<TABLE>
HISTORICAL FINANCIAL REVIEW OF SUN MICROSYSTEMS, INC.


Summary Consolidated Statements of Income                                                                       Years Ended June 30,

<CAPTION>
(In millions, except per share amounts)           1997              1996               1995             1994                1993
------------------------------------------------------------------------------------------------------------------------------------
                                        Dollars      %      Dollars    %     Dollars      %     Dollars     %     Dollars      %
------------------------------------------------------------------------------------------------------------------------------------
<S>                                    <C>         <C>     <C>       <C>     <C>        <C>     <C>       <C>     <C>        <C>
Net revenues                           $ 8,598     100.0   $ 7,095   100.0   $ 5,902    100.0   $ 4,690   100.0   $ 4,309    100.0
------------------------------------------------------------------------------------------------------------------------------------
Costs and expenses:
 Cost of sales                           4,320      50.2     3,921    55.3     3,336     56.5     2,753    58.7     2,518     58.4
 Research and development                  826       9.6       653     9.2       563      9.5       500    10.7       445     10.3
 Selling, general and administrative     2,402      27.9     1,788    25.2     1,503     25.5     1,160    24.7     1,105     25.7
 Nonrecurring charges                       23       0.3        58     0.8      --        --       --       --       --        --
Total costs and expenses                 7,571      88.0     6,420    90.5     5,402     91.5     4,413    94.1     4,068     94.4
------------------------------------------------------------------------------------------------------------------------------------
Operating income                         1,027      12.0       675     9.5       500      8.5       277     5.9       241      5.6
Gain on sale of equity investment           62       0.7       --      --       --        --       --       --       --        --
Interest income (expense), net              32       0.4        34     0.5        23      0.4         6     0.1        (2)     --
Litigation settlement                      --        --        --      --       --        --       --       --        (15)    (0.4)
Income before income taxes               1,121      13.1       709    10.0       523      8.9       283     6.0       224      5.2
Provision for income taxes                 359       4.2       232     3.3       167      2.8        87     1.8        67      1.6
------------------------------------------------------------------------------------------------------------------------------------
Net income                              $  762       8.9   $   477     6.7   $   356      6.1   $   196     4.2   $   157      3.6
Net income per share                    $ 1.96             $  1.21           $  0.91            $  0.50           $  0.37
------------------------------------------------------------------------------------------------------------------------------------
Weighted average common and common-
 equivalent shares outstanding             389                 393               394                388               420
------------------------------------------------------------------------------------------------------------------------------------


(In millions, except per share amounts)           1992              1991               1990             1989                1988
------------------------------------------------------------------------------------------------------------------------------------
                                        Dollars      %      Dollars    %     Dollars      %     Dollars     %     Dollars      %
------------------------------------------------------------------------------------------------------------------------------------
Net revenues                           $ 3,589     100.0   $ 3,221   100.0   $ 2,466    100.0   $ 1,765   100.0   $ 1,052    100.0
------------------------------------------------------------------------------------------------------------------------------------
Costs and expenses:
 Cost of sales                           1,963      54.7     1,758    54.6     1,399     56.7     1,010    57.2       551     52.3
 Research and development                  382      10.6       356    11.1       302     12.2       234    13.3       140     13.3
 Selling, general and administrative       983      27.4       812    25.2       588     23.9       433    24.5       250     23.8
 Nonrecurring charges                      --        --        --      --       --        --       --       --       --        --
Total costs and expenses                 3,328      92.7     2,926    90.9     2,289     92.8     1,677    95.0       941     89.4
------------------------------------------------------------------------------------------------------------------------------------
Operating income                           261       7.3       295     9.1       177      7.2        88     5.0       111     10.6
Gain on sale of equity investment          --        --        --      --       --        --       --       --       --        --
Interest income (expense), net              (6)     (0.2)      (11)   (0.3)      (23)    (0.9)      (10)   (0.6)     --       (0.1)
Litigation settlement                      --        --        --      --       --        --       --       --       --        --
Income before income taxes                 255       7.1       284     8.8       154      6.3        78     4.4       111     10.5
Provision for income taxes                  82       2.3        94     2.9        43      1.8        17     1.0        45      4.2
------------------------------------------------------------------------------------------------------------------------------------
Net income                             $   173       4.8   $   190     5.9   $   111      4.5   $    61     3.4   $    66      6.3
Net income per share                   $  0.43             $  0.47           $  0.30            $  0.19           $  0.22
------------------------------------------------------------------------------------------------------------------------------------
Weighted average common and common-
 equivalent shares outstanding             406                 412               378                340               312
------------------------------------------------------------------------------------------------------------------------------------
</TABLE>

                                                                 18
<PAGE>

<TABLE>
Operating and Capitalization Data                                                                               Years Ended June 30,
<CAPTION>
                                                  1997          1996          1995           1994          1993         1992
------------------------------------------------------------------------------------------------------------------------------------
<S>                                             <C>          <C>           <C>           <C>           <C>           <C>
Total assets (millions)                         $ 4,697      $  3,801      $  3,545      $  2,898      $  2,768      $  2,672
------------------------------------------------------------------------------------------------------------------------------------
Long-term debt and other obligations (millions) $   106      $     60      $     91      $    122      $    178      $    348
------------------------------------------------------------------------------------------------------------------------------------
Current ratio                                       2.0           2.0           2.2           2.0           2.4           2.6
------------------------------------------------------------------------------------------------------------------------------------
Long-term debt-to-equity ratio                    0.015         0.018         0.039         0.075          0.11          0.23
------------------------------------------------------------------------------------------------------------------------------------
Return on average equity                             31%           22%           19%           12%           10%           13%
------------------------------------------------------------------------------------------------------------------------------------
Return on average capital                            30%           23%           18%           12%            9%           10%
------------------------------------------------------------------------------------------------------------------------------------
Return on average assets                             18%           13%           11%            7%            6%            7%
------------------------------------------------------------------------------------------------------------------------------------
Effective income tax rate                            32%           33%           32%           33%           30%           32%
------------------------------------------------------------------------------------------------------------------------------------
Average shares and equivalents (thousands)       388,967      393,380       393,700       387,056       420,500       406,560
------------------------------------------------------------------------------------------------------------------------------------
Book value per outstanding share                $   7.40     $   6.05      $   5.39      $   4.34      $   4.03      $   3.72
------------------------------------------------------------------------------------------------------------------------------------
</TABLE>

<TABLE>
<CAPTION>
                                                  1991          1990          1989           1988
--------------------------------------------------------------------------------------------------
<S>                                             <C>           <C>           <C>           <C>
Total assets (millions)                         $  2,326      $  1,779      $  1,269      $   757
--------------------------------------------------------------------------------------------------
Long-term debt and other obligations (millions) $    401      $    359      $    145      $   127
--------------------------------------------------------------------------------------------------
Current ratio                                        2.5           2.6           1.9          2.1
--------------------------------------------------------------------------------------------------
Long-term debt-to-equity ratio                      0.33          0.39          0.22         0.34
--------------------------------------------------------------------------------------------------
Return on average equity                              18%           14%           12%          22%
--------------------------------------------------------------------------------------------------
Return on average capital                             13%           11%            9%          15%
--------------------------------------------------------------------------------------------------
Return on average assets                               9%            7%            6%          10%
--------------------------------------------------------------------------------------------------
Effective income tax rate                             33%           28%           22%          40%
--------------------------------------------------------------------------------------------------
Average shares and equivalents (thousands)       412,268       377,476       340,664      311,520
--------------------------------------------------------------------------------------------------
Book value per outstanding share                $   3.15      $   2.51      $   1.97     $   1.28
--------------------------------------------------------------------------------------------------
</TABLE>

                                                                 19
<PAGE>

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


The  following  table sets forth  items from Sun's  Consolidated  Statements  of
Income as a percentage of net revenues:

                                           1997        1996        1995
-------------------------------------------------------------------------
Net revenues                              100.0%      100.0%      100.0%
Cost of sales                              50.2        55.3        56.5
-------------------------------------------------------------------------
Gross margin                               49.8        44.7        43.5
Research and development                    9.6         9.2         9.5
Selling, general and administrative        27.9        25.2        25.5
Nonrecurring charges                        0.3         0.8        --
-------------------------------------------------------------------------
Operating income                           12.0         9.5         8.5
Gain on sale of investment                  0.7        --          --
Interest income, net                        0.4         0.5         0.4
-------------------------------------------------------------------------
Income before income taxes                 13.1        10.0         8.9
Provision for income taxes                  4.2         3.3         2.8
-------------------------------------------------------------------------
Net income                                  8.9%        6.7%        6.1%
-------------------------------------------------------------------------

This Annual Report,  including the following section,  contains  forward-looking
statements  within the  meaning of the  Private  Securities  Reform Act of 1995,
particularly  statements  regarding market  opportunities,  market share growth,
competitive  growth,  new  product   introductions,   success  of  research  and
development,  research and  development  expenses,  customer  acceptance  of new
products,  gross margin, and marketing and general and administrative  expenses.
These  forward-looking  statements  involve  risks  and  uncertainties,  and the
cautionary  statements set forth below,  specifically those contained in "Future
operating  results,"  identify important factors that could cause actual results
to differ  materially from those in any such  forward-looking  statements.  Such
factors  include,  but are not limited to, adverse  changes in general  economic
conditions,  including  changes  in  the  specific  markets  for  the  Company's
products,  adverse  business  conditions,  decreased  or lack of  growth  in the
computing  industry,  adverse  changes in  customer  order  patterns,  increased
competition,  lack of  acceptance of new products,  pricing  pressures,  lack of
success in technological advancements,  risks associated with foreign operations
and other factors, including those listed below.


Results of operations

Net revenues

Sun's net revenues increased $1,504 million, or 21%, to $8,598 million in fiscal
1997,  compared with an increase of $1,193 million, or 20%, in fiscal 1996. Over
75% of the increase in net revenues in fiscal 1997 was due to the strong  demand
experienced  by Sun  throughout  the  fiscal  year  for its  workgroup  servers,
departmental  servers,  enterprise  servers,  and high-end desktop  systems.  In
addition,  the increase in net revenues  resulted from memory,  storage options,
and accessories shipped to both new and installed-base customers purchasing more
richly  configured  systems.  Revenues  from  other  Sun  businesses,  including
service,  microprocessors,  and  software,  in  total  increased  slightly  as a
percentage of net revenues and increased  approximately  30% in absolute dollars
during fiscal 1997. The increase in net revenues in fiscal 1996 over fiscal 1995
was primarily  attributable to increased shipments of richly configured servers,
and higher revenues from memory, storage options, and accessories.

In fiscal  1997 and fiscal  1996,  domestic  net  revenues  grew by 25% and 20%,
respectively, while international net revenues (including United States exports)
grew  17%  and  21%,  respectively.   Revenues  from  international   operations
represented  49% in  fiscal  1997 and 50% in  fiscal  1996 and 1995 of total net
revenues.

20


<PAGE>

Sun Microsystems, Inc. 1997 Annual Report


European net revenues  increased 20% in fiscal 1997,  primarily due to continued
market acceptance of Sun's network computing products and services in the United
Kingdom, parts of northern Europe, and Germany.

Japan net revenues increased 3% for fiscal 1997,  compared to an increase of 13%
in fiscal 1996.  The Company  attributes  the decrease in the growth of revenues
from  13% in  fiscal  1996 to 3% in  fiscal  1997  to  current  economic  trends
affecting the Japanese market,  including  currency  movements  against the U.S.
dollar, which the Company does not expect to change materially in the near term.
If the  economic  trends in Japan  significantly  worsen in a quarter or decline
over an extended period of time, the Company's  results from operations and cash
flows would be adversely affected.

Net revenues in Rest of World increased by 29% in fiscal 1997, compared with 28%
in fiscal 1996,  primarily due to expanding  markets in China,  Korea, and Latin
America.

A portion  of the  Company's  operations  consists  of  manufacturing  and sales
activities in foreign jurisdictions. As a result, the Company's results could be
significantly  adversely affected by factors such as changes in foreign currency
exchange rates or real economic  conditions in the foreign  markets in which the
Company distributes its products. The Company is primarily exposed to changes in
exchange rates on the Japanese yen,  British pound sterling,  French franc,  and
German deutsche mark. When the U.S. dollar strengthens against these currencies,
the U.S. dollar value of non-U.S.  dollar-based  sales decreases.  When the U.S.
dollar  weakens  against  these  currencies,  the U.S.  dollar value of non-U.S.
dollar-based sales increases. Correspondingly, the U.S. dollar value of non-U.S.
dollar-based costs increases when the U.S. dollar weakens and decreases when the
U.S. dollar  strengthens.  Overall,  the Company is a net receiver of currencies
other than the U.S.  dollar and, as such,  benefits  from a weaker dollar and is
adversely affected by a stronger dollar relative to major currencies  worldwide.
Accordingly, changes in exchange rates, and in particular a strengthening of the
U.S.  dollar,  may adversely affect the Company's  consolidated  sales and gross
margins as expressed in U.S. dollars.

To mitigate the short-term  effect of changes in currency  exchange rates on the
Company's  non-U.S.  dollar-based  sales,  product  procurement,  and  operating
expenses,  the Company regularly hedges its net non-U.S.  dollar-based exposures
by  entering  into  foreign  exchange  forward  and  option  contracts  to hedge
anticipated transactions. Currently, hedges of transactions do not extend beyond
three  months.  Given the short term nature of the  Company's  foreign  exchange
forward and option  contracts,  the Company's  exposure to risk  associated with
currency  market  movements  on the  instruments  in  place  at year  end is not
material.  See  "Other  Financial  Instruments"  in  Note  1 of  the  "Notes  to
Consolidated Financial Statements" for more details.  Compared with fiscal 1996,
the dollar in fiscal 1997 has  strengthened  against the  Japanese  yen and most
major  European  currencies.  Management  has  estimated  that the net impact of
currency fluctuations on operating results, while slightly unfavorable,  was not
significant in any of the fiscal years in the  three-year  period ended June 30,
1997.

Gross margin

Gross margin was 49.8% for fiscal 1997, compared with 44.7% and 43.5% for fiscal
1996 and 1995, respectively.  Over half of the increase in gross margin resulted
from sales of more richly configured, higher margin servers and desktop systems.
The increase also resulted partly from the aggregate effect of revenue increases
in other Sun businesses.

The factors described above resulted in a favorable impact on gross margin.  The
Company  continuously  evaluates the  competitiveness  of its product offerings.
These  evaluations  could  result in repricing  actions in the near term.  Sun's
future operating  results would be adversely  affected if such repricing actions
were to occur and the  Company  were  unable to mitigate  the  resulting  margin
pressure by maintaining a favorable mix of systems, software, service, and other
products and by achieving component cost reductions, operating efficiencies, and
higher volumes.

Between fiscal 1995 and fiscal 1996, gross margin increased slightly.  Increased
revenues from higher margin servers and desktop  systems had a favorable  impact
on gross margin in fiscal 1996.

Research and development

Research and  development  (R&D) expenses  increased $173 million,  or 26.5%, in
fiscal 1997 to $826 million, compared with an increase of $90 million, or 16.0%,
in fiscal 1996. As a percentage of

21

<PAGE>


Management's  discussion  and  analysis of  financial  condition  and results of
operations


net revenues,  R&D expenses were 9.6%,  9.2% and 9.5% in fiscal 1997,  1996, and
1995, respectively. R&D spending continued at a substantial level throughout the
three-year  period  ended June 30,  1997,  as the  Company  invested in specific
projects in support of new  software  and  hardware  product  introductions  and
continued   development   of  the   SPARC(TM)   microprocessor   product   line.
Approximately  half of the  dollar  increase  in R&D  expenses  in  fiscal  1997
reflects  development  of hardware and software  products  that utilize the Java
architecture  and new server and storage  products.  The  remaining  increase in
dollar  amount  of  such  expenses  is  primarily   attributable   to  continued
development of UltraSPARC  systems,  further  development  of products  obtained
through acquisitions,  and increased compensation due primarily to higher levels
of staffing. The increase as a percentage of net revenues reflects the Company's
belief that to maintain its competitive  position in a market  characterized  by
rapid rates of  technological  advancement,  the Company must continue to invest
significant resources in new systems, software, and microprocessor  development,
as well as in enhancements to existing products.

Selling, general and administrative

Selling,  general and administrative  (SG&A) expenses increased $615 million, or
34.4%,  in fiscal  1997 to $2,402  million  compared  with an  increase  of $285
million,  or 18.9%,  in fiscal 1996.  As a  percentage  of net  revenues,  these
expenses  were  27.9%,  25.2%,  and  25.5%  in  fiscal  1997,  1996,  and  1995,
respectively.  Approximately  half of the dollar  increase  is  attributable  to
increased  marketing  costs  related  to new  product  introductions  and  other
promotional programs,  and an increase in compensation  resulting primarily from
higher  levels of  marketing  and sales head  count.  The dollar  increase  also
reflects investments aimed at improving Sun's own business processes. The dollar
increase in fiscal 1996  resulted  primarily  from  increased  marketing  costs,
compensation,  and investments in  demand-creation  programs.  The increase as a
percentage  of net  revenues in fiscal 1997  reflects,  in part,  the  Company's
ongoing  efforts to expand its  demandcreation  programs and service and support
organizations.  In fiscal  1998,  the  Company  expects to continue to invest in
efforts to achieve  additional  operating  efficiencies  through  the  continual
review and improvement of business processes.  In addition,  the Company expects
to continue to hire personnel to drive its demand-creation  programs and service
and support operations.

Nonrecurring Charges

Nonrecurring  charges represents charges for purchased  in-process  research and
development associated with the Company's acquisition of Long View Technologies,
LLC,   Integrated   Micro  Products  plc,  and  Lighthouse   Design,   Ltd.  See
"Acquisitions" in Note 2 of the "Notes to Consolidated Financial Statements" for
additional information.

Gain on sale of equity investment

The gain on sale of equity investment  represents the net proceeds from the sale
of the Company's equity investment in Iona Technologies, plc.

Interest income (expense), net

The Company's  interest  income and expense are most sensitive to changes in the
general  level of U.S.  interest  rates.  In this  regard,  changes  in the U.S.
interest rates affect the interest earned on the Company's cash  equivalents and
short-term  investments as well as interest paid on its short-term and long-term
borrowings.  To mitigate the impact of fluctuations in U.S.  interest rates, the
Company  has  entered  into an  interest  rate  swap  transaction.  This swap is
intended to better match the Company's floating-rate interest income on its cash
equivalents  and  short-term  investments  with  the  interest  expense  on  its
long-term debt.

Net interest  income  decreased to $32.4  million in fiscal 1997,  compared with
$33.9  million and $22.9  million in fiscal 1996 and fiscal 1995,  respectively.
The decrease in net interest  income for fiscal 1997 is primarily  the result of
lower  interest  earnings  due  to a  smaller  average  portfolio  of  cash  and
investments as compared to the  corresponding  period in fiscal 1996. The growth
in net  interest  income  for fiscal  1996,  as  compared  to fiscal  1995,  was
primarily  the  result of  interest  savings  from  reduced  debt  levels and an
increase in the effective interest rate earned on investments.

The  principal/notional  amount of the Company's cash equivalents and short-term
investments, which

22

<PAGE>


Sun Microsystems, Inc. 1997 Annual Report


bear interest rate risk, by year of expected  maturity and average interest rate
are as follows:

                                                                At June 30, 1997
                                  1998        1999        Total      Fair Value
--------------------------------------------------------------------------------
Cash equivalents and short-term
     investments                 $643.8     $ 52.6       $696.4       $696.6
--------------------------------------------------------------------------------
Average interest rate               5.2%       5.5%        --            --
--------------------------------------------------------------------------------


Income taxes

The  effective  tax rate for fiscal  1997 was 32%.  The  effective  tax rate for
fiscal  1996  was  32%  before  a  $5.7  million  tax  charge  resulting  from a
nonrecurring  write-off of in-process  research and development  associated with
the acquisition of Lighthouse  Design,  Ltd. The effective tax rate for 1995 was
also 32%.

The Company  currently expects its tax rate to increase to approximately 33% for
fiscal 1998.  The  estimate is based on current tax law and current  estimate of
earnings, and is subject to change.

Future operating results

The market for Sun's products and services is intensely  competitive and subject
to  continuous,  rapid  technological  change,  short  product life cycles,  and
frequent  product  performance  improvements  and price  reductions.  Due to the
breadth of the Company's  product lines and the  scalability of its products and
network  computing model, Sun competes in many segments of the network computing
market  across a broad  spectrum  of  customers.  The Company  expects  that the
markets for its products and  technologies,  as well as its  competitors  within
such markets,  will continue to change as the rightsizing  trend shifts customer
buying  patterns to  network-based  systems,  which often employ  solutions from
multiple  vendors.  Competition in these markets will also continue to intensify
as Sun and  its  competitors,  principally  Hewlett-Packard  Co.,  International
Business  Machines  Corporation,  Digital  Equipment  Corporation,  and  Silicon
Graphics,  Inc.,  aggressively position themselves to benefit from this shifting
of customer buying patterns and demand.  The Company is also facing  competition
from these  competitors,  as well as other systems  manufacturers such as Compaq
Computer Corporation and Dell Computer Corporation,  whose products are based on
microprocessors  from Intel Corporation coupled with Windows NT operating system
software from Microsoft Corporation. These products demonstrate the viability of
certain networked personal computer solutions and have increased the competitive
pressure, particularly in the Company's workstation and lower-end server product
lines.  Finally,  the timing of  introductions  of new  products and services by
Sun's  competitors  may negatively  impact the future  operating  results of the
Company, particularly when such introductions occur in periods leading up to the
Company's  introduction of its own enhanced  products.  The Company expects this
pressure to continue and intensify into fiscal 1998. While many other technical,
service,  and support  capabilities  affect a customer's  buying  decision,  the
Company's  future  operating  results  will depend,  in part,  on its ability to
compete with these technologies.

The Company's future operating  results will depend to a considerable  extent on
its  ability to rapidly  and  continuously  develop,  introduce,  and deliver in
quantity  new  systems,   software,   and  service  products,  as  well  as  new
microprocessor  technologies,  that offer its customers enhanced  performance at
competitive prices. The development of new  high-performance  computer products,
such as the Company's development of the UltraSPARC microprocessor, is a complex
and uncertain  process  requiring  high levels of innovation  from the Company's
designers  and  suppliers,   as  well  as  accurate   anticipation  of  customer
requirements and technological trends. Once a hardware product is developed, the
Company must rapidly bring such products to volume manufacturing, a process that
requires accurate forecasting of volumes,  mix of products,  and configurations,
among other things, in order to achieve acceptable yields and costs.

23

<PAGE>


Management's  discussion  and  analysis of  financial  condition  and results of
operations


Future operating  results will depend to a considerable  extent on the Company's
ability to closely manage product introductions in order to minimize unfavorable
patterns of customer orders, to reduce levels of older inventory,  and to ensure
that adequate supplies of new products can be delivered to meet customer demand.
The ability of the Company to match supply and demand is further  complicated by
the  Company's  need to adjust  prices to reflect  changing  competitive  market
conditions as well as the variability and timing of customer orders with respect
to the Company's older products.  As a result,  the Company's  operating results
could be adversely  affected if the Company is not able to correctly  anticipate
the level of demand for the mix of products. Because the Company is continuously
engaged in this product development,  introduction,  and transition process, its
operating results may be subject to considerable fluctuation,  particularly when
measured on a quarterly basis.

The Company is increasingly dependent on the ability of its suppliers to design,
manufacture,   and  deliver   advanced   components   required  for  the  timely
introduction  of new products.  The failure of any of these suppliers to deliver
components  on time or in  sufficient  quantities,  or the failure of any of the
Company's own designers to develop innovative  products on a timely basis, could
result in a significant adverse impact on the Company's  operating results.  The
inability to secure enough components to build products, including new products,
in the quantities and configurations  required, or to produce, test, and deliver
sufficient  products to meet demand in a timely manner,  would adversely  affect
the Company's  net revenues and  operating  results.  To secure  components  for
development,   production,   and  introduction  of  new  products,  the  Company
frequently  makes advanced  payments to certain  suppliers and often enters into
noncancelable purchase commitments with vendors early in the design process. Due
to the  variability  of material  requirement  specifications  during the design
process,  the Company must closely  manage  material  purchase  commitments  and
respective delivery schedules.  In the event of a delay or flaw in the Company's
design process,  the Company's operating results could be adversely affected due
to the Company's obligations to fulfill such noncancelable purchase commitments.

Generally,   the  computer   systems  sold  by  Sun,  such  as  the   UltraSPARC
processor-based  products,  are the result of hardware and software development,
such that  delays in the  software  development  can  delay the  ability  of the
Company to ship new hardware products. In addition, adoption of a new release of
an operating  system may require  effort on the part of the customer and porting
by  software  vendors  providing  applications.  As  a  result,  the  timing  of
conversion to a new release is  inherently  unpredictable.  Moreover,  delays by
customers  in  adopting  a new  release  of an  operating  system  can limit the
acceptability  of hardware  products  tied to that  release.  Such delays  could
adversely affect the future operating results of the Company.

Seasonality also affects the Company's  operating  results,  particularly in the
first  and third  quarter  of each  fiscal  year.  In  addition,  the  Company's
operating  expenses  are  increasing  as the  Company  continues  to expand  its
operations,  and future operating results will be adversely affected if revenues
do not  increase  accordingly.  Additionally,  the Company  plans to continue to
evaluate and, when appropriate, make acquisitions of complementary technologies,
products,  or businesses.  As part of this process, the Company will continue to
evaluate the changing value of its assets, and when necessary,  make adjustments
thereto.

In order to remain  competitive in a rapidly-changing  industry,  the Company is
continually  improving  and  changing  its business  practices,  processes,  and
information systems. In this regard, the Company has begun to implement a number
of new business  practices  and a series of related  information  systems;  such
activities  are currently  planned to be fully  operational in the first half of
fiscal  year  1999.   Implementing  a  number  of  new  business  practices  and
information  systems is a complex process,  affecting  numerous  operational and
financial  systems and  processes  as well as requiring  comprehensive  employee
training.  While the Company tests these new systems and processes in advance of
implementation,  there are  inherent  limitations  in the  Company's  ability to
simulate a full-scale operating environment in advance of system cutover. To the
extent that the Company  encounters  problems  after  introduction  of these new
systems and practices that prevent or limit their full utilization,  there could
be a material, adverse impact on the Company's operating results.

24

<PAGE>

Sun Microsystems, Inc. 1997 Annual Report


While the Company cannot  predict what effect these various  factors may have on
its financial  results,  the  aggregate  effect of these and other factors could
result in significant  volatility in the Company's future  performance and stock
price.

Liquidity and capital resources

The Company's financial  condition  strengthened as of fiscal 1997 year end when
compared with fiscal 1996. During fiscal 1997,  operating  activities  generated
$1,105  million  in cash and cash  equivalents,  compared  with $688  million in
fiscal 1996.  Accounts  receivable  increased  $335  million,  or 27%, to $1,667
million,  due primarily to a 26% increase in net revenues in the fourth  quarter
of fiscal 1997 as compared with the corresponding  period of 1996.  Deferred tax
assets,  and other current and noncurrent assets increased $70 million,  or 12%,
to $680  million,  due  primarily to the timing of payments for income and other
taxes.  Accrued  payroll-related  liabilities,  accrued  liabilities,  and other
increased $288 million, or 26%, due in part to increases in compensation, sales,
and marketing  costs.  Accounts payable  increased $144 million,  or 44%, due in
part to additional operating expenses associated with the expansions of business
and corresponding increases in head count.

The Company's investing  activities used $543 million of cash in fiscal 1997, an
increase of $418 million from the $125 million used in fiscal 1996. The increase
resulted  primarily  from the  Company  investing  more of the  fiscal  1997 net
operating  cash flow in cash  equivalents  and less in  short-term  investments.
Additions to  property,  plant and  equipment,  totaled  $554  million,  up $258
million,  or 87%, from fiscal 1996  additions,  primarily due to the purchase of
Phase II of the campus located in Menlo Park,  California,  additions to support
increased  marketing and tradeshow  programs,  and capital  additions to support
increased head count.  In association  with the  acquisition of Encore  Computer
Corporation and other acquisitions expected to be completed, contingent upon the
completion of various  closing  conditions,  in the first and second quarters of
fiscal 1998, the Company expects to record  in-process  research and development
write-offs that are not likely to exceed $160 million. In addition,  the Company
plans to expend $300 to $600  million  during  fiscal 1998  associated  with the
development of additional campuses in Colorado, Massachusetts, and California.

Approximately  $430 million of cash was used by financing  activities  in fiscal
1997,  compared with $449 million used in fiscal 1996.  This change is primarily
due to a reduction in the dollar value of shares  repurchased  from $522 million
for fiscal 1996 to $456 million for fiscal 1997,  retirement  of the  receivable
purchase agreement of $125 million and additional  short-term  borrowings of $52
million.

The Company's  exposure to interest rate risk on the $40 million  mortgage loan,
due in May 1999, and the international  short-term borrowings of $101 million is
not  material,  given  the  short-term  maturity  of these  instruments  and the
Company's  evaluation  of the potential  for rate changes  associated  with such
instruments.  The  Company  has entered  into an  interest  rate swap  agreement
(exchanging a fixed rate for variable) related to the $40 million mortgage loan.
The potential  impact of this swap  arrangement  on the Company's  mortgage loan
interest rate is not expected to be material.

At June 30, 1997, the Company's primary sources of liquidity  consisted of cash,
cash equivalents,  and short-term  investments of $1,113 million and a revolving
credit facility with banks aggregating $300 million, which was available subject
to  compliance  with certain  covenants,  and $440 million of  borrowings  under
available  lines of  credit to the  Company's  international  subsidiaries.  The
Company  believes  that the liquidity  provided by existing cash and  short-term
investment balances and the borrowing  arrangements  described above may have to
be supplemented with additional  resources to provide sufficient capital to meet
the Company's  requirements  through fiscal 1998. The Company believes the level
of financial  resources is a significant  competitive factor in its industry and
may  choose  at any time to raise  additional  capital  through  debt or  equity
financing to strengthen its financial  position,  facilitate growth, and provide
the  Company  with   additional   flexibility  to  take  advantage  of  business
opportunities that may arise.

25

<PAGE>
CONSOLIDATED STATEMENTS OF INCOME

                                                            Years Ended June 30,
(In thousands, except share and
 per share amounts)                        1997         1996        1995
--------------------------------------------------------------------------------
Net revenues                            $8,598,346   $7,094,751   $5,901,885
Cost and expenses:
 Cost of sales                           4,320,460    3,921,228    3,335,610
 Research and development                  825,968      653,044      562,895
 Selling, general and administrative     2,402,442    1,787,567    1,503,024
 Nonrecurring charges                       22,958       57,900        --
--------------------------------------------------------------------------------
Total costs and expenses                 7,571,828    6,419,739    5,401,529
Operating income                         1,026,518      675,012      500,356
Gain on sale of equity investment           62,245        --           --
Interest income                             39,899       42,976       40,778
Interest expense                            (7,455)      (9,114)     (17,836)
--------------------------------------------------------------------------------
Income before income taxes               1,121,207      708,874      523,298
Provision for income taxes                 358,787      232,486      167,456
--------------------------------------------------------------------------------
Net income                              $  762,420   $  476,388   $  355,842
--------------------------------------------------------------------------------
Net income per common
and common-equivalent share             $     1.96   $     1.21   $     0.91
--------------------------------------------------------------------------------
Common and common-equivalent 
shares used in the calculation of 
net income per share                       388,967      393,380      393,700
--------------------------------------------------------------------------------
See accompanying notes. 

26

<PAGE>


<TABLE>
CONSOLIDATED BALANCE SHEETS

<CAPTION>
                                                                                                                         At June 30,
(In thousands, except share and per share amounts)                                                  1997                    1996
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                            <C>                      <C>        
Assets
Current assets:
 Cash and cash equivalents                                                                     $   660,170              $   528,854
 Short-term investments                                                                            452,590                  460,743
 Accounts receivable, net of allowances for
  price protection, cooperative marketing programs,
  and bad debts of $196,091 in 1997 and $100,730 in 1996                                         1,666,523                1,206,612
 Inventories                                                                                       437,978                  460,914
 Deferred tax assets                                                                               286,720                  177,554
 Other current assets                                                                              224,469                  199,059
------------------------------------------------------------------------------------------------------------------------------------
    Total current assets                                                                         3,728,450                3,033,736
Property, plant and equipment:
 Machinery and equipment                                                                         1,057,239                  928,361
 Furniture and fixtures                                                                             93,078                   69,059
 Leasehold improvements                                                                            166,745                   91,052
 Land and buildings                                                                                341,279                  193,912
------------------------------------------------------------------------------------------------------------------------------------
                                                                                                 1,658,341                1,282,384
Accumulated depreciation and amortization                                                         (858,448)                (748,535)
------------------------------------------------------------------------------------------------------------------------------------
                                                                                                   799,893                  533,849
Other assets, net                                                                                  168,931                  233,324
------------------------------------------------------------------------------------------------------------------------------------
                                                                                               $ 4,697,274              $ 3,800,909
------------------------------------------------------------------------------------------------------------------------------------
Liabilities and Stockholders' Equity
Current liabilities:
 Short-term borrowings                                                                         $   100,930              $    49,161
 Accounts payable                                                                                  468,912                  325,067
 Accrued payroll-related liabilities                                                               337,412                  282,778
 Accrued liabilities and other                                                                     625,600                  518,772
 Deferred service revenues                                                                         197,616                  140,157
 Income taxes payable                                                                              118,568                  134,934
 Current portion of long-term debt                                                                    --                     38,400
------------------------------------------------------------------------------------------------------------------------------------
    Total current liabilities                                                                    1,849,038                1,489,269
Long-term debt and other obligations                                                               106,299                   60,154
Commitments and contingencies
Stockholders' equity:
 Preferred stock, $0.001 par value, 10,000,000 shares
  authorized; no shares issued and outstanding                                                        --                       --
 Common stock, $0.00067 par value, 950,000,000 shares
  authorized; issued: 430,535,886 shares in 1997 and
  426,320,118 shares in 1996                                                                           288                       72
 Additional paid-in capital                                                                      1,229,797                1,164,349
 Retained earnings                                                                               2,409,850                1,662,355
 Treasury stock, at cost: 60,050,380 shares in 1997 and
  54,355,876 shares in 1996                                                                       (915,426)                (596,910)
 Currency translation adjustment and other                                                          17,428                   21,620
------------------------------------------------------------------------------------------------------------------------------------
    Total stockholders' equity                                                                   2,741,937                2,251,486
------------------------------------------------------------------------------------------------------------------------------------
                                                                                               $ 4,697,274              $ 3,800,909
------------------------------------------------------------------------------------------------------------------------------------
<FN>
See accompanying notes. 
</FN>
</TABLE>

27

<PAGE>


<TABLE>
CONSOLIDATED STATEMENTS OF CASH FLOWS


<CAPTION>
                                                                                                              Years  Ended  June 30,
(In  thousands)                                                                                1997           1996            1995
------------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                       <C>            <C>            <C>        
Cash flow from operating activities:
 Net income                                                                               $   762,420    $   476,388    $   355,842
 Adjustments to reconcile net income to operating cash flows:
  Depreciation and amortization                                                               341,727        284,083        240,626
  Gain on sale of equity investment                                                           (62,245)          --             --
  Tax benefit of options exercised                                                             63,825         53,000         20,837
  Other non-cash items                                                                         33,208         68,358          2,482
  Net increase in receivables                                                                (334,911)      (160,238)      (188,773)
  Net decrease (increase) in inventories                                                       22,936       (135,742)       (24,724)
  Net increase (decrease) in accounts payable                                                 143,845         17,275        (59,833)
  Net increase in other current and non-current assets                                       (152,510)       (43,701)        (2,006)
  Net increase in other current and non-current liabilities                                   286,793        128,891        293,043
------------------------------------------------------------------------------------------------------------------------------------
Net cash provided from operating activities                                                 1,105,088        688,314        637,494
------------------------------------------------------------------------------------------------------------------------------------
Cash flow from investing activities:
 Additions to property, plant and equipment                                                  (554,018)      (295,638)      (242,436)
 Acquisition of other assets                                                                  (37,645)       (83,889)       (68,089)
 Acquisition of short-term investments                                                       (973,884)    (1,301,798)    (3,470,614)
 Payment for acquisitions                                                                     (22,958)       (96,100)          --
 Proceeds from sale of equity investment                                                       62,245           --             --
 Maturities of short-term investments                                                         634,765      1,424,324      2,300,824
 Sales of short-term investments                                                              347,771        228,377        804,862
------------------------------------------------------------------------------------------------------------------------------------
Net cash used by investing activities                                                        (543,724)      (124,724)      (675,453)
------------------------------------------------------------------------------------------------------------------------------------
Cash flow from financing activities:
 Issuance of stock, net of employee repurchases                                                52,969         59,554         79,613
 Acquisition of treasury stock                                                               (456,090)      (522,336)       (36,107)
 Proceeds from employee stock purchase plans                                                   81,313         54,840         42,750
 Proceeds (reduction) of short-term borrowings, net                                            51,769         (1,625)       (27,901)
 Retirement of receivable purchase agreement                                                 (125,000)          --             --
 Reduction of long-term borrowings and other                                                  (35,009)       (39,038)       (40,464)
------------------------------------------------------------------------------------------------------------------------------------
Net cash (used by) provided from financing activities                                        (430,048)      (448,605)        17,891
------------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents                                          131,316        114,985        (20,068)
------------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, beginning of year                                                  528,854        413,869        433,937
------------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year                                                    $   660,170    $   528,854    $   413,869
------------------------------------------------------------------------------------------------------------------------------------
Supplemental  disclosures of cash-flow information:
  Cash paid during the period for:
    Interest                                                                              $    15,126    $    18,140    $    14,229
    Income taxes                                                                          $   380,814    $   193,461    $   113,999
Supplemental schedule of non-cash investing and financing activities:
The Company  purchased all of the assets of Integrated Micro Products plc during
 fiscal 1996. In conjunction with the  acquisition,  liabilities were assumed as
 follows:
  Fair value of assets acquired                                                                  --      $   101,500           --
  Cash paid for assets                                                                           --          (96,100)          --
------------------------------------------------------------------------------------------------------------------------------------
  Liabilities assumed                                                                            --      $     5,400           --
------------------------------------------------------------------------------------------------------------------------------------
Stock issued in conjunction with acquisitions                                                    --      $    19,012           --
------------------------------------------------------------------------------------------------------------------------------------
<FN>
See accompanying notes.
</FN>
</TABLE>

28

<PAGE>


<TABLE>
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<CAPTION>
                                              Common stock                                                   Treasury stock
                                           Shares          Amount         Additional      Retained       Shares            Amount
                                                                             Paid-in      Earnings                               
Three years ended June 30, 1997                                              Capital                                             
(in thousands, except share amounts)
------------------------------------------------------------------------------------------------------------------------------------
<S>                                      <C>            <C>            <C>             <C>              <C>            <C>          
Balances at June 30, 1994                425,576,800    $         72   $  1,066,571    $    879,135     (50,171,500)   $   (329,245)
Issuance of stock, net of
 employee repurchases                        (66,876)           --             --           (29,494)     23,190,140         159,285
Treasury stock purchased                        --              --             --              --        (4,470,956)        (36,107)
Net income                                      --              --             --           355,842            --              --   
Tax benefit and other                           --              --           22,907            --              --              --   
------------------------------------------------------------------------------------------------------------------------------------
Balances at June 30, 1995                425,509,924              72      1,089,478       1,205,483     (31,452,316)       (206,067)
Issuance of stock, net of
 employee repurchases                        (40,468)           --             --           (19,516)     14,561,928         131,493
Issuance of restricted stock                 850,662            --           19,012            --              --              --   
Treasury stock purchased                        --              --             --              --       (37,465,488)       (522,336)
Net income                                      --              --             --           476,388            --              --   
Tax benefit and other                           --              --           55,859            --              --              --   
------------------------------------------------------------------------------------------------------------------------------------
Balances at June 30, 1996                426,320,118              72      1,164,349       1,662,355     (54,355,876)       (596,910)
Issuance of stock, net of
 employee repurchases                        (10,000)           --             --           (14,710)     10,378,115         137,574
Treasury stock purchased                        --              --             --              --       (16,072,619)       (456,090)
Exercise of warrants                       4,225,768               1          1,611            --              --              --   
Net income                                      --              --             --           762,420            --              --   
Tax benefit and other                           --              --           63,837            --              --              --
Issuance of common
 stock dividend                                 --               215            --             (215)           --              --   
Balances at June 30, 1997                430,535,886    $        288   $  1,229,797    $  2,409,850     (60,050,380)   $   (915,426)
------------------------------------------------------------------------------------------------------------------------------------

</TABLE>

                                                   Currency                Total
                                                Translation        Stockholders'
                                                Adjustments               Equity
                                                  and Other
--------------------------------------------------------------------------------
Balances at June 30, 1994                        $    11,790        $ 1,628,323
Issuance of stock, net of
 employee repurchases                                   --              129,791
Treasury stock purchased                                --              (36,107)
Net income                                              --              355,842
Tax benefit and other                                 21,839             44,746
--------------------------------------------------------------------------------
Balances at June 30, 1995                             33,629          2,122,595
Issuance of stock, net of
 employee repurchases                                   --              111,977
Issuance of restricted stock                            --               19,012
Treasury stock purchased                                --             (522,336)
Net income                                              --              476,388
Tax benefit and other                                (12,009)            43,850
--------------------------------------------------------------------------------
Balances at June 30, 1996                             21,620          2,251,486
Issuance of stock, net of
 employee repurchases                                   --              122,864
Treasury stock purchased                                --             (456,090)
Exercise of warrants                                    --                1,612
Net income                                              --              762,420
Tax benefit and other                                 (4,192)            59,645
Issuance of common
 stock dividend                                        --                 --   
Balances at June 30, 1997                        $    17,428        $ 2,741,937
--------------------------------------------------------------------------------
See accompanying notes.

29

<PAGE>


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1. Summary of Significant Accounting Policies

Description of business

Sun  Microsystems,  Inc.  ("Sun" or the  "Company")  is a  supplier  of  network
computing products including workstations,  servers, software,  microprocessors,
and a full range of  services  and  support.  The Company  markets its  products
primarily to business, government, and education customers. The Company operates
in a single industry segment across geographically diverse markets.

Basis of presentation

The  consolidated  financial  statements  include  the  accounts  of Sun and its
wholly-owned  subsidiaries.  Intercompany  accounts and  transactions  have been
eliminated.  Certain amounts from prior years have been  reclassified to conform
to current-year presentation.

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

Cash equivalents and short-term investments

Cash   equivalents   consist   primarily  of  highly  liquid   investments  with
insignificant interest rate risk and original maturities of three months or less
at the date of acquisition.

Short-term  investments  consist  primarily of time deposits,  commercial paper,
tax-exempt  securities,  and foreign debt with original  maturities beyond three
months. The Company's policy is to protect the value of its investment portfolio
and minimize principal risk by earning returns based on current interest rates.

The Company  accounts for  investments in accordance  with Financial  Accounting
Standards No. 115 (FAS 115),  "Accounting  for Certain  Investments  in Debt and
Equity  Securities."  Under FAS 115, debt  securities  that the Company does not
have the  positive  intent and  ability to hold to maturity  and all  marketable
equity securities are classified as either trading or available-for-sale and are
carried  at  fair  market  value.  All of the  Company's  cash  equivalents  and
short-term investments are classified as available-for-sale at June 30, 1997 and
1996. Unrealized holding gains and losses on  available-for-sale  securities are
carried net of tax as a separate component of stockholders'  equity in "Currency
translation adjustment and other."

Gross  unrealized  gains and losses are computed on the specific  identification
method.  The change in net unrealized  gains and losses in  investments,  net of
income taxes,  resulted in a decrease to stockholders' equity in fiscal 1997 and
1996. The net unrealized loss included in stockholders'  equity at June 30, 1997
and 1996, was not material.

Inventories

Inventories are stated at the lower of cost (first in, first out) or market (net
realizable  value).  Given  the  volatility  of the  market  for  the  Company's
products,  the Company makes inventory  write downs for  potentially  excess and
obsolete inventory based on backlog and forecast demand.  However,  such backlog
and forecast demand is subject to revisions,  cancellations,  and  rescheduling.
Actual demand will inevitably differ from such backlog and forecast demand,  and
such  differences  may be  material  to the  financial  statements.  Inventories
consist of:

                    (In thousands)        1997       1996
                     Raw materials      $236,900   $267,811
                     Work in progress     50,577     58,337
                     Finished goods      150,501    134,766
                     --------------------------------------
                                        $437,978   $460,914
                     --------------------------------------

Property, plant and equipment

Property,  plant and equipment are stated at cost. Depreciation and amortization
are provided  principally  on the  straight-line  method over the shorter of the
estimated useful lives of the assets (ranging from one to twenty-five  years) or
the applicable lease term.

 30


<PAGE>


Sun Microsystems, Inc. 1997 Annual Report


Other assets

Included in other assets are purchased technology rights, other intangibles, and
spare parts that are amortized using the straight-line  method over their useful
lives  ranging  from six  months  to seven  years.  The  Company  evaluates  the
recoverability of the intangibles on a quarterly basis.

Currency translation

Sun translates the assets and liabilities of international  non-U.S.  functional
currency subsidiaries into dollars at the rates of exchange in effect at the end
of the period. Revenues and expenses are translated using rates that approximate
those in effect during the period.  Gains and losses from  currency  translation
are  included  in  stockholders'  equity  in the  consolidated  balance  sheets.
Currency  transaction  gains or losses are recognized in current  operations and
have not been significant to the Company's operating results in any period.

Other financial instruments

The Company  enters into  interest-rate  swap  agreements to modify the interest
characteristics  of  its  outstanding  long-term  debt.  An  interest-rate  swap
agreement is designated as a hedge, and  effectiveness is determined by matching
the principal balance and terms with that of a specific debt obligation. Such an
agreement  involves the exchange of amounts  based on a fixed  interest rate for
amounts based on variable  interest rates over the life of the agreement without
an  exchange  of  the  notional  amount  upon  which  payments  are  based.  The
differential  to be paid or  received as  interest  rates  change is accrued and
recognized as an adjustment of interest expense related to the debt (the accrual
method  of  accounting).  The  related  amount  payable  to or  receivable  from
counterparties is included in other liabilities or assets.

The Company purchases foreign currency option contracts that effectively  enable
it to sell  currencies  expected  to be  received  as a result of certain of its
foreign  currency  denominated  sales during the ensuing three to five months at
specified  dollar  amounts.  The  option  contracts,  which  have  only  nominal
intrinsic  value at the time of purchase,  are  denominated  in the same foreign
currency in which sales are expected to be denominated.

These  contracts are designated and effective as hedges of a portion of probable
foreign currency exposure on anticipated net sales transactions  during the next
quarter,  which  otherwise  would expose the Company to foreign  currency  risk.
Premiums related to option contracts are recognized into income over the life of
the contract.  Gains on foreign  currency  option  contracts that are designated
hedges on anticipated  transactions  are deferred until the designated net sales
are  recorded.  Option  contracts  that would result in losses if exercised  are
allowed to expire.

The Company uses forward  foreign  exchange  contracts  that are  designated  to
reduce a portion of its exposure to foreign  currency risk from  operational and
balance-sheet  exposures  resulting  from changes in foreign  currency  exchange
rates.  Such  exposures  result  from the portion of the  Company's  operations,
assets,  and  liabilities  that are  denominated  in  currencies  other than the
functional  currency of the legal  entity in which the  contracts  are  entered,
including  local currency  denominated  assets and  liabilities  in U.S.  dollar
functional  currency  entities.   Forward  contracts  are  accounted  for  on  a
mark-to-market  basis with realized and  unrealized  gains or losses  recognized
currently. Discounts or premiums are recognized into income over the life of the
contract.  Amounts  receivable and payable on certain forward  foreign  exchange
contracts  are  recorded  as  other  current  assets  and  accrued  liabilities,
respectively.

The  Company  does not use  derivative  financial  instruments  for  speculative
trading  purposes,  nor does it hold or  issue  leveraged  derivative  financial
instruments.

Revenue recognition

Sun generally recognizes revenue from hardware and software sales at the time of
shipment,   with  allowances  established  for  price  protection,   cooperative
marketing  programs with  distributors,  and estimated product returns.  Service
revenues are recognized  ratably over the contractual  period or as the services
are provided.

31


<PAGE>


Notes to consolidated financial statements


Advertising costs

Advertising costs are charged to expense when incurred.  Advertising expense was
$272 million,  $168 million,  and $152 million for fiscal years 1997,  1996, and
1995, respectively.

Self-insurance

The  Company is  self-insured  up to specific  levels for  certain  liabilities.
Accruals  are  provided  each year based on  historical  claim costs and include
estimated  amounts for incurred but not reported claims.  The Company  maintains
stop loss  coverage  with  third-party  insurance  companies to cover  aggregate
annual losses in excess of $25 million.

Warranty expense

The Company  provides  currently  for the  estimated  costs that may be incurred
under warranties for products shipped.

Net income per common and common-equivalent share

Net income per common and common-equivalent share is computed using the weighted
average  number of common and  dilutive  common-equivalent  shares  outstanding.
Dilutive  common-equivalent  shares consist of the  incremental  shares issuable
upon the  exercise  of stock  options and  warrants  (using the  treasury  stock
method).  Fully diluted  earnings per share has not been  presented  because the
additional dilution effect is immaterial.

Concentration of credit risk

Financial  instruments that potentially subject the Company to concentrations of
credit risk consist  principally  of  investment  securities,  foreign  exchange
contracts,  and  interest-rate  instruments  as well as trade  receivables.  The
counterparties   to  the  agreements   relating  to  the  Company's   investment
securities, foreign exchange contracts, and interest-rate instruments consist of
various major  corporations and financial  institutions of high credit standing.
The Company does not believe there is  significant  risk of  non-performance  by
these counterparties because the Company limits the amount of credit exposure to
any one financial institution and any one type of investment. The credit risk on
receivables  due from  counterparties  related to foreign  exchange and currency
option  contracts  was  immaterial  at June 30,  1997 and  1996.  The  Company's
receivables are derived  primarily from sales of hardware and software  products
and services to customers in  diversified  industries as well as to a network of
resellers.  The Company  performs  ongoing credit  evaluations of its customers'
financial  condition  and  limits  the  amount of credit  extended  when  deemed
necessary  but  generally  requires  no  collateral.  In fiscal 1997 the Company
provided  approximately  $20 million for doubtful  accounts ($11 million and $12
million in 1996 and 1995, respectively).

Stock dividend

The Company effected a two-for-one  stock split (effected in the form of a stock
dividend) to  stockholders of record as of the close of business on November 18,
1996.  Share and per-share  amounts  presented have been adjusted to reflect the
stock dividend.

Stock-based  compensation

The  Company  adopted  Financial   Accounting   Standards  No.  123  (FAS  123),
"Accounting  for Stock-Based  Compensation"  in fiscal 1997. As permitted by FAS
123, the Company continued to measure  compensation  expense for its stock-based
employee compensation plans using the intrinsic method prescribed by APB No. 25,
"Accounting for Stock Issued to Employees," and has provided in Note 8 pro forma
disclosures  of the effect on net income and  earnings  per share as if the fair
value-based  method  prescribed  by  FAS  123  had  been  applied  in  measuring
compensation expense.

Long-lived assets

The  Company  adopted  Financial   Accounting   Standards  No.  121  (FAS  121),
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be  Disposed  Of" in fiscal  1997.  Adoption  of FAS 121 did not have a material
effect on the Company's consolidated financial position or operating results.

Other recent pronouncements

In 1997 Financial  Accounting Standards No. 128 (FAS 128), "Earnings per Share,"
was issued and is effective for fiscal years commencing after December 15, 1997.
The future  adoption of FAS 128 is not expected to have a material effect on the
Company's reported earnings per share.

32

<PAGE>


Sun Microsystems, Inc. 1997 Annual Report


In  1997  Financial   Accounting   Standards  No.  130  (FAS  130),   "Reporting
Comprehensive  Income," was issued and is effective for fiscal years  commencing
after  December 15, 1997. The Company will comply with the  requirements  of FAS
130 in fiscal year 1999.

In 1997 Financial  Accounting  Standards No. 131 (FAS 131),  "Disclosures  About
Segments of an Enterprise and Related  Information," was issued and is effective
for fiscal years  commencing  after  December 15, 1997.  The Company will comply
with the requirements of FAS 131 in fiscal year 1999.

2. Acquisitions

On February 14, 1997, the Company  acquired all of the outstanding  interests of
Long View Technologies, LLC ("Long View"), a limited liability development-stage
company,  for  $22,957,500  in cash.  None of Long View's  products had achieved
technological  feasibility and no alternative  uses have been established by the
Company. The transaction was accounted for as a purchase. The purchase price has
been allocated to purchased  in-process  research and development  based upon an
independent  third-party  valuation.   The  purchased  in-process  research  and
development  resulted in a write-off of  $22,957,500.  Results of  operations of
Long View for the last five months of the fiscal year ended June 30,  1997,  are
included in the Company's consolidated statement of income and were not material
to the Company.

During  April 1996,  the  Company  acquired  substantially  all of the assets of
Integrated  Micro  Products plc, and its  wholly-owned  subsidiaries  Integrated
Micro Products (UK),  Ltd. and Integrated  Micro Products,  Inc.,  (collectively
IMP) for $96,100,000 in cash. In addition,  the Company  assumed  liabilities of
$5,400,000,   and  incurred   acquisition-related   expenses  of   approximately
$4,200,000.  The transaction was accounted for as a purchase and, on this basis,
the excess  purchase  price over the  estimated  fair value of the net  tangible
assets has been allocated to various intangible assets,  primarily consisting of
purchased research and development and goodwill based on independent third-party
valuation.  The  purchased  in-process  research and  development  resulted in a
write-off of  $43,000,000.  Intangible  assets,  including  goodwill,  are being
amortized over periods ranging from two to five years.  Results of operations of
IMP for the last two  months  of the  fiscal  year  ending  June 30,  1996,  are
included in the Company's consolidated statement of income and were not material
to the Company.

On June 28, 1996, the Company  completed a merger with Lighthouse  Design,  Ltd.
("Lighthouse").  Approximately 850,000 shares of stock valued at $19,000,000 and
$3,200,000  in cash were  exchanged for all of the  outstanding  common stock of
Lighthouse.  The transaction was accounted for as a purchase and, on this basis,
the excess  purchase  price over the  estimated  fair value of the net  tangible
assets has been allocated to various intangible assets,  primarily consisting of
purchased research and development and goodwill based on independent third-party
valuation.  The  purchased  in-process  research and  development  resulted in a
write-off of  $14,900,000.  Intangible  assets,  including  goodwill,  are being
amortized over periods ranging from two to three years.

3. Fair Value of Financial Instruments

Fair values of cash and cash equivalents and short-term investments  approximate
cost due to the short  period of time to  maturity.  The fair value of long-term
debt is estimated  based on current  interest rates available to the Company for
debt instruments with similar terms, degrees of risk, and remaining  maturities.
The estimated fair value of forward foreign  exchange  contracts is based on the
estimated  amount at which they could be settled based on market exchange rates.
The fair value of foreign currency option contracts and the  interest-rate  swap
agreement is obtained from dealer quotes and represents the estimated amount the
Company would receive or pay to terminate the agreements.  However, considerable
judgment is required in  interpreting  market data to develop the  estimates  of
fair value.  Accordingly,  the estimates  presented  herein are not  necessarily
indicative  of the amounts that the Company  could  realize in a current  market
exchange.

33

<PAGE>


Notes to consolidated financial statements


<TABLE>
The fair value of the Company's cash  equivalents and short-term  investments is
as follows:

<CAPTION>
                                                                         At June 30, 1997
                                              Cost        Gross        Gross    Estimated
                                                     Unrealized   Unrealized   Fair Value
(In thousands)                                            Gains       Losses   
-----------------------------------------------------------------------------------------
<S>                                         <C>        <C>        <C>          <C>     
State and local government debt             $166,449   $     16   $     56     $166,409
Corporate and other non-governmental debt    282,240          5         89      282,156
U.S. government debt                          85,628        233         13       85,848
Foreign debt                                  15,026         24       --         15,050
Money market fund                            119,600       --         --        119,600
Other investments                             27,500       --         --         27,500
-----------------------------------------------------------------------------------------
Total                                       $696,443   $    278   $    158     $696,563
-----------------------------------------------------------------------------------------

                                                                         At June 30, 1996
                                              Cost        Gross        Gross    Estimated
                                                     Unrealized   Unrealized   Fair Value
(In thousands)                                            Gains       Losses   
-----------------------------------------------------------------------------------------
State and local government debt             $343,616   $    121   $    173     $343,564
Corporate and other non-governmental debt    137,342        275      2,340      135,277
U.S. government debt                          46,364          1         39       46,326
Foreign debt                                  22,256          9         13       22,252
Money market fund                            108,900       --         --        108,900
Other investments                             50,400       --         --         50,400
-----------------------------------------------------------------------------------------
Total                                       $708,878   $    406   $  2,565     $706,719
-----------------------------------------------------------------------------------------
</TABLE>


The  cost  and  estimated  fair  values  of  cash   equivalents  and  short-term
investments by contractual maturity are as follows:

Cash equivalents and short-term
investments                                             At June 30, 1997
                                      Cost                    Estimated
 (In thousands)                                              Fair Value
-----------------------------------------------------------------------
Maturing in one year or less        $643,820                  $643,846
Maturing after one year
 through three years                  52,623                    52,717
-----------------------------------------------------------------------
Total                               $696,443                  $696,563
-----------------------------------------------------------------------

34

<PAGE>


Sun Microsystems, Inc. 1997 Annual Report


<TABLE>
The fair  value of the  Company's  borrowing  arrangements  and other  financial
instruments is as follows:
<CAPTION>
                                     At June 30, 1997             At June 30, 1996
                                     Asset (Liability)           Asset (Liability)
                                      Carrying        Fair      Carrying         Fair
(In thousands)                          Amount       Value        Amount        Value
--------------------------------------------------------------------------------------
<S>                                  <C>          <C>          <C>          <C>     
10.55% senior notes                       --           --      $ (38,400)   $ (39,855)
10.18% mortgage loan                 $ (40,000)   $ (42,541)     (40,000)     (43,230)
Forward foreign exchange contracts      (2,861)      (2,861)       1,877        1,877
Foreign currency option contracts         --          1,262         --          3,094
Short-term borrowings                 (100,930)    (100,930)     (49,161)     (49,161)
Interest-rate swap agreement              --            196         --            260
--------------------------------------------------------------------------------------
</TABLE>

4. Derivative Financial Instruments

Outstanding  notional  amounts for  derivative  financial  instruments at fiscal
year-ends were as follows:

 (In thousands)               1997              1996
-----------------------------------------------------
Swaps hedging debt         $ 40,000          $ 78,400
Forward foreign exchange
 contracts                  856,979           549,188
Foreign currency option
 contracts                  254,182           207,568
-----------------------------------------------------

While the  contract  or  notional  amounts  provide one measure of the volume of
these  transactions,  they do not represent the amount of the Company's exposure
to credit risk. The amounts potentially subject to credit risk (arising from the
possible  inability of  counterparties to meet the terms of their contracts) are
generally  limited  to  the  amounts,  if  any,  by  which  the  counterparties'
obligations  exceed the obligations of the Company.  The Company controls credit
risk through credit approvals, limits, and monitoring procedures.  Credit rating
criteria  for  off  balance  sheet   transactions   are  similar  to  those  for
investments.

At June 30, 1997 and 1996, the Company had forward foreign exchange contracts of
less than three months duration,  to exchange  principally Japanese yen, British
pounds sterling,  and French francs for U.S. dollars in the total gross notional
amount  of $857  million  and $549  million,  respectively.  Of  these  notional
amounts, forward contracts to purchase foreign currency represented $128 million
and $85 million and forward contracts to sell foreign currency  represented $729
million and $464 million, at June 30, 1997 and 1996,  respectively.  The Company
also has purchased foreign currency options of less than two months duration, to
exchange  principally  Japanese yen, British pounds sterling,  German marks, and
French francs for U.S. dollars.

5. Borrowing Arrangements

Long-term debt consists of the following:

                                                At June 30,
 (In thousands)                     1997              1996
-----------------------------------------------------------
10.55% senior notes               $  --             $38,400
10.18% mortgage                    40,000            40,000
                                   40,000            78,400
-----------------------------------------------------------
Less portion due within one year     --              38,400
-----------------------------------------------------------
Long-term debt                    $40,000           $40,000

In September and December 1989, the Company  signed  agreements  with a group of
insurance  companies  and received  $192 million from the sale of 10.55%  senior
notes due  September  1996 and  warrants to purchase  5,176,720  shares of Sun's
common  stock at an  effective  exercise  price of $6.20  per  share,  after and
subject to, further antidilution adjustments. During September 1996, the Company
made the final  principal  payment and all of the warrants were exercised by the
holders thereof.

The $40  million  mortgage  loan is secured  by real  property  and a  building.
Principal is due to the bank at maturity on May 18, 1999, with interest  payable
semiannually,  in arrears.  The loan agreement  provides for interest at a fixed
interest  rate  of  10.18%.  However,  the  Company  has an  interest-rate  swap
agreement with a third party (receive fixed,

35

<PAGE>


Notes to consolidated financial statements


pay variable)  that results in the Company  paying a rate based on LIBOR,  which
was 5.81% at June 30, 1997. The  interest-rate  swap agreement  matures with the
loan agreement.

In June 1996, the Company  negotiated a $300 million unsecured  revolving credit
agreement with an international group of 16 banks. The agreement expires on June
1, 2000.  Any  borrowings  under this agreement bear interest at a floating rate
based on prime,  certificates of deposit,  or Eurodollar rates, at the Company's
option.  Under the  agreement,  Sun is required to  maintain  various  financial
ratios. Sun was in compliance with all covenants at June 30, 1997. There were no
borrowings under this facility at June 30, 1997.

At June 30, 1997,  Sun's  international  subsidiaries  had uncommitted  lines of
credit  aggregating  approximately  $541 million,  of which  approximately  $101
million,  denominated  principally in yen, had been drawn.  The average interest
rate on the borrowings at June 30, 1997, was 2.30%.

6. Income Taxes

Income  before  income taxes and the  provision  for income taxes consist of the
following:

                                                            Years Ended June 30,
(In thousands)                               1997           1996           1995
--------------------------------------------------------------------------------
Income before income taxes:
 United States                        $   566,554    $   291,126    $   249,569
 Foreign                                  554,653        417,748        273,729
--------------------------------------------------------------------------------
Total income before income taxes      $ 1,121,207    $   708,874    $   523,298
--------------------------------------------------------------------------------
Provision for income taxes
 Current:
  United States federal               $   303,537    $   152,514    $   122,769
  State                                    46,894         16,192         10,121
  Foreign                                  67,234         61,796         57,395
--------------------------------------------------------------------------------
    Total current income taxes            417,665        230,502        190,285
--------------------------------------------------------------------------------
Deferred:
 United States federal                    (50,791)        (3,332)       (17,129)
 State                                     (5,231)         1,178          5,319
 Foreign                                   (2,856)         4,138        (11,019)
--------------------------------------------------------------------------------
    Total deferred income taxes           (58,878)         1,984        (22,829)
--------------------------------------------------------------------------------
Provision for income taxes            $   358,787    $   232,486    $   167,456
--------------------------------------------------------------------------------

36

<PAGE>


Sun Microsystems, Inc. 1997 Annual Report


Deferred  income  taxes  reflect  the net tax effects of  temporary  differences
between the carrying  amounts of assets and liabilities for financial  reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax liabilities and assets are as follows:

                                                            Years Ended June 30,
(In thousands)                                            1997           1996
--------------------------------------------------------------------------------
Deferred tax assets:
 Inventory valuation                                   $  66,057      $  42,855
 Reserves and other accrued expenses                     115,722         56,272
 Fixed asset basis differences                            63,717         49,460
 Compensation not currently deductible                    38,979         29,015
 State income taxes                                       21,926          2,135
 Other                                                    33,901         13,059
--------------------------------------------------------------------------------
Gross tax assets                                         340,302        192,796
Deferred tax liabilities:
 Net undistributed profits of subsidiaries              (112,758)       (20,008)
 Other                                                      (928)        (5,050)
--------------------------------------------------------------------------------
Gross deferred tax liabilities                          (113,686)       (25,058)
Net deferred tax assets                                $ 226,616      $ 167,738
--------------------------------------------------------------------------------

<TABLE>
The provision for income taxes differs from the amount  computed by applying the
statutory federal income tax rate to income before income taxes. The sources and
tax effects of the difference are as follows:

<CAPTION>
                                                                     At June 30,
(In thousands)                                      1997         1996         1995
-------------------------------------------------------------------------------------
<S>                                              <C>          <C>          <C>      
Expected tax rate at 35%                         $ 392,423    $ 248,106    $ 183,154
State income taxes, net of federal tax benefit      27,081       11,291       10,036
Foreign earnings permanently reinvested in
  foreign operations                               (63,550)     (36,580)     (20,460)
Other                                                2,833        9,669       (5,274)
-------------------------------------------------------------------------------------
Provision for income taxes                       $ 358,787    $ 232,486    $ 167,456
-------------------------------------------------------------------------------------
</TABLE>

As of June 30, 1997, the Company has  unrecognized  deferred tax  liabilities of
approximately  $124 million related to cumulative net undistributed  earnings of
foreign   subsidiaries  of  approximately  $399  million.   These  earnings  are
considered to be permanently invested in operations outside the United States.

37

<PAGE>


Notes to consolidated financial statements


The  current  federal  and  state  provisions  do not  reflect  the tax  savings
resulting from  deductions  associated  with the Company's  various stock option
plans. These savings (in thousands) were $59,799; $53,079; and $20,837 in fiscal
1997, 1996, and 1995,  respectively,  and were credited to stockholders' equity.
The  Company's  United States income tax returns for fiscal years ended June 30,
1988 through 1994, are under  examination,  and the Internal Revenue Service has
proposed  certain  adjustments.  Management  believes that adequate amounts have
been  provided  for any  adjustments  that  may  ultimately  result  from  these
examinations.

7. Commitments

The  Company  leases  certain  facilities  and  equipment  under   noncancelable
operating  leases.  The future minimum  annual lease payments are  approximately
$110 million,  $92 million, $68 million, $46 million, and $39 million for fiscal
years 1998, 1999, 2000, 2001, and 2002,  respectively,  and  approximately  $159
million for years following  fiscal 2002.  Rent expense under the  noncancelable
operating  leases was $113 million in 1997, $99 million in 1996, and $82 million
in 1995.

8. Stockholders' Equity

Common stock

In April 1989, the Company's Board of Directors approved a plan, as amended,  to
protect stockholders' rights in the event of a proposed takeover of the Company.
Under the plan,  the Board of Directors  declared a dividend  distribution  of a
common share  purchase  right (a "Right") on each share of the Company's  common
stock (a "Common  Share")  outstanding  on May 26,  1989,  and each Common Share
issued thereafter (subject to certain  limitations).  Upon becoming exercisable,
each Right will  entitle its holder to purchase  one Common Share at an exercise
price  of  $50  subject  to  adjustment.  The  Rights  are  not  exercisable  or
transferable apart from the Common Shares unless certain events occur, including
a  public  announcement  that a person  or group  (an  "Acquiring  Person")  has
acquired  or  obtained  the  right to  acquire  10% or more  (20% or more for an
Acquiring  Person who has filed a Schedule 13G in accordance with the Securities
Act of 1934  ["13G  Filer"])  of the  outstanding  Common  Shares  or until  the
commencement  or announcement of an intention to make a tender or exchange offer
for 30% or  more  of the  outstanding  Common  Shares.  Unless  the  Rights  are
redeemed,  in the event that an  Acquiring  Person  acquires 10% or more (20% or
more if the Acquiring  Person is a 13G Filer) of the  outstanding  Common Shares
(other than  pursuant to a tender  offer deemed fair by the  Company's  Board of
Directors),  each Right not held by the Acquiring Person will entitle the holder
to purchase for the exercise  price that number of Common Shares having a market
value equal to two times the exercise  price.  In the event that (i) the Company
is acquired in a merger or business  combination in which the Company is not the
surviving  corporation  or in which the Common Shares are exchanged for stock or
assets of  another  entity,  or (ii) 50% or more of the  Company's  consolidated
assets or earning power is sold, each Right not held by an Acquiring Person will
entitle the holder to purchase for the  exercise  price that number of shares of
common stock of the acquiring  company  having a market value equal to two times
the exercise price. The Rights are redeemable,  in whole but not in part, at the
Company's option, at $0.0025 per Right at any time prior to becoming exercisable
and  in  certain  other  circumstances.  The  Rights  expire  on May  25,  1999.

Stock-option and incentive plans

The Company's 1990 Long-Term  Equity  Incentive Plan ("1990 Incentive Plan") and
other  employee  stock  option  plans  provide  the  Board  of  Directors  broad
discretion  in creating  employee  equity  incentives  and authorize it to grant
incentive and  nonstatutory  stock  options as well as certain other awards.  In
addition, these plans provide for issuance to eligible employees of nonstatutory
stock options to purchase common stock at or below fair market value at the date
of grant subject to certain  limitations  set forth in the 1990 Incentive  Plan.
Options  expire  up to ten  years  from the date of grant or up to three  months
following  termination of employment or service on the Board,  whichever  occurs
earlier, and are exercisable at specified times prior to such expiration.  Under
the 1990  Incentive  Plan,  common  stock may also be issued  pursuant  to stock
purchase  agreements  that grant Sun certain  rights to repurchase the shares at
their  original  issue price in the event that the employment of the employee is
terminated prior to certain predetermined vesting dates. The above

38

<PAGE>

Sun Microsystems, Inc. 1997 Annual Report


described  plans  provide  that shares of common  stock may be sold at less than
fair market value, which results in compensation expense equal to the difference
between  the  market  value on the date of grant and the  purchase  price.  This
expense,  which is  immaterial,  is  recognized  over the vesting  period of the
shares. Sun's 1988 DirectorsO Stock Option Plan provides for the automatic grant
of stock options to nonemployee directors at each annual meeting of stockholders
and on the date each such person  becomes a director.  These options are granted
at fair  market  value  on the  date of  grant  and  have a term of five  years.
Finally,  in connection  with the  acquisition  of Lighthouse  Design,  Ltd., in
fiscal year 1996,  former  shareholders who are now employees of the Company are
entitled to receive up to approximately 650,000 shares of stock upon achievement
of specific  performance  criteria over the next three years.

<TABLE>
Information  with respect to stock option and stock purchase  rights activity is
as follows:

<CAPTION>
                                                                    Outstanding Options/Rights
                                             Shares           Number           Price per Share     Weighted
                                          Available        of Shares                                Average
(In thousands, except per share amounts)  for Grant                                          Exercise Price
-------------------------------------------------------------------------------------------------------------
<S>                                        <C>               <C>               <C>                 <C>   
Balance at June 30, 1994                   2,172             53,696            $   0.00017-$9.25   $ 5.99
Additional shares reserved                13,400               --                    --              --   
Grants                                   (14,372)            14,372            $ 0.00017-$12.282   $ 8.50
Exercises                                   --              (14,312)           $  0.00017-$8.532   $ 5.71
Cancellations                              3,484             (4,508)           $     4.19-$8.719   $ 6.49
-------------------------------------------------------------------------------------------------------------
Balance at June 30, 1995                   4,684             49,248            $  0.0025-$12.282   $ 6.84
Additional shares reserved                49,040               --                    --              --
Grants                                   (12,886)            12,886            $ 0.00034-$30.125   $20.25
Exercises                                   --               (9,762)           $   0.00034-$19.5   $ 6.78
Cancellations                              4,440             (4,616)           $   0.005-$30.125   $ 7.64
-------------------------------------------------------------------------------------------------------------
Balance at June 30, 1996                  45,278             47,756            $   0.005-$30.125   $10.84
Additional shares reserved                   300               --                    --              --
Grants                                   (13,289)            13,289            $0.00067-$33.9375   $26.90
Exercises                                   --               (7,367)           $    0.01-$30.125   $ 6.99
Cancellations                              1,840             (2,319)           $    0.01-$33.375   $13.32
-------------------------------------------------------------------------------------------------------------
Balance at June 30, 1997                  34,129             51,359            $0.00067-$33.9375   $15.44
-------------------------------------------------------------------------------------------------------------
</TABLE>

39

<PAGE>


Notes to consolidated financial statements


<TABLE>
The following table summarizes significant ranges of outstanding and exercisable
options at June 30, 1997:
<CAPTION>
 
                                      Outstanding Options                     Options Exercisable
-------------------------------------------------------------------------------------------------------
Range of                     Shares       Weighted        Weighted           Shares           Weighted
Exercise Prices                            Average         Average                             Average
                                         Remaining        Exercise                            Exercise
                                     Life in Years           Price                               Price
-------------------------------------------------------------------------------------------------------
<S>                       <C>                <C>          <C>             <C>                 <C>     
$0.00067-$5.00            4,288,300          4.0          $ 4.5504        2,278,900           $ 4.5733
$  5.001-$10.00          21,839,399          5.4          $ 7.4012        6,886,896           $ 7.2443
$10.0001-$15.00           2,749,740          6.0          $11.5599          442,300           $11.7329
$15.0001-$20.00           1,985,000          6.4          $19.5000          304,680           $19.5000
$20.0001-$25.00           8,175,662          7.2          $23.6645        1,068,788           $23.3494
$25.0001-$30.00           9,803,134          7.6          $27.1950            2,500           $26.6250
$30.0001-$33.9375         2,517,930          7.6          $32.2730          159,306           $30.1250
-------------------------------------------------------------------------------------------------------
                         51,359,165          6.2          $15.4370       11,143,370           $ 9.0874
</TABLE>


At June 30,  1997,  options to  purchase  approximately  11,143,000  shares were
exercisable  at prices  from  $4.1875 to  $30.1250  with a weighted  average and
aggregate  exercise price of $9.0874 and $101,264,000,  respectively  (8,898,000
shares at an aggregate price of $57,012,000 at June 30, 1996).

At June 30, 1997,  the Company  retains  repurchase  rights to 1,059,000  shares
issued pursuant to stock-purchase agreements and other stock plans.

The  weighted  average  fair value at date of grant for options  granted  during
1997, 1996, and 1995 was $17.873, $11.517, and $4.904 per option,  respectively.
The  fair  value  of  options  at the  date of grant  was  estimated  using  the
Black-Scholes model with the following weighted average assumptions:

                 1997               1996             1995
------------------------------------------------------------
Expected life     8.1               7.7              7.6
Interest rate     6.06%             6.36%            7.25%
Volatility       46.60%            57.99%           38.86%
Dividend yield       0                 0                0
------------------------------------------------------------

Employee stock-purchase plan

To provide employees with an opportunity to purchase common stock of Sun through
payroll deductions, Sun established the 1990 Employee Stock Purchase Plan. Under
this plan, Sun's employees, subject to certain restrictions, may purchase shares
of common stock at 85% of the fair market value at either the date of enrollment
or

40

<PAGE>


Sun Microsystems, Inc. 1997 Annual Report


the date of purchase whichever is less. Pursuant to this plan, and the Company's
1984 Employee Stock Purchase Plan (which terminated in August 1992), the Company
issued approximately 2,928,689;  4,714,000; and 8,808,000 shares of common stock
in fiscal 1997, 1996, and 1995,  respectively.  At June 30, 1997,  approximately
13,235,825 shares remained available for future issuance.

Common stock repurchase programs

In December  1990,  the Board of Directors  approved a  systematic  common stock
repurchase  program  related to the 1990 Employee Stock Purchase Plan. In fiscal
1997, the Company  repurchased  2,919,632 shares at a cost of approximately  $88
million  under this program  (3,077,488  shares at a cost of  approximately  $63
million in fiscal 1996).

In June 1995, the Board of Directors approved a plan to repurchase approximately
48 million shares of the Company's common stock.  During fiscal 1997 the Company
repurchased  8,904,258 shares at a cost of approximately $236 million under this
program (34,388,000 shares at a cost of approximately $460 million in 1996).

In August  1996,  the Board of  Directors  approved a  systematic  common  stock
repurchase  program  related to the 1990  Long-Term  Equity  Incentive  Plan. In
fiscal 1997, the Company repurchased 4,248,729 shares at a cost of approximately
$132 million under this program.

When the treasury  shares are  reissued,  any excess of the average  acquisition
cost of the shares  over the  proceeds  from  reissuance  is charged to retained
earnings.

Stock-based compensation

The Company has elected to follow Accounting  Principles Board (APB) Opinion No.
25,  "Accounting  for Stock Issued to Employees,"  and related  interpretations,
which require  compensation expense for options to be recognized when the market
price of the underlying stock exceeds the exercise price on the date of grant.

Financial  Accounting  Standards No. 123 (FAS 123),  "Accounting for Stock-Based
Compensation," permits companies to recognize as expense over the vesting period
the fair value of all  stock-based  awards on the date of grant. In management's
opinion, the existing stock option valuation models do not necessarily provide a
reliable single measure of the fair value of stock-based awards.  Therefore,  as
permitted,  the Company  will  continue to apply the existing  accounting  rules
under APB 25 and provide pro forma net income and pro forma  earnings  per share
disclosures   for   stock-based   awards   made   during  the  year  as  if  the
fair-value-based  method defined in FAS 123 had been applied. For employee stock
options,  the fair value of the stock  options was  estimated  as of the date of
grant using the Black-Scholes  option pricing model. Input variables used in the
model include a weighted  average  risk-free  interest rate using the eight-year
Treasury  Yield as of the date of grant  ranging  from 6.02% to 6.90% for fiscal
year 1997,  expected  dividend yield of 0%, estimated  volatility  factor of the
expected market price of the Company's  common stock of 46.6%,  and an estimated
option life of 8.1 years.

For the Employee Stock Purchase Plan, the fair value of the stock was calculated
using actuals for the plans  expiring  during the year. For plans expiring after
year end, the fair value was calculated  using estimated  shares to be purchased
and estimated purchase price.

Stock-based  compensation  costs would have reduced pretax income by $76,033,000
and  $35,116,000  in  fiscal  1997  and  1996,  respectively,  ($51,703,000  and
$23,879,000  after tax and $.08 and $.05 per  share)  if the fair  values of the
options granted in that year had been  recognized as  compensation  expense on a
straight line basis over the vesting  period of the grant.  The pro forma effect
on net income for fiscal  1997 and 1996 is not  representative  of the pro forma
effect  on net  income  in the  future  years  because  it does  not  take  into
consideration  pro forma  compensation  expense  related to grants made prior to
fiscal 1996.

Pro forma net income and earnings per share are as follows:

 (In thousands, except per share amounts)    1997             1996
------------------------------------------------------------------
Pro forma net income                     $710,717         $452,509
------------------------------------------------------------------
Pro forma common
 stock equivalents                        377,288          390,390
------------------------------------------------------------------
Pro forma earnings per share             $   1.88         $   1.16
------------------------------------------------------------------

41

<PAGE>


Notes to consolidated financial statements


9. Industry-Segment, Geographic, and Customer Information

Sun,  which  operates  in a  single  industry  segment,  designs,  manufactures,
markets,  and services  network  computing  systems and software  solutions that
feature networked desktops and servers. No customer accounted for 10% or more of
revenues  in  fiscal  1997,   1996,  or  1995.   Operations  of  Sun's  overseas
subsidiaries consist of sales, service, distribution, and manufacturing.

Intercompany transfers between geographic areas are accounted for at prices that
approximate arm's length transactions.  In addition,  United States export sales
approximated  3.0%, 3.8%, and 3.6% of net revenues during fiscal 1997, 1996, and
1995, respectively.

<TABLE>
Information regarding geographic areas at June 30, 1997, 1996, and 1995, and for
each of the years then ended, is as follows:

<CAPTION>
                                                      Geographic Area
                                                      United         Europe        Japan        Rest of   Eliminations      Total
(In thousands)                                        States                                      World
------------------------------------------------------------------------------------------------------------------------------------
<S>                                               <C>           <C>           <C>           <C>           <C>            <C>        
June 30, 1997, and for the year then ended:
Sales to unaffiliated
 customers                                        $ 4,709,343   $ 2,177,319   $   958,753   $   752,931   $      --      $ 8,598,346
Intercompany transfers                                978,981     2,018,531        17,973        61,724    (3,077,209)          --
------------------------------------------------------------------------------------------------------------------------------------
Net revenues                                      $ 5,688,324   $ 4,195,850   $   976,726   $   814,655   $(3,077,209)   $ 8,598,346
------------------------------------------------------------------------------------------------------------------------------------
Operating income                                  $   477,136   $   522,575   $    13,958   $     8,116   $     4,733    $ 1,026,518
------------------------------------------------------------------------------------------------------------------------------------
Identifiable assets                               $ 4,079,585   $ 2,408,106   $   360,814   $   385,763   $(2,536,994)   $ 4,697,274
------------------------------------------------------------------------------------------------------------------------------------
Liabilities                                       $ 2,351,239   $ 1,284,970   $   350,076   $   369,868   $(2,400,816)   $ 1,955,337
------------------------------------------------------------------------------------------------------------------------------------
June 30, 1996, and for the year then ended:
Sales to unaffiliated
 customers                                        $ 3,791,154   $ 1,778,712   $   991,044   $   533,841   $      --      $ 7,094,751
Intercompany transfers                                944,785     1,586,615        16,847        50,868    (2,599,115)          --
------------------------------------------------------------------------------------------------------------------------------------
Net revenues                                      $ 4,735,939   $ 3,365,327   $ 1,007,891   $   584,709   $(2,599,115)   $ 7,094,751
------------------------------------------------------------------------------------------------------------------------------------
Operating income                                  $   280,296   $   370,034   $    23,690   $     6,497   $    (5,505)   $   675,012
------------------------------------------------------------------------------------------------------------------------------------
Identifiable assets                               $ 3,721,745   $ 1,542,890   $   325,417   $   319,262   $(2,108,405)   $ 3,800,909
------------------------------------------------------------------------------------------------------------------------------------
Liabilities                                       $ 2,023,047   $   891,360   $   305,045   $   318,834   $(1,988,863)   $ 1,549,423
------------------------------------------------------------------------------------------------------------------------------------
June 30, 1995, and for the year then ended:
Sales to unaffiliated
 customers                                        $ 3,136,328   $ 1,490,960   $   866,440   $   408,157   $      --      $ 5,901,885
Intercompany transfers                                945,264     1,189,536        17,590        36,458    (2,188,848)          --
------------------------------------------------------------------------------------------------------------------------------------
Net revenues                                      $ 4,081,592   $ 2,680,496   $   884,030   $   444,615   $(2,188,848)   $ 5,901,885
------------------------------------------------------------------------------------------------------------------------------------
Operating income                                  $   242,078   $   251,248   $    17,385   $     9,371   $   (19,726)   $   500,356
------------------------------------------------------------------------------------------------------------------------------------
Identifiable assets                               $ 3,573,509   $ 1,301,731   $   378,052   $   215,750   $(1,924,489)   $ 3,544,553
------------------------------------------------------------------------------------------------------------------------------------
Liabilities                                       $ 1,793,964   $   934,427   $   337,589   $   199,800   $(1,843,822)   $ 1,421,958
------------------------------------------------------------------------------------------------------------------------------------

</TABLE>

42

<PAGE>


Sun Microsystems, Inc. 1997 Annual Report


10. Contingencies

In March 1990 Sun received a letter from Texas Instruments  Incorporated  ("TI")
alleging that a substantial  number of Sun's products  infringe  certain of TI's
patents.  Based on  discussions  with TI, Sun  believes  that it will be able to
negotiate a license  agreement  with TI and that the outcome of this matter will
not have a material adverse impact on Sun's financial position or its results of
operations or cash flows in any given fiscal year. Such a negotiated license may
or may not have a material adverse impact on Sun's results of operations or cash
flows in a given fiscal quarter  depending upon various  factors,  including but
not  limited  to the  structure  and  amount  of  royalty  payments,  offsetting
consideration  from TI, if any, and  allocation  of  royalties  between past and
future  product  shipments,  none  of  which  can be  forecast  with  reasonable
certainty at this time.

In the normal course of business,  the Company receives and makes inquiries with
regard to other  possible  patent  infringements.  Where deemed  advisable,  the
Company may seek or extend licenses or negotiate settlements.

The estimate of the  potential  impact on the  Company's  financial  position or
overall  results of operations for the above legal  proceedings  could change in
the future.


11. Quarterly Financial Data (unaudited)

                                                       Fiscal 1997 Quarter Ended
(In thousands,
 except per share amounts)      June 30     March 30   December 29  September 29
--------------------------------------------------------------------------------
Net revenues                   $2,543,121   $2,114,618   $2,081,588   $1,859,019
Gross margin                    1,281,358    1,061,424    1,048,186      886,918
Operating income                  337,679      257,010      255,845      175,984
Net income                        237,178      223,511      178,341      123,390
Net income per share           $     0.61   $     0.58   $     0.46   $     0.31
--------------------------------------------------------------------------------


                                                       Fiscal 1996 Quarter Ended
(In thousands,
 except per share amounts)      June 30     March 30   December 31     October 1
--------------------------------------------------------------------------------
Net revenues                   $2,018,062   $1,840,028   $1,751,383   $1,485,278
Gross margin                      903,020      823,340      778,718      668,445
Operating income                  182,306      201,791      177,971      112,944
Net income                        122,336      143,307      126,049       84,696
Net income per share           $     0.31   $     0.37   $     0.32   $     0.21
--------------------------------------------------------------------------------

12. Subsequent Events (unaudited)

On July 17, 1997, the Company signed a definitive  agreement to purchase certain
assets from Encore  Computer  Corporation,  for  $185,000,000  in cash,  and the
assumption of specific liabilities. Upon and subject to closing, the transaction
will be accounted for as a purchase and, on this basis,  the purchase price will
be allocated  to tangible  and  intangible  assets and  in-process  research and
development.

The closing of this  acquisition  is contingent  upon the  completion of various
closing  conditions. 

During  August  1997,  the Company  acquired  all of the  outstanding  shares of
capital stock of Diba, Inc. The transaction  will be accounted for as a purchase
and, on this basis,  the purchase  price will be  allocated to tangible  assets,
intangible assets, and in-process research and development.

43

<PAGE>


Report of Ernst & Young LLP, Independent Auditors


The Board of Directors and Stockholders, Sun Microsystems,  Inc.

We  have  audited  the   accompanying   consolidated   balance   sheets  of  Sun
Microsystems,  Inc. as of June 30, 1997 and 1996,  and the related  consolidated
statements of income, stockholders' equity, and cash flows for each of the three
years in the period  ended June 30, 1997.  These  financial  statements  are the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these financial statements based on our audits.

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

In our opinion,  the financial  statements  referred to above present fairly, in
all material respects,  the consolidated financial position of Sun Microsystems,
Inc. at June 30, 1997 and 1996, and the  consolidated  results of its operations
and its cash  flows for each of the three  years in the  period  ended  June 30,
1997, in conformity with generally accepted accounting principles.

                                                    /s/Ernst & Young LLP


Palo Alto, California
July 16, 1997

44