<PAGE>   1

                                                                      EXHIBIT 13

                                  FINANCIAL REVIEW

                   OPEN HERE FOR A LONG-TERM VIEW OF SUN'S GROWTH
<PAGE>   2

                HISTORICAL FINANCIAL REVIEW OF SUN MICROSYSTEMS, INC.

                      SUMMARY CONSOLIDATED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
                                                              YEARS ENDED JUNE 30,
                                      ---------------------------------------------------------------------
                                           1998              1997              1996              1995
                                      ---------------   ---------------   ---------------   ---------------
                                      DOLLARS     %     DOLLARS     %     DOLLARS     %     DOLLARS     %
                                      -------   -----   -------   -----   -------   -----   -------   -----
                                                     (IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
<S>                                   <C>       <C>     <C>       <C>     <C>       <C>     <C>       <C>
Net revenues........................  $9,791    100.0   $8,598    100.0   $7,095    100.0   $5,902    100.0
                                      ------    -----   ------    -----   ------    -----   ------    -----
Costs and expenses:
  Cost of sales.....................   4,693     47.9    4,320     50.2    3,921     55.3    3,336     56.5
  Research and development..........   1,014     10.4      826      9.6      653      9.2      563      9.5
  Selling, general and
     administrative.................   2,777     28.4    2,402     27.9    1,788     25.2    1,503     25.5
  Purchased in-process research and
     development....................     177      1.8       23      0.3       58      0.8       --       --
          Total costs and
            expenses................   8,661     88.5    7,571     88.0    6,420     90.5    5,402     91.5
                                      ------    -----   ------    -----   ------    -----   ------    -----
Operating income....................   1,130     11.5    1,027     12.0      675      9.5      500      8.5
Gain on sale of equity investment...      --       --       62      0.7       --       --       --       --
Interest income (expense), net......      46      0.5       32      0.4       34      0.5       23      0.4
Litigation settlement...............      --       --       --       --       --       --       --       --
Income before income taxes..........   1,176     12.0    1,121     13.1      709     10.0      523      8.9
Provision for income taxes..........     413      4.2      359      4.2      232      3.3      167      2.8
                                      ------    -----   ------    -----   ------    -----   ------    -----
Net income..........................  $  763      7.8   $  762      8.9   $  477      6.7   $  356      6.1
Net income per common share -- diluted... $ 1.93        $ 1.96            $ 1.21            $ 0.91
                                      ------            ------            ------            ------
Shares used in the calculation of
  net income per common
  share -- diluted..................     394               389               393               394
</TABLE>

                       OPERATING AND CAPITALIZATION DATA

<TABLE>
<CAPTION>
                                                                  YEARS ENDED JUNE 30,
                                                        -----------------------------------------
                                                          1998       1997       1996       1995
                                                        --------   --------   --------   --------
<S>                                                     <C>        <C>        <C>        <C>
Total assets (millions)...............................  $  5,771   $  4,697   $  3,801   $  3,545
                                                        --------   --------   --------   --------
Long-term debt and other obligations (millions).......  $     75   $    106   $     60   $     91
Current ratio.........................................       2.0        2.0        2.0        2.2
Long-term debt-to-equity ratio........................        --      0.015      0.018      0.039
Return on average equity..............................        24%        31%        22%        19%
Return on average capital.............................        24%        30%        23%        18%
Return on average assets..............................        15%        18%        13%        11%
Effective income tax rate.............................      35.1%        32%        33%        32%
                                                        --------   --------   --------   --------
Average shares and equivalents (thousands)............   394,274    388,967    393,380    393,700
                                                        --------   --------   --------   --------
Book value per outstanding share......................  $   9.34   $   7.40   $   6.05   $   5.39
                                                        --------   --------   --------   --------
</TABLE>

                                       F-1
<PAGE>   3

             HISTORICAL FINANCIAL REVIEW OF SUN MICROSYSTEMS, INC.

                   SUMMARY CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
                                                    YEARS ENDED JUNE 30,
                                -------------------------------------------------------------
                                     1994              1993              1992          1991
                                ---------------   ---------------   ---------------   -------
                                DOLLARS     %     DOLLARS     %     DOLLARS     %     DOLLARS
                                -------   -----   -------   -----   -------   -----   -------
                                           (IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
<S>                             <C>       <C>     <C>       <C>     <C>       <C>     <C>
Net revenues..................  $4,690    100.0   $4,309    100.0   $3,589    100.0   $3,221
                                ------    -----   ------    -----   ------    -----   ------
Costs and expenses:
  Cost of sales...............   2,753     58.7    2,518     58.4    1,963     54.7    1,758
  Research and development....     500     10.7      445     10.3      382     10.6      356
  Selling, general and
    administrative............   1,160     24.7    1,105     25.7      983     27.4      812
  Purchased in-process
    research and
    development...............      --       --       --       --       --       --       --
   Total costs and expenses...   4,413     94.1    4,068     94.4    3,328     92.7    2,926
                                ------    -----   ------    -----   ------    -----   ------
Operating income..............     277      5.9      241      5.6      261      7.3      295
Gain on sale of equity
  investment..................      --       --       --       --       --       --       --
Interest income (expense),
  net.........................       6      0.1       (2)      --       (6)    (0.2)     (11)
Litigation settlement.........      --       --      (15)    (0.4)      --       --       --
Income before income taxes....     283      6.0      224      5.2      255      7.1      284
Provision for income taxes....      87      1.8       67      1.6       82      2.3       94
                                ------    -----   ------    -----   ------    -----   ------
Net income....................  $  196      4.2   $  157      3.6   $  173      4.8   $  190
Net income per common share --
  diluted.....................  $ 0.50            $ 0.37            $ 0.42            $ 0.45
                                ------            ------            ------            ------
Shares used in the calculation
  of net income per common
  share -- diluted............     388               430               431               439
                                ------            ------            ------            ------

<CAPTION>
                                          YEARS ENDED JUNE 30,
                                -----------------------------------------
                                1991         1990              1989
                                -----   ---------------   ---------------
                                  %     DOLLARS     %     DOLLARS     %
                                -----   -------   -----   -------   -----
                                 (IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
<S>                             <C>     <C>       <C>     <C>       <C>
Net revenues..................  100.0   $2,466    100.0   $1,765    100.0
                                -----   ------    -----   ------    -----
Costs and expenses:
  Cost of sales...............   54.6    1,399     56.7    1,010     57.2
  Research and development....   11.1      302     12.2      234     13.3
  Selling, general and
    administrative............   25.2      588     23.9      433     24.5
  Purchased in-process
    research and
    development...............     --       --       --       --       --
   Total costs and expenses...   90.9    2,289     92.8    1,677     95.0
                                -----   ------    -----   ------    -----
Operating income..............    9.1      177      7.2       88      5.0
Gain on sale of equity
  investment..................     --       --       --       --       --
Interest income (expense),
  net.........................   (0.3)     (23)    (0.9)     (10)    (0.6)
Litigation settlement.........     --       --       --       --       --
Income before income taxes....    8.8      154      6.3       78      4.4
Provision for income taxes....    2.9       43      1.8       17      1.0
                                -----   ------    -----   ------    -----
Net income....................    5.9   $  111      4.5   $   61      3.4
Net income per common share --
  diluted.....................          $ 0.30            $ 0.19
                                        ------            ------
Shares used in the calculation
  of net income per common
  share -- diluted............             395               348
                                        ------            ------
</TABLE>

                       OPERATING AND CAPITALIZATION DATA

<TABLE>
<CAPTION>
                                                          YEARS ENDED JUNE 30,
                                     ---------------------------------------------------------------
                                       1994       1993       1992       1991       1990       1989
                                     --------   --------   --------   --------   --------   --------
<S>                                  <C>        <C>        <C>        <C>        <C>        <C>
Total assets (millions)............  $  2,898   $  2,768   $  2,672   $  2,326   $  1,779   $  1,269
                                     --------   --------   --------   --------   --------   --------
Long-term debt and other
  obligations (millions)...........  $    122   $    178   $    348   $    401   $    359   $    145
Current ratio......................       2.0        2.4        2.6        2.5        2.6        1.9
Long-term debt-to-equity ratio.....     0.075       0.11       0.23       0.33       0.39       0.22
Return on average equity...........        12%        10%        13%        18%        14%        12%
Return on average capital..........        12%         9%        10%        13%        11%         9%
Return on average assets...........         7%         6%         7%         9%         7%         6%
Effective income tax rate..........        33%        30%        32%        33%        28%        22%
                                     --------   --------   --------   --------   --------   --------
Average shares and equivalents
  (thousands)......................   387,056    420,500    406,560    412,268    377,476    340,664
                                     --------   --------   --------   --------   --------   --------
Book value per outstanding share...  $   4.34   $   4.03   $   3.72   $   3.15   $   2.51   $   1.97
                                     --------   --------   --------   --------   --------   --------
</TABLE>

                                       F-2
<PAGE>   4

        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:

<TABLE>
<CAPTION>
                                                              1998     1997     1996
                                                              -----    -----    -----
<S>                                                           <C>      <C>      <C>
Net revenues:
  Products..................................................   87.9     90.1     90.2
  Services..................................................   12.1      9.9      9.8
                                                              -----    -----    -----
          Total net revenues................................  100.0%   100.0%   100.0%
Cost of sales:
  Products..................................................   40.5     44.0     48.9
  Services..................................................    7.4      6.2      6.4
                                                              -----    -----    -----
          Total cost of sales...............................   47.9     50.2     55.3
Gross margin................................................   52.1     49.8     44.7
Research and development....................................   10.4      9.6      9.2
Selling, general and administrative.........................   28.4     27.9     25.2
Purchased in-process research and development...............    1.8      0.3      0.8
                                                              -----    -----    -----
Operating income............................................   11.5     12.0      9.5
Gain on sale of investment..................................     --      0.7       --
Interest income, net........................................    0.5      0.4      0.5
                                                              -----    -----    -----
Income before income taxes..................................   12.0     13.1     10.0
Provision for income taxes..................................    4.2      4.2      3.3
                                                              -----    -----    -----
Net income..................................................    7.8%     8.9%     6.7%
                                                              -----    -----    -----
</TABLE>

     This Annual Report, including the following sections, contains
forward-looking statements within the meaning of the Private Securities
Litigation 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 selling, 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 predicted in any such
forward-looking statements. Such factors include, but are not limited to,
adverse changes in general economic conditions, including adverse 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 (including the downturn of economic
trends and unfavorable currency movements in the Asia Pacific marketplace),
risks associated with the Company's efforts to comply with Year 2000
requirements, and other factors, including those listed below.

RESULTS OF OPERATIONS

NET REVENUES

     Sun's products net revenues increased $856 million, or 11%, to $8,603
million in fiscal 1998, compared with an increase of $1,355 million, or 21%, in
fiscal 1997. More than 50% of the increase in products revenues in fiscal 1998
resulted from increased demand throughout the fiscal year for workgroup,
enterprise, and departmental servers and high-end desktop systems and to a
lesser extent from high-end storage, memory and related products. The increase
in products revenues in fiscal 1997 over fiscal 1996 was primarily attributable
to increased shipments of richly configured servers, and higher revenues from
memory, storage options, and accessories.

                                       F-3
<PAGE>   5

     Sun's services net revenues increased $336 million, or 40%, to $1,188
million in fiscal 1998, compared with an increase of $149 million, or 21%, in
fiscal 1997. The increase in services revenues is primarily the result of a
larger installed product base due to increased product unit sales as described
above, as well as increased revenues associated with Sun professional services.
The increase in services revenue from fiscal 1996 to fiscal 1997 is primarily
the result of products revenue growth.

     In fiscal 1998 and fiscal 1997, domestic net revenues grew by 16% and 25%,
respectively, while international net revenues (including United States exports)
grew 12% and 17%, respectively. Revenues from international operations
represented 48%, 49%, and 50% of total revenues in fiscal 1998, 1997, and 1996,
respectively.

     European net revenues increased 20% in fiscal 1998 and 1997, primarily due
to continued market acceptance of Sun's network computing products and services
in most major European markets.

     Japan net revenues decreased 5% for fiscal 1998, compared to a decrease of
3% in fiscal 1997. The Company attributes the decrease in revenues to current
macroeconomic trends affecting the Japanese market, including currency movements
against the U.S. dollar. The Company does not expect these trends to change
materially in the near term. The foregoing is a forward-looking statement that
is subject to risks and uncertainties, and actual results may differ materially
from those set forth in such statement as a result of a number of factors. In
particular, 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 9% in fiscal 1998, compared with
33% in fiscal 1997, primarily due to expanding markets in China, Australia, and
Latin America. This slowing in the growth rate in fiscal 1998 is attributable to
a downturn in economic trends and unfavorable currency movements in the Asia
Pacific marketplace.

     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 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
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 movement on these instruments is not material. See "Other Financial
Instruments" in Note 1 of the "Notes to Consolidated Financial Statements" for
more details.

GROSS MARGIN

     Products gross margin was 53.8% for fiscal 1998, compared with 51.1% and
45.7% for fiscal 1997 and 1996, respectively.

     The increase in products gross margin in fiscal 1998 resulted primarily
from sales of more richly configured, higher margin servers and desktop systems,
and to a lesser extent, from decreased component
                                       F-4
<PAGE>   6

costs. The increase in products gross margin in fiscal 1997 over fiscal 1996 was
primarily due to increased shipments of richly configured servers and higher
revenues from memory, storage options, and accessories.

     Services gross margin was 39.3% for fiscal 1998, compared with 37.7% and
35.5% for fiscal 1997 and 1996, respectively. These increases reflect the
increase in services revenues year over year as the result of a larger installed
base and increased investment by the Company in its services business.

     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 was 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 increasing volumes.

RESEARCH AND DEVELOPMENT

     Research and development (R&D) expenses increased $188 million, or 22.7%,
in fiscal 1998 to $1,014 million, compared with an increase of $173 million, or
26.5%, in fiscal 1997. As a percentage of net revenues, R&D expenses were 10.4%,
9.6%, and 9.2% in fiscal 1998, 1997, and 1996, respectively. The increase in R&D
spending, both in dollars and as a percentage of revenues, was a result of the
Company's continued significant investment related to the 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 for systems and software products, as well as
microprocessor technologies, the Company must continue to invest significant
resources in new systems, software, and microprocessor development, as well as
in enhancements to existing products. The Company expects R&D expenses to
increase in dollar amount in fiscal 1999 while remaining in the range of 10% of
revenue.

SELLING, GENERAL AND ADMINISTRATIVE

     Selling, general and administrative (SG&A) expenses increased $375 million,
or 15.6%, in fiscal 1998 to $2,777 million compared with an increase of $615
million, or 34.4%, in fiscal 1997. As a percentage of net revenues, these
expenses were 28.4%, 27.9%, and 25.2% in fiscal 1998, 1997, and 1996,
respectively. The increase as a percentage of net revenues in fiscal 1998
reflects, in part, the Company's ongoing efforts to expand its demand creation
programs and service and support organizations. The dollar increase also
reflects investments aimed at improving Sun's own business processes. The
increase in dollar amount of SG&A expenses in fiscal 1997 was primarily
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. In fiscal 1999,
the Company expects SG&A expenses to increase in dollar amount, as the Company
continues 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 organizations.

PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT

  IPRD Overview

     The following paragraphs contain forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995, particularly
statements regarding the Company's expectations, including percentage of
completion, expected product release dates, dates for which the Company expects
to begin generating benefits from projects, expected product capabilities and
product life cycles, costs and efforts to complete projects, growth rates,
projected revenue and expense information used by the Company to

                                       F-5
<PAGE>   7

calculate discounted cash flows, and discount rates. These forward-looking
statements involve risks and uncertainties, and the cautionary statements
including those set forth below and in "Future Operating Results" identify
important factors that could cause actual results to differ materially from
those predicted in any such forward-looking statement. Such factors include but
are not limited to, delays in the development of in-process technologies or the
release of products into the market, the complexity of the technology, the
Company's ability to successfully manage product introductions, lack of customer
acceptance, competition and changes in technological trends, and market or
general economic conditions. In addition, there can be no assurance that any of
the new products discussed below will be completed, that such products will meet
either technological or commercial success or that the Company will receive any
economic benefit from such products as a result of delays in the development of
the technology, the complexity of the technology, changes in customer needs, or
for other reasons, including those described above.

     Purchased in-process research and development ("IPRD") of $176.4 million,
$23 million, and $57.9 million in fiscal 1998, 1997, and 1996, respectively,
represents the write-off of in-process technologies associated with the
Company's acquisitions of Diba, Inc. ("Diba"), Integrity Arts, Inc. ("Integrity
Arts"), Chorus Systems, S.A. ("Chorus"), Red Cape Software, Inc. ("Red Cape"),
and the storage products business of Encore Computer Corporation ("Encore") in
fiscal 1998, Long View Technologies, LLC ("Long View") in fiscal 1997 and
Integrated Micro Products, plc and its wholly-owned subsidiaries, Integrated
Micro Products (UK), Ltd. and Integrated Micro Products Inc. (collectively
"IMP"), and Lighthouse Design, Ltd. ("Lighthouse") in fiscal 1996 (collectively
the "Acquired Companies"). At the date of each acquisition noted above, the
projects associated with the IPRD efforts had not yet reached technological
feasibility and the R&D in progress had no alternative future uses. Accordingly,
these amounts were expensed on the respective acquisition dates of each of the
Acquired Companies. Also see Footnote 2 -- "Acquisitions".

     In response to recent actions and comments from the Securities and Exchange
Commission regarding its views on the application of valuation methodologies to
purchased IPRD, the Company has expanded its disclosures related to acquisitions
involving IPRD charges for each of the Acquired Companies. The Company believes
that it is in compliance with all of the rules and related guidance as they
currently exist.

  Valuation of IPRD

     The following table summarizes the significant assumptions underlying the
valuations in 1998, 1997, and 1996 related to the IPRD from each of the Acquired
Companies (in millions, except percentages).


<TABLE>
<CAPTION>
                                                         ACQUISITION ASSUMPTIONS
                                      --------------------------------------------------------------
                                        ESTIMATED COST
                                         TO COMPLETE                                 RISK ADJUSTED
                                      TECHNOLOGY AT TIME                             DISCOUNT RATE
           ENTITY/PROJECT               OF ACQUISITION        LICENSE RATE(1)      ON IN-PROCESS R&D
           --------------             ------------------    -------------------    -----------------
<S>                                   <C>                   <C>                    <C>
Red Cape............................        $  7.4                  n/a                   25%
Encore..............................        $ 30.0              12% in 1999               30%
                                                                10% in 2000
                                                             6% for 2001-2005
Chorus -- JaZZr1.1..................        $  0.2              21% in 1999               25%
                                                                19% in 2000
                                                                17% in 2001
                                                             15% for 2002-2005
Chorus -- Other IPRD................        $  3.0                  n/a                   25%
Integrity Arts......................        $ 16.0                  n/a                   38%
Diba................................        $105.0                  n/a                   36%
Long View...........................        $  8.1                 6.5%                   33%
Lighthouse..........................        $ 13.0                  n/a                   25%
IMP.................................        $ 15.0                  n/a                   22%
</TABLE>


---------------

(1) Represents the license rate (as a percentage of revenue) that a third party
    would have paid and therefore would avoid paying, as the result of acquiring
    the related technology

n/a = not applicable based upon valuation method utilized

                                       F-6
<PAGE>   8


     The following table provides information regarding the status of IPRD
projects upon acquisition and as of June 30, 1998:



<TABLE>
<CAPTION>
                                                                            ACTUAL OR
                                                 PERCENTAGE COMPLETE        EXPECTED
                                                     AT TIME OF          PRODUCT RELEASE
                                                     ACQUISITION              DATE
                                                 -------------------    -----------------
<S>                                              <C>                    <C>
Red Cape.......................................          15%               Q4 Fiscal 1999
Encore.........................................          60%                  Fiscal 1999
Chorus -- JaZZr1.1.............................          50%             Q4 Fiscal 1998(1)
Chorus -- Other IPRD...........................          20%               Q4 Fiscal 1999
Integrity Arts.................................           5%             Q3 Fiscal 1998(2)
Diba...........................................          10%               Q4 Fiscal 1999
Long View......................................          25%             Q4 Fiscal 1998(3)
Lighthouse.....................................          80%             Q1 Fiscal 1998(4)
IMP............................................          10%               Q3 Fiscal 1999
</TABLE>


---------------

(1) Revised expected release date is Q3 Fiscal 1999.



(2) Revised expected release date is Q4 Fiscal 1999.



(3) Revised expected release date is Q2 Fiscal 1999.



(4) Project was abandoned in Q3 of Fiscal 1997. See additional discussion at
    "Overall Status of IPRD".


     The Company calculated amounts allocated to IPRD using established
valuation techniques in the high technology industry and expensed such amounts
in the quarter that each such acquisition was consummated because technological
feasibility had not been achieved and no alternative future uses had been
established. The income approach used gave consideration to relevant market
sizes and growth factors, expected industry trends, the anticipated nature and
timing of new product introductions by Sun and its competitors, individual
product sales cycles, and the estimated life of each product's underlying
technology.

     The values assigned to developed technologies related to each acquisition
were based upon future discounted cash flows related to each of the existing
product's projected income stream. The discount rates used in the present value
calculations were generally derived from a weighted average cost of capital,
adjusted upward to reflect the additional risks inherent in the development life
cycle, including the useful life of the technology, profitability levels of the
technology, and the uncertainty of technology advances that are known at the
date of each acquisition. The Company does not expect to achieve a material
amount of expense reductions or synergies, therefore the valuation assumptions
do not include significant anticipated cost savings.

  Overall Status of IPRD

     With respect to the Company's acquisitions completed in the three years
ended June 30, 1998, with the exception of Encore and IMP which are discussed
separately below, management believes that the projections the Company used in
performing its valuations with respect to each acquisitions are still valid, in
all material respects, however, there can be no assurance that the projected
results will be achieved. Management expects to continue the development of each
project and believes that there is a reasonable chance of successfully
completing such development efforts, except for IPRD technology acquired from
Lighthouse which is discussed below. However, there is risk associated with the
completion of the in-process projects and there can be no assurance that any
project will meet with either technological or commercial success. Failure to
successfully develop and commercialize these in-process projects would result in
the loss of the expected economic return inherent in the fair value allocation.
Additionally, the value of other intangible assets acquired may become impaired.
Although there have been delays in the development efforts related to certain
acquired IPRD technologies, as of June 30, 1998 and for each of the three fiscal
years then ended, the impact upon the Company's consolidated results of
operations or financial position with respect to the success or lack thereof
related to any acquisition, individually or in aggregate, is not considered
material.

                                       F-7
<PAGE>   9

     The Company terminated its development efforts with respect to the IPRD
technology acquired through the acquisition of Lighthouse, a company conducting
development and engineering associated with the completion of a suite of
software products using the NEXTSTEP and OpenStep operating environments for
Solaris and Windows NT systems (collectively the "Lighthouse Software
Products"). During fiscal 1997 Sun's commitment to OpenStep was scaled back
thereby impacting development decisions related to the Lighthouse Software
Products. The decision to abandon the in-process technologies acquired from
Lighthouse was based upon a change in the long term strategy for certain of
Sun's products, the impact of which was not material to the consolidated results
of operations or financial position of Sun.

     Included below are further details regarding the nature of technology
acquired, the valuation assumptions and the status of the IPRD related to Encore
and IMP, the Company's two largest acquisitions in the three years ended June
30, 1998.

ENCORE

  IPRD Overview -- Encore

     At the time of the acquisition (November 24, 1997), Encore was conducting
development and engineering activities associated with its Intershare and
DASD-NET products (the "Encore Products"). It is anticipated that completion of
the Encore Products would help the Company establish a viable position in the
computer mainframe/open systems storage market. In addition, Encore's current
products and technology would help facilitate efforts to develop a high end
"intelligent" storage product, which can also be modified to address the low-end
storage market. As of the date of the acquisition, the release of the Encore
products was expected to commence in fiscal 1999, at which time the Company
expected to generate economic benefits from the value of the development
associated with the IPRD.

     At the acquisition date, Encore needed to perform substantial development
efforts before reaching technological feasibility. These efforts include
converting the box-system architecture to a storage-area-network, developing an
alternative to the interconnect technology used by Encore which will provide the
price and performance required to compete within the market place, and resolving
several design issues during the porting phase of development.

  Valuation of IPRD -- Encore


     At the acquisition date, the Company estimated that total revenue related
to the IPRD technology would increase at a compound annual growth rate of
approximately 55% from fiscal 1999 to 2002. The Company projected that revenues
would peak in fiscal 2002 and decline thereafter as new product technologies
were expected to be introduced by the Company. These projections were based on
management's estimates of market size and growth, expected trends in technology,
and the expected timing of new product introductions. The product life cycle
utilized by the Company resulted in the use of estimated licensing rates of 12%
in 1999, 10% in 2000 and 6% for 2001-2005 of the analysis. The 12% rate was
based upon a 25% operating margin related to the storage product and with 80% of
the value of the product being related to software and 60% of the software being
related to the acquired technology. The rate decline is attributable to
proportionately lower levels of acquired technology in advancing products.


     The Company selected a discount rate of 30%. In the selection of the
appropriate discount rate, consideration was given to the Company's weighted
average cost of capital ("WACC"), as well as other factors including the useful
life of the technology, profitability levels of the technology, the uncertainty
of technology advances that are known at the acquisition date, and the stage of
completion of the technology. The discount rate chosen was greater than the
Company's WACC as the technology had not yet reached technological feasibility
as of the date of the valuation.

     The value assigned to the IPRD reflects the Company's determination of the
relative value and contribution of the acquired research and development. The
Company arrived at the value of the IPRD by giving consideration to the R&D's
stage of completion, the complexity of the work completed to date, the

                                       F-8
<PAGE>   10

difficulty in completing the remaining development, costs already incurred, and
the projected costs to complete the project.

  Comparison to Actual Results -- Encore

     At June 30, 1998, the Company had made progress on the development efforts
related to the Encore Products that was underway as of the acquisition date.
Approximately $5 million of the estimated total cost to complete of $30 million
had been incurred as of June 30, 1998. Although the research and development
effort was approximately twelve months behind schedule at June 30, 1998, the
total expected cost to complete the IPRD technology acquired from Encore has not
increased nor is it expected to exceed the original anticipated cost to complete
the development efforts. Based upon a planned introduction date of late fiscal
1999, the impact of this delay to the consolidated results of operations or
financial position of Sun was not considered material for fiscal 1998.

     Given the uncertainties of the development process, no assurance can be
given that deviations from these estimates will not occur. Management expects to
continue the development of each project and believes that there is a reasonable
chance of successfully completing such development. However, as there is risk
associated with the completion of the in-process projects due to the remaining
efforts to achieve technological feasibility, rapidly changing customer needs,
complexity of technology and growing competitive pressures, there can be no
assurance that any project will meet with either technological or commercial
success. Failure to successfully develop and commercialize these in-process
projects would result in the loss of the expected economic return inherent in
the fair value allocation. Additionally, the value of other intangible assets
acquired may become impaired.

INTEGRATED MICRO PRODUCTS

  IPRD Overview -- IMP

     At the time of the acquisition (April 23, 1996), IMP was conducting
development and engineering activities associated with a next generation
fault-tolerant computer based on Sun's UltraSPARC(TM) microprocessor. The
UltraSPARC-based system will incorporate scalability to multiple processors,
performance improvements, and a new standard bus architecture. The development
of a fault-tolerant UltraSPARC product could enable the deployment of
fault-tolerant functionality across a wide range of Sun's highly scaleable Ultra
Enterprise(TM) Servers. At the acquisition date it was anticipated that the
UltraSPARC product would require approximately one and one-half years of further
development and engineering work. At the acquisition date, IMP was in the
process of developing a fault-tolerant UltraSPARC product line and substantial
development efforts remained, which included design, coding, testing and other
implementation efforts.

  Valuation of IPRD -- IMP

     The Company estimated that total revenue related to the acquired technology
would increase at a compound annual growth rate of approximately 40% from 1997
to 2002. These projections were based on management's estimates of market size
and growth, expected trends in technology, and the expected timing of new
product introductions.

     Management's assumptions with respect to operating expenses used in the
valuation analysis include: (i) cost of goods sold, (ii) SG&A expenses, and
(iii) R&D expenses. Selected operating expense assumptions were based on an
evaluation of IMP's overall business model, including both historic and expected
direct expense levels, and an assessment of general industry metrics. The
Company projected cost of revenues (expressed as a percentage of revenues) for
the IPRD to average 51% over the projection period. Management estimated SG&A
for the IPRD to be 22% and 25% of revenues, respectively, in the first two years
following acquisition, and an average of 13% over the remainder of the
projection period. Management estimated that maintenance R&D related to the IPRD
to be 5% and 3% of revenues, respectively, in the first two years following
acquisition, and an average of 2% of revenues over the full projection period.

                                       F-9
<PAGE>   11

     The Company selected a discount rate for the IPRD of 22%. In the selection
of the appropriate discount rate, consideration was given to Sun's WACC, as well
as other factors including the useful life of the technology, profitability
levels of the technology, the uncertainty of technology advances that were known
at the acquisition date, and the stage of completion of the technology. The
discount rate utilized for the IPRD was determined to be greater than Sun's WACC
due to the fact that the technology had not yet reached technological
feasibility as of the date of the valuation.


     The value of the IPRD reflects the Company's determination of the relative
value and contribution of the acquired research and development. At the
acquisition date, the UltraSPARC based technology was in the design stage of
development. The nature and complexity to complete the product required hardware
engineering, software development, the development and implementation of
verification tests, and the building of engineering prototypes. Management
expected the cost to complete the IPRD would total approximately $15 million,
with an initial expected completion date during the second quarter of fiscal
1998. The remaining work required to complete the product is difficult and
complex, and deviations from the current development plan could have a
significant impact on both the completion date and the associated
cost-to-complete.


  Comparison to Actual Results -- IMP


     Management's projections included a planned introduction date of late
calendar 1997 for IMP's fault tolerant computers based on Sun's UltraSPARC
microprocessors. Management expected the cost to complete the IPRD efforts to be
incurred during fiscal 1997 and 1998 and to total approximately $15 million. As
of June 30, 1998, the development efforts were behind schedule as a result of
increased complexities surrounding the development efforts. As of June 30, 1998,
the revised introduction date is expected to be during the third quarter of
fiscal 1999. Since the expected introduction date was delayed by approximately
one year, the total expected cost to complete the IPRD technology acquired from
IMP has increased to approximately $25 million at June 30, 1998, and
approximately $14 million had been incurred. The impact of the delayed release
of the product based upon IMP's IPRD technology was not considered material to
the consolidated results of operations or financial position of Sun for fiscal
1997 and fiscal 1998.


     Given the uncertainties of the development process, no assurance can be
given that deviations from these estimates will not occur. Management expects to
continue the development of each project and believes that there is a reasonable
chance of successfully completing such development. However, as there is risk
associated with the completion of the in-process projects due to the remaining
efforts to achieve technological feasibility, rapidly changing customer needs,
complexity of technology and growing competitive pressures, there can be no
assurance that any project will meet with either technological or commercial
success. Failure to successfully develop and commercialize these in-process
projects would result in the loss of the expected economic return inherent in
the fair value allocation. Additionally, the value of other intangible assets
acquired may become impaired.

GAIN ON SALE OF EQUITY INVESTMENT

     In fiscal 1997, the gain on sale of equity investment of $62 million
represents 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 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 note payable.

     Net interest income increased to $46.1 million in fiscal 1998, compared
with $32.4 million and $33.9 million in fiscal 1997 and fiscal 1996,
respectively. The increase in net interest income for fiscal 1998 is primarily
the result of higher interest earnings due to a larger average portfolio of cash
and investments as
                                      F-10
<PAGE>   12

compared with the corresponding period in fiscal 1997. The decrease in net
interest income for fiscal 1997, as compared with fiscal 1996, was 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 principal/notional amount of the Company's cash equivalents and
short-term investments at June 30, 1998 were $783.8 million. These investments,
which generally mature in fiscal 1999, bear interest at an average rate of 5.2%
and have a fair market value of $783.9 million.

INCOME TAXES

     The effective tax rate for fiscal 1998 was 33% before a $25.2 million tax
charge resulting from a nonrecurring write-off of in-process research and
development associated with the acquisitions of Diba, Inc.; Integrity Arts,
Inc.; and Red Cape Software, Inc. 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 Company currently expects its effective tax rate to remain at 33% for
fiscal 1999. This rate excludes the impact of potential mergers and
acquisitions, the tax effect of which will be accounted for in the interim
quarter in which the transaction takes place. The expected rate is based on
current tax law and current estimate of earnings, and is subject to change.

FUTURE OPERATING RESULTS

     The markets for Sun's products and services are 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 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, Compaq Computer 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 certain
systems manufacturers, including Dell Computer Corporation and certain of its
competitors listed above, whose products are based on micro-processors 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 new enhanced products. The Company expects
this pressure to continue and intensify into fiscal 1999. 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. Future
operating results will depend to a considerable extent on the Company's ability
to closely manage product introductions in order to minimize

                                      F-11
<PAGE>   13

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 advanced 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 non-cancelable 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 products based on
UltraSPARC processors, 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.

     A significant portion of the Company's revenues is derived from
international sales and is therefore subject to inherent risks related thereto,
including the general economic and political conditions in each country,
currency exchange rate fluctuations, the effect of the tax structures of various
jurisdictions, changes to and compliance with a variety of foreign laws and
regulations, trade protection measures, and import and export licensing
requirements. There can be no assurance that the economic crisis and currency
issues currently being experienced in certain parts of Asia will not have an
adverse effect on the Company's revenue or revenue growth rates in the future.
The impact of any of the foregoing factors could have an adverse effect on the
Company's future financial condition and operating results.

     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 value of its assets, and when necessary, make adjustments thereto.
Acquisitions may involve the amortization of acquired intangible assets in
periods following such acquisitions. In addition, acquisition transactions are
accompanied by a number of risks, including, among other things, those
associated with integrating operations, personnel, and technologies acquired,
and the potential for unknown liabilities of the acquired business.

     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
                                      F-12
<PAGE>   14

implement a number of new business practices and a series of related information
systems across the enterprise that affect numerous operational and financial
systems and processes. Such activities are currently planned to be fully
operational in the first half of fiscal 1999. The time period in which the new
business practices and related information systems will be implemented are
forward-looking statements subject to risks and uncertainties, and actual
results may differ materially from those set forth above as a result of a number
of risk factors. In particular, the timing and duration of the implementation of
the new business practices and information systems are subject to a number of
risks, including the complexity of the conversion process and the new systems
themselves, the transfer of business data and information from the previous
system to the new system, and the need for substantial and comprehensive
employee training in connection with the adoption of such new business practices
and information systems. 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
implementing these systems. In addition, the implementation of these systems
will require the Company to be without certain capabilities critical to normal
operation of its business (such as processing orders and shipping product) for a
period of time as the Company shifts to the new systems. There can be no
assurance that this interruption in the use and availability of enterprise-wide
information systems will not have a material adverse effect on the Company's
business and operating results. In addition, 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.

     Many currently installed computer systems and software products are coded
to accept only two digit entries in the date code field. As the year 2000
approaches, these code fields will need to accept four digit entries to
distinguish years beginning with "19" from those beginning with "20." As a
result, in less than two years, computer systems and/or software products used
by many companies may need to be upgraded to comply with such Year 2000
requirements. The Company is currently expending resources to review its
products and services, as well as its internal-use software in order to identify
and modify those products, services, and systems that are not Year 2000
compliant. The costs associated with this effort are not incremental to the
Company, but represent reallocation of existing resources. The Company believes
any modifications deemed necessary will be made on a timely basis and does not
believe that the cost of such modifications will have a material effect on the
Company's operating results. In addition, the Company believes that its internal
system implementation efforts (as described in the above paragraph), principally
conducted to improve operating efficiencies, will also address the Company's
internal Year 2000 compliance issues. Additionally, the Company is in the
process of evaluating the need for contingency plans with respect to Year 2000
requirements. The necessity of any contingency plan must be evaluated on a
case-by-case basis and will vary considerably in nature depending on the Year
2000 issue it may need to address. The Company's expectations as to the extent
and timeliness of modifications required in order to achieve Year 2000
compliance is a forward-looking statement subject to risks and uncertainties.
Actual results may vary materially as a result of a number of factors,
including, among others, those described in this paragraph and the paragraph
below. There can be no assurance however, that the Company will be able to
successfully modify on a timely basis such products, services, and systems to
comply with Year 2000 requirements, which failure could have a material adverse
effect on the Company's operating results.

     Based on the Company's assessment to date, most newly introduced products
and services of the Company are Year 2000 compliant, however some of the
Company's customers are running product versions that are not Year 2000
compliant. The Company has been encouraging such customers to migrate to current
product versions. In addition, the Company faces risks to the extent that
suppliers of products, services, and systems purchased by the Company and others
with whom the Company transacts business on a worldwide basis do not have
business systems or products that comply with the Year 2000 requirements. To the
extent that Sun is not able to test technology provided by third-party hardware
or software vendors, Sun is in the process of obtaining assurances from such
vendors that their systems are Year 2000 compliant. In the event any such third
parties cannot, in a timely manner, provide the Company with products, services,
or systems that meet the Year 2000 requirements, the Company's operating results
could be materially adversely effected. Although the Company believes that the
cost of Year 2000 modifications for both internal-use software and systems or
the Company's products are not material, there can be no assurance that various
factors relating to
                                      F-13
<PAGE>   15

the Year 2000 compliance issues, including litigation, will not have a material
adverse effect on the Company's business, operating results, or financial
position.

     Eleven of the 15 member countries of the European Union are scheduled to
establish fixed conversion rates between their existing sovereign currencies and
the Euro, and to adopt the Euro as their common legal currency effective January
1, 1999. The Euro will then trade on currency exchanges and be available for
non-cash transactions. The Company is currently expending resources to review
and modify its products to support the Euro's requirements, determine pricing
strategies in the new economic environment, analyze the legal and contractual
implications for contracts, evaluate system capabilities, and ensure banking
vendors can support the Company's operations with respect to Euro transactions.
The Company expects that modifications will be made to its business operations
and systems on a timely basis and does not believe that the cost of such
modifications will have a material adverse impact on the Company's operating
results. There can be no assurance, however, the Company will be able to
complete such modifications to comply with Euro requirements, which could have a
material adverse effect on the Company's operating results. In addition, the
Company faces risks to the extent that vendors upon whom the Company relies and
their suppliers are unable to make appropriate modifications to support Euro
transactions. The Company has not yet completed it evaluation of the impact of
the Euro upon its functional currency designations.

     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. Also see Footnote 1 "Summary of Significant Accounting Policies."

LIQUIDITY AND CAPITAL RESOURCES

     The Company's financial condition strengthened as of fiscal 1998 year end
when compared with fiscal 1997. During fiscal 1998, operating activities
generated $1,527 million in cash and cash equivalents, compared with $1,105
million in fiscal 1997. Accounts receivable increased $179 million, or 11%, to
$1,846 million, due primarily to a 13% increase in net revenues in the fourth
quarter of fiscal 1998 as compared with the corresponding period of 1997.
Deferred tax assets and other current and noncurrent assets increased $240
million, or 35% to $920 million, due primarily to the timing of payments for
income and other taxes, and due to the recording of goodwill and other
intangible assets related to the Company's acquisitions. Accrued liabilities and
other increased $185 million, or 30%, due in part to increases in sales and
marketing costs. Accounts payable increased $27 million, or 6% due in part to
additional operating expenses associated with the expansions of business and
corresponding increase in head count.

     The Company's investing activities used $1,169 million of cash in fiscal
1998, an increase of $625 million from the $544 million used in fiscal 1997. The
increase resulted primarily from payments made for additions to property, plant
and equipment, and in connection with acquisitions. Additions to property, plant
and equipment totaled $830 million, up $276 million, or 50%, from fiscal 1997
additions, primarily due to the real estate development of the Company's
facilities and capital additions to support increased head count. The Company
plans to expend $800 to $900 million during fiscal 1999 related to fixed asset
additions, including approximately $300 million associated with the development
of additional campuses in Colorado, Massachusetts, California, and the United
Kingdom. In connection with the acquisition of NetDynamics, Inc. and other
acquisitions expected to be completed in the first and second quarters of fiscal
1999, contingent upon the completion of various closing conditions, the Company
also expects to record in-process research and development write-offs that are
not likely to exceed $170 million.

     Approximately $195 million of cash was used by financing activities in
fiscal 1998, compared with $430 million used in fiscal 1997. This change is
primarily due to a reduction in the dollar value of shares repurchased, from
$456 million for fiscal 1997 to $284 million for fiscal 1998, retirement of the
receivable purchase agreement of $125 million in 1997, and repayment of
short-term borrowings of $93 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 $7 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
                                      F-14
<PAGE>   16

to the $40 million mortgage loan. The potential impact of this swap agreement on
the Company's mortgage loan interest rate is not expected to be material.

     At June 30, 1998, the Company's primary sources of liquidity consisted of
cash, cash equivalents, and short-term investments of $1,298 million, and a
revolving credit facility with banks aggregating $500 million, which was
available subject to compliance with certain covenants, and $694 million of
borrowings under available lines of credit to the Company's international
subsidiaries. On October 16, 1997, the Company filed a Registration Statement
with the Securities and Exchange Commission relating to the registration for
public offering of senior and subordinated debt securities and common stock with
an aggregate initial public offering price of up to $1 billion. On October 24,
1997, the Registration Statement became effective, so that the Company may now
choose to offer, from time to time, the debt securities and common stock
pursuant to Rule 415 in one or more separate series, in amounts, at prices, and
on terms to be set forth in the prospectus contained in the Registration
Statement and in one or more supplements to the prospectus. The Company believes
that the liquidity provided by existing cash and short-term investment balances
and the borrowing arrangements described above will provide sufficient capital
to meet the Company's requirements through fiscal 1999. However 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.

                                      F-15
<PAGE>   17

                       CONSOLIDATED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
                                                                   YEARS ENDED JUNE 30,
                                                         -----------------------------------------
                                                            1998           1997           1996
                                                         -----------    -----------    -----------
                                                         (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                                      <C>            <C>            <C>
Net revenues:
  Products.............................................  $8,603,259     $7,747,115     $6,392,358
  Services.............................................   1,187,581        851,231        702,393
                                                         ----------     ----------     ----------
          Total net revenues...........................   9,790,840      8,598,346      7,094,751
Costs and expenses:
  Cost of sales -- products............................   3,972,283      3,790,284      3,468,416
  Cost of sales -- services............................     721,053        530,176        452,812
  Research and development.............................   1,013,782        825,968        653,044
  Selling, general and administrative..................   2,777,264      2,402,442      1,787,567
  Purchased in-process research and development........     176,384         22,958         57,900
                                                         ----------     ----------     ----------
          Total costs and expenses.....................   8,660,766      7,571,828      6,419,739
Operating income.......................................   1,130,074      1,026,518        675,012
Gain on sale of equity investment......................          --         62,245             --
Interest income........................................      47,663         39,899         42,976
Interest expense.......................................      (1,571)        (7,455)        (9,114)
                                                         ----------     ----------     ----------
Income before income taxes.............................   1,176,166      1,121,207        708,874
Provision for income taxes.............................     413,304        358,787        232,486
                                                         ----------     ----------     ----------
Net income.............................................  $  762,862     $  762,420     $  476,388
                                                         ----------     ----------     ----------
Net income per common share -- basic...................  $     2.04     $     2.07     $     1.28
                                                         ----------     ----------     ----------
Net income per common share -- diluted.................  $     1.93     $     1.96     $     1.21
                                                         ----------     ----------     ----------
Shares used in the calculation of net income per common
  share -- basic.......................................     373,728        368,426        371,134
                                                         ----------     ----------     ----------
Shares used in the calculation of net income per common
  share -- diluted.....................................     394,274        388,967        393,380
                                                         ----------     ----------     ----------
</TABLE>

                            See accompanying notes.
                                      F-16
<PAGE>   18

                          CONSOLIDATED BALANCE SHEETS

                                     ASSETS

<TABLE>
<CAPTION>
                                                                      AT JUNE 30,
                                                              ----------------------------
                                                                 1998             1997
                                                              -----------      -----------
                                                              (IN THOUSANDS, EXCEPT SHARE
                                                                 AND PER SHARE AMOUNTS)
<S>                                                           <C>              <C>
Current assets:
  Cash and cash equivalents.................................  $  822,267       $  660,170
  Short-term investments....................................     476,185          452,590
  Accounts receivable, net of allowances of $235,563 in 1998
     and $196,091 in 1997...................................   1,845,765        1,666,523
  Inventories...............................................     346,446          437,978
  Deferred tax assets.......................................     371,841          286,720
  Other current assets......................................     285,021          224,469
                                                              ----------       ----------
          Total current assets..............................   4,147,525        3,728,450
Property, plant and equipment:
  Machinery and equipment...................................   1,251,660        1,057,239
  Furniture and fixtures....................................     113,636           93,078
  Leasehold improvements....................................     256,233          166,745
  Land and buildings........................................     635,699          341,279
                                                              ----------       ----------
                                                               2,257,228        1,658,341
Accumulated depreciation and amortization...................    (956,616)        (858,448)
                                                              ----------       ----------
                                                               1,300,612          799,893
Other assets, net...........................................     262,925          168,931
                                                              ----------       ----------
                                                              $5,711,062       $4,697,274
                                                              ==========       ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Short-term borrowings.....................................  $    7,169       $  100,930
  Accounts payable..........................................     495,603          468,912
  Accrued payroll-related liabilities.......................     315,929          337,412
  Accrued liabilities and other.............................     810,562          625,600
  Deferred service revenues.................................     264,967          197,616
  Income taxes payable......................................     188,641          118,568
  Note payable..............................................      40,000               --
                                                              ----------       ----------
          Total current liabilities.........................   2,122,871        1,849,038
Deferred income taxes and other obligations.................      74,563          106,299
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: 430,311,441 shares in 1998 and
     430,535,886 shares in 1997.............................         288              288
  Additional paid-in capital................................   1,345,508        1,229,797
  Retained earnings.........................................   3,150,935        2,409,850
  Treasury stock, at cost: 54,007,866 shares in 1998 and
     60,050,380 shares in 1997..............................  (1,003,191)        (915,426)
  Currency translation adjustment and other.................      20,088           17,428
                                                              ----------       ----------
          Total stockholders' equity........................   3,513,628        2,741,937
                                                              ----------       ----------
                                                              $5,711,062       $4,697,274
                                                              ==========       ==========
</TABLE>

                            See accompanying notes.
                                      F-17
<PAGE>   19

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                    YEARS ENDED JUNE 30,
                                                           --------------------------------------
                                                              1998          1997         1996
                                                           -----------   ----------   -----------
                                                                       (IN THOUSANDS)
<S>                                                        <C>           <C>          <C>
Cash flows from operating activities:
  Net income.............................................  $   762,862   $  762,420   $   476,388
  Adjustments to reconcile net income to operating cash
     flows:
     Depreciation and amortization.......................      439,921      356,003       294,541
     Gain on sale of equity investment...................           --      (62,245)           --
     Tax benefit of options exercised....................      111,375       59,799        53,000
     Purchased in-process research and development.......      176,384       22,958        57,900
     Net increase in accounts receivable.................     (176,075)    (334,911)     (160,238)
     Net (increase) decrease in inventories..............       97,394       22,936      (135,742)
     Net increase (decrease) in accounts payable.........      (12,298)     143,845        17,275
     Net increase in other current and non-current
       assets............................................     (206,210)    (152,510)      (43,701)
     Net increase in other current and non-current
       liabilities.......................................      333,159      286,793       128,891
                                                           -----------   ----------   -----------
Net cash provided from operating activities..............    1,526,512    1,105,088       688,314
                                                           -----------   ----------   -----------
Cash flows from investing activities:
  Additions to property, plant and equipment.............     (830,143)    (554,018)     (295,638)
  Acquisition of other assets............................      (91,521)     (37,645)      (83,889)
  Acquisition of short-term investments..................     (958,354)    (973,884)   (1,301,798)
  Maturities of short-term investments...................      523,032      634,765     1,424,324
  Sales of short-term investments........................      432,047      347,771       228,377
  Proceeds from sale of equity investment................           --       62,245            --
  Payments for acquisitions, net of cash acquired........     (244,020)     (22,958)      (96,100)
                                                           -----------   ----------   -----------
Net cash used by investing activities....................   (1,168,959)    (543,724)     (124,724)
                                                           -----------   ----------   -----------
Cash flows from financing activities:
  Issuance of stock, net of employee repurchases.........       71,975       52,969        59,554
  Acquisition of treasury stock..........................     (284,396)    (456,090)     (522,336)
  Proceeds from employee stock purchase plans............       93,581       81,313        54,840
  Proceeds (reduction) of short-term borrowings, net.....      (92,967)      51,769        (1,625)
  Repayment of receivable purchase agreement.............           --     (125,000)           --
  Proceeds (reduction) of note payable and other.........       16,351      (35,009)      (39,038)
                                                           -----------   ----------   -----------
Net cash used by financing activities....................     (195,456)    (430,048)     (448,605)
Net increase in cash and cash equivalents................      162,097      131,316       114,985
Cash and cash equivalents, beginning of year.............      660,170      528,854       413,869
                                                           -----------   ----------   -----------
Cash and cash equivalents, end of year...................  $   822,267   $  660,170   $   528,854
                                                           ===========   ==========   ===========
Supplemental disclosures of cash flow information:
  Cash paid during the year for:
     Interest............................................  $       905   $   15,126   $    18,140
     Income taxes........................................  $   334,550   $  380,814   $   193,461
Supplemental schedule of non-cash investing and financing
  activities:
In conjunction with the Company's acquisitions,
  liabilities were assumed as follows:
     Fair value of assets acquired.......................  $   301,415           --   $   101,500
     Cash paid for assets................................     (249,806)          --       (96,100)
                                                           -----------   ----------   -----------
     Liabilities assumed.................................  $    51,609           --   $     5,400
                                                           -----------   ----------   -----------
Stock issued in conjunction with acquisitions............           --           --   $    19,012
                                                           -----------   ----------   -----------
</TABLE>

                            See accompanying notes.
                                      F-18
<PAGE>   20

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                        THREE YEARS ENDED JUNE 30, 1998
<TABLE>
<CAPTION>
                                            COMMON STOCK       ADDITIONAL
                                        --------------------    PAID-IN      RETAINED
                                          SHARES      AMOUNT    CAPITAL      EARNINGS
                                        -----------   ------   ----------   ----------
                                             (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<S>                                     <C>           <C>      <C>          <C>
Balances at June 30, 1995.............  425,509,924    $ 72    $1,089,478   $1,205,483
Issuance of stock, net of employee
  repurchases.........................      (40,468)     --            --      (19,516)
Issuance of restricted stock..........      850,662      --        19,012           --
Treasury stock purchased..............           --      --            --           --
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
Issuance of stock, net of employee
  repurchases.........................      (10,000)     --            --      (14,710)
Treasury stock purchased..............           --      --            --           --
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
Issuance of stock, net of employee
  repurchases.........................     (224,445)     --            (2)     (21,777)
Treasury stock purchased..............           --      --            --           --
Net income............................           --      --            --      762,862
Tax benefit and other.................           --      --       115,713           --
Balances at June 30, 1998.............  430,311,441    $288    $1,345,508   $3,150,935
                                        -----------    ----    ----------   ----------

<CAPTION>
                                             TREASURY STOCK          CURRENCY         TOTAL
                                        -------------------------   TRANSLATION   STOCKHOLDERS'
                                          SHARES        AMOUNT      ADJUSTMENT       EQUITY
                                        -----------   -----------   -----------   -------------
                                                 (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<S>                                     <C>           <C>           <C>           <C>
Balances at June 30, 1995.............  (31,452,316)  $  (206,067)    $33,629      $2,122,595
Issuance of stock, net of employee
  repurchases.........................   14,561,928       131,493          --         111,977
Issuance of restricted stock..........           --            --          --          19,012
Treasury stock purchased..............  (37,465,488)     (522,336)         --        (522,336)
Net income............................           --            --          --         476,388
Tax benefit and other.................           --            --     (12,009)         43,850
Balances at June 30, 1996.............  (54,355,876)     (596,910)     21,620       2,251,486
Issuance of stock, net of employee
  repurchases.........................   10,378,115       137,574          --         122,864
Treasury stock purchased..............  (16,072,619)     (456,090)         --        (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.............  (60,050,380)     (915,426)     17,428       2,741,937
Issuance of stock, net of employee
  repurchases.........................   12,638,384       196,631          --         174,852
Treasury stock purchased..............   (6,595,870)     (284,396)         --        (284,396)
Net income............................           --            --          --         762,862
Tax benefit and other.................           --            --       2,660         118,373
Balances at June 30, 1998.............  (54,007,866)  $(1,003,191)    $20,088      $3,513,628
                                        -----------   -----------     -------      ----------
</TABLE>

                            See accompanying notes.
                                      F-19
<PAGE>   21

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

DESCRIPTION OF BUSINESS

     Sun Microsystems, Inc. (the Company or Sun) 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, floating rate notes, 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, 1998 and 1997.

     Realized and unrealized gains and losses are computed on the specific
identification method based upon actual and quoted market prices, respectively.
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." The change in net unrealized gains and losses
in investments, net of income taxes, included in stockholders' equity at June
30, 1998 and 1997, 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

                                      F-20
<PAGE>   22
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

backlog and forecast demand, and such differences may be material to the
financial statements. Inventories consist of:

<TABLE>
<CAPTION>
                                                               AT JUNE 30,
                                                           -------------------
                                                             1998       1997
                                                           --------   --------
                                                             (IN THOUSANDS)
<S>                                                        <C>        <C>
Raw materials............................................  $ 92,197   $236,900
Work in progress.........................................    58,765     50,577
Finished goods...........................................   195,484    150,501
                                                           --------   --------
          Total..........................................  $346,446   $437,978
                                                           ========   ========
</TABLE>

PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment are stated at cost. Depreciation and
amortization are provided principally on the straight-line method. Depreciation
of fixed assets is generally calculated for machinery and equipment, furniture
and fixtures, and buildings based upon useful lives of one to five years, five
years and twenty-five years, respectively. Leasehold improvement useful lives
are the shorter of five years or the applicable lease term.

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. Amortization
expense for fiscal 1998, 1997, and 1996 was $41.8 million, $26.6 million, and
$13.4 million, respectively. The Company evaluates the recoverability of
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 its effectiveness is determined by
matching 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 accrued liabilities or other assets, respectively.

     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 quarter 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

                                      F-21
<PAGE>   23
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

contract. Gains on foreign currency option contracts that are designated as
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 or 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. When
significant obligations remain after products are delivered, revenue is only
recognized after such obligations are fulfilled. Service revenues are recognized
ratably over the contractual period or as the services are provided.

ADVERTISING COSTS

     Advertising costs are charged to expense when incurred. Advertising
expenses were $235 million, $272 million, and $168 million for fiscal years
1998, 1997, and 1996, 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

     The Company provides currently for the estimated costs that may be incurred
under warranties for product shipped. Included in the balance sheet caption
"Accrued liabilities and other" is an accrued warranty liability of $115.5
million and $87.9 million at June 30, 1998 and 1997, respectively.

NET INCOME PER COMMON SHARE

     In 1997, the Financial Accounting Standards Board issued Financial
Accounting Standards No. 128 (FAS 128), "Earnings Per Share" which replaced the
calculation of primary and fully diluted earnings per share with basic and
diluted earnings per share. Unlike primary earnings per share, basic earnings
per share excludes any dilutive effects of options, warrants, and convertible
securities. Dilutive earnings per share is very similar to the previously
reported fully diluted earnings per share. The Company adopted FAS 128 in the
second quarter of fiscal 1998. Share and per share amounts for all periods
presented have been restated to comply with FAS 128.

                                      F-22
<PAGE>   24
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

<TABLE>
<CAPTION>
                                                                       YEARS ENDED JUNE 30,
                                                             -----------------------------------------
                                                                1998           1997           1996
                                                             -----------    -----------    -----------
                                                             (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                                          <C>            <C>            <C>
Net income.................................................   $762,862       $762,420       $476,388
                                                              --------       --------       --------
  Shares used to compute net income per common
     share -- basic........................................    373,728        368,426        371,134
  Effect of dilutive securities, options and warrants......     20,546         20,541         22,246
                                                              --------       --------       --------
  Shares used to compute net income per common
     share -- diluted......................................    394,274        388,967        393,380
                                                              --------       --------       --------
  Net income per common share -- basic.....................   $   2.04       $   2.07       $   1.28
                                                              --------       --------       --------
  Net income per common share -- diluted...................   $   1.93       $   1.96       $   1.21
                                                              --------       --------       --------
</TABLE>

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 is immaterial at June 30, 1998 and 1997.
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 1998 the
Company provided approximately $23 million for doubtful accounts ($20 million
and $11 million in 1997 and 1996, 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

     As permitted by Financial Accounting Standards No. 123 (FAS 123),
"Accounting for Stock-Based Compensation," the Company measures 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 net
income per common share as if the fair value-based method prescribed by FAS 123
had been applied in measuring compensation expense.

LONG-LIVED ASSETS

     The Company reviews its long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable.

OTHER RECENT PRONOUNCEMENTS

     The Company intends to adopt Financial Accounting Standards No. 130 (FAS
130), "Reporting Comprehensive Income" and Financial Accounting Standards No.
131 (FAS 131), "Disclosures About Segments of an Enterprise and Related
Information" in fiscal 1999. Both will require additional disclosure but will
not have a material effect on the Company's consolidated financial position or
results of operations. FAS 130 will be reflected in the Company's first quarter
of 1999 interim financial statements. Components of comprehensive income for the
Company include items such as net income and changes in the value of
                                      F-23
<PAGE>   25
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

available-for-sale securities. FAS 131 requires segments to be determined based
upon how management measures performance and makes decisions about allocating
resources. FAS 131 will first be reflected in the Company's 1999 Annual Report.

     In 1998, Financial Accounting Standards No. 133 (FAS 133), "Accounting for
Derivative Instruments and Hedging Activities" was issued and is effective for
fiscal years commencing after June 15, 1999. The Company will comply with the
requirements of FAS 133 in fiscal year 2000 and does not expect the adoption of
FAS 133 will be material to the Company's consolidated results of operations.

     In 1997, the American Institute of Certified Public Accountants (AICPA)
issued Statement of Position (SOP) 97-2, "Software Revenue Recognition." SOP
97-2 establishes standards relating to the recognition of all aspects of
software revenue. SOP 97-2, as amended by SOP 98-4 "Deferral of the Effective
Date of a Provision of SOP 97-2, Software Revenue Recognition," is effective for
all transactions entered into in fiscal years beginning after December 15, 1997.
The Company will comply with the requirements of SOP 97-2, as amended by SOP
98-4, in fiscal year 1999. The Company has not yet completed its assessment of
the impact of SOP 97-2, as amended by SOP 98-4, on the Company's consolidated
results of operations.

     In 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." SOP 98-1 is effective for
fiscal years beginning after December 15, 1998 with early adoption permitted.
The Company has not yet completed its assessment of the impact of SOP 98-1 on
the Company's consolidated financial position or results of operations and may
adopt SOP 98-1 in fiscal 1999.

 2. ACQUISITIONS

     During the three years ended June 30, 1998, the Company completed eight
acquisitions which were accounted for under the purchase method of accounting.
Pro forma results of operations have not been presented for any of the
acquisitions because the effects of these acquisitions were not material to the
Company on either an individual or an aggregate basis. The results of operations
of each acquisition are included in the Company's consolidated statement of
income from the date of each acquisition and were not material to the Company on
either an individual or an aggregate basis.

     The Company completed five acquisitions in fiscal 1998. On May 29, 1998,
the Company completed its acquisition of Red Cape Software, Inc. ("Red Cape"), a
company which was conducting engineering and testing activities to further
develop its Framework for Policy Management Software, a Java(TM) technology-
based, goal-oriented, policy-based storage management software that can be used
across platforms. On November 24, 1997, the Company completed its acquisition of
Encore Computer Corporation's Storage Products Business ("Encore"). Encore was
conducting development and engineering activities associated with its Intershare
and DASD-NET products (the "Encore Products") for the computer mainframe/open
systems storage market. The acquired technology of the Encore Products will
facilitate the Company's efforts to develop a high-end "intelligent" storage
product, which can be modified to address the low-end storage market. On October
21, 1997 the Company completed its acquisition of Chorus Systems, S.A.
("Chorus"). Chorus was conducting development, engineering and testing
activities associated with certain software products which will allow the
Company to create a robust product line leveraging the Java programming
language, including a tool set and flash file system, as well as embedded
operating systems. On September 22, 1997, the Company completed its acquisition
of Integrity Arts, Inc. ("Integrity Arts"), a company developing a smart card
Application Programming Interface ("API"). An API defines the concepts, terms
and structures of a software platform that can be followed by application
designers and architects and describes application functionality, data
management principles, communication principles, and network infrastructure.
Integrity Arts was also developing the related smart card and terminal run-time
software modules, software development tools, card application architectures,
and data security software. On August 22, 1997, the Company completed its
acquisition of Diba, Inc. ("Diba"). Diba was conducting development and
engineering activities associated with the completion of a consumer information
appliance which will offer improved performance

                                      F-24
<PAGE>   26

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

and efficiency by allowing processing of software applications at either the
local area network located in the consumer's home or at another location.

     The Company completed one acquisition, Long View Technologies, LLC ("Long
View") during fiscal 1997. Long View was acquired on February 14, 1997 and at
the time was conducting development and engineering activities associated with
the completion of a virtual machine for the MS Windows '95 and NT operating
systems which would contribute to the speed and robustness of the Sun Java
platform's ability to operate in the network computing market.

     During fiscal 1996, the Company completed two acquisitions. On April 23,
1996, the Company completed its acquisition of Integrated Micro Products, Inc.
("IMP"), a company conducting development and engineering activities associated
with the development of fault tolerant computers. On June 28, 1996, the Company
completed its acquisition of Lighthouse Design, Ltd. ("Lighthouse") a company
conducting development and engineering activities associated with the completion
of a suite of software products for end-users and developers. These software
products included spreadsheets, wordprocessors, database development and project
management tools, as well as the objects used by software developers to build
tools for enterprises using the NEXTSTEP or OpenStep operating environments for
Solaris(TM) and Windows NT systems.

     A summary of the Company's purchase transactions which included in-process
research and development ("IPRD") charges is included in the following table (in
millions).

<TABLE>
<CAPTION>
                                                             IPRD             FORM OF CONSIDERATION
      ENTITY NAME         CONSIDERATION       DATE          CHARGE                & OTHER NOTES
      -----------         -------------       ----          ------            ---------------------
<S>                       <C>             <C>            <C>             <C>
Fiscal 1998 Acquisitions
Red Cape................     $ 16.7       May 29, 1998       $14.1       Cash
Encore..................     $186.2       Nov 29, 1997       $97.0       Cash; developed technology and
                                                                         goodwill and other intangibles
                                                                         of $56 and $6.7, respectively
Chorus..................     $ 26.5       Oct 21, 1997       $13.1       Cash
Integrity Arts..........     $ 30.2       Sep 22, 1997       $29.9       Cash
Diba....................     $ 29.7       Aug 22, 1997       $22.3       $25.6 in cash and assumed
                                                                         liabilities of $4.1
Fiscal 1997 Acquisitions
Long View...............     $ 23.0       Feb 14, 1997       $23.0       Cash
Fiscal 1996 Acquisitions
Lighthouse..............     $ 22.8       Jun 28, 1996       $14.9       $19 in common stock; $3.2 in
                                                                         cash and assumed liabilities of
                                                                         $0.6
IMP.....................     $106.5       Apr 23, 1996       $43.0       $96.1 in cash and assumed
                                                                         liabilities of $10.4; developed
                                                                         technology and goodwill and
                                                                         other intangibles of $36.5 and
                                                                         $12, respectively
</TABLE>

     The Company calculated amounts allocated to IPRD using established
valuation techniques in the high technology industry and expensed such amounts
in the quarter that each such acquisition was consummated because technological
feasibility of the in-process technologies so acquired had not been achieved and
no alternative future uses had been established. The income approach used gave
consideration to relevant market sizes and growth factors, expected industry
trends, the nature and timing of new product introductions by Sun and its
competitors, individual product sales cycles, and the estimated life of each
product's underlying technology.

     The excess purchase price over the estimated value of the net tangible
assets acquired was allocated to various intangible assets, consisting primarily
of developed technology and goodwill, as well as other goodwill-like assets,
such as customer base and assembled workforce. The values assigned to developed
technologies related to each acquisition were based upon future discounted cash
flows related to the existing products'

                                      F-25
<PAGE>   27

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

projected income streams. The values of the customer bases were determined based
upon the value of existing relationships and the expected revenue stream. The
values of the assembled workforces were based upon the cost to replace those
workforces. Amounts allocated to goodwill and other intangibles are amortized on
a straight-line basis over periods ranging from two to five years.

     On June 30, 1998, the Company entered into an Agreement and Plan of
Reorganization (Merger Agreement) with NetDynamics, Inc. (NetDynamics). Upon the
effectiveness of the Merger Agreement, NetDynamics' shareholders will exchange
all of their shares of common stock and preferred stock for shares of common
stock of Sun at an agreed-upon exchange ratio. See Footnote 12 "Subsequent
Events."

 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.

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

<TABLE>
<CAPTION>
                                                            GROSS         GROSS       AT JUNE 30, 1998
                                                          UNREALIZED    UNREALIZED       ESTIMATED
                                                COST        GAINS         LOSSES         FAIR VALUE
                                              --------    ----------    ----------    ----------------
                                                                   (IN THOUSANDS)
<S>                                           <C>         <C>           <C>           <C>
State and local government debt.............  $ 94,843       $ 22          $11            $ 94,854
Corporate and other non-governmental debt...   421,573         --           --             421,573
U.S. government debt........................    53,474         74           --              53,548
Floating rate notes.........................    99,460         --           --              99,460
Money market fund...........................    97,900         --           --              97,900
Other investments...........................    16,599         --           --              16,599
                                              --------       ----          ---            --------
          Total.............................  $783,849       $ 96          $11            $783,934
                                              ========       ====          ===            ========
</TABLE>

<TABLE>
<CAPTION>
                                                            GROSS         GROSS       AT JUNE 30, 1997
                                                          UNREALIZED    UNREALIZED       ESTIMATED
                                                COST        GAINS         LOSSES         FAIR VALUE
                                              --------    ----------    ----------    ----------------
                                                                   (IN THOUSANDS)
<S>                                           <C>         <C>           <C>           <C>
State and local government debt.............  $120,579       $ 16          $ 56           $120,539
Corporate and other non-governmental debt...   282,240          5            89            282,156
U.S. government debt........................    85,628        233            13             85,848
Floating rate notes.........................    45,870         --            --             45,870
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
                                              ========       ====          ====           ========
</TABLE>

                                      F-26
<PAGE>   28
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

<TABLE>
<CAPTION>
                                                                 AT JUNE 30, 1998
                                                              ----------------------
                                                                          ESTIMATED
        CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS             COST      FAIR VALUE
        -------------------------------------------           --------    ----------
                                                                  (IN THOUSANDS)
<S>                                                           <C>         <C>
Maturing in one year or less................................  $684,389     $684,474
Maturing after one year.....................................    99,460       99,460
                                                              --------     --------
          Total.............................................  $783,849     $783,934
                                                              ========     ========
</TABLE>

     The fair value of the Company's borrowing arrangements and other financial
instruments is as follows:

<TABLE>
<CAPTION>
                                                       AT JUNE 30, 1998       AT JUNE 30, 1997
                                                       ASSET (LIABILITY)      ASSET (LIABILITY)
                                                      -------------------   ---------------------
                                                      CARRYING     FAIR     CARRYING      FAIR
                                                       AMOUNT     VALUE      AMOUNT       VALUE
                                                      --------   --------   ---------   ---------
                                                                    (IN THOUSANDS)
<S>                                                   <C>        <C>        <C>         <C>
10.18% mortgage loan................................  $(40,000)  $(41,495)  $ (40,000)  $ (42,541)
Forward foreign exchange contracts..................     4,265      4,265      (2,861)     (2,861)
Foreign currency option contracts...................        --      7,531          --       1,262
Short-term borrowings...............................    (7,169)    (7,169)   (100,930)   (100,930)
Interest-rate swap agreement........................        --        292          --         196
                                                      --------   --------   ---------   ---------
</TABLE>

 4. DERIVATIVE FINANCIAL INSTRUMENTS

     Outstanding notional amounts for derivative financial instruments were as
follows:

<TABLE>
<CAPTION>
                                                                  AT JUNE 30,
                                                              --------------------
                                                                1998        1997
                                                              --------    --------
                                                                 (IN THOUSANDS)
<S>                                                           <C>         <C>
Swap hedging debt...........................................  $ 40,000    $ 40,000
Forward foreign exchange contracts..........................   930,155     856,979
Foreign currency option contracts...........................   241,861     254,182
                                                              --------    --------
</TABLE>

     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. See additional information at "Other financial instruments"
contained in Footnote 1.

     At June 30, 1998 and 1997, the Company had forward foreign exchange
contracts of less than three months duration, to exchange principally Japanese
yen, British pounds sterling, French francs, and German marks for U.S. dollars
in the total gross notional amounts of $930 million and $857 million,
respectively. Of these notional amounts, forward contracts to purchase foreign
currency represented $139 million and $128 million and forward contracts to sell
foreign currency represented $791 million and $729 million, at June 30, 1998 and
1997, respectively. The Company also has purchased foreign currency options of
less than two months duration, to exchange principally Japanese yen, British
pounds sterling, French francs, and German marks for U.S. dollars.

                                      F-27
<PAGE>   29
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5. BORROWING ARRANGEMENTS

     The Company has a $40 million mortgage loan which is secured by real
property and a building and is included in note payable and other obligations at
June 30, 1998 and 1997, respectively. 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,
pay variable) that results in the Company paying a rate based on three-month
LIBOR, which was 5.625% at June 30, 1998. The interest-rate swap agreement
matures with the loan agreement.

     In August 1997, the Company negotiated a $500 million unsecured revolving
credit agreement with an international group of 20 banks. The agreement expires
on August 28, 2002. 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, 1998.
There were no borrowings under this facility at June 30, 1998.

     At June 30, 1998, Sun's international subsidiaries had uncommitted lines of
credit aggregating approximately $694 million, of which approximately $7
million, denominated in Japanese yen, had been drawn. The average interest rate
at June 30, 1998 was 0.89%.

     On October 16, 1997, the Company filed a Registration Statement with the
Securities and Exchange Commission relating to the registration for public
offering of senior and subordinated debt securities and common stock with an
aggregate initial public offering price of up to $1 billion. On October 24,
1997, the Registration Statement became effective, so that the Company may now
choose to offer, from time to time, the debt securities and common stock
pursuant to Rule 415 in one or more separate series, in amounts, at prices, and
on terms to be set forth in the prospectus contained in the Registration
Statement and in one or more supplements to the prospectus.

 6. INCOME TAXES

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

<TABLE>
<CAPTION>
                                                                  YEARS ENDED JUNE 30,
                                                          ------------------------------------
                                                             1998          1997         1996
                                                          ----------    ----------    --------
                                                                     (IN THOUSANDS)
<S>                                                       <C>           <C>           <C>
Income before income taxes:
  United States.........................................  $  589,387    $  566,554    $291,126
  Foreign...............................................     586,779       554,653     417,748
                                                          ----------    ----------    --------
          Total income before income taxes..............  $1,176,166    $1,121,207    $708,874
                                                          ==========    ==========    ========
Provision for income taxes:
  Current:
     United States federal..............................  $  349,095    $  303,537    $146,351
     State..............................................      47,270        46,894      16,192
     Foreign............................................     106,192        67,234      67,959
                                                          ----------    ----------    --------
          Total current income taxes....................     502,557       417,665     230,502
                                                          ----------    ----------    --------
Deferred:
  United States federal.................................     (81,319)      (66,027)    (10,419)
  State.................................................      (6,492)       (5,231)      1,178
  Foreign...............................................      (1,442)       12,380      11,225
                                                          ----------    ----------    --------
          Total deferred income taxes...................     (89,253)      (58,878)      1,984
                                                          ----------    ----------    --------
Provision for income taxes..............................  $  413,304    $  358,787    $232,486
                                                          ==========    ==========    ========
</TABLE>

                                      F-28
<PAGE>   30
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     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:

<TABLE>
<CAPTION>
                                                                   AT JUNE 30,
                                                              ----------------------
                                                                1998         1997
                                                              ---------    ---------
                                                                  (IN THOUSANDS)
<S>                                                           <C>          <C>
Deferred tax assets:
  Inventory valuation.......................................  $  67,006    $  66,057
  Reserves and other accrued expenses.......................    165,724      115,722
  Fixed asset basis differences.............................     81,926       63,717
  Compensation not currently deductible.....................     41,407       38,979
  State income taxes........................................     15,468       21,926
  Other.....................................................     68,687       33,901
                                                              ---------    ---------
Gross deferred tax assets...................................    440,218      340,302
Deferred tax liabilities:
  Net undistributed profits of subsidiaries.................   (124,777)    (112,758)
  Other.....................................................        428         (928)
                                                              ---------    ---------
Gross deferred tax liabilities..............................   (124,349)    (113,686)
                                                              ---------    ---------
Net deferred tax assets.....................................  $ 315,869    $ 226,616
                                                              =========    =========
</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:

<TABLE>
<CAPTION>
                                                                   YEARS ENDED JUNE 30,
                                                             --------------------------------
                                                               1998        1997        1996
                                                             --------    --------    --------
                                                                      (IN THOUSANDS)
<S>                                                          <C>         <C>         <C>
Expected tax rate at 35%...................................  $411,658    $392,423    $248,106
State income taxes, net of federal tax benefit.............    26,506      27,081      11,291
Foreign earnings permanently reinvested in foreign
  operations...............................................   (49,600)    (63,550)    (36,580)
Acquired in-process research and development...............    25,194          --       5,690
Other......................................................      (454)      2,833       3,979
                                                             --------    --------    --------
  Provision for income taxes...............................  $413,304    $358,787    $232,486
                                                             ========    ========    ========
</TABLE>

     As of June 30, 1998, the Company has unrecognized deferred tax liabilities
of approximately $173 million related to cumulative net undistributed earnings
of foreign subsidiaries of approximately $559 million. These earnings are
considered to be permanently invested in operations outside the United States.

     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 $111,375, $59,799, and $53,000 in
fiscal 1998, 1997 and 1996, respectively, and were credited to stockholders'
equity.

     The Company's United States income tax returns for fiscal years ended June
30, 1988 through 1996, are under examination, and the Internal Revenue Services
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
$132 million, $114 million, $86 million, $69 million, and $52 million for fiscal
years 1999, 2000, 2001, 2002, and 2003, respectively, and approximately $175
million for

                                      F-29
<PAGE>   31
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

years following fiscal 2003. Rent expense under the noncancelable operating
leases was $139 million in 1998, $113 million in 1997, and $99 million in 1996.

 8. STOCKHOLDERS' EQUITY

COMMON STOCK

     The Company has adopted a share purchase rights plan to protect
stockholders' rights in the event of a proposed takeover of the Company. Under
the plan, a preferred share purchase right (a "Right") is associated with each
share of the Company's common stock (a "Common Share"). Upon becoming
exercisable, each Right will entitle its holder to purchase 1/1000th of a share
of Series A participating preferred stock of the Company, a designated series of
preferred stock for which each 1/1000th of a share has economic attributes and
voting rights equivalent to one Common Share at an exercise price of $300,
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 10% 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, each Right not held by the Acquiring Person
will entitle the holder to purchase for the exercise price that number of Common
Shares having 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 $0.01 per Right at any time prior
to becoming exercisable and in certain other circumstances. The Rights expire on
February 11, 2008.

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 non-statutory stock options as well as certain other awards. In
addition, these plans provide for issuance to eligible employees of
non-statutory 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 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 Directors' Stock Option Plan provides for the
automatic grant of stock options to non-employee 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 fiscal 1996 acquisition of
Lighthouse Design, Ltd., former shareholders who are employees of the Company
were entitled to receive up to approximately 650,000 shares of stock upon
achievement of specific performance criteria over a three year period. Of this
amount, approximately 325,000 shares have vested.

                                      F-30
<PAGE>   32
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

<TABLE>
<CAPTION>
                                                 OUTSTANDING OPTIONS/RIGHTS
                                        ---------------------------------------------
                                         SHARES                                             WEIGHTED
                                        AVAILABLE     NUMBER                                AVERAGE
                                        FOR GRANT    OF SHARES      PRICE PER SHARE      EXERCISE PRICE
                                        ---------    ---------    -------------------    --------------
                                                   (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                     <C>          <C>          <C>                    <C>
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
  Additional shares reserved..........     5,172          --                       --            --
  Grants..............................   (14,881)     14,881      $0.0006  - $47.3750        $37.81
  Exercises...........................        --      (9,263)     $0.0006  - $33.9375        $ 8.53
  Cancellations.......................     1,991      (1,991)     $1.350   - $47.3750        $21.25
                                         -------      ------      -------------------        ------
  Balance at June 30, 1998............    26,411      54,986      $0.00067 - $47.3750        $22.28
                                         -------      ------      -------------------        ------
</TABLE>

     The following table summarizes significant ranges of outstanding and
exercisable options at June 30, 1998:

<TABLE>
<CAPTION>
                                                   OUTSTANDING OPTIONS        OPTIONS EXERCISABLE
                                                -------------------------    ----------------------
                                                  WEIGHTED       WEIGHTED                  WEIGHTED
                                                   AVERAGE       AVERAGE                   AVERAGE
                                                  REMAINING      EXERCISE                  EXERCISE
                                    SHARES      LIFE IN YEARS     PRICE        SHARES       PRICE
                                  ----------    -------------    --------    ----------    --------
<S>                               <C>           <C>              <C>         <C>           <C>
  $ 0.0007 - $ 5.00.............   2,247,449         5.4         $ 4.4713     1,407,509    $ 4.6831
  $ 5.0001 - $10.00.............  16,491,580         4.6         $ 7.4620     8,415,847    $ 7.2509
  $10.0001 - $15.00.............   2,222,150         5.0         $11.5499       581,070    $11.6474
  $15.0001 - $20.00.............   1,699,320         5.4         $19.5000       485,520    $19.5000
  $20.0001 - $25.00.............   7,245,162         6.2         $23.6803     1,864,404    $23.5609
  $25.0001 - $30.00.............   9,075,495         6.6         $27.1952     1,641,853    $27.1933
  $30.0001 - $40.00.............   5,040,863         7.3         $32.9105       559,492    $31.9555
  $40.0001 - $45.00.............  10,302,247         8.1         $40.5786            --    $     --
  $45.0001 - $47.3750...........     661,500         7.2         $46.8873         4,240    $47.3750
                                  ----------         ---         --------    ----------    --------
                                  54,985,766         6.1         $22.2831    14,959,935    $12.7343
                                  ----------         ---         --------    ----------    --------
</TABLE>

     At June 30, 1998, options to purchase approximately 14,960,000 shares were
exercisable at prices from $0.8496 to $47.3750 with a weighted average and
aggregate exercise price of $12.7343 and $190,505,000, respectively, (11,143,000
shares at an aggregate price of $101,264,000 at June 30, 1997). At June 30,
1998, the Company retains repurchase rights to 1,003,536 shares issued pursuant
to stock purchase agreements and other stock plans.

     The weighted average fair value at date of grant for options granted during
1998, 1997, and 1996 were $26.179, $17.873, and $11.517 per option,
respectively.

                                      F-31
<PAGE>   33
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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 the date of purchase, whichever is less. Pursuant to this
plan, the Company issued approximately 3,505,046, 2,928,689, and 4,714,000
shares of common stock in fiscal 1998, 1997, and 1996, respectively. At June 30,
1998, approximately 19,730,799 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
1998, the Company repurchased 2,941,640 shares at a cost of approximately $127
million under this program (2,919,632 shares at a cost of approximately $88
million in 1997).

     In June 1995, the Board of Directors approved a plan to repurchase
approximately 48 million shares of the Company's common stock. In July and
August 1996, the Company repurchased 8,904,258 shares at a cost of approximately
$236 million under this program.

     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 1998, the Company repurchased 3,654,230 shares at a cost of approximately
$157 million under this program (4,248,729 shares at a cost of approximately
$132 million in 1997).

     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 No. 25 and provide pro forma net income and pro forma
net income per common share disclosures for stock-based awards made during the
year as if the fair-value-based method defined in FAS No. 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 7.75 year Treasury Yield as of the date of grant, ranging from 5.38%
to 6.37% for fiscal year 1998.

     The fair value of options at the date of grant was estimated using the
Black-Scholes model with the following weighted average assumptions:

<TABLE>
<CAPTION>
                                                     YEARS ENDED JUNE 30,
                                                  ---------------------------
                                                  1998       1997       1996
                                                  -----      -----      -----
<S>                                               <C>        <C>        <C>
  Expected life.................................    7.8        8.1        7.7
  Interest rate.................................   5.73%      6.06%      6.36%
  Volatility....................................  49.60%     46.60%     57.99%
  Dividend yield................................     --         --         --
                                                  -----      -----      -----
</TABLE>

                                      F-32
<PAGE>   34
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     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
$132,985,000, $76,033,000, and $35,116,000 in 1998, 1997, and 1996,
respectively, ($89,374,000, $51,703,000, and $23,879,000 after tax, and $.17,
$.08, and $.05 per diluted 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
1998, 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 1996.

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

<TABLE>
<CAPTION>
                                                                    YEARS ENDED JUNE 30,
                                                              ---------------------------------
                                                                1998        1997        1996
                                                              ---------   ---------   ---------
                                                               (IN THOUSANDS, EXCEPT PER SHARE
                                                                          AMOUNTS)
<S>                                                           <C>         <C>         <C>
Pro forma net income........................................  $673,488    $710,717    $452,509
                                                              --------    --------    --------
Basic:
  Pro forma shares used in the calculation of pro forma net
     income per common share................................   373,728     368,426     371,134
                                                              --------    --------    --------
  Pro forma net income per common share.....................  $   1.80    $   1.93    $   1.22
                                                              --------    --------    --------
Diluted:
  Pro forma shares used in the calculation of pro forma net
     income per common share................................   383,377     377,288     390,390
                                                              --------    --------    --------
  Pro forma net income per common share.....................  $   1.76    $   1.88    $   1.16
                                                              --------    --------    --------
</TABLE>

 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. In fiscal 1998, one customer accounted
for 14% of revenues. No customer accounted for 10% or more of revenues in fiscal
1997 or 1996. 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 2.3%, 3.0%, and 3.8% of net revenues during fiscal 1998,
1997, and 1996, respectively.

                                      F-33
<PAGE>   35
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

     Information regarding geographic areas at June 30, 1998, 1997, and 1996,
and for each of the years then ended, is as follows:

<TABLE>
<CAPTION>
                                                   GEOGRAPHIC AREA
                                        --------------------------------------
                                          UNITED                                  REST OF
                                          STATES        EUROPE        JAPAN        WORLD      ELIMINATIONS      TOTAL
                                        ----------    ----------    ----------    --------    ------------    ----------
<S>                                     <C>           <C>           <C>           <C>         <C>             <C>
June 30, 1998, and for the year then
  ended:
  Sales to unaffiliated customers.....  $5,349,634    $2,708,514    $  899,029    $833,663    $        --     $9,790,840
  Intercompany transfers..............     969,752     1,938,940        17,609      45,652     (2,971,953)            --
                                        ----------    ----------    ----------    --------    -----------     ----------
  Net revenues........................  $6,319,386    $4,647,454    $  916,638    $879,315    $(2,971,953)    $9,790,840
                                        ----------    ----------    ----------    --------    -----------     ----------
  Operating income....................  $  642,685    $  510,919    $   25,225    $ 16,480    $   (65,235)    $1,130,074
                                        ----------    ----------    ----------    --------    -----------     ----------
  Identifiable assets.................  $4,005,490    $2,939,584    $  352,529    $556,087    $(2,142,628)    $5,711,062
                                        ----------    ----------    ----------    --------    -----------     ----------
  Liabilities.........................  $1,763,617    $1,484,335    $  345,115    $543,080    $(1,938,713)    $2,197,434
                                        ----------    ----------    ----------    --------    -----------     ----------
  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
                                        ----------    ----------    ----------    --------    -----------     ----------
</TABLE>

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.

                                      F-34
<PAGE>   36
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

11. QUARTERLY FINANCIAL DATA (UNAUDITED)

<TABLE>
<CAPTION>
                                                                           FISCAL 1998 QUARTER ENDED,
                                                                           --------------------------
                                                  JUNE 30      MARCH 29    DECEMBER 28   SEPTEMBER 28
                                                 ----------   ----------   -----------   ------------
                                                       (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                              <C>          <C>          <C>           <C>
Net revenues...................................  $2,881,065   $2,360,928   $2,450,243     $2,098,604
  Gross margin.................................   1,488,429    1,259,292    1,278,613      1,071,170
  Operating income.............................     402,448      333,916      212,835        180,875
  Net income...................................     272,988      232,009      149,432        108,433
  Net income per common share -- diluted.......  $     0.69   $     0.59   $     0.38     $     0.27
                                                 ----------   ----------   ----------     ----------
</TABLE>

<TABLE>
<CAPTION>
                                                                           FISCAL 1997 QUARTER ENDED,
                                                                           --------------------------
                                                  JUNE 30      MARCH 30    DECEMBER 29   SEPTEMBER 29
                                                 ----------   ----------   -----------   ------------
                                                       (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                              <C>          <C>          <C>           <C>
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 common share -- diluted.......  $     0.61   $     0.58   $     0.46     $     0.32
                                                 ----------   ----------   ----------     ----------
</TABLE>

12. SUBSEQUENT EVENTS (UNAUDITED)

     On August 28, 1998, the Company acquired all of the outstanding capital
stock of NetDynamics, by means of a merger transaction pursuant to which all the
shares of NetDynamics capital stock were converted into the right to receive
shares of Sun common stock as described in Footnote 2. The transaction will be
accounted for as a purchase, and the purchase price will be allocated to
tangible and intangible assets and in-process research and development.

     On September 2, 1998, the Company signed a definitive agreement to acquire
all the outstanding capital stock of iPlanet, Inc. by means of a merger
transaction pursuant to which all of the shares of iPlanet, Inc. will be
converted into the right to receive cash. Upon and subject to closing, the
transaction will be accounted for as a purchase, and 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.

                                      F-35
<PAGE>   37

               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, 1998 and 1997, and the related consolidated
statements of income, stockholders' equity, and cash flows for each of the three
years in the period ended June 30, 1998. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable 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, 1998 and 1997, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended June 30, 1998, in conformity with generally accepted accounting
principles.

                                          /s/ ERNST & YOUNG LLP

Palo Alto, California
July 15, 1998

                                      F-36
<PAGE>   38

                             ABOUT YOUR INVESTMENT

                                  STOCK SYMBOL
                                      SUNW

STOCK MARKET

     The Company's stock trades on The Nasdaq Stock Market.

STOCK TRADING

     The following table sets forth the per share high and low sales prices for
each quarter shown, as well as the per share closing sales prices on the last
trading day of each quarter. In addition, the table shows the average trading
volume for each quarter listed.

<TABLE>
<CAPTION>
                                                                       CLOSING       DAILY AVERAGE
                                               HIGH        LOW       SALES PRICES    TRADING VOLUME
                                             --------    --------    ------------    --------------
<S>                                          <C>         <C>         <C>             <C>
Fiscal year ended June 30, 1998
  First quarter............................  $53.3125    $35.9375      $46.8125        5,062,402
  Second quarter...........................   48.0469     30.3750       39.8750        7,340,261
  Third quarter............................   50.0000     37.6250       41.7188        6,947,744
  Fourth quarter...........................   45.5625     38.1875       43.4375        4,633,556
Fiscal year ended June 30, 1997
  First quarter............................  $32.5625    $22.0000      $31.0625        9,502,834
  Second quarter...........................   35.1250     25.5000       25.6875        8,704,392
  Third quarter............................   35.0000     26.2500       28.8750        5,834,969
  Fourth quarter...........................   38.7500     25.8750       37.2188        5,076,927
</TABLE>

COMPARISON OF TWO-YEAR CUMULATIVE TOTAL RETURN

     $100 invested on June 30, 1995, in stock or applicable index assuming
reinvestment of dividends.

                              [PERFORMANCE GRAPH]

                            STOCK OWNERSHIP PROFILE
                             (AS OF JUNE 30, 1998)

                                   [GRAPHIC]

                                      F-37