Consolidated Balance Sheets
(In thousands, except share amounts)
<TABLE>
<CAPTION>
At December 31, 1996 and December 31, 1995                        1996      1995
Assets                                                        --------  -------- 
<S>                                                           <C>       <C>
Current assets:
  Cash and cash equivalents                                   $ 28,530  $ 43,378
  Short-term marketable securities                              22,037    28,782
                                                              --------  --------   
  Total cash and short-term marketable securities               50,567    72,160
  Accounts receivable (net of allowance for doubtful
   accounts of $2,140 and $1,540 at December 31, 1996
   and December 31, 1995, respectively)                         75,469    53,501
  Inventories                                                    8,794     6,620
  Prepaid expenses and other                                     8,336     6,573
  Deferred income taxes                                          5,641     3,735
                                                              --------  --------   
Total current assets                                           148,807   142,589
                                                              --------  --------   
Property, net                                                   28,329    25,796
Capitalized software, net                                            -     1,226
Long-term marketable securities                                 16,705    18,395
Other                                                            1,838     1,676
                                                              --------  --------
Total assets                                                  $195,679  $189,682
                                                              ========  ========   

Liabilities and Stockholders' Equity
Current liabilities:
  Accounts payable                                            $ 16,752  $ 16,073
  Accrued liabilities:
    Compensation                                                10,728    10,997
    Income taxes payable                                         2,152     2,228
    Unearned maintenance revenue                                 5,554     5,761
    Royalties                                                    4,531     3,572
    Other                                                       19,751    17,604
                                                              --------  --------  
Total current liabilities                                       59,468    56,235
                                                              --------  --------   
Deferred income taxes                                            3,405     2,289
Stockholders' equity:
  Convertible preferred stock - $.001 par value;
   authorized, 39,000,000 shares; 35,232,029 issued
   and outstanding shares and 1,531,485 common equivalent
   shares at the liquidation preference at December 31, 1995         -    19,879
  Common stock - $.01 par value; authorized, 100,000,000
   shares; issued and outstanding, 15,230,566 and 13,254,222  
   shares at December 31, 1996 and December 31, 1995,
   respectively                                                127,813   100,719
  Retained earnings                                              7,874    10,518
  Other                                                          1,687        42
                                                              --------  --------   
                                                               137,374   131,158
  Less 200,000 Treasury shares at cost                           4,568         -
                                                              --------  --------   
Total stockholders' equity                                     132,806   131,158
                                                              --------  --------   
Total liabilities and stockholders' equity                    $195,679  $189,682
                                                              ========  ========
</TABLE>
See notes to consolidated financial statements.

<PAGE>

Consolidated Statements of Operations
(In thousands, except per share amounts)
<TABLE>
<CAPTION>
Years ended December 31, 1996, December 31, 1995
and January 1, 1995                                     1996      1995      1994
                                                    --------  --------  --------
<S>                                                 <C>       <C>       <C>
Revenue
  Software revenue                                  $140,659  $116,052  $ 81,102
  Service revenue                                     82,118    67,174    60,753
  Hardware revenue                                    46,136    46,152    50,480
                                                    --------  --------  --------
Total revenue                                        268,913   229,378   192,335
                                                    --------  --------  --------
Costs and expenses
  Cost of software revenue                            16,464    15,146    12,472
  Cost of service revenue                             53,568    44,277    41,645
  Cost of hardware revenue                            29,633    28,800    30,999
  Research and development                            36,502    24,711    18,274
  Selling, general and administrative                117,761    96,499    71,267
  Merger, restructuring and write-off of purchased  
   in-process research and development costs          16,011     6,393         -
                                                    --------  --------  --------
Total costs and expenses                             269,939   215,826   174,657
                                                    --------  --------  --------
Operating income (loss)                               (1,026)   13,552    17,678
  Other income                                         2,838     2,780     1,821
                                                    --------  --------  --------
Income before income taxes                             1,812    16,332    19,499
  Provision for income taxes                           4,456     8,116     5,356
                                                    --------  --------  --------

Net income (loss)                                   $ (2,644) $  8,216  $ 14,143
                                                    ========  ========  ========

Net income (loss) per share                         $  (0.18) $   0.52  $   0.95
                                                    ========  ========  ========

Weighted average common and common equivalent
 shares outstanding                                   15,007    15,856    14,834
                                                    ========  ========  ========
</TABLE>
See notes to consolidated financial statements.

<PAGE>

Consolidated Statements of Stockholders' Equity
(In thousands, except share amounts)
<TABLE>
<CAPTION>
                                                           Convertible                                                            
                                     Common stock        preferred stock    Retained   Treasury stock
                                  Shares     Amount     Shares     Amount   earnings   Shares   Amount    Other     Total
                                ----------  --------  ---------  --------  --------- --------- --------  -------  ---------
<S>                             <C>         <C>       <C>        <C>       <C>        <C>      <C>       <C>      <C>
Balances,
 January 2, 1994                11,710,614  $ 73,518  1,357,656  $ 16,895  $(11,841)        -  $     -   $ (189)  $ 78,383
Stock options exercised            325,882     3,512                                                                 3,512
Income tax benefit from
 the exercise or disposition  
 of stock options                              1,142                                                                 1,142
Common stock issued under
 the Employee Qualified
 Stock Purchase Plan                43,222       658                                                                   658
Preferred stock
 issued by Saros                                        173,829     2,984                                            2,984
Watermark common stock
 converted to redeemable
 preferred stock                  (659,606)
Accretion to liquidation value  
 of Watermark redeemable
 preferred stock                                 (52)                                                                  (52)
Foreign currency translation
 adjustment                                                                                                 234        234
Net income                                                                   14,143                                 14,143
Other                                                                                                         2          2
                                ----------  --------  ---------  --------  --------- --------- --------  -------  ---------
Balances, 
 January 1, 1995                11,420,112    78,778  1,531,485    19,879     2,302         -        -       47    101,006
Stock options exercised            542,142     7,471                                                                 7,471
Income tax benefit from the
 exercise or disposition of
 stock options                                 3,722                                                                 3,722
Common stock issued under
 the Employee Qualified
 Stock Purchase Plan                35,235       814                                                                   814
Proceeds from exercise of
 Saros warrants                    194,421     2,235                                                                 2,235
Conversion of Watermark
 redeemable convertible
 preferred stock to FileNet
 common stock                    1,062,312     7,699                                                          8      7,707
Foreign currency translation
 adjustment                                                                                                 (53)       (53)
Net income                                                                    8,216                                  8,216
Other                                                                                                        40         40
                                ----------  --------  ---------  --------  --------- --------- --------  -------  ---------
Balances,
 December 31, 1995              13,254,222   100,719  1,531,485    19,879    10,518         -        -       42    131,158
Stock options exercised            398,041     3,330                                                                 3,330
Income tax benefit from the
 exercise or disposition of
 stock options                                 2,606                                                                 2,606
Common stock issued under
 the Employee Qualified
 Stock Purchase Plan                37,693     1,028                                                                 1,028
Proceeds from exercise of
 Saros warrants                      9,125       251                                                                   251
Conversion of Saros
 convertible preferred stock
 to FileNet common stock         1,531,485    19,879 (1,531,485)  (19,879)                                               -
Repurchase of treasury
 shares at cost                                                                      (200,000)  (4,568)             (4,568)
Foreign currency translation
 adjustment                                                                                               1,671      1,671
Net loss                                                                     (2,644)                                (2,644)
Other                                                                                                       (26)       (26)
                                ----------  --------  ---------  --------  --------- --------- --------  -------  ---------
Balances,
 December 31, 1996              15,230,566  $127,813          -  $      -  $  7,874  (200,000) $(4,568)  $1,687   $132,806
                                ==========  ========  =========  ========  ========= ========= ========  =======  =========
</TABLE>

See notes to consolidated financial statements.

<PAGE>

Consolidated Statements of Cash Flows
(In thousands)
<TABLE>
<CAPTION>

Years ended December 31, 1996, December 31, 1995
and January 1, 1995                                   1996       1995      1994
                                                   --------- --------- ---------
<S>                                                 <C>       <C>       <C>
Cash flows from operating activities
Net income (loss)                                 $ (2,644)  $  8,216  $ 14,143
Adjustments to reconcile net income (loss) to net
 cash provided by operating activities
  Write-off of capitalized and purchased in-process
   research and development costs                   10,011      1,393         -
  Depreciation and amortization                     11,823     10,275     8,531
  Software amortization                              1,226      1,800     3,600
  Provision for losses on accounts receivable          591        809       134
  Deferred taxes                                      (780)       196       440
  Changes in operating assets and liabilities,
   net of effect of business acquisition
     Accounts receivable                           (21,307)   (10,674)   (5,044)
     Inventories                                    (2,161)    (1,464)    2,115
     Prepaid expenses and other                     (1,764)    (2,497)      101
     Accounts payable                                  639      4,683     1,434
     Accrued liabilities
     Compensation                                     (270)     2,689     2,380
     Income taxes payable                             (174)       537    (1,907)
     Unearned maintenance revenue                     (207)     1,864        16
     Royalties                                         959      1,125       687
  Other                                              2,263      5,734       796
Net cash provided (used) by operating activities    (1,795)    24,686    27,426

Cash flows from investing activities
  Capital expenditures                             (17,866)   (14,692)  (11,033)
  Proceeds from sale of property                     3,304        393       946
  Capitalized software                                   -     (1,600)   (3,200)
  Payment for purchase of IFSL, net of
   assets acquired                                 (10,011)         -         -
  Purchase of marketable securities                (32,092)   (49,815)  (45,346)
  Proceeds from sale and maturity of
   marketable securities                            39,990     45,402    24,036
Net cash used by investing activities              (16,675)   (20,312)  (34,597)

Cash flows from financing activities
  Debt repayments, net                                   -       (163)     (650)
  Short-term bank borrowings, net                        -          -    (2,855)
  Proceeds from notes receivable from stockholders       -          -     1,250
  Proceeds from issuance of convertible preferred
   and common stock                                  4,609     10,520    11,084
  Common stock repurchased                          (4,568)         -         -
  Stock option income tax benefits                   2,606      3,722     1,142
Net cash provided by financing activities            2,647     14,079     9,971
Effect of exchange rate changes on cash and
 cash equivalents                                      975        (25)       (6)

Net increase (decrease) in cash and 
 cash equivalents                                  (14,848)    18,428     2,794
Cash and cash equivalents, beginning of year        43,378     24,950    22,156
Cash and cash equivalents, end of year            $ 28,530   $ 43,378  $ 24,950

Supplemental cash flow information
  Interest paid                                   $    443   $    229  $    194
  Income taxes paid                               $  3,236   $  3,527  $  5,286
</TABLE>

See notes to consolidated financial statements.

<PAGE>

Notes to Consolidated Financial Statements

     Note 1: Summary of Significant Accounting Practices

     Nature of  Operations  FileNet  Corporation  ("FileNet"  or the  "Company")
develops,   markets  and  services  an  open,  integrated  family  of  workflow,
document-imaging,  electronic  document-management  and computer output to laser
disk ("COLD") client/server software solutions.  The Company's software products
manage and  control  the  movement  of  document  images,  data,  text and other
information   throughout   an   enterprise.   Software   from  FileNet   enables
organizations in industries, such as banking and financial services,  insurance,
manufacturing,  services, telecommunications and healthcare and in all levels of
government worldwide,  to maximize enterprise  productivity.  Additionally,  the
Company  manufactures a line of 12-inch optical storage and retrieval  libraries
(OSARs).  The  Company  markets  its  products  through a direct  sales force in
Australia,  Canada,  France,  Germany, the United Kingdom ("UK"), and the United
States. In addition,  the Company markets through ValueNet  partners,  resellers
and OEMs in both the United States and international markets.

     Consolidation The consolidated financial statements include the accounts of
FileNet  and  its  wholly-owned  subsidiaries.  All  intercompany  balances  and
transactions  have been eliminated.  Watermark  Software Inc.  ("Watermark") and
Saros Corporation ("Saros"), formerly wholly-owned subsidiaries of FileNet, were
merged into FileNet on July 25, 1996 and August 26, 1996, respectively (see Note
2).

     Year End The Company  changed its fiscal year end to December 31  beginning
in fiscal 1996.  The Company's  year end had been the Sunday closest to December
31. Fiscal 1995 ended on December 31, 1995,  and fiscal 1994 ended on January 1,
1995.

     Investments  The  Company  accounts  for  investments  in  accordance  with
Statement of Financial  Accounting  Standards ("SFAS") No. 115,  "Accounting for
Certain  Investments and Equity  Securities." The Company's  investments consist
primarily of high-grade  corporate and government  securities with maturities of
less than three  years and  considers  investments  purchased  with an  original
maturity of three months or less 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 the  unrealized  gains  and  losses,  net of tax,
reported  in  a  separate  component  of  stockholders'  equity.   Realized  and
unrealized gains and losses on available-for-sale securities were immaterial.

     Other Financial  Instruments Effective January 2, 1995, the Company adopted
the  provisions  of  SFAS  No.  119,   "Disclosure  about  Derivative  Financial
Instruments  and Fair Value of Financial  Instruments."

     The Company  enters into  forward  foreign  exchange  contracts  as a hedge
against  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  statement 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,  and the Company does not  anticipate a loss  resulting from any
credit risk of these institutions.

     At  December  31,  1996 and  December  31,  1995,  the  Company had forward
currency sales  contracts open in 10 currencies  with a notional amount of $59.6
million and 7 currencies with a notional amount of $27.1 million,  respectively;
all having maturities within three months.  The unrealized gains and losses from
these contracts were immaterial at both December 31, 1996 and December 31, 1995.

     Fair Value of  Financial  Instruments  The  recorded  amounts of assets and
liabilities at December 31, 1996 and December 31, 1995 approximate fair value in
accordance  with  SFAS No.  107,  "Disclosures  About  Fair  Value of  Financial
Instruments" 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 3). The Company regularly  monitors  inventory for excess or
obsolete items and makes any necessary adjustments at each balance sheet date.

     Foreign  Currency  Translation  In  accordance  with SFAS No. 52,  "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 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 4).

<PAGE>

     Research and  Development  The Company  expenses  research and  development
costs as incurred.  SFAS No. 86,  "Accounting for the Costs of Computer Software
to Be Sold,  Leased,  or Otherwise  Marketed,"  does not  materially  affect the
Company. The Company did capitalize certain software development costs up to and
including the second  quarter of 1995.  Capitalization  was $1.6 million for the
year ended  December  31, 1995 and $3.2  million  for the year ended  January 1,
1995.  The  Company  amortized  the  remaining  capitalized  software,   net  of
accumulated  amortization during 1996.  Capitalized  software net of accumulated
amortization  was  amortized  over the  expected  life of the related  products,
estimated to be one year  commencing  upon the delivery of the related  product.
Amortization  expense was $1.2 million,  $1.8 million,  and $3.6 million for the
years  ended  December  31,  1996,  December  31,  1995,  and  January  1, 1995,
respectively.

     Included  in  1996  merger,   restructuring   and  write-off  of  purchased
in-process  research and development  costs is the write-off of $10.0 million of
in-process   research  and   development   costs  related  to  the  purchase  of
International  Financial  Systems,  Ltd.  ("IFSL").  Included  in  1995  merger,
restructuring  and write-off of purchased  in-process  research and  development
costs is the write-off of $1.4 million of capitalized  research and  development
expenses for FileNet  projects made redundant by the Watermark  acquisition (see
Note 2).

     Revenue Recognition Revenue from software and hardware sales related to the
Company's electronic document-management, document-imaging and workflow software
products is generally  recognized  when the product is delivered to the customer
in  accordance  with the  American  Institute of  Certified  Public  Accountants
Statement  of  Position  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 Company  accounts for income taxes under the provisions of
SFAS No. 109, "Accounting for Income Taxes" (see Note 7).

     Net Income (Loss) Per Share Net loss per share for the year ended  December
31, 1996 was computed using the weighted  average number of actual common shares
outstanding.  Net income per share for the years  ended  December  31,  1995 and
January 1, 1995 were  computed  based on the weighted  average  number of common
shares and dilutive common equivalent shares outstanding after the effect of the
conversion of the then outstanding shares of Watermark's  redeemable convertible
preferred stock and Saros' convertible  preferred stock into common stock, which
conversion occurred upon completion of the acquisitions (see Notes 2 and 6).

     Use of Estimates The preparation of financial statements in conformity with
generally accepted accounting principles necessarily 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 these estimates.

     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 and financial  condition.  The Company
has qualified and is selling  51/4-inch  optical  storage and retrieval  devices
from an alternative  company 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."

     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  which indicate that their carrying value may
not be recoverable.

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

<PAGE>

     Note 2:  Acquisitions
     Acquisition of Saros Corporation On March 1, 1996, FileNet acquired all the
outstanding shares of Saros, a Washington corporation (the "Saros Acquisition").
The Saros  Acquisition  was  consummated  pursuant to an  Agreement  and Plan of
Merger (the "Saros Merger Agreement") dated January 17, 1996 by and among Saros,
the  Company,  and FileNet  Acquisition  Corporation  ("Acquisition  Corp."),  a
Washington corporation and wholly-owned  subsidiary of the Company.  Pursuant to
the Saros Merger  Agreement,  Acquisition  Corp. was merged with and into Saros,
with Saros  surviving as a  wholly-owned  subsidiary  of the Company.  The Saros
stockholders  received an aggregate of  approximately  1.9 million shares of the
Company's  common  stock and  approximately  337,000  options  to  purchase  the
Company's  common  stock in exchange  for all of their Saros stock and  options.
Approximately  188,000 of the total number of the Company's shares issued to the
Saros  stockholders (the "Saros Escrow Shares") were placed in an escrow account
upon  consummation of the Saros  Acquisition.  Pursuant to the escrow  agreement
entered into by the Company,  the stockholders'  agent and the escrow agent, the
Company  may  recover  from the escrow up to the entire  amount of Saros  Escrow
Shares in the event the Company  incurs any loss,  expense,  liability  or other
damages  (collectively,  "Damages")  due  to a  breach  by  Saros  of any of its
representations,  warranties and covenants in the Saros Merger  Agreement in the
event Damages exceed $1.0 million in the aggregate.  The Company believes it has
certain  claims for damages and intends to make a claim against all or a portion
of the Saros Escrow Shares.

     The Saros  Acquisition  was  accounted  for as a  pooling-of-interests  for
financial reporting purposes. The  pooling-of-interests  method of accounting is
intended  to  present  as a single  interest  two or more  common  stockholders'
interests  which  were  previously  independent;   accordingly,  the  historical
financial statements for the periods prior to the acquisition have been restated
as though the companies had been combined.  Saros  Acquisition fees and expenses
aggregating $4.2 million were expensed in the first quarter of 1996. Included in
the charges are professional fees, write-off of certain contractual  obligations
and settlement  costs,  write-off of certain fixed assets  (including  redundant
hardware and software systems) and other integration costs.

     Net  revenue,  net income  (loss)  and net  income  (loss) per share of the
companies  for the years  ended  December  31,  1995 and  January 1, 1995 are as
follows:
<TABLE>
<CAPTION>
(In thousands, except per share amounts)                         1995       1994
<S>                                                          <C>        <C>
Net revenue
  FileNet                                                    $215,477   $176,924
  Saros                                                        13,901     15,411
                                                             --------   --------
  Combined                                                   $229,378   $192,335
                                                             ========   ========
Net income (loss)
  FileNet                                                    $ 14,830   $ 13,263
  Saros                                                        (6,614)       880
                                                             --------   --------
  Combined                                                   $  8,216   $ 14,143
                                                             ========   ========
Net income (loss) per share
  FileNet                                                    $   0.94   $   0.89
  Saros                                                         (0.42)      0.06
                                                             --------   -------- 
  Combined                                                   $   0.52   $   0.95
                                                             ========   ========
</TABLE>

     Acquisition of International  Financial Systems,  Ltd. On January 30, 1996,
the  Company  purchased  for cash all of the  outstanding  shares  of IFSL,  the
developer of a COLD software  product for archiving  documents.  The acquisition
was  accounted  for as a purchase,  and the purchase  price was allocated to net
assets of $1.7 million and in-process  research and  development  costs of $10.0
million.

     Acquisition of Watermark Software Inc. In August 1995, the Company acquired
Watermark by issuing approximately 1.3 million shares of FileNet common stock in
exchange for all of the  outstanding  shares of Watermark.  The  transaction was
accounted for as a pooling-of-interests  for financial reporting purposes.  Fees
and expenses of $6.4 million before tax, related to the merger and consolidation
of the two companies, were expensed in the third quarter of 1995.

     Restructuring  Costs The  Company  incurred  a $1.8  million  restructuring
charge in the first quarter of 1996. 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 paid during 1997.


<PAGE>

     Note 3:  Inventories  Inventories  consist of the following at December 31,
1996 and December 31, 1995:
<TABLE>
<CAPTION>
(In thousands)                                                 1996       1995
<S>                                                          <C>        <C>
Raw materials                                                $2,606     $3,418
Work-in-process                                               2,648      1,147
Finished goods                                                3,540      2,055
                                                             ------     ------
Total                                                        $8,794     $6,620
                                                             ======     ======
</TABLE>

     Note 4: Property and Leases Property  consists of the following at December
31, 1996 and December 31, 1995:
<TABLE>
<CAPTION>
(In thousands)                                                 1996       1995
<S>                                                        <C>        <C>
Machinery, equipment and software                          $ 66,404   $ 67,115
Furniture and fixtures                                        9,242      7,541
Leasehold improvements                                        5,120      3,502
                                                           --------   --------
Total                                                        80,766     78,158
Less accumulated depreciation and amortization              (52,437)   (52,362)
                                                           --------   --------
Property, net                                              $ 28,329   $ 25,796
                                                           ========   ========
</TABLE>

     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 $9.6 million,  $9.3 million,  and
$8.1 million  during the years ended  December 31, 1996,  December 31, 1995, and
January 1, 1995,  respectively.  The following table  summarizes  future minimum
lease payments required under operating leases:
<TABLE>
<CAPTION>

Fiscal year                                                       (In thousands)
<S>                                                                     <C>   
1997                                                                    $10,171
1998                                                                      7,290
1999                                                                      4,843
2000                                                                      2,884
2001                                                                      1,532
Thereafter                                                                1,713
                                                                        -------
Total                                                                   $28,433
                                                                        =======
</TABLE>
   
     Note 5:  Borrowing  Arrangements  The Company has a $20 million  commercial
line of credit which expires in April 1997. 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,  1996  after  consideration  of a waiver  received  related to the
purchase of treasury shares. The Company expects to renew or replace the line of
credit under a similar arrangement in 1997.

     The Company has four additional borrowing  arrangements with foreign banks,
which expire at various times during 1997, under which the Company may borrow up
to 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
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, 1996 and December 31, 1995. Interest expense was $443,000, $288,000
and $193,000  for the years ended  December  31,  1996,  December 31, 1995,  and
January 1, 1995, respectively.


<PAGE>

     Note 6:  Stockholders'  Equity 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 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 During 1996,  the Company  purchased  200,000 shares of its
common stock 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 and reserved  450,000 shares of its
common stock for purchases under the plan. Under the terms of the plan,  options
to purchase common stock may be granted in successive six-month offering periods
to eligible  employees of the Company at 85% of the lower of the market price of
the  common  stock at the date of  grant  or at the date of  exercise.  The plan
covers substantially all domestic employees of the Company.  Each participant is
limited in any plan year to the  acquisition of that number of shares which have
an aggregate fair market value of not more than $25,000. There are no charges or
credits to income in connection  with the plan.  At December 31, 1996,  $341,000
had been withheld  from  employees  pursuant to the plan to exercise  options to
purchase common stock at the lower of $21.25 per share or 85% of the fair market
value of common stock at March 31, 1997.

     Stock Option Plans In November 1983, the Company adopted the 1983 Incentive
Stock Option Plan under which options to purchase an aggregate of 400,000 shares
of the Company's common stock were granted to officers and employees. There were
no options exercisable as of December 31, 1996. Options to purchase 1,850 common
shares were  exercisable  as of December 31, 1995.  This plan was  terminated in
March  1988 with  respect  to  future  option  grants.  Options  granted  became
exercisable  in 20%  installments  beginning one year from the date of grant and
expired  ten years from the date of grant.  The  exercise  price of all  options
granted was the fair market value of the common stock at the date of grant.

     In April 1986,  the Company  adopted the 1986 Stock Option Plan.  Under the
amended  terms of the 1986 plan,  options to  purchase  3,250,000  shares of the
Company's common stock were available for issuance to employees,  officers,  and
directors.   Options  to  purchase   821,548  and  666,791  common  shares  were
exercisable  at December 31, 1996 and December  31, 1995,  respectively.  In May
1995, the 1986 plan was  terminated  and the remaining  reserve of 70,049 shares
was rolled into the 1995 Stock  Option Plan and no common  shares are  available
for future  grants  under the 1986 plan.  Options  granted are either  incentive
stock options or non-qualified stock options. Options granted become exercisable
in 20% 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
non-qualified  options may not 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 and reserved
350,000  shares of common stock for issuance  under the terms of the Plan.  This
reserve was added to the 70,049 shares of common stock then available  under the
1986 Stock Option Plan (the "Predecessor  Plan").  Outstanding options under the
Predecessor  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, 1996, 309,130 options of the
Predecessor Plan had been terminated and were rolled into the 1995 Plan. Options
granted  under the 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% installments beginning one year from the date of grant. As of
December 31, 1996,  1,867,915 options had been granted  (including 530,571 under
the  cancellation/regrant  program  discussed  below)  and 52,173  options  were
exercisable under the Plan.


<PAGE>

     Prior to the merger,  Watermark had adopted the 1993 Stock  Incentive Plan.
The  Watermark  Plan was assumed by FileNet and  outstanding  options  under the
Watermark  Plan were  converted into options to purchase an aggregate of 151,075
shares of FileNet's common stock at a price equivalent (after conversion) to the
original  grant  price  (which  was not less than the  estimated  fair  value of
Watermark  common  stock at the  grant  date).  Outstanding  options  under  the
Watermark  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 not be available  for  subsequent  option  grant.  Options  granted
become  exercisable  in 20%  installments  one year  from  date of grant  and in
additional 5%  installments  for each full  three-month  period  thereafter.  At
December 31, 1996, a total of 30,813  options were  outstanding  and 15,808 were
exercisable.

     Prior to the merger, Saros had adopted the 1988 Restated Stock Option Plan.
The Saros Plan was assumed by FileNet and  outstanding  options  under the Saros
Plan were  converted  into options to purchase an aggregate of 336,913 shares of
FileNet's common stock at a price equivalent (after  conversion) to the original
grant price  (which was not less than the  estimated  fair value of Saros common
stock at the grant date). Outstanding options under the Saros 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 not be available
for  subsequent  option grant.  Options  granted may be either  incentive  stock
options or non-qualified stock options and are exercisable over a period of four
years.  The initial  option granted to the optionee  becomes  exercisable on the
ninth month of the  anniversary  date of hire at a rate of 18.75% and each month
thereafter at the rate of 2.0833%.  Options granted following the initial option
grant become  exercisable at the rate of 2.0833% for each month from grant date.
At December  31, 1996, a total of 183,922  shares were  outstanding  and 135,344
were exercisable.

     In  December  1989,  the  Company  adopted  the 1989 Stock  Option Plan for
Non-Employee  Directors.  Under the terms of the 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, 1996, options to purchase 26,000 shares of
common stock were  exercisable and 20,000 have been exercised to date. This plan
was terminated in May 1995 with respect to future option  grants.  Future grants
to  non-employee  directors are granted  under the  provisions of the 1995 Stock
Option Plan.

     On August 8, 1996 the Company approved a stock option  cancellation/regrant
program (the  "Program")  which allowed  employees,  excluding all directors and
reporting officers defined in Section 16 of the Securities  Exchange Act of 1934
as amended,  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
Program,  the regranted options are 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:
<TABLE>
<CAPTION>
                                                  Number of    Weighted average
                                                   options      exercise price
<S>                                              <C>                <C>  
Balances, January 2, 1994                        2,355,386          $13.03
 Granted                                           729,433          $20.84
 Exercised                                        (325,882)         $10.80
 Canceled                                         (154,763)         $16.07
                                                 ----------         ------          
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
                                                 ==========         ======
</TABLE>


<PAGE>

     The following table summarizes information concerning currently outstanding
and exercisable options:
<TABLE>
<CAPTION>
                                 Options outstanding                          Options exercisable
                     -----------------------------------------------     -----------------------------  
                                  Weighted average
Range of exercise       Number       remaining      Weighted average       Number     Weighted average
    prices           outstanding  contractual life   exercise price      exercisable   exercise price
<S>                   <C>              <C>              <C>                <C>            <C>
$ 0.06 - $20.00       1,054,328        5.69             $11.75             717,600        $11.11
$20.00 - $30.00       1,256,083        8.49             $24.96             255,465        $23.23
$30.00 - $40.00         295,922        8.95             $34.34              37,348        $32.29
$40.00 - $50.00         164,550        8.95             $40.83              41,700        $40.87
$50.00 - $64.42          30,000        9.34             $54.08                   -             -
                      ---------                                          ---------
$ 0.06 - $64.42       2,800,883                                          1,052,113
                      =========                                          =========     
</TABLE>

     As  discussed  in Note 1,  the  Company  continues  to  apply  APB No.  25,
"Accounting  for Stock  Issued to  Employees,"  and related  interpretations  in
accounting  for  its  plans.  Accordingly,  no  compensation  expense  has  been
recognized for its stock-based compensation plans. Had compensation cost for the
Company's  stock-based  compensation  plans  been  determined  based on the fair
market value at the grant dates for awards under those plans consistent with the
method of SFAS No. 123, "Accounting for Stock-Based Compensation," the Company's
net  income  (loss) and net income  (loss) per share  would have  changed to the
pro forma amounts indicated below:
<TABLE>
<CAPTION>
(In thousands, except per share amounts)                        1996       1995
<S>                                                          <C>         <C> 
Net income (loss) - as reported                              $(2,644)    $8,216
Net income (loss) - pro forma                                 (7,320)     7,273

Net income (loss) per share - as reported                      (0.18)      0.52
Net income (loss) per share - pro forma                        (0.49)      0.46

</TABLE>

     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 1996 and  1995:  expected  volatility  of 60%,
risk-free  interest  rates of 5.9% to 6.9%,  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.

     Watermark Common and Redeemable  Convertible  Preferred Stock On August 18,
1995, Watermark's  capitalization consisted of common stock and Series A through
C of Redeemable  Convertible  Preferred Stock ("Watermark  Preferred Stock"). In
May 1994,  Watermark  converted  certain  then  outstanding  common  stock  into
Watermark Preferred Stock in connection with a financing. Upon conversion of the
outstanding shares of Watermark Preferred Stock, the preferred stockholders were
entitled to receive from Watermark the then current liquidation amount per share
of  Watermark   Preferred   Stock  as  stated  in  the  Watermark   Articles  of
Incorporation.

     Saros  Common and  Convertible  Preferred  Stock On March 1,  1996,  Saros'
capitalization  consisted  of common  stock and  Series A through E  Convertible
Preferred  Stock  ("Saros  Preferred  Stock").  The Saros  Preferred  Stock gave
certain rights to the holders,  was noncumulative,  and was convertible,  at the
option of the holder, into an equal number of shares of common stock. Each share
of Saros  Preferred  Stock had voting  rights  equivalent to those of the common
shareholders  and a conversion  right that  allowed them to convert  outstanding
shares of Saros  Preferred  Stock into  common  stock.  Upon  conversion  of the
outstanding  shares of Saros Preferred  Stock, the preferred  stockholders  were
entitled  to receive  from Saros the  liquidation  amount  ranging  from $.33 to
$1.875 per share.

     Note 7:  Income  Taxes The  provision  for  income  taxes  consists  of the
following:
<TABLE>
<CAPTION>
(In thousands)
Years ended December 31, 1996, December 31, 1995
and January 1, 1995                                      1996     1995     1994
<S>                                                    <C>      <C>      <C>   
Current:
  Federal                                              $2,930   $4,017   $3,200
  State                                                    75       867     514
  Foreign                                               2,241    2,458    1,202
Deferred:
  Federal                                                (772)     834      441
  State                                                   (18)     (60)      (1)
                                                       ------   ------   ------      
  Total provision                                      $4,456   $8,116   $5,356
                                                       ======   ======   ======             
</TABLE>


<PAGE>

     A  reconciliation  of the  Company's  effective  tax rate  compared  to the
statutory federal tax rate is as follows:
<TABLE>
<CAPTION>
Years ended December 31, 1996, December 31, 1995
and January 1, 1995                                      1996     1995     1994
<S>                                                      <C>       <C>      <C>
Income taxes at statutory federal rate                     35%      35%      35%
State taxes, net of federal benefit                         4        5        2
Unbenefited/utilized domestic losses                       42       21        2
Foreign tax rate differential/unbenefited losses         (130)     (14)     (13)
Non-deductible acquisition costs                          291        5        -
Other                                                       4       (2)       1
                                                          ----      ---      ---
Total                                                     246%      50%      27%
                                                          ====      ===      ===
</TABLE>
  
     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, 1996 and December 31,
1995 are as follows:
<TABLE>
<CAPTION>
(In thousands)
Years ended December 31, 1996 and December 31, 1995              1996      1995
<S>                                                          <C>        <C>   
Deferred taxes:
  Foreign loss carryforwards                                 $  1,445   $   975
  Domestic loss carryforwards                                   9,198     9,479
  Tax credit carryforwards                                      1,954     1,579
  Accrued expenses                                              1,745     1,851
  Inventory reserves                                              241       232
  Sales returns and allowance reserves                          1,359     1,169
  Capitalized software                                           (206)     (783)
  Depreciable assets                                              802      (131)
  Residual U.S. tax on foreign earnings                        (3,710)   (2,027)
  Other                                                         2,420     2,105
                                                               ------    ------    
Total                                                          15,248    14,449
                                                               ------    ------
Valuation allowance                                           (13,012)  (13,003)
                                                               ------    ------
Net deferred tax asset                                       $  2,236 $   1,446
                                                             ======== =========
</TABLE>

     The Company has an  approximate  $27 million loss  carryforward  related to
Watermark and Saros which can be used to reduce future taxable income.  Sections
382 and 383 of the Internal  Revenue Code of 1986 place certain  limitations  on
the use of these acquired  losses. A maximum of $18 million of the net operating
loss  carryforward  can  be  utilized  in  1997,  and  if  not  utilized,   will
carryforward to 1998 and subsequent  years.  The remaining $9 million of the net
operating loss carryforward will be available in 1998 and, if not utilized, will
carryforward  to subsequent  years.  Any net  operating  loss  carryforward  not
utilized will begin  expiring in 2004. The Company has an approximate $2 million
tax credit carryforward which will expire beginning in 2004.  Utilization of the
loss and credit  carryforwards will result in a reduction of income tax expense.
A valuation  allowance  has been  established  for 100% of the net  deferred tax
assets related to Watermark and Saros.

     The Company has not  provided any residual  U.S. tax on  approximately  $15
million  of a  portion  of the  Company's  foreign  subsidiaries'  undistributed
earnings as the Company intends to indefinitely reinvest such earnings.

     At December 31, 1996, the Company had Dutch,  UK and French  subsidiary tax
loss  carryforwards  relating  to its  foreign  subsidiary  operations  of  $1.8
million,  $1.8  million  and  $0.7  million,  respectively,  as  well  as  other
immaterial  foreign  tax  loss   carryforwards.   The  Dutch  and  UK  tax  loss
carryforwards  have no  expiration.  The French  losses  will begin to expire in
1997.  Valuation  allowances  have been  established for 100% of the foreign tax
loss carryforwards.

     Note 8:  Development  Contracts  The Company has entered  into  development
contracts  in 1996 and prior  years with third  parties  under which the Company
receives  funding  for  certain  development  activities.  Cumulatively  through
December  31,  1996,  $5.6  million  of  expenses  related  to  the  development
activities had been funded under this arrangement. The Company has also incurred
aggregate  royalty  expenses of $3.8 million through December 31, 1996 to one of
the third parties based on shipments of the related products.


<PAGE>

Note 9: Geographical Information
<TABLE>
<CAPTION>
(In thousands)
Years ended December 31, 1996, December 31, 1995
and January 1, 1995                                    1996      1995      1994
<S>                                                <C>       <C>       <C>
Revenue
  United States*
    Customers                                      $174,618  $155,728  $137,420
    Intercompany                                     23,355    14,597    14,180
                                                   --------  --------  --------    
      Total                                         197,973   170,325   151,600
  Europe*
    Customers                                        83,786    67,916    49,725
    Intercompany                                     15,815    11,448     6,825
                                                   --------  --------  --------
      Total                                          99,601    79,364    56,550
  Other
    Customers                                        10,509     5,734     5,190
    Intercompany                                      1,794     2,086       496
                                                   --------  --------  --------
      Total                                          12,303     7,820     5,686
    Eliminations                                    (40,964)  (28,131)  (21,501)
                                                   --------  --------  --------
Total revenue                                      $268,913  $229,378  $192,335
                                                   ========  ========  ========
Operating income (loss)
  United States**                                  $(18,588) $    369  $ 14,408
  Europe**                                           17,680    12,589     3,051
  Other                                               1,691       629       234
  Eliminations                                       (1,809)      (35)      (15)
                                                   --------  --------  --------
Total operating income (loss)                      $ (1,026) $ 13,552  $ 17,678
                                                   ========  ========  ========
Assets
  United States                                    $132,781  $151,929  $123,716
  Europe                                             56,971    38,993    31,278
  Other                                               6,043     2,672     3,124
  Eliminations                                         (116)   (3,912)   (5,476)
                                                   --------  --------  --------
Total assets                                       $195,679  $189,682  $152,642
                                                   ========  ========  ========
</TABLE>
*U.S.  revenue includes hardware sales to third-party  international  resellers.
European  revenue  includes  software  sales  to all  third-party  international
resellers.

**U.S.  operating income includes $16.0 million in 1996 and $3.9 million in 1995
for merger,  restructuring  and write-off of purchased  in-process  research and
development costs and European operating income includes $2.5 million for merger
and other costs in 1995. 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.

     Note 10:  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.
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.  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 cannot 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.


<PAGE>

     On December 20,  1996,  plaintiff  Michael I. Goldman  filed a class action
complaint  against the Company and certain of its officers and  directors in the
Superior Court of California, County of Orange. The 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. Plaintiff alleges that the Company
and other  defendants  violated Cal. Corp.  Code Sections 25400 and 25500,  Cal.
Civ. Code Sections  1709-1710 and Cal. Bus. & Prof.  Code Sections 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;  however, at this time it is
not possible to determine the potential  liability,  if any. The Company has not
yet responded to the  complaint.  The Company  believes the complaint is without
merit and intends to defend the action vigorously.

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

     Note 11:  Related Party  Transaction  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
which is included in merger and other costs in 1995.

Note 12: Quarterly Financial Information (Unaudited)
<TABLE>
<CAPTION>
(In thousands, except per share amounts)
Year ended December 31, 1996       First     Second   Third    Fourth   Fiscal
                                  quarter*  quarter  quarter*  quarter   year
<S>                               <C>       <C>      <C>       <C>     <C>          
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)
Net income (loss) per share       $ (0.79)  $  0.15  $  0.22   $  0.20 $  (0.18)

Year ended December 31, 1995       
Revenue                           $48,421   $56,121  $57,098   $67,738 $229,378
Income (loss) before income taxes   4,842     3,354     (644)    8,780   16,332
Net income (loss)                   3,149     1,331   (1,466)    5,202    8,216
Net income (loss) per share       $  0.20   $  0.09  $ (0.10)  $  0.32 $   0.52
</TABLE>
*Includes a one-time  after-tax  charge of $16.0 million in the first quarter of
1996 and $5.0 million in the third quarter of 1995 for merger, restructuring and
write-off of purchased in-process research and development costs.

<PAGE>

Independent Auditors' Report

To the Stockholders and Board of Directors of FileNet Corporation:

We  have  audited  the  accompanying  consolidated  balance  sheets  of  FileNet
Corporation and its  subsidiaries as of December 31, 1996 and December 31, 1995,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for the years ended December 31, 1996, December 31, 1995, and January
1, 1995.  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, 1996 and  December 31, 1995 and the results of
their  operations  and their cash flows for the years ended  December  31, 1996,
December 31, 1995,  and January 1, 1995 in conformity  with  generally  accepted
accounting principles.


/S/ Deloitte & Touche LLP

February 10, 1997
Costa Mesa, California