time, the Company or
its  competitors may announce new products,  capabilities  or technologies  that
have the  potential  to  replace  or shorten  the life  cycles of the  Company's
existing  products.  There can be no assurance that  announcements  of currently
planned or other new products will not cause customers to delay their purchasing
decisions in anticipation of such products,  which could have a material adverse
effect on the Company's business and operating results.

     Prior growth rates in the Company's  revenue and operating  results  should
not necessarily be considered  indicative of future growth or operating results.
Future operating results will depend upon many factors, including the demand for
the Company's  products,  the effectiveness of the Company's efforts to continue
to integrate  various products it has developed or acquired through  acquisition
of  others  and to  achieve  the  desired  levels  of sales  from  such  product
integration,  the level of  product  and price  competition,  the  length of the
Company's sales cycle,  seasonality of individual customer buying patterns,  the
size and timing of  individual  transactions,  the delay or deferral of customer
implementations, the budget cycles of the Company's customers, the timing of new
product   introductions  and  product   enhancements  by  the  Company  and  its
competitors,  the mix of sales by products,  services and distribution channels,
levels of international sales,  acquisitions by competitors,  changes in foreign
currency  exchange  rates,  the ability of the Company to develop and market new
products and control costs, and general domestic and international  economic and
political  conditions.  As a result of these  factors,  revenues  and  operating
results for any quarter are subject to variation  and are not  predictable  with
any  significant  degree of  accuracy.  Therefore,  the  Company  believes  that
period-to-period  comparisons of its results of operations  are not  necessarily
meaningful and should not be relied upon as  indications of future  performance.
Moreover,  such factors could cause the Company's  operating  results in a given
quarter to be below the expectations of public market analysts and investors. In
either  case,  the  price of the  Company's  common  stock  could be  materially
adversely affected.

     The document imaging, workflow,  computer output to laser disk ("COLD") and
document  management  software  markets  are highly  competitive,  and there are
certain competitors of the Company with substantially greater sales,  marketing,
development and financial  resources.  The Company believes that the competitive
factors  affecting the market for its products and services  include  vendor and
product reputation;  product quality, performance and price; the availability of
products on multiple platforms;  product  scalability;  product integration with
other  enterprise  applications;  product  functionality  and features;  product
ease-of use; and the quality of customer  support  services  and  training.  The
relative  importance of each of these factors depends upon the specific customer
involved.  While the Company  believes it  competes  favorably  in each of these
areas,  there can be no assurance that it will continue to do so. Moreover,  the
Company's  present  or  future  competitors  may be  able  to  develop  products
comparable  or  superior  to those  offered by the  Company,  offer  lower price
products or adapt more quickly than the Company to new  technologies or evolving
customer  requirements.  Competition  is expected to  intensify.  In order to be
successful  in the future,  the Company  must respond to  technological  change,
customer  requirements and competitors' current products and innovations.  There
can be no assurance  that it will be able to continue to compete  effectively in
its market or that future competition will not have a material adverse effect on
its business, operating results and financial condition.

     The  Company's  success  depends  in part on its  ability  to  protect  its
proprietary  rights to the  technologies  used in its  principal  products.  The
Company  relies on a  combination  of  copyrights,  trademarks,  trade  secrets,
confidentiality procedures and contractual provisions to protect its proprietary
rights.  There  can be no  assurance  that  the  Company's  existing  or  future
copyrights, trademarks, trade secrets or other intellectual property rights will
be  of  sufficient  scope  or  strength  to  provide  meaningful  protection  or
commercial advantage to the Company.  FileNet has no software patents.  Also, in
selling  certain of its products,  the Company  relies on "shrink wrap" licenses
that are not signed by licensees and, therefore,  may be unenforceable under the

<PAGE>

laws of certain  jurisdictions.  In addition, the laws of some foreign countries
do not protect  the  Company's  proprietary  rights to the same extent as do the
laws of the United States. There can be no assurance that such factors would not
have a material adverse effect on the Company's business or operating results.

     The Company may from time to time be notified that it is infringing certain
patent or  intellectual  property  rights of others.  Combinations of technology
acquired through past or future  acquisitions and the Company's  technology will
create  new  products  and   technology   which  may  give  rise  to  claims  of
infringement. While no actions other than the ones discussed below are currently
pending  against  the Company for  infringement  of patent or other  proprietary
rights of third  parties,  there can be no assurance that third parties will not
initiate  infringement  actions against the Company in the future.  Infringement
actions can result in  substantial  cost to and  diversion  of  resources of the
Company.  If the Company  were found to infringe  upon the rights of others,  no
assurance can be given that licenses would be obtainable on acceptable  terms or
at all, that significant  damages for past infringement would not be assessed or
that further litigation  relative to any such licenses or usage would not occur.
The failure to successfully  defend any claims or obtain  necessary  licenses or
other rights, the ultimate disposition of any claims or the advent of litigation
arising out of any claims of infringement,  could have a material adverse effect
on the Company's business, financial condition or results of operations.

     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. 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  Software  Inc.
("Watermark"),  formerly a  wholly-owned  subsidiary  that was  merged  into the
Company,  is  infringing  three  of the same  patents  asserted  in the  initial
complaint.  On October 9, 1996,  Wang withdrew its claim that one of the patents
it  initially  asserted  is  infringed  by the  Company's  products  which  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.  Based on the  Company's  analysis  of these  Wang
patents and their  respective file histories,  the Company  believes that it has
meritorious  defenses to Wang's  claims;  however,  the ultimate  outcome or any
resulting potential loss cannot be determined at this time.

     In January 1997,  Wang and Eastman Kodak Company  ("Kodak")  announced that
they have  entered  into an  agreement  under which Kodak will  acquire the Wang
business unit that has  responsibility  for this litigation.  The acquisition is
scheduled to close in March-April  1997 and the Company can not predict what, if
any,  impact this will have on the  litigation.  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.

     The Company has entered into a number of  co-marketing  relationships  with
other companies such as Microsoft Corporation,  Compaq Computer Corporation, SAP
AG,  Hewlett-Packard  Company ("HP") and Sun Microsystems,  Inc. There can be no
assurance  that  these   companies   will  not  reduce  or   discontinue   their
relationships  with or support of the Company and its  products.  Disruption  of
these  relationships  could  have a  material  adverse  effect on the  Company's
business and operating results.

     The Company's  success  depends to a significant  degree upon the continued
contributions  of its  key  management,  marketing,  technical  and  operational
personnel,  including  members of senior  management and technical  personnel of
acquired companies.  The Company has no agreements  providing for the employment
of any of its key  employees or any fixed term  contracts  and the Company's key
employees may  voluntarily  terminate  their  employment with the Company at any
time.  The loss of the  services  of one or more key  employees,  including  key
employees of acquired  companies,  could have a material  adverse  effect on the
Company's  operating results.  The Company also believes its future success will
depend in large part upon its  ability to attract and retain  additional  highly
skilled management,  technical,  marketing,  product development and operational
personnel.  Competition  for such  personnel  is  intense,  and  there can be no
assurance  that the Company will be successful in attracting  and retaining such
personnel.

     Historically,  the Company has derived approximately one-third of its total
revenues from international sales.  International business is subject to certain
risks  including  varying  technical  standards,  tariffs  and  trade  barriers,
political and economic instability, reduced protection for intellectual property
rights in certain  countries,  difficulties in staffing and maintaining  foreign
operations,  difficulties in managing foreign distributors,  potentially adverse
tax consequences, currency exchange fluctuations, the burden of complying with a
wide variety of complex operations,  foreign laws,  regulations and treaties and
the possibility of difficulties in collecting accounts receivable.  There can be
no assurance  that any of these factors will not have a material  adverse effect
on the Company's business or operating results.

     The Company  recently  completed the  acquisitions of Watermark,  Saros and
International Financial Systems Ltd. ("IFSL").  These recent acquisitions by the
Company have presented and will continue to present it with numerous challenges,
including  difficulties in the assimilation of the operations,  technologies and
products of the acquired companies and managing separate geographic  operations.
The challenges have absorbed and may continue to absorb  significant  management
attention that would  otherwise be available for the ongoing  development of the
Company's  business.  If the  Company's  management  does not  respond  to these

<PAGE>

challenges  effectively,  the Company's results of operations could be adversely
affected.  Moreover,  there can be no assurance that the anticipated benefits of
the acquisitions will be realized.  The Company and the acquired companies could
experience  difficulties or delays in integrating their respective  technologies
or developing and  introducing new products.  In particular,  one of the reasons
for FileNet's acquisition of Saros was the perceived market potential for Saros'
new products,  including the recently  announced  @mezzanine  and Saros Document
Server for BackOffice,  which have yet to be proven in the marketplace,  as well
as other products  currently under  development.  Delays in or non-completion of
the  development  of these new  products,  or lack of market  acceptance of such
products,  could  have an  adverse  impact on the  Company's  future  results of
operations  and  result in a failure  to  realize  anticipated  benefits  of the
acquisitions.

     The  Company's   license   agreements  with  customers   typically  contain
provisions  designed to limit  their  exposure to  potential  product  liability
claims. However, it is possible that such limitation of liability provisions may
not be effective under the laws of certain  jurisdictions.  Although the Company
has not experienced any product  liability  claims to date, the sale and support
of  products  by them may  entail the risk of such  claims,  and there can be no
assurance  that the Company will not be subject to such claims in the future.  A
successful  product  liability  claim  brought  against the Company could have a
material  adverse  effect upon the  Company's  business,  operating  results and
financial condition.

     The Company believes that a variety of factors could cause the price of its
common stock to fluctuate,  perhaps substantially,  including quarter-to-quarter
variations in operating  results;  announcements of developments  related to its
business; fluctuations in its order levels; general conditions in the technology
sector or the worldwide economy; announcements of technological innovations, new
products  or  product  enhancements  by  the  Company  or its  competitors;  key
management  changes;  changes  in  joint  marketing  and  development  programs;
developments  relating  to  patents  or other  intellectual  property  rights or
disputes;  and developments in the Company's  relationships  with its customers,
distributors  and  suppliers.  In addition,  in recent years the stock market in
general, and the market for shares of high technology stocks in particular,  has
experienced  extreme price  fluctuations  which have often been unrelated to the
operating  performance of affected companies.  Such fluctuations could adversely
affect the market price of the Company's common stock.

     Revenue As shown  below,  the Company  derived 52% of its 1996 revenue from
the licensing of the Company's software products compared to 51% in 1995 and 42%
in 1994.  Service  revenue  consisting  of revenue  from  software  and hardware
maintenance services provided to the Company's customer installed base and other
revenue that includes professional services, training, and supplies increased to
31% of total revenue,  compared to 29% in 1995 and 32% in 1994. Hardware revenue
consisting primarily of 12-inch optical storage and retrieval libraries ("OSAR")
and third-party server hardware represented 17% of total revenue compared to 20%
in 1995 and 26% in 1994.
<TABLE>
<CAPTION>
                                                Percent           Percent
(Dollars in millions)                   1996    change    1995    change    1994  
<S>                                   <C>        <C>    <C>        <C>    <C>
Software revenue                      $140.7     21%    $116.1     43%    $ 81.1
  As a percentage of total revenue       52%               51%               42%
Service  revenue                      $ 82.1     22%    $ 67.2     11%    $ 60.7 
  As a percentage of total revenue       31%               29%               32%
Hardware revenue                      $ 46.1      -     $ 46.1     (9%)   $ 50.5
  As a percentage of total revenue       17%               20%               26%
                                      ------------------------------------------
Total revenue                         $268.9     17%    $229.4      19%   $192.3
                                      ==========================================
</TABLE>

     Total  revenue  increased  17% in 1996  and 19% in 1995.  Software  revenue
increased  in 1996 and 1995 from an increase in the volume of product  shipments
from the addition of new products and reselling  partners and additional revenue
generated  through the Company's  co-marketing  arrangement with HP. The Company
believes the software  revenue growth rate for 1996 was  negatively  impacted by
difficulties  experienced  with  integrating  the  Saros and  Watermark  selling
efforts and personnel into FileNet's sales organization.

     Service revenue increased 22% in 1996 compared to 11% in 1995. The increase
in  service  revenue  in 1996 was due to the  growth of the  Company's  customer
installed  base,  an increase in training  due  primarily to the training of new
resellers,  and the  recognition  of $7.6  million of revenue  from the sale and
repair of spare parts in connection  with the  continued  transition of hardware
maintenance  activities  to HP.  There were no such sales in 1995 and 1994,  and
future sales to HP are not expected to be significant in 1997. Growth in service
revenue in 1995 was lower due to the impact of the Company's decision in 1994 to
begin outsourcing its hardware maintenance to HP and others. By the end of 1995,
all worldwide  hardware  maintenance  was being  performed by third parties.  In
spite of this,  service  revenue  increased  in 1995  due to the  growth  of the
Company's  installed  base  and an  increase  in  the  volume  of  international
consulting contracts.

<PAGE>

     Hardware  revenue  remained  flat in 1996 compared to a 9% decline in 1995.
Despite  stronger  than  expected  OSAR sales in 1996 which  contributed  to the
consistency  of hardware  revenue  between  1996 and 1995,  the Company  expects
hardware  revenue  to  continue  to decline in both  absolute  dollars  and as a
percentage  of total  revenue as the Company  focuses on  increasing  its higher
margin software revenue.

     The Company sells its products through its direct sales force in Australia,
Canada,  France,  Germany,  the  United  Kingdom  and  the  United  States;  and
indirectly  in the United  States and in 60  countries  internationally  through
ValueNet partners,  resellers,  and OEMs. Domestic and international  revenue by
source are shown in the following table (revenue is attributed to the customer's
location):
<TABLE>
<CAPTION>
                                                Percent           Percent
(Dollars in millions)                   1996    change    1995    change    1994
<S>                                   <C>        <C>    <C>        <C>    <C>
Domestic
Software revenue                      $ 87.6     12%    $ 77.9     46%    $ 53.5
Service revenue                         61.4     29%      47.5      7%      44.6
Hardware revenue                        28.3      3%      27.4    (19%)     34.0
                                      ------------------------------------------  
Domestic revenue                      $177.3     16%    $152.8     16%    $132.1
  As a percentage of total revenue       66%               67%               69%

International
Software revenue                      $ 53.1     39%    $ 38.2     38%    $ 27.6
Service revenue                         20.7      5%      19.7     22%      16.1
Hardware revenue                        17.8     (5%)     18.7     13%      16.5
                                      ------------------------------------------
International revenue                 $ 91.6     20%     $76.6     27%    $ 60.2
  As a percentage of total revenue       34%               33%               31%
                                      ------------------------------------------
Total revenue                         $268.9     17%    $229.4     19%    $192.3
                                      ==========================================
</TABLE>

     Total domestic revenue  increased 16% in 1996 and 1995.  Domestic  software
revenue  increased  12% in 1996 compared to 46% in 1995 due to the reasons cited
above.  Domestic  service revenue  increased 29% in 1996 compared to 7% in 1995.
The increase in service  revenue for 1996 was positively  impacted by the repair
and sale of  spare  parts  to HP  discussed  above.  Domestic  hardware  revenue
increased  3% in 1996  compared to a 19%  decline in 1995 due to  stronger  than
expected sales of the Company's OSAR products. As a percentage of total revenue,
domestic revenue decreased to 66% in 1996 from 67% in 1995 and 69% in 1994. This
trend is expected to continue as the Company  continues to expand its operations
internationally.

     Total  international  revenue  increased  20% in  1996  and  27%  in  1995.
International  software revenue increased 39% in 1996, remaining fairly constant
with the 38% increase in 1995.  Service revenue  increased 5% in 1996 and 22% in
1995. The growth in  international  service  revenue slowed due to the impact of
hardware  maintenance  outsourcing  partially  offset  by  an  increase  in  the
international customer installed base.  International hardware revenue decreased
5% in 1996 as expected.  International  revenue as a percentage of total revenue
increased to 34% in 1996 from 33% in 1995 and 31% in 1994.

     Cost of Revenue Cost of revenue as a percentage  of revenue is shown in the
table below for each of the last three years:
<TABLE>
<CAPTION>
                                                Percent           Percent
(Dollars in millions)                   1996    change    1995    change    1994
<S>                                    <C>        <C>    <C>       <C>     <C>
Cost of software revenue               $16.5      9%     $15.1     21%     $12.5
  As a percentage of software revenue    12%               13%               15%
Cost of service revenue                $53.6     21%     $44.3      6%     $41.6
  As a percentage of service revenue     65%               66%               69%
Cost of hardware revenue               $29.6      3%     $28.8     (7%)    $31.0
  As a percentage of hardware revenue    64%               62%               61%
                                       -----------------------------------------
Cost of total revenue                  $99.7     13%     $88.2      4%     $85.1
                                       =========================================
</TABLE>

     The cost of software  revenue  includes  royalties  paid to third  parties,
amortization  of  capitalized   software  and  the  cost  of  manufacturing  and
distributing  software. In 1996 and 1995, the cost of software revenue increased
9% and 21%, respectively,  over the previous year due to the increased volume of
software  revenue.  The cost of  software  revenue as a  percentage  of software
revenue  decreased  to 12% in 1996  from  13% in 1995  and 15% in 1994  due to a
decrease in the amount of capitalized  software amortized and savings related to
the consolidation of software manufacturing and distributing activities.

<PAGE>

     The cost of service  revenue  includes  software  support and  professional
services personnel,  supplies, and the cost of third party hardware maintenance.
The  cost of  service  revenue  increased  21% in 1996  and 6% in 1995 due to an
increase in software support and professional  services personnel to support the
increase  in the  Company's  installed  base.  The cost of service  revenue as a
percentage of service revenue  decreased to 65% in 1996 from 66% in 1995 and 69%
in 1994.  The  decrease  in 1996 was the  result of the sale and repair of spare
parts at  favorable  margins in  connection  with the  continued  transition  of
hardware  maintenance  activities to HP, offset by lower margins associated with
international  maintenance.  The  decrease  in 1995 was the  result of  improved
efficiencies in the Company's  international  professional services and customer
support operations.

     The  cost  of  hardware   revenue  includes  the  Company's  cost  of  OSAR
manufacturing,   third-party   purchased  hardware  and  the  cost  of  hardware
integration personnel.  The cost of hardware revenue as a percentage of hardware
revenue has remained  relatively  consistent at 64% in 1996, 62% in 1995 and 61%
in 1994.  The slight  increase in 1996 was due to a less  favorable mix from the
Company's  OSAR  product  line and lower  margins  from  third  party  purchased
equipment.

Operating Expenses
<TABLE>
<CAPTION>
                                                Percent           Percent
(Dollars in millions)                   1996    change    1995    change    1994
<S>                                   <C>        <C>     <C>       <C>     <C>
Research and development              $ 36.5     48%     $24.7     35%     $18.3
  As a percentage of total revenue       14%               11%               10%
Selling, general and administrative   $117.8     22%     $96.5     35%     $71.3
  As a percentage of total revenue       44%               42%               37%
</TABLE>

     The Company's  research and development  expenses increased 48% in 1996 and
35% in 1995  due to the  addition  of  development  personnel  and  the  related
facilities  and  depreciation  expenses  to  fund  new  development  activities.
Research  and  development  expenses  reported  in the  above  table  are  after
capitalized  software development costs of $1.6 million in 1995 and $3.2 million
in 1994. As a percentage of total  revenue,  research and  development  expenses
increased to 14% in 1996 from 11% in 1995 and 10% in 1994.  The increase in 1996
was due to the  increase in research  and  development  personnel to support new
development  activities without the corresponding expected revenue growth, and a
decrease in the amount of capitalized  software  development costs. The increase
in 1995 was due to a decrease in the amount of capitalized  software development
costs.

     Selling,  general and administrative expenses increased 22% in 1996 and 35%
in 1995.  The increase in 1996 was due primarily to an increase in the number of
marketing and sales support personnel  employed  internationally  as the Company
expanded its  international  reseller and sales operations and to an increase in
commissions  associated with higher revenues.  The increase in 1995 was a result
of international expansion,  increased commissions, an adverse effect of foreign
currency  fluctuations  on  international  expenses,  the costs  associated with
implementing a new corporate  business  information  system and higher costs for
Watermark in relation to revenue due to its early stage of operations.  In 1996,
selling,  general and  administrative  expenses as a percentage of total revenue
increased to 44% from 42% in 1995 and 37% in 1994  primarily  due to the reasons
cited above.

     Geographic Information The operating loss from the United States operations
was $18.6 million in 1996  compared to operating  income of $0.4 million in 1995
and $14.4  million  in 1994.  The  decrease  in 1996 and 1995 was due to merger,
restructuring  and write-off of purchased  in-process  research and  development
costs and the  increase  in  corporate  research  and  development  and  general
administrative  expenses.  Operating income from European operations,  including
the income from all international  software sales, increased to $17.7 million in
1996 from $12.6 million in 1995 and $3.1 million in 1994.  Operating  income for
other  international  operations  increased  to $1.7  million  in 1996 from $0.6
million in 1995 and $0.2  million  in 1994 (see Note 9 to Notes to  Consolidated
Financial  Statements for  information  related to the operating  results of the
Company's various geographic locations).

     Merger,  Restructuring and Write-off of Purchased  In-process  Research and
Development  Costs The $16.0  million  merger,  restructuring  and  write-off of
purchased  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 IFSL  acquisition,  $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  charge represents the costs of
consolidating  the various  companies'  sales and  administrative  functions and
includes $1.4 million for  severance  payments for 30 employees and $0.4 million
for the write-off of certain  contractual  obligations and professional fees. At
December 31, 1996,  accrued  restructuring  costs of $1.3 million is included in
other  accrued   liabilities.   The  Company   anticipates  that  the  remaining
restructuring  costs  will be  expended  during  1997  (see  Note 2 to  Notes to
Consolidated Financial Statements for information related to the acquisitions of
Watermark, Saros and IFSL).

<PAGE>

     The  $6.4  million  merger,   restructuring   and  write-off  of  purchased
in-process  research and development costs in 1995 consisted of a charge for the
buyout of certain  Watermark  European  marketing and  manufacturing  rights,  a
write-off of capitalized  research and development expenses for FileNet projects
made redundant by the Watermark acquisition and other direct acquisition related
fees and expenses.

     Other Income Other income, net of other expenses,  was $2.8 million in both
1996 and 1995 and $1.8 million in 1994.  The increase in 1995 was  primarily due
to  increased  interest  income  on a  higher  balance  of cash  and  marketable
securities.

     Provision  for Income Taxes The  provision for income taxes was a charge of
$4.5 million in 1996,  down from $8.1 million and $5.4 million  recorded in 1995
and 1994, respectively. The Company's effective tax rate was 50% in 1995 and 27%
in 1994.  The 1996 effective tax rate is not  meaningful.  The 1996 provision is
impacted from  expensing the purchased  in-process  research and  development as
part of the acquisition of IFSL with no corresponding tax benefit, nondeductible
one-time  costs  associated  with the  Saros  merger  and a result  of  earnings
generated  in  certain  international  jurisdictions,  partially  offset  by the
benefit of tax losses incurred in the United States.

     The Company currently anticipates that the effective tax rate for 1997 will
be approximately  28%. However,  the actual tax rate may differ due to a variety
of factors  including  the  geographical  mix of revenues and the ability to use
certain deferred tax assets.

     Net Income (Loss) In 1996, the Company reported a net loss of $2.6 million,
or $0.18 per share, on 15.0 million shares outstanding compared to net income of
$8.2 million,  or $0.52 per share, on 15.9 million  weighted  average common and
common  equivalent  shares  outstanding in 1995 and $14.1 million,  or $0.95 per
share,  on 14.8 million  weighted  average common and common  equivalent  shares
outstanding  in 1994.  Income  before  one-time  after-tax  charges  for merger,
restructuring  and write-off of purchased  in-process  research and  development
costs of $16.0  million and $5.0  million for 1996 and 1995,  respectively,  was
$13.4 million,  or $0.83 per share, on 16.1 million  weighted average common and
common  equivalent  shares  outstanding in 1996,  compared to $13.2 million,  or
$0.83 per share, on 15.9 million weighted  average common and common  equivalent
shares  outstanding in 1995. The 1994 net income per share figure includes $0.12
per share due to a deferred revenue  transaction  related to the settlement of a
customer dispute.

     Foreign Currency  Fluctuations and Inflation The Company's  performance can
be affected by changes in foreign currency values relative to the U.S. dollar as
discussed above in relation to the Company's revenue and operating expenses. The
net  impact  to net  income  from  foreign  exchange  transactions  and  hedging
activities  are  immaterial  for all  periods  reported.  The  foreign  currency
translation  adjustment included in stockholders'  equity increased $1.7 million
during  1996 over  1995 due  primarily  to the  strength  of the Irish  currency
against the U.S. dollar applied to the Company's net assets in Ireland.

     Management  believes that inflation has not had a significant impact on the
prices of the Company's  products,  the cost of its materials,  or its operating
results during 1994 through 1996.

     Liquidity  and Capital  Resources As of December 31, 1996,  combined  cash,
cash equivalents,  and marketable  securities  (short- and long-term) were $67.3
million, a decrease of $23.3 million from the $90.6 million at the end of 1995.

     Cash used by operating  activities in 1996 was $1.8 million. The balance is
primarily  due to a net  loss  and the  effect  of  higher  accounts  receivable
balances   associated   with  higher  revenue  and  higher  average  sales  days
outstanding  offset  in  part by  the  noncash  additions  to net  loss  for the
write-off of  capitalized  and  purchased  in-process  research and  development
costs,  depreciation,  and  amortization of capitalized  software.  Cash used by
investing  activities totaled $16.7 million,  consisting of capital expenditures
and  the  purchase  of IFSL  (see  Note 2 to  Notes  to  Consolidated  Financial
Statements for information related to the Company's purchase of IFSL), offset by
proceeds  from the sale of equipment and the net sale and maturity of marketable
securities.  Net cash provided by financing  activities was $2.6 million and was
the result of proceeds from the issuance of common stock and stock option income
tax benefits offset by the repurchase of common stock.

     Cash  provided  by  operating  activities  in 1995 was $24.7  million.  The
balance is primarily  due to net income and the noncash  additions to net income
for  the  write-off  of  capitalized  and  purchased   in-process  research  and
development costs, depreciation,  and amortization of capitalized software. Cash
used by  investing  activities  totaled  $20.3  million,  consisting  of capital
expenditures,  capitalized software and a net purchase of marketable securities.
Net cash provided by financing  activities in 1995 was $14.1 million  consisting
of  proceeds  from the  issuance  of common  stock and stock  option  income tax
benefits.

     The  Company's  capital  expenditures  were $17.9  million  in 1996,  $14.7
million  in 1995,  and $11.0  million in 1994.  The  Company's  primary  capital
equipment expenditures are for research and development costs, demonstration and
training  equipment  and  enhancements  to its internal  business  systems.  The
Company  anticipates that it will acquire  approximately  $20 million of capital
equipment in 1997. The Company also  anticipates that its present cash balances,
together with internally generated funds and credit lines, will be sufficient to
meet its working capital and capital expenditure needs throughout 1997 (see Note
5 to Notes to Consolidated  Financial  Statements for information related to the
Company's credit facilities).


<PAGE>

     OTHER MATTERS On March 7, 1994, the Company's  Board of Directors  resolved
to dissolve  FileNet S.A., its French  subsidiary.  The Company is now marketing
and supporting its products and customers in France through a branch of the U.S.
corporation.  The dissolution of FileNet S.A.  resulted in a U.S. tax benefit in
1994 of approximately  $2.1 million due to the utilization of losses  previously
sustained by its French subsidiary.

     The Company is not aware of any issues  related to  environmental  concerns
that have or are expected to materially affect its business.

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     This annual report contains  forward-looking  statements that involve risks
and   uncertainties,   including,   but  not  limited  to,  those  discussed  in
"Management's  Discussion  and Analysis of Results of  Operations  and Financial
Condition - Factors  That May Affect  Future  Operating  Results  and  Financial
Condition"  in this annual  report and those  discussed  in  "Business - Certain
Considerations"  in the Company's  annual report on Form 10-K for the year ended
December  31,  1996.  The actual  results  that the Company  achieves may differ
materially   from  any   forward-looking   statements  due  to  such  risks  and
uncertainties.
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