<PAGE>   1
                                                                    EXHIBIT 13.1

Annual Report 1999 o Sun Microsystems, Inc. S11

Management's Discussion and Analysis o Page S12

Consolidated Financial Statements o Page S16

Notes to Consolidated Financial Statements o Page S18

Report of Independent Auditors o Page S22


--------------------------------------------------------------------------------
                                FINANCIAL REVIEW
--------------------------------------------------------------------------------

The Last Ten Years

Sun's revenues have grown an average of 21% annually over the past decade as
demand for our open, network computing products and services has increased. With
over 49% of revenues generated from outside the United States in fiscal 1999,
Sun's portfolio of revenues by geography is well balanced.

   Cash from operating activities has grown an average of 70% annually over the
past ten years, demonstrating the strength and consistency of Sun's business
model.

   While Sun's vision and strategy have remained consistent, the market
opportunities for Sun's products and technologies have expanded as companies
embrace Internet computing. Increasingly, Sun's business is being driven by
customer efforts to implement e-commerce, middleware, network storage, and
enterprise software. Customers are also increasingly demanding Sun's
high-quality enterprise services to help them implement, manage, and monitor
their Internet/network computing environments.

   In addition, Sun's component technologies, Java, Jini, and UltraSPARC, are
increasingly being implemented in consumer and telecommunications environments,
promising to increase the number of Internet-enabled devices and thus Internet
traffic. The greater the demand for information and services over the Internet,
the greater the opportunity for Sun to sell servers, storage, and software.

   In order to capitalize on these opportunities, Sun has invested carefully--in
research and development, enterprise services, and other demand creation
activities.

   Sun's excellence in financial and asset management continues to yield
outstanding results in almost every conventional measure of profitability and
productivity. Our balance sheet is superb, and we are strongly capitalized,
effectively positioning Sun for the .com era.

NET REVENUES
(in millions of dollars)

<TABLE>
<CAPTION>
 90      91      92      93      94      95      95      96      97      98      99
----    ----    ----    ----    ----    ----    ----    ----    ----    ----    ----
<S>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>
2,466                                                                           11,726
</TABLE>

Net revenues grew to $11,726 million in fiscal 1999, an increase of 20% from
$9,791 million in fiscal 1998.

NET INCOME PER COMMON
SHARE--DILUTED (in dollars)

<TABLE>
<CAPTION>
 90      91      92      93      94      95      95      96      97      98      99
----    ----    ----    ----    ----    ----    ----    ----    ----    ----    ----
<S>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>
0.15                                                                            1.27
</TABLE>

Earnings per share for fiscal 1999, including
acquisition-related charges, totaled $1.27, an increase of 31% over fiscal 1998.
Over the past ten years, Sun has grown earnings per share an average of 33%.

OPERATING INCOME
(in millions of dollars)

<TABLE>
<CAPTION>
 90      91      92      93      94      95      95      96      97      98      99
----    ----    ----    ----    ----    ----    ----    ----    ----    ----    ----
<S>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>
177                                                                             1,522
</TABLE>

Operating income as a percent of revenues for fiscal 1999 reached a record level
of 13%. Over the past decade, Sun's operating income has increased 37% on an
average annual basis.

R&D INVESTMENT
(in millions of dollars)

<TABLE>
<CAPTION>
 90      91      92      93      94      95      95      96      97      98      99
----    ----    ----    ----    ----    ----    ----    ----    ----    ----    ----
<S>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>
302                                                                             1,263
</TABLE>

During fiscal 1999, Sun invested nearly 11% of revenues in research and
development, primarily in the areas of system design, SPARC microprocessors,
Solaris software, network storage, and Java technologies. Sun's investments in
research and development have led to increasingly innovative products and
technologies that promise to change the ways in which customers use the
Internet.

CASH PORTFOLIO (in millions of dollars)

<TABLE>
<CAPTION>
 90      91      92      93      94      95      95      96      97      98      99
----    ----    ----    ----    ----    ----    ----    ----    ----    ----    ----
<S>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>
393                                                                             2,665
</TABLE>

Excellence in financial management resulted in another record cash balance for
fiscal 1999. Sun's cash portfolio, which includes cash, cash equivalents, and
short-term investments, totaled $2,665 million at the end of fiscal 1999.

CASH FROM OPERATING ACTIVITIES
(in millions of dollars)

<TABLE>
<CAPTION>
 90      91      92      93      94      95      95      96      97      98      99
----    ----    ----    ----    ----    ----    ----    ----    ----    ----    ----
<S>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>
298                                                                             2,517
</TABLE>

In fiscal 1999, Sun achieved record cash from operating activities increasing by
nearly $1 billion over fiscal 1998 to reach $2,517 million during fiscal 1999.

LONG-TERM DEBT-TO-EQUITY RATIO
(percentage)

<TABLE>
<CAPTION>
 90      91      92      93      94      95      95      96      97      98      99
----    ----    ----    ----    ----    ----    ----    ----    ----    ----    ----
<S>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>
39.0                                                                            0.0
</TABLE>

At the end of fiscal 1998 and 1999, Sun had no long-term debt, resulting in a
0.0% debt-to-equity ratio.

RETURN ON AVERAGE EQUITY
(percentage)

<TABLE>
<CAPTION>
 90      91      92      93      94      95      95      96      97      98      99
----    ----    ----    ----    ----    ----    ----    ----    ----    ----    ----
<S>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>
14.0                                                                            25.0
</TABLE>

In fiscal 1999, Sun's return on equity was 25%, demonstrating the strong
customer acceptance of Sun's server, storage, workstation, and software products
and technologies.

REVENUES BY GEOGRAPHY
(in millions of dollars)

[ ] Rest of World
[ ] Europe
[ ] U.S.

<TABLE>
<CAPTION>
 90      91      92      93      94      95      95      96      97      98      99
----    ----    ----    ----    ----    ----    ----    ----    ----    ----    ----
<S>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>     <C>
2,466                                                                           11,726
</TABLE>

Sun is a global company with more than 49% of its revenues generated outside the
United States. Despite the ongoing macroeconomic difficulties in Japan and
Southeast Asia, Sun continued to experience strong revenue growth in the United
States, Europe, and Latin America, demonstrating the value of a balanced
geographical portfolio.

--------------------------------------------------------------------------------
<PAGE>   2

--------------------------------------------------------------------------------
SUMMARY CONSOLIDATED STATEMENTS OF INCOME
--------------------------------------------------------------------------------
(In millions, except per share amounts)

<TABLE>
<CAPTION>
Years Ended June 30,                    1999              1998             1997              1996             1995
                                   ---------------   ---------------  ---------------    --------------   --------------
                                   Dollars     %     Dollars     %    Dollars     %      Dollars      %   Dollars      %
------------------------------------------------------------------------------------------------------------------------

<S>                                <C>       <C>      <C>      <C>     <C>      <C>      <C>      <C>     <C>      <C>
Net revenues                       $11,726   100.0    $9,791   100.0   $8,598   100.0    $7,095   100.0   $5,902   100.0

Costs and expenses:

 Cost of sales                       5,648    48.2     4,693    47.9    4,320    50.2     3,921    55.3    3,336    56.5
 Research and development            1,262    10.8     1,014    10.4      826     9.6       653     9.2      563     9.5
 Selling, general and
  administrative                     3,173    27.1     2,777    28.4    2,402    27.9     1,788    25.2    1,503    25.5
 Purchased in-process
  research and development             121     0.9       177     1.8       23     0.3        58     0.8       --      --
Total costs and expenses            10,204    87.0     8,661    88.5    7,571    88.0     6,420    90.5    5,402    91.5
------------------------------------------------------------------------------------------------------------------------

Operating income                     1,522    13.0     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          84     0.7        46     0.5       32     0.4        34     0.5       23     0.4
Litigation settlement                   --      --        --      --       --      --        --      --       --      --
Income before income taxes           1,606    13.7     1,176    12.0    1,121    13.1       709    10.0      523     8.9
Provision for income taxes             575     4.9       413     4.2      359     4.2       232     3.3      167     2.8
------------------------------------------------------------------------------------------------------------------------

Net income                         $ 1,031     8.8    $  763     7.8   $  762     8.9    $  477     6.7   $  356     6.1
Net income per common
 share--diluted                     $ 1.27            $ 0.97           $ 0.98            $ 0.61           $ 0.46
------------------------------------------------------------------------------------------------------------------------

Shares used in the calculation
of net income per common
 share--diluted                        814               788              778               786              788
------------------------------------------------------------------------------------------------------------------------


<CAPTION>
Years Ended June 30,                   1994              1993             1992             1991              1990
                                   --------------    --------------   --------------     ------------    -------------
                                   Dollars      %    Dollars      %   Dollars      %     Dollars    %    Dollars     %
----------------------------------------------------------------------------------------------------------------------

<S>                                <C>      <C>      <C>      <C>     <C>      <C>      <C>     <C>     <C>      <C>
Net revenues                       $4,690   100.0    $4,309   100.0   $3,589   100.0    $3,221  100.0   $2,466   100.0

Costs and expenses:

 Cost of sales                      2,753    58.7     2,518    58.4    1,963    54.7     1,758   54.6    1,399    56.7
 Research and development             500    10.7       445    10.3      382    10.6       356   11.1      302    12.2
 Selling, general and
  administrative                    1,160    24.7     1,105    25.7      983    27.4       812   25.2      588    23.9
 Purchased in-process
  research and development             --      --        --      --       --      --        --     --       --      --
Total costs and expenses            4,413    94.1     4,068    94.4    3,328    92.7     2,926   90.9    2,289    92.8
----------------------------------------------------------------------------------------------------------------------

Operating income                      277     5.9       241     5.6      261     7.3       295    9.1      177     7.2
Gain on sale of equity
 investment                           --       --        --      --         --    --          --   --         --    --
Interest income (expense), net          6     0.1        (2)     --       (6)   (0.2)      (11)  (0.3)     (23)   (0.9)
Litigation settlement                 --       --       (15)   (0.4)      --    --          --   --         --      --
Income before income taxes            283     6.0       224     5.2      255     7.1       284    8.8      154     6.3
Provision for income taxes             87     1.8        67     1.6       82     2.3        94    2.9       43     1.8
----------------------------------------------------------------------------------------------------------------------

Net income                         $  196     4.2    $  157     3.6   $  173     4.8    $  190    5.9   $  111     4.5
Net income per common
 share--diluted                    $ 0.25            $ 0.19           $ 0.21            $ 0.23          $ 0.15
----------------------------------------------------------------------------------------------------------------------

Shares used in the calculation
of net income per common
 share--diluted                       776               860              862               878             790
----------------------------------------------------------------------------------------------------------------------
</TABLE>

<PAGE>   3

--------------------------------------------------------------------------------
OPERATING AND CAPITALIZATION DATA
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
Years Ended June 30,                1999      1998      1997      1996      1995      1994      1993      1992      1991      1990
----------------------------------------------------------------------------------------------------------------------------------
<S>                              <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>
Total assets (millions)          $ 8,420   $ 5,711   $ 4,697   $ 3,801   $ 3,545   $ 2,898   $ 2,768   $ 2,672   $ 2,326   $ 1,779
----------------------------------------------------------------------------------------------------------------------------------
Long-term debt, deferred
  income taxes, and other
  obligations (millions)         $   382   $    75   $   106   $    60   $    91   $   122   $   178   $   348   $   401   $   359
----------------------------------------------------------------------------------------------------------------------------------
Current ratio                        1.9       2.0       2.0       2.0       2.2       2.0       2.4       2.6       2.5       2.6
----------------------------------------------------------------------------------------------------------------------------------
Long-term debt-to-equity ratio        --        --      0.02      0.02      0.04      0.08      0.11      0.23      0.33      0.39
----------------------------------------------------------------------------------------------------------------------------------
Return on average equity              25%       24%       31%       22%       19%       12%       10%       13%       18%       14%
----------------------------------------------------------------------------------------------------------------------------------
Return on average capital             23%       24%       30%       23%       18%       12%        9%       10%       13%       11%
----------------------------------------------------------------------------------------------------------------------------------
Return on average assets              15%       15%       18%       13%       11%        7%        6%        7%        9%        7%
----------------------------------------------------------------------------------------------------------------------------------
Effective income tax rate             36%       35%       32%       33%       32%       33%       30%       32%       33%       28%
----------------------------------------------------------------------------------------------------------------------------------
Average shares and
  equivalents (thousands)        814,241   788,548   777,934   786,760   787,400   774,112   841,000   813,120   824,536   754,952
----------------------------------------------------------------------------------------------------------------------------------
Book value per
  outstanding share              $  6.19   $  4.67   $  3.70   $  3.03   $  2.70   $  2.17   $  2.02   $  1.86   $  1.58   $  1.26
----------------------------------------------------------------------------------------------------------------------------------
</TABLE>

<PAGE>   4

S12 Annual Report 1999 o SUN MICROSYSTEMS, INC.
================================================================================
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
--------------------------------------------------------------------------------
The following table sets forth items from our Consolidated Statements of Income
as a percentage of total net revenues:

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
                                                         1999     1998    1997
--------------------------------------------------------------------------------
<S>                                                     <C>      <C>      <C>
Net revenues
  Products                                               86.1     87.9     90.1
  Services                                               13.9     12.1      9.9
--------------------------------------------------------------------------------
Total net revenues                                      100.0%   100.0%   100.0%

Cost of sales:
  Products                                               39.9     40.5     44.0
  Services                                                8.3      7.4      6.2
--------------------------------------------------------------------------------
Total cost of sales                                      48.2     47.9     50.2
--------------------------------------------------------------------------------
Gross margin                                             51.8     52.1     49.8

Research and development                                 10.8     10.4      9.6

Selling, general and administrative                      27.1     28.4     27.9

Purchased in-process research and development             0.9      1.8      0.3

Operating income                                         13.0     11.5     12.0

Gain on sale of investment                                 --       --      0.7

Interest income (expense), net                            0.7      0.5      0.4
--------------------------------------------------------------------------------
Income before income taxes                               13.7     12.0     13.1

Provision for income taxes                                4.9      4.2      4.2
--------------------------------------------------------------------------------
Net income                                                8.8%     7.8%     8.9%
--------------------------------------------------------------------------------
</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 economic trends in geographic markets,
trends relating to customer buying patterns, and the Company's expectations
relating to future research and development and selling, general and
administrative expenses. These forward-looking statements involve risks and
uncertainties, and the cautionary statements set forth below and 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 our 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.

<PAGE>   5

RESULTS OF OPERATIONS

NET REVENUES

Our products net revenues increased $1,488 million, or 17.3%, to $10,091 million
in fiscal 1999, compared with an increase of $856 million, or 11%, in fiscal
1998. More than 50% of the increase in products revenues in fiscal 1999 was
primarily due to strong demand for our enterprise and workgroup servers, and to
a lesser extent from increased revenues generated by our storage products. The
growth in products revenue was partially offset by a decline in high-end desktop
system volumes as the result of a shift in customer purchasing patterns towards
low-end desktop systems and workgroup servers. More than 50% of the increase in
net revenues in fiscal 1998 over fiscal 1997 resulted from increased demand for
workgroup, enterprise, and departmental servers and high-end desktop systems and
to a lesser extent from high-end storage, memory, and related products.

     Our services net revenues increased $448 million, or 37.7%, to $1,635
million in fiscal 1999, compared with an increase of $336 million, or 40%, in
fiscal 1998. The dollar increase in services revenues in fiscal 1999 was
primarily the result of a shift in product mix toward premium-priced service and
support contracts and a larger installed product base due to increased product
unit sales, as well as increased revenues associated with our professional and
education services. The increase in services revenues from fiscal 1997 to fiscal
1998 was primarily the result of a larger installed product base due to
increased product unit sales, as well as increased revenues associated with our
professional services.

     In fiscal 1999 and fiscal 1998, domestic net revenues grew by 19% and 16%,
respectively, while international net revenues (including United States exports)
grew 21% and 12%, respectively. Revenues from international operations
represented 49%, 48%, and 49% of total revenues in fiscal 1999, 1998, and 1997,
respectively.

     European net revenues increased 23% and 20% in fiscal 1999 and 1998,
respectively. The increase in fiscal 1999 was due to increased demand for our
network computing products and services. We experienced continued growth in all
European regions during fiscal 1999, with the strongest growth in Germany and
Southern Europe. The increase in fiscal 1998 was primarily due to continued
market acceptance of our network computing products and services in most major
European markets. Although we have experienced U.S. dollar revenue growth in the
European marketplace on a year over year basis, there can be no assurance that
such trends will continue. In particular, if capital spending declines in
certain countries or industries, our results of operations and cash flow could
suffer.

     Japan net revenues increased 14% for fiscal 1999, compared to a decrease of
5% in fiscal 1998. The increase in fiscal 1999 was primarily due to increased
demand within the region for our products, with the most notable increase in
demand for our servers. We attribute the decrease in revenues in fiscal 1998 to
macroeconomic trends affecting the Japanese market, including currency movements
against the U.S. dollar. We remain cautious with regard to the Japanese market
and do not expect the current Japanese macroeconomic trends to change
significantly in the near term. In addition, if the economic trends in Japan
significantly worsen in a quarter or decline over an extended period of time,
our results of operations and cash flows could suffer.

     Net revenues in Rest of World increased by 22% in fiscal 1999 compared with
9% in fiscal 1998. The increases in fiscal 1999 and fiscal 1998 were primarily
due to increased demand for our network computing products and services from
expanding markets in China, Australia, and Latin America.

     A portion of our operations consists of manufacturing and sales activities
in foreign jurisdictions. As a result, our results of operations 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 we
distribute our products. We are primarily exposed to changes in exchange rates
on the Japanese yen, British pound, 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 we are a net receiver of currencies other than the U.S. dollar and, as
such, benefit from a weaker dollar, and are 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 our consolidated sales and operating margins as expressed in U.S.
dollars.

     To mitigate the short-term effect of changes in currency exchange rates on
our non-U.S. dollar-based sales, product procurement, and operating expenses, we
regularly hedge our 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 our foreign exchange forward and option contracts, our exposure to risk
associated with currency market movement on the instruments is not material. See
"Other Financial Instruments" in Note 1--"Summary of Significant Accounting
Policies."


<PAGE>   6

GROSS MARGIN

Products gross margin was 53.7% for fiscal 1999, compared with 53.8% and 51.1%
for fiscal 1998 and 1997, respectively. Fiscal year 1999 products gross margin
was relatively flat in relation to fiscal 1998. Products gross margin was
adversely impacted by increased volumes of low-end desktop systems and certain
workgroup servers, as well as increased manufacturing costs, the effects of
which were offset by an increased volume of higher margin, richly configured
enterprise servers and storage products. The increase in gross margin in fiscal
1998 over fiscal 1997 resulted primarily from sales of more richly configured,
higher margin servers and desktop systems, and to a lesser extent from decreased
component costs. There could be a further downward impact on our products gross
margins as the result of continued shifts in customer purchasing patterns toward
low-end desktop systems and workgroup servers.

     Services gross margin was 40.4% for fiscal 1999, compared with 39.3% and
37.7% for fiscal 1998 and 1997, respectively. The increase in fiscal 1999
reflects increased market penetration in enterprise data center accounts, an
overall shift toward premium priced service and support contracts resulting from
a larger installed base of high-end server products, continued growth in
professional services, and increased economies of scale in certain geographic
markets. The increase in services gross margin in fiscal 1998 over fiscal 1997
was primarily the result of a larger installed base offset by our increased
investment in services business. There can be no assurance that services gross
margins will continue to grow at rates consistent with the rates previously
realized.

     We continuously evaluate the competitiveness of our product and service
offerings. These evaluations could result in repricing actions in the near term.
Our future operating results would be adversely affected if such repricing
actions were to occur and we were unable to mitigate the resulting margin
pressure by maintaining a favorable mix of systems, software, service, and other
products, and by achieving component cost reductions, operating efficiencies,
and increasing volumes.

RESEARCH AND DEVELOPMENT

Research and development (R&D) expenses increased $249 million, or 24.5%, in
fiscal 1999 to $1,263 million, compared with an increase of $188 million, or
22.7%, in fiscal 1998. As a percentage of net revenues, R&D expenses were 10.8%,
10.4%, and 9.6% in fiscal 1999, 1998, and 1997, respectively. The increase in
spending in fiscal 1999 was focused on the development of a broad line of
scalable hardware products, including servers, workstations, and storage
technologies, software products which utilize the Java platform, Solaris
operating environment software, and SPARC(TM) microprocessors. The remaining
increase in R&D expenses was due to further development of products acquired
through acquisitions and increased compensation and compensation-related costs
due primarily to higher levels of R&D staffing. The increase as a percentage of
net revenues reflects our belief that to maintain our competitive position in a
market characterized by rapid rates of technological advancement, we must
continue to invest significant resources in new systems, software, and
microprocessor development, as well as in enhancements to existing products. The
Company expects research and development expenses to increase in dollar amount
in fiscal 2000 while remaining in the range of 11% of revenue in fiscal 2000.

SELLING, GENERAL AND ADMINISTRATIVE

Selling, general and administrative (SG&A) expenses increased $396 million, or
14.2%, in fiscal 1999 to $3,173 million compared with an increase of $375
million, or 15.6%, in fiscal 1998. As a percentage of net revenues, these
expenses were 27.1%, 28.4%, and 27.9% in fiscal 1999, 1998, and 1997,
respectively. The increase in dollar amount in fiscal 1999 was primarily
attributable to increased compensation and compensation-related expenses
resulting from higher levels of headcount, principally in the sales
organization, annual salary adjustments, and to a lesser extent, marketing costs
related to promotional programs and increased goodwill amortization expense
resulting from several acquisitions. We also made additional investments aimed
at improving our own business processes. In fiscal 2000, we expect SG&A expenses
to increase in dollar amount, as we continue to invest in efforts to achieve
additional operating efficiencies through the continual review and improvement
of business processes. In addition, we expect to continue to hire personnel to
drive demand-creation programs and service and support organizations.

<PAGE>   7

PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT

The following paragraphs contain forward-looking statements within the meaning
of the Private Securities Litigation Reform Act of 1995, particularly statements
regarding our expectations, including percentage of completion, expected product
release dates, dates for which we expect to begin generating benefits from
projects, expected product capabilities and product life cycles, costs and
efforts to complete projects, growth rates, royalty rates, projected revenue and
expense information used by us to 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, our 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
achieve either technological or commercial success or that we 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 $121 million, $176
million, and $23 million in fiscal 1999, 1998, and 1997, respectively,
represents the write-off of in-process technologies associated with our
acquisitions of NetDynamics, Inc. (NetDynamics), Maxstrat Corporation
(Maxstrat), i-Planet, Inc. (i-Planet), and Beduin Communications Incorporated
(Beduin) in fiscal 1999, 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, and Long View Technologies, LLC (Long View) in fiscal 1997 (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 process had no alternative future uses. Accordingly,
these amounts were expensed on the respective acquisition dates of each of the
Acquired Companies. Also see Note 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, we have expanded our disclosures related to acquisitions
involving IPRD charges for each of the Acquired Companies.

VALUATION OF IPRD

The following table summarizes the significant assumptions underlying the
valuations in fiscal years 1999, 1998, and 1997 related to the IPRD from each of
the Acquired Companies (in millions, except percentages).

--------------------------------------------------------------------------------
Acquisition Assumptions
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                    ESTIMATED
                                COST TO COMPLETE                             RISK ADJUSTED
                                  TECHNOLOGY AT                            DISCOUNT RATE ON
   ENTITY/PROJECT              TIME OF ACQUISITION    LICENSE RATE(1)       IN-PROCESS R&D
-------------------------------------------------------------------------------------------
<S>                            <C>                    <C>                  <C>
   FISCAL 1999 ACQUISITIONS

     NetDynamics                      $ 5.7                 n/a                   20%
-------------------------------------------------------------------------------------------
     Maxstrat                         $ 8.0                 n/a                   25%
-------------------------------------------------------------------------------------------
     i-Planet                         $ 6.0                 n/a                   25%
-------------------------------------------------------------------------------------------
     Beduin                           $ 0.4                 n/a                   40%
-------------------------------------------------------------------------------------------
   FISCAL 1998 ACQUISITIONS

     Red Cape                         $ 7.4                 n/a                   25%
-------------------------------------------------------------------------------------------
     Encore                          $ 30.0             12% in 1999               30%
                                                        10% in 2000
                                                     6% for 2001-2005
-------------------------------------------------------------------------------------------
     Chorus-JaZZr.1.1                 $ 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%
-------------------------------------------------------------------------------------------
   FISCAL 1997 ACQUISITION

     Long View                        $ 8.1                6.5%                   33%
-------------------------------------------------------------------------------------------
</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 the valuation method used.


<PAGE>   8

The following table provides information regarding the status of IPRD projects
upon acquisition and as of June 30, 1999 (except as otherwise described in the
footnotes):

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
                             PERCENTAGE COMPLETE AT         ACTUAL OR EXPECTED
   ENTITY/PROJECT              TIME OF ACQUISITION          PRODUCT RELEASE DATE
--------------------------------------------------------------------------------
   NetDynamics                         60%                    Q3 Fiscal 1999
--------------------------------------------------------------------------------
<S>                          <C>                            <C>
   Maxstrat                            70%                    Q1 Fiscal 2000
--------------------------------------------------------------------------------
   i-Planet                            30%                    Q4 Fiscal 1999
--------------------------------------------------------------------------------
   Beduin                              65%                    Q2 Fiscal 2000
--------------------------------------------------------------------------------
   Red Cape                            15%                    Q4 Fiscal 1999
--------------------------------------------------------------------------------
   Encore                              60%                     Fiscal 1999(1)
--------------------------------------------------------------------------------
   Chorus-JaZZr.1.1                    50%                    Q4 Fiscal 1998(2)
--------------------------------------------------------------------------------
   Chorus-Other IPRD                   20%                    Q4 Fiscal 1999(3)
--------------------------------------------------------------------------------
   Integrity Arts                       5%                    Q3 Fiscal 1998(4)
--------------------------------------------------------------------------------
   Diba                                10%                    Q4 Fiscal 1999(5)
--------------------------------------------------------------------------------
   Long View                           25%                    Q4 Fiscal 1998(6)
--------------------------------------------------------------------------------
</TABLE>

(1) Revised expected release date is Q1 Fiscal 2000.

(2) Released in Q4 Fiscal 1999.

(3) Revised expected release date is Q2 Fiscal 2000.

(4) Released in Q4 Fiscal 1999.

(5) Project was abandoned in Fiscal 1999. See additional discussion at "Overall
    status of IPRD acquired prior to fiscal 1999."

(6) Released in Q4 Fiscal 1999.

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

     The values assigned to developed technologies related to each acquisition
were based upon future discounted cash flows related to the existing products'
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. We do 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 ACQUIRED PRIOR TO FISCAL 1999

With respect to acquisitions completed prior to fiscal 1999, with the exception
of Encore, which is discussed separately below, we believe that the projections
we used in performing our valuations with respect to each acquisition are still
valid; however, there can be no assurance that the projected results will be
achieved. We expect to continue the development of each project and believe that
there is a reasonable chance of successfully completing such development
efforts, except for IPRD technology acquired from Lighthouse and Diba, 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. As of June
30, 1999 and for each of the three fiscal years then ended, the impact upon our
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, except as discussed below.

     In fiscal 1997, we terminated our 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 our commitment to OpenStep was scaled back
thereby impacting development decisions related to the Lighthouse Software
Products. Additionally, in fiscal 1999 we terminated our development efforts
with respect to the IPRD technology acquired from Diba, which related to the
completion of a set-top box product. The decisions to abandon the in-process
technologies acquired from Lighthouse and Diba were based upon changes in the
long-term strategy for certain of our products, the impact of which was not
material to our consolidated results of operations or financial position.

     Included below are further details regarding the nature of technology
acquired, the valuation assumptions, and the status of the IPRD related to our
acquisitions completed during fiscal 1999, as well as Encore, our largest
additional acquisition, completed during the three years ended June 30, 1999.

<PAGE>   9

NETDYNAMICS

IPRD OVERVIEW--NETDYNAMICS

At the acquisition date (August 28, 1998), NetDynamics was conducting
development, engineering, and testing activities associated with the completion
of a new enterprise application platform product. This new product offering
(NetDynamics New Product Offering) employs a new server-side component model,
based on the Enterprise JavaBeans(TM) (EJB) architecture, which allows business
logic to reside in the middle tier of the enterprise computing model independent
of the client presentation layer and independent of legacy and database systems.
This architecture is significantly different than the business logic
architecture in NetDynamics' existing product offering, which is tightly
integrated with the presentation interface. The EJB architecture allows for the
development of more robust and scalable applications with improved reusability,
better connectivity to a wide variety of data sources, and a more-industry
standard interface through the use of Java enterprise application programming
interfaces. Other new features include significant security enhancements and
performance improvements, and the addition of new platform adaptor components
for legacy systems integration.

VALUATION ANALYSIS--NETDYNAMICS

We calculated the value of the IPRD technology using a discounted cash flow
analysis on the anticipated income stream of the related product sales. The
discounted cash flow analysis was based upon our forecast of future revenues,
cost of revenues, and operating expenses related to the product and technology
acquired from NetDynamics, which are intended to be used in our future
enterprise application platform products. We projected total revenue for
NetDynamics to increase at a compound growth rate of approximately 30% from
fiscal 1999 through 2008. Revenues are expected to peak in fiscal 2000 and
decline thereafter, as we expect to introduce new product technologies. These
projections are based on our estimates of market size and growth, expected
trends in technology, and the expected timing of new product introductions.

     Our assumptions with respect to operating expenses used in the valuation
analysis included: (i) cost of goods sold, (ii) SG&A expenses, and (iii) R&D
expenses. Selected operating expense assumptions we used were based on an
evaluation of NetDynamics' overall business model, including both historical and
expected direct expense levels (as appropriate), and an assessment of general
industry metrics. We projected that the cost of revenues (expressed as a
percentage of revenue) for the IPRD would decrease over time from approximately
26% in fiscal 1999 to 15% in fiscal 2005. We estimated SG&A (expressed as a
percentage of revenue) for the IPRD to average 34% over the projection period.
Maintenance R&D related to the IPRD was estimated to be approximately 1% of
revenue over the projection period.

     The discount rate we selected for the IPRD was 20%. In the selection of the
appropriate discount rate, we gave consideration to our 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 were known at the valuation date, and the stage of
completion of the technology. The discount rate we used for the IPRD was
determined to be greater than our 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 relative value and contribution of the
acquired research and development. We gave consideration to the R&D's stage of
completion, the complexity of the work completed at the valuation date, the
difficulty of completing the remaining development, costs already incurred, and
the projected cost to complete the project in determining the value assigned to
IPRD.

COMPARISON TO ACTUAL RESULTS--NETDYNAMICS

The NetDynamics New Product Offering was completed in March 1999 for a total
cost of approximately $4.7 million, compared to the planned total cost of $5.7
million. We began to realize the benefits of the NetDynamics acquired technology
during the fourth quarter of fiscal 1999. Through June 30, 1999, no significant
adjustments have been made in the economic assumptions or expectations which
underlie our acquisition decision and related purchase accounting.

     Given the uncertainties of the commercialization process, no assurance can
be given that deviations from our estimates will not occur. We believe there is
a reasonable chance of realizing the economic return expected from the acquired
in-process technology. However, as there is risk associated with the realization
of benefits related to commercialization of an in-process project due to rapidly
changing customer needs, complexity of technology, and growing competitive
pressures, there can be no assurance that any project will meet with commercial
success. Failure to successfully commercialize an in-process project would
result in the loss of the expected economic return inherent in the fair value
allocation. Additionally, the value of our intangible assets acquired may become
impaired.

<PAGE>   10

MAXSTRAT

IPRD OVERVIEW--MAXSTRAT

At the acquisition date (January 22, 1999), Maxstrat was conducting development,
engineering, and testing activities associated with the completion of a new
modular mass data storage system product family (Noble Product Offering)
scheduled to be released during the first quarter of fiscal 2000. The Noble
Product Offering utilizes Fibre Channel, a fiber-optic technology designed for
mass storage devices requiring very high bandwidth. Using optical fiber to
connect devices, each Fibre Channel Arbitrated Loop (FC-AL) supports full-duplex
data transfer rates of 100 mbps. Multiple FC-ALs increase the redundancy and
availability of the system. If an FC-AL fails, another automatically takes over
to keep the traffic flow consistent and predictable.

     At the acquisition date, Maxstrat had made substantial progress in the
areas of specifications, design, and implementation. Remaining efforts necessary
to complete the Noble Product Offering relate primarily to coding, testing, and
addressing additional implementation issues. We anticipate that the Noble
Product Offering will be complete by the end of our first quarter of fiscal
2000, after which we expect to begin generating economic benefits from the IPRD
associated with the Noble Product Offering. Expenditures to complete the Noble
Product Offering are expected to total approximately $8 million during fiscal
1999 and fiscal 2000.

VALUATION ANALYSIS--MAXSTRAT

We calculated the IPRD technology using a discounted cash flow analysis on the
anticipated income stream of the related product sales. The discounted cash flow
analysis was based upon our forecast of future revenues, cost of revenues, and
operating expenses related to the product and technology acquired from Maxstrat,
which are intended to be used in our future enterprise application platform
products. We projected total revenue for Maxstrat to increase at a compound
growth rate of approximately 30% from fiscal 1999 through 2008. We also expect
revenues to peak in fiscal 2003 and decline thereafter, as we expect to
introduce new product technologies. These projections are based on our estimates
of market size and growth, expected trends in technology, and the expected
timing of new product introductions.

     Operating expenses used in the valuation analysis included: (i) cost of
goods sold, (ii) SG&A expenses, and (iii) R&D expenses. Selected operating
expense assumptions we used were based on an evaluation of Maxstrat's overall
business model, including both historical and expected direct expense levels (as
appropriate), and an assessment of general industry metrics. Cost of revenues
(expressed as a percentage of revenue) for the IPRD averages 50% over the
projection period. SG&A (expressed as a percentage of revenue) for the IPRD
averages 20% over the projection period. Maintenance R&D related to the IPRD was
estimated to be approximately 2% of revenue over the projection period.

     The discount rate we selected for the IPRD was 25%. In the selection of the
appropriate discount rate, we gave consideration to our 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
valuation date, and the stage of completion of the technology. The discount rate
we used for the IPRD was determined to be greater than our 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 relative value and contribution of the
acquired research and development. We gave consideration to the R&D's stage of
completion, the complexity of the work completed to date, the difficulty
completing the remaining development, costs already incurred, and the projected
cost to complete the project in determining the value assigned to IPRD.

COMPARISON TO ACTUAL RESULTS--MAXSTRAT

At June 30, 1999, significant progress had been made on the development related
to the Noble Product Offering that was underway as of the acquisition date. We
are continuing to invest in the development of new technologies that were
underway at the consummation of the Maxstrat acquisition. At June 30, 1999, we
had incurred approximately $5 million of the planned total cost to complete of
$8 million, and no significant adjustments have been made in the economic
assumptions or expectations which underlie our acquisition decision and related
purchase accounting. We are continuing our development efforts related to the
IPRD technology acquired. These development efforts are advancing at a rate
consistent with our expectations.

     Given the uncertainties of the development and commercialization process,
no assurance can be given that deviations from these estimates will not occur.
We expect to continue the development of the Noble Product Offering and believe
that there is a reasonable chance of successfully completing such development.
However, as there is risk associated with the completion of the in-process
project 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 this in-process project would result in the loss of the expected
economic return inherent in the fair value allocation. Additionally, the value
of our intangible assets acquired may become impaired.

<PAGE>   11

IPRD OVERVIEW--i-PLANET

At the acquisition date (September 28, 1998), i-Planet was conducting
development, engineering, and testing activities associated with the completion
of a new Java technology-based remote Internet access product scheduled to be
released in early calendar year 1999. It was anticipated that this new product
offering (i-Planet(TM) New Product Offering) would allow cost-effective, secure,
and ubiquitous Internet access for applications such as remote access to
corporate intranets, supply chain management, and commerce applications.

     At the acquisition date, i-Planet was performing development efforts in the
areas of specifications, design, and implementation. Remaining efforts necessary
to complete the i-Planet New Product Offering related primarily to coding,
testing, and addressing additional implementation issues. Approximately $3
million of the total costs to complete the i-Planet New Product Offering of $6
million had been incurred at June 1999. We completed and released the product
related to the i-Planet technology, i-Planet Webtop, in May 1999. As of June 30,
1999, no significant adjustments have been made in the economic assumptions or
expectations which underlie our acquisition decision and related purchase
accounting.

IPRD OVERVIEW--BEDUIN

At the acquisition date (October 16, 1998), Beduin was conducting development,
engineering, and testing activities associated with the completion of a suite of
products (Beduin New Product Offerings) which included the Lifestyle Manager
Personal Information Manager (PIM) (a next-generation PIM targeted at smart
devices incorporating Java technology), and "e-mail client" (a next generation
e-mail client specialized to take advantage of the benefits of these smart
devices). We anticipate that these Beduin New Product Offerings will provide the
core functionality for smart devices incorporating Java technology and enable
more efficient communication, regardless of time, location, or type of device.
These Beduin New Product Offerings are designed to integrate and synchronize
communications and data processing systems, enabling communications across time
and space.

     At the acquisition date, Beduin was performing development efforts and
substantial progress had been made in the areas of specifications, design, and
implementation. Remaining efforts necessary to complete the Beduin New Product
Offerings relate primarily to coding, testing, and addressing additional
implementation issues. We anticipate that the Beduin New Product Offerings will
be completed during the second quarter of our fiscal year ending June 30, 2000,
after which we expect to begin generating economic benefits from the value of
the completed development associated with the IPRD. We expect that the total
costs to complete the Beduin New Product Offerings will approximate $2 million.

VALUATIONS OF IPRD--i-PLANET AND BEDUIN

Forecasts of future results that we believe are likely to occur were our basis
for assigning value to IPRD. For the i-Planet and Beduin acquisitions, we
assigned values to IPRD by estimating the costs to develop the purchased
in-process technology into commercially viable products, estimating the
resulting net cash flows from each project, excluding the cash flows related to
the portion of each project that was incomplete at the acquisition date, and
discounting the resulting net cash flows to their present value. Each of our
forecasts was based upon future discounted cash flows, taking into account the
state of development of each in-process project, the cost to complete that
project, the expected income stream, the life cycle of the product ultimately
developed, and the risks associated with successful development and
commercialization of each project. Projected future net cash flows attributable
to the in-process technology, assuming successful development of such
technologies, were discounted to their present value using a discount rate that
was derived based on our estimated WACC plus a risk premium to account for the
inherent uncertainty surrounding the successful completion of each project and
the associated estimated cash flows. The discount rates used in valuing the net
cash flows from each purchased in-process technology were 25% for the i-Planet
acquisition and 40% for the Beduin acquisition. These discount rates are higher
than our WACC due to the inherent uncertainties in the estimates described
above, including the uncertainty surrounding the successful development of the
purchased in-process technologies, the useful life of such technologies, the
profitability levels of such technologies, and the uncertainty of technological
advances that are unknown at this time.

     The estimates we used in the valuation of the IPRD charges are subject to
change. Given the uncertainties of the development and commercialization
process, no assurance can be given that deviations from these estimates will not
occur. We expect to continue the development of each project and believe 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 our intangible assets acquired may become impaired.

<PAGE>   12

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). We anticipated that completion of the
Encore Products would help us 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 could 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 we 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 that 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, we 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. We projected that revenues would peak in fiscal 2002
and decline thereafter as we expect to introduce new product technologies. These
projections were based on our estimates of market size and growth, expected
trends in technology, and the expected timing of new product introductions. The
product life cycle used by us resulted in the use of estimated royalty rates of
12% in 1999, 10% in 2000, and 6% for 2001 through 2005. 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.

     We selected a discount rate of 30%. In the selection of the appropriate
discount rate, we considered our 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 chosen was greater
than our WACC, as the technology had not yet reached technological feasibility
as of the valuation date.

     The value assigned to the IPRD reflects our determination of the relative
value and contribution of the acquired research and development. We 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 difficulty in completing the
remaining development, costs already incurred, and the projected costs to
complete the project.

COMPARISON TO ACTUAL RESULTS--ENCORE

As of June 30, 1999, we had made progress on the development efforts related to
the Encore Products that were underway as of the acquisition date, and
approximately $19 million of the estimated total cost to complete of $30 million
had been incurred. Although the research and development effort is behind
schedule, 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. As of June 30, 1999, we have delayed
our expected release of the Encore Products from the fourth quarter of fiscal
1999 until the first quarter of fiscal 2000. We have experienced this delay in
the realization of benefits related to the acquired technology as the result of
increased complexities associated with the completion of the project. The impact
of the delay in completion of the Encore Products has resulted in a net
shortfall from our original projections of approximately $40 million on our
consolidated results of operations for the year ended June 30, 1999. This amount
reflects a shortfall in our original plan assumptions with regard to the
technologies acquired from Encore only, and does not reflect any offsetting
benefits we may have achieved from our overall business plan, including those
resulting from a reallocation of resources among alternative development
projects. Although the realization of benefits related to the Encore Products
has been delayed, we are actively developing the acquired technology and expect
over the long term to realize benefits associated with the Encore Products that
are consistent with the initial acquisition strategy.

     Given the uncertainties of the development and commercialization process,
no assurance can be given that deviations from these estimates will not occur.
We expect to continue the development of each project and believe 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 our intangible
assets acquired may become impaired.

<PAGE>   13

INTEREST INCOME (EXPENSE), NET

Our interest income and expense are 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 our cash equivalents and short-term investments, as well
as interest paid on our short-term borrowings. To mitigate the impact of
fluctuations in U.S. interest rates, we entered into an interest rate swap
transaction. This swap was intended to better match our floating-rate interest
income on cash equivalents and short-term investments with the interest expense
on our note payable.

     Net interest income increased to $84 million in fiscal 1999, compared with
$46 million and $32 million in fiscal 1998 and fiscal 1997, respectively. The
increase in net interest income for fiscal 1999 was primarily the result of
higher interest earnings due to a larger average portfolio of cash and
investments as compared with the corresponding periods in fiscal 1998 and 1997.

     The principal/notional amount of our cash equivalents and short-term
investments at June 30, 1999 was $2,035 million. These investments, which
generally mature in fiscal 2000, bear interest at an average rate of 4.6% and
have a fair market value of $2,034 million.

INCOME TAXES

Our effective income tax rate for fiscal 1999 was 33% before non-recurring tax
charges of $45 million resulting from our write-off of IPRD associated with the
acquisitions of Maxstrat, i-Planet and NetDynamics. The effective tax rate
including such charges was 35.8%. Our effective income tax rate for fiscal 1998
was 33% before non-recurring tax charges of $25 million resulting from the
write-off of IPRD associated with the acquisitions of Red Cape, Diba, and
Integrity Arts. The effective tax rate including such charges was 35.1%. Our
effective tax rate for fiscal 1997 was 32%.

     We currently expect an effective tax rate of 33% for fiscal 2000. The
expected rate excludes the impact of potential mergers and acquisitions. The tax
effects of merger and acquisition transactions would be accounted for in the
interim quarter in which the transactions occur. The expected rate is based on
current tax law and current estimates of earnings, and is subject to change.

LIQUIDITY AND CAPITAL RESOURCES

Our financial condition strengthened as of the end of fiscal 1999 when compared
with fiscal 1998. During fiscal 1999, operating activities generated $2,517
million in cash, compared with $1,527 million in fiscal 1998. Accounts
receivable increased $433 million, or 23%, to $2,287 million, due primarily to a
20% increase in net revenues in fiscal 1999 as compared with the fiscal 1998.
Deferred tax assets, other current and noncurrent assets increased $533 million,
or 58%, to $1,552 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 our acquisitions. Other current and noncurrent liabilities
increased $1,186 million, or 72% due to liabilities resulting from the strategic
development and marketing agreement with America Online, Inc. (AOL), increased
compensation and compensation-related costs, and increases in sales and
marketing costs. Accounts payable increased $256 million, or 52%, due to
additional operating expenses associated with the expansion of our business.

     Our investing activities used $2,096 million of cash in fiscal 1999, an
increase of $927 million from the $1,169 million used in fiscal 1998. The
increase resulted primarily from additions to short-term investments. Additions
to short-term investments totaled $2,433 million, up $1,474 million, or 154%,
from fiscal 1998 additions, primarily due to having additional resources
available for investment. Also included in investing activities is capital
spending for real estate development, as well as capital additions to support
increased headcount, primarily in our engineering, services, and marketing
organizations.

     Approximately $154 million of cash was used by financing activities in
fiscal 1999, compared with $195 million used in fiscal 1998. The decrease was
primarily due to an increase in stock issuances, as well as a decrease in
short-term borrowings.

     Our exposure to interest rate risk on the international short-term
borrowings of $1.6 million was not material, given the short-term maturity of
these instruments and our evaluation of the potential for rate changes
associated with such instruments.

     At June 30, 1999, our primary sources of liquidity consisted of cash, cash
equivalents, and short-term investments of $2,665 million and a revolving credit
facility with banks aggregating $500 million, which was available subject to
compliance with certain covenants, and $740 million of borrowings under
available lines of credit to our international subsidiaries. On October 16,
1997, we filed a shelf 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, this shelf registration
statement became effective. On June 18, 1999, we filed an additional shelf
registration statement with the Securities and Exchange Commission relating to
the registration for public offering of senior and subordinated debt securities
and common and preferred stock with an aggregate initial public offering price
of up to $3 billion. On July 14, 1999, this shelf registration statement became
effective. As a result, we may choose to offer up to $4 billion, from time to
time, of debt securities and common and preferred 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 these registration statements and in one or more
supplements to the prospectus. On August 4, 1999, the Company issued $1.5
billion in unsecured debt securities in four tranches. Each tranche is comprised
of the following notes (the Senior Notes): $200 million (due on August 15, 2002
and bearing interest at 7%), $250 million (due on August 15, 2004 and bearing
interest at 7.35%), $500 million (due on August 15, 2006 and bearing interest at
7.5%), $550 million (due on August 15, 2009 and bearing interest at 7.65%). Sun
also entered into various interest rate swap agreements to modify the interest
characteristics of the Senior Notes such that the interest associated with these
Senior Notes becomes variable.

     We believe that the liquidity provided by existing cash and short-term
investments, and the borrowing arrangements described above will provide
sufficient capital to meet our requirements through fiscal 2000. We believe the
level of financial resources is a significant competitive factor in our industry
and may choose at any time to raise additional capital through debt or equity
financings to strengthen our financial position, facilitate growth, and provide
us with additional flexibility to take advantage of business opportunities that
may arise.

<PAGE>   14

FUTURE OPERATING RESULTS

IF WE ARE UNABLE TO COMPETE EFFECTIVELY WITH EXISTING OR NEW COMPETITORS, OUR
RESULTING LOSS OF COMPETITIVE POSITION COULD RESULT IN PRICE REDUCTIONS, FEWER
CUSTOMER ORDERS, REDUCED REVENUES, REDUCED MARGINS, REDUCED LEVELS OF
PROFITABILITY, AND LOSS OF MARKET SHARE.

We compete in the hardware and software products and services markets. These
markets are intensely competitive. If we fail to compete successfully in these
markets, the demand for our products would decrease. Any reduction in demand
could lead to a decrease in the prices of our products, fewer customer orders,
reduced revenues, reduced margins, reduced levels of profitability, and loss of
market share. These competitive pressures could seriously harm our business and
operating results.

     Our competitors are some of the largest, most successful companies in the
world. They include Hewlett-Packard Company (HP), International Business
Machines Corporation (IBM), Compaq Computer Corporation (Compaq), and EMC
Corporation (EMC). Our future competitive performance depends on a number of
factors, including our ability to: continually develop and introduce new
products and services with better prices and performance than offered by our
competitors; offer a wide range of products and solutions from small
single-processor systems to large complex enterprise-level systems; offer
solutions to customers that operate effectively within a computing environment
that includes hardware and software from multiple vendors; offer products that
are reliable and that ensure the security of data and information; create
products for which third-party software vendors will develop a wide range of
applications; and offer high-quality products and services.

     We also compete with systems manufacturers and resellers of systems based
on microprocessors from Intel Corporation (Intel) and Windows NT operating
system software from Microsoft Corporation (Microsoft). These competitors
include Dell Computer Corporation (Dell), HP, and Compaq, in addition to Intel
and Microsoft. This competition creates increased pressure, including pricing
pressure, on our workstation and lower-end server product lines. We expect this
competitive pressure to intensify considerably during our fiscal year 2000 with
the anticipated releases of new software products from Microsoft and new
microprocessors from Intel.

     The computer systems that we sell are made up of many products and
components, including workstations, servers, storage products, microprocessors,
the Solaris operating environment and other software products. In addition, we
sell some of these components separately and as add-ons to installed systems. If
we are unable to offer products and services that compete successfully with the
products and services offered by our competitors or that meet the complex needs
of our customers, our business and operating results could be seriously harmed.
In addition, if in responding to competitive pressures, we are forced to lower
the prices of our products and services and we are unable to reduce our
component costs or improve operating efficiencies, our business and operating
results would be seriously harmed.

     Over the last two years, we have invested significantly in our storage
products business with a view to increasing the sales of these products both on
a stand-alone basis to customers using the systems of our competitors, and as
part of the systems that we sell. The intelligent storage products business is
intensely competitive. EMC is currently the leader in this market. To the extent
we are unable to penetrate this market and compete effectively, our business and
operating results could be seriously harmed. In addition, we will be making
significant investments over the next few years to develop, market, and sell
software products under our recent alliance with AOL and have agreed to
significant minimum revenue commitments. These alliance products are targeted at
the e-commerce market and are strategic to our ability to successfully compete
in this market. If we are unable to successfully compete in this market, our
business and operating results could be seriously harmed.

THE PRODUCTS WE MAKE ARE VERY COMPLEX AND IF WE ARE UNABLE TO RAPIDLY AND
SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS, WE WILL NOT BE ABLE TO SATISFY
CUSTOMER DEMAND.

We operate in a highly competitive, quickly changing environment, and our future
success depends on our ability to develop and introduce new products that our
customers choose to buy. If we are unable to develop new products, our business
and operating results would be seriously harmed. We must quickly develop,
introduce, and deliver in quantity new, complex systems, software, and hardware
products and components including our UltraSPARC microprocessors, the Solaris
operating environment, our intelligent storage products, and other software
products, such as those products under development or to be developed under our
recent alliance with AOL. The development process for these complicated products
is very uncertain. It requires high levels of innovation from both our product
designers and our suppliers of the components used in our products. The
development process is also lengthy and costly. If we fail to accurately
anticipate our customers' needs and technological trends, or are otherwise
unable to complete the development of a product on a timely basis, we will be
unable to introduce new products into the market on a timely basis, if at all,
and our business and operating results would be adversely affected. In addition,
the successful development of software products under our alliance with AOL
depends on many factors, including our ability to work effectively within the
alliance on complex product development and any encumbrances that may arise from
time to time that may prevent us from developing, marketing, or selling these
alliance software products. If we are unable to successfully develop, market, or
sell the alliance software products or other software products, our business and
operating results could be seriously harmed.

<PAGE>   15

     Software and hardware products such as ours may contain known as well as
undetected errors, and these defects may be found following introduction and
shipment of new products or enhancements to existing products. Although we
attempt to fix errors that we believe would be considered critical by our
customers prior to shipment, we may not be able to detect or fix all such
errors, and this could result in lost revenues and delays in customer
acceptance, and could be detrimental to our business and reputation.

     The manufacture and introduction of our new hardware and software products
is also a complicated process. Once we have developed a new product we face the
following challenges in the manufacturing process. We must be able to
manufacture new products in high enough volumes so that we can have an adequate
supply of new products to meet customer demand. We must be able to manufacture
the new products at acceptable costs. This requires us to be able to accurately
forecast customer demand so that we can procure the appropriate components at
optimal costs. Forecasting demand requires us to predict order volumes, the
correct mixes of our software and hardware products, and the correct
configurations of these products. We must manage new product introductions so
that we can minimize the impact of customers delaying purchases of existing
products in anticipation of the new product release. We must also try to reduce
the levels of older product and component inventories to minimize inventory
write-offs. We may also decide to adjust prices of our existing products during
this process in order to try to increase customer demand for these products. If
we are introducing new products at the same time or shortly after the price
adjustment, this will complicate our ability to anticipate customer demand for
our new products.

     If we were unable to timely develop, manufacture, and introduce new
products in sufficient quantity to meet customer demand at acceptable costs, or
if we were unable to correctly anticipate customer demand for our new products,
our business and operating results could be significantly harmed.

OUR RELIANCE ON SINGLE SOURCE SUPPLIERS COULD DELAY PRODUCT SHIPMENTS AND
INCREASE OUR COSTS.

We depend on many suppliers for the necessary parts and components to
manufacture our products. There are a number of vendors producing the parts and
components that we need. However, there are some components that can only be
purchased from a single vendor due to price, quality, or technology reasons. For
example, we depend on Sony for various monitors, and on Texas Instruments for
our SPARC microprocessors. If we were unable to purchase the necessary parts and
components from a particular vendor and we had to find a new supplier for such
parts and components, our new and existing product shipments could be delayed,
severely affecting our business and operating results.

OUR FUTURE OPERATING RESULTS DEPEND ON OUR ABILITY TO PURCHASE A SUFFICIENT
AMOUNT OF COMPONENTS TO MEET THE DEMANDS OF OUR CUSTOMERS.

We depend heavily on our suppliers to timely design, manufacture, and deliver
the necessary components for our products. While many of the components we
purchase are standard, we do purchase some components, specifically color
monitors and custom memory integrated circuits such as SRAMs and VRAMs, that
require long lead times to manufacture and deliver. Long lead times make it
difficult for us to plan component inventory levels in order to meet the
customer demand for our products. In addition, in the past, we have experienced
shortages in certain of our components (specifically DRAMs and SRAMs). If a
component delivery from a supplier is delayed, if we experience a shortage in
one or more components, or if we are unable to provide for adequate levels of
component inventory, our new and existing product shipments could be delayed and
our business and operating results could suffer.

SINCE WE ORDER OUR COMPONENTS (AND IN SOME CASES COMMIT TO PURCHASE) FROM
SUPPLIERS IN ADVANCE OF RECEIPT OF CUSTOMER ORDERS FOR OUR PRODUCTS THAT INCLUDE
THESE COMPONENTS, WE FACE A SUBSTANTIAL INVENTORY RISK.

As part of our component inventory planning, we frequently pay certain suppliers
well in advance of receipt of customer orders. For example, we often enter into
noncancelable purchase commitments with vendors early in the manufacturing
process of our microprocessors to make sure we have enough of these components
for our new products to meet customer demand. Because the design and
manufacturing process for these components is very complicated it is possible
that we could experience a design or manufacturing flaw that could delay or even
prevent the production of the components for which we have previously committed
to pay. We also face the risk of ordering too many components, or conversely,
not enough components, since the orders are based on the forecasts of customer
orders rather than actual orders. If we cannot change or be released from the
noncancelable purchase commitments, we could incur significant costs from the
purchase of unusable components, due to a delay in the production of the
components or as a result of inaccurately predicting component orders in advance
of customer orders. Our business and operating results could be seriously harmed
as a result of these increased costs.

<PAGE>   16

DELAYS IN PRODUCT DEVELOPMENT OR CUSTOMER ACCEPTANCE AND IMPLEMENTATION OF NEW
PRODUCTS AND TECHNOLOGIES COULD SERIOUSLY HARM OUR BUSINESS.

Delays in product development and customer acceptance and implementation of new
products could seriously harm our business. Delays in the development and
introduction of our products may occur for various reasons. For example, delays
in software development could delay shipments of related new hardware products.
Generally, the computer systems we sell to customers incorporate hardware and
software products that we sell, such as the UltraSPARC microprocessor, the
Solaris operating environment, and intelligent storage products. Any delay in
the development of the software and hardware included in our systems could delay
our shipment of these systems.

     In addition, if customers decided to delay the adoption and implementation
of new releases of our Solaris operating environment this could also delay
customer acceptance of new hardware products tied to that release. Adopting a
new release of an operating environment requires a great deal of time and money
for a customer to convert its systems to the new release. The customer must also
work with software vendors who port their software applications to the new
operating system and make sure these applications will run on the new operating
system. As a result, customers may decide to delay their adoption of a new
release of an operating system because of the cost of a new system and the
effort involved to implement it. Also, customers may wait to implement new
systems until after January 1, 2000 so that there is less likelihood of Year
2000 computer problems.

IF WE ARE UNABLE TO CONTINUE GENERATING SUBSTANTIAL REVENUES FROM INTERNATIONAL
SALES, OUR BUSINESS COULD BE SUBSTANTIALLY HARMED.

Currently, approximately half of our revenues come from international sales. Our
ability to sell our products internationally is subject to the following risks:
general economic and political conditions in each country could adversely affect
demand for our products and services in these markets, as recently occurred in
certain Asian and Latin American markets; currency exchange rate fluctuations
could result in lower demand for our products, as well as currency translation
losses; changes to and compliance with a variety of foreign laws and regulations
may increase our cost of doing business in these jurisdictions; trade protection
measures and import and export licensing requirements subject us to additional
regulation and may prevent us from shipping products to a particular market, and
increase our operating costs.

WE EXPECT OUR QUARTERLY REVENUES AND OPERATING RESULTS TO FLUCTUATE FOR A NUMBER
OF REASONS.

Future operating results will continue to be subject to quarterly fluctuations
based on a wide variety of factors, including:

     Seasonality. Our operating results usually fluctuate downward in the first
and third quarters of each fiscal year due to customer buying patterns for
hardware and software products and services.

     Increases in Operating Expenses. Our operating expenses will continue to
increase as we continue to expand our operations. Our operating results could
suffer if our revenues do not increase at least as fast as our expenses.

     Acquisitions/Alliances. If, in the future, we acquire technologies,
products, or businesses, or we form alliances with companies requiring
technology investments or revenue commitments (such as our recent alliance with
AOL), we will face a number of risks to our business. The risks we may encounter
include those associated with integrating or comanaging operations, personnel,
and technologies acquired or licensed, and the potential for unknown liabilities
of the acquired or combined business. Also, we will include amortization expense
of acquired intangible assets in our financial statements for several years
following these acquisitions. Our business and operating results on a quarterly
basis could be harmed if our acquisition or alliance activities are not
successful.

     Significant Customers. Only one of our customers accounted for more than
10% of our revenues in fiscal 1999 and fiscal 1998. Sales to this customer
accounted for approximately 14% of our fiscal 1999 and 1998 revenues. Our
business could suffer if this customer or another significant customer
terminated its business relationship with us or significantly reduced the amount
of business it did with us.

OUR FAILURE OR THE FAILURE OF OUR BUSINESS PARTNERS AND CUSTOMERS TO BE YEAR
2000 COMPLIANT COULD HARM OUR BUSINESS.

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 be able to distinguish years
beginning with "19" from those beginning with "20." As a result, in less than
six months, computer systems and/or software products used by many companies may
need to be upgraded to comply with such Year 2000 requirements. We are currently
expending resources to review our products and services, as well as our
internal-use software in order to identify and modify those products, services,
and systems that are not Year 2000 compliant. We believe that the vast majority
of these costs are not incremental to us but represent a reallocation of
existing resources and include regularly scheduled systems upgrades and
maintenance. In addition, we have made custom coding enhancements to our
mission-critical internal business systems, and we believe that such internal
systems are now Year 2000 compliant. We are working to make our remaining
internal systems Year 2000 compliant by September 30, 1999.

<PAGE>   17

     Although we believe that the costs associated with the aforementioned Year
2000 efforts are not material, we currently estimate that such costs will be
between $40 to $45 million, of which approximately $25 million had been spent
through June 30, 1999. The aforementioned costs are estimates due in large part
to the fact that we do not separately track the internal labor costs associated
with Year 2000 compliance, unless such costs are incurred by individuals devoted
primarily to Year 2000 compliance efforts. These cost estimates do not include
any potential costs related to any customer or other claim. In addition, these
cost estimates are based on the current assessment of the ongoing activities
described above, and are subject to change as we continuously monitor these
activities. We believe any modifications deemed necessary will be made on a
timely basis and we do not believe that the cost of such modifications will
seriously harm our business. We currently expect the aforementioned evaluation
of our products, services, and systems and any remediation necessary will be
completed by September 30, 1999. As of June 30, 1999, we had not identified any
items or areas that would require material remediation efforts. Our expectations
as to the extent and timeliness of any modifications required in order to
achieve Year 2000 compliance and the costs related thereto are forward-looking
statements 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 section. We cannot be sure, however, that we will be able to
successfully modify on a timely basis such products, services, and systems to
comply with Year 2000 requirements. Our business could suffer if we fail to make
our products, services, and systems Year 2000 compliant in time.

     We have established a program to assess whether certain of our products are
Year 2000 compliant. Under this program, we are in the process of performing
tests on Sun products listed on our price lists. To monitor this program and to
help customers evaluate their Year 2000 issues we have created a Web site at
http://sun.com/y2000/cpl.html that identifies the following categories: products
that were released Year 2000 compliant; products that require modifications to
be Year 2000 compliant; products under review; products that are not Year 2000
compliant and need to be replaced with a Year 2000 compliant product; source
code products that could be modified and implemented without our review; and
products that do not process or manipulate date data or have no date-related
technology. We update this list periodically as our analysis of additional
products is completed.

     Based on our assessment to date, most of our newly introduced products and
services are Year 2000 compliant; however, we cannot be sure that our current
products do not contain undetected errors or defects associated with Year 2000
functions that may result in material costs to us. In addition, some of our
customers are running products that are not Year 2000 compliant and will require
an upgrade or other remediation to become Year 2000 compliant. We provide
limited warranties as to Year 2000 compliance on certain of our products and
services. Except as specifically provided for in the limited warranties, we do
not believe that we are legally responsible for costs incurred by customers to
achieve Year 2000 compliance. We have been taking steps to identify affected
customers, raise customer awareness related to noncompliance of our older
products, and encourage such customers to migrate to current products or product
versions. It is possible that we may experience increased expenses if we need to
upgrade or perform other remediation on products that our customers are using
that are not Year 2000 compliant. Our business may also materially suffer if
customers become concerned about or are dissatisfied with our products and
services as a result of Year 2000 issues.

     We also face risks to the extent that suppliers of products, services, and
systems purchased by us or the suppliers of others with whom we transact
business cannot timely provide us with products, components, services, or
systems that meet Year 2000 requirements. To the extent that we are not able to
test technology provided by third-party hardware or software vendors, we are in
the process of carrying out audits and obtaining Year 2000 compliance
certifications from each of our major vendors that their products and internal
systems, as applicable, are Year 2000 compliant. In the event any such third
parties cannot timely provide us with products, services, or systems that meet
the Year 2000 requirements, our business could be harmed. Furthermore, a
reasonably likely worst-case scenario would be if one of our major vendors
experienced a material disruption in business, which caused us to experience a
material disruption in business. If either our internal systems or the internal
systems, products, or services of one or more of our major vendors (including
banks, energy suppliers, and transportation providers) fail to achieve Year 2000
compliance, our business could be seriously harmed. We are currently developing
contingency plans to deal with potential Year 2000 problems related to our
internal systems that are deemed to be high risk and with respect to products
and services provided by outside vendors. We expect these plans to be complete
by September 30, 1999. If these plans are not timely completed or if they are
not successful or if new Year 2000 problems not covered by our contingency plans
emerge, our business and operating results may be seriously harmed.

     Although we believe that the cost of Year 2000 modifications for both
internal use software and systems, as well as Sun's products are not material,
we cannot be sure that various factors relating to the Year 2000 compliance
issues will not seriously harm our business or operating results. For example, a
significant amount of litigation may arise out of Year 2000 compliance issues
and we cannot be sure about the extent to which we may be affected by any of
this litigation. Even though we do not believe that we are legally responsible
for our customers' Year 2000 compliance obligations, it is unclear whether
different governments or governmental agencies may decide to allocate liability
relating to Year 2000 compliance to us without regard to specific warranties or
warranty disclaimers. Our business could suffer in any given quarter if any
liability is allocated to us. Furthermore, we do not know how customer spending
patterns may be affected by Year 2000 issues. We believe, however, that
customers will focus on preparing their businesses for the Year 2000 and that
their capital budgets will be spent in large part on remediation efforts,
potentially delaying the purchase and implementation of new systems, thereby
creating less demand for our products and services. Our business could be harmed
if customers delay purchasing our products during the first half of our fiscal
Year 2000 because of Year 2000 concerns, or if our customers are unable to
conduct their business or are prevented from placing orders or paying us because
of their own Year 2000 problems. A significant disruption of our financial
management and control systems or a lengthy interruption in our operations
caused by a Year 2000 related issue could also result in a material adverse
impact on our operating results and financial condition.

<PAGE>   18

OUR ACQUISITION AND ALLIANCE ACTIVITIES COULD DISRUPT OUR ONGOING BUSINESS.

We intend to continue to make investments in companies, products, and
technologies, either through acquisitions or investment alliances. For example,
we have purchased several companies in the past and formed alliances, including
our recent alliance with AOL. Acquisitions and alliance activities often involve
risks, including: we may experience difficulty in assimilating the acquired
operations and employees; we may experience difficulty in managing product
codevelopment activities with our alliance partners; we may be unable to retain
the key employees of the acquired operation; the acquisition or investment may
disrupt our ongoing business; we may not be able to incorporate successfully the
acquired technology and operations into our business and maintain uniform
standards, controls, policies, and procedures; and we may lack the experience to
enter into new markets, products, or technologies.

     Some of these factors are beyond our control. Failure to manage these
alliance activities effectively and to integrate acquisitions could affect our
operating results or financial condition.

WE DEPEND ON KEY EMPLOYEE AND FACE COMPETITION IN HIRING AND RETAINING QUALIFIED
EMPLOYEES.

Our employees are vital to our success, and our key management, engineering, and
other employees are difficult to replace. We generally do not have employment
contracts with our key employees. Further, we do not maintain key person life
insurance on any of our employees. The expansion of high technology companies in
Silicon Valley and Colorado, as well as many other cities, has increased demand
and competition for qualified personnel. We may not be able to attract,
assimilate, or retain additional highly qualified employees in the future. These
factors could harm our business.


<PAGE>   19

--------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
   (In thousands, except share and per share amounts)             YEARS ENDED JUNE 30,
                                                            1999          1998            1997
<S>                                                  <C>            <C>             <C>
Net revenues:
   Products                                          $10,091,046    $8,603,259      $7,747,115
   Services                                            1,635,251     1,187,581         851,231
----------------------------------------------------------------------------------------------------

Total net revenues                                    11,726,297     9,790,840       8,598,346

Cost and expenses:
   Cost of sales--products                             4,674,390     3,972,283       3,790,284
   Cost of sales--services                               973,970       721,053         530,176
   Research and development                            1,262,517     1,013,782         825,968
   Selling, general and administrative                 3,172,955     2,777,264       2,402,442
   Purchased in-process research and development         120,700       176,384          22,958
----------------------------------------------------------------------------------------------------
Total costs and expenses                              10,204,532     8,660,766       7,571,828

Operating income                                       1,521,765     1,130,074       1,026,518
Gain on sale of equity investment                             --            --          62,245
Interest income                                           84,599        47,663          39,899
Interest expense                                            (675)      ( 1,571)        ( 7,455)
----------------------------------------------------------------------------------------------------
Income before income taxes                             1,605,689     1,176,166       1,121,207
Provision for income taxes                               574,355       413,304         358,787
----------------------------------------------------------------------------------------------------
Net income                                           $ 1,031,334    $  762,862      $  762,420
----------------------------------------------------------------------------------------------------
Net income per common share--basic                         $1.35         $1.02           $1.03
----------------------------------------------------------------------------------------------------
Net income per common share--diluted                       $1.27         $0.97           $0.98
----------------------------------------------------------------------------------------------------
Shares used in the calculation of net income per
   common share--basic                                   765,853       747,456         736,852
----------------------------------------------------------------------------------------------------
Shares used in the calculation of net income per
   common share--diluted                                 814,241       788,548         777,934

See accompanying notes.
</TABLE>


<PAGE>   20

--------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
   (In thousands, except share and per share amounts)                           AT JUNE 30,
                                                                            1999           1998
                                                                     -----------    -----------
<S>                                                                  <C>            <C>
   ASSETS
   Current assets:
     Cash and cash equivalents                                       $ 1,088,972    $   822,267
     Short-term investments                                            1,576,079        476,185
     Accounts receivable, net of allowances of $338,771 in 1999
       and $235,563 in 1998                                            2,286,911      1,845,765
     Inventories                                                         307,873        346,446
     Deferred tax assets                                                 487,150        371,841
     Other current assets                                                369,365        285,021
-----------------------------------------------------------------------------------------------
       Total current assets                                            6,116,350      4,147,525

   Property, plant and equipment:
     Machinery and equipment                                           1,552,184      1,251,660
     Furniture and fixtures                                              172,912        113,636
     Leasehold improvements                                              287,740        256,233
     Land, buildings and building improvements                           858,512        635,699
-----------------------------------------------------------------------------------------------
                                                                       2,871,348      2,257,228

   Accumulated depreciation and amortization                          (1,262,427)      (956,616)
-----------------------------------------------------------------------------------------------
                                                                       1,608,921      1,300,612
   Other assets, net                                                     695,081        262,925
-----------------------------------------------------------------------------------------------
                                                                     $ 8,420,352    $ 5,711,062
-----------------------------------------------------------------------------------------------

   LIABILITIES AND STOCKHOLDERS' EQUITY
   Current liabilities:
     Short-term borrowings                                           $     1,646    $     7,169
     Accounts payable                                                    753,838        495,603
     Accrued payroll-related liabilities                                 520,068        315,929
     Accrued liabilities and other                                     1,126,497        810,562
     Deferred service revenues                                           422,115        264,967
     Income taxes payable                                                402,813        188,641
     Note payable                                                             --         40,000
-----------------------------------------------------------------------------------------------
       Total current liabilities                                       3,226,977      2,122,871

   Deferred income taxes and other obligations                           381,595         74,563
   Commitments and contingencies

   Stockholders' equity:

   Preferred stock, $0.001 par value, 10,000,000 shares authorized
     (3,000,000 of which have been designated as Series A Preferred
     participating stock); no shares issued and outstanding                   --             --

   Common stock, $0.00067 par value, 1,800,000,000 shares authorized;
     issued: 867,254,728 shares in 1999 and 860,622,882 shares
     in 1998                                                                 581            288
   Additional paid-in capital                                          1,742,652      1,345,508
   Retained earnings                                                   4,124,607      3,150,935
   Treasury stock, at cost: 89,919,137 shares in 1999 and
     108,015,732 shares in 1998                                       (1,045,961)    (1,003,191)
-----------------------------------------------------------------------------------------------
   Accumulated other comprehensive income (loss)                         (10,099)        20,088
-----------------------------------------------------------------------------------------------
       Total stockholders' equity                                      4,811,780      3,513,628
-----------------------------------------------------------------------------------------------
                                                                     $ 8,420,352    $ 5,711,062
-----------------------------------------------------------------------------------------------
</TABLE>

   See accompanying notes.



<PAGE>   21

--------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
--------------------------------------------------------------------------------


<TABLE>
<CAPTION>
   (In thousands)                                                                            YEARS ENDED JUNE 30,
                                                                                      1999            1998           1997
<S>                                                                            <C>             <C>             <C>
Cash flow from operating activities:
   Net income                                                                  $ 1,031,334     $   762,862     $  762,420
   Adjustments to reconcile net income to operating cash flows:
     Depreciation and amortization                                                 626,946         439,921        356,003
     Gain on sale of equity investment                                                  --              --        (62,245)
     Tax benefit of options exercised                                              222,364         111,375         59,799
     Purchased in-process research and development                                 120,700         176,384         22,958
     Net increase in accounts receivable                                          (433,136)       (176,075)      (334,911)
     Net decrease in inventories                                                    39,206          97,394         22,936
     Net increase (decrease) in accounts payable                                   256,117         (12,298)       143,845
     Net increase in other current and non-current assets                         (532,979)       (206,210)      (152,510)
     Net increase in other current and non-current liabilities                   1,186,305         333,159        286,793
-------------------------------------------------------------------------------------------------------------------------
Net cash provided from operating activities                                      2,516,857       1,526,512      1,105,088
-------------------------------------------------------------------------------------------------------------------------
Cash flow from investing activities:
   Additions to property, plant and equipment                                     (738,707)       (830,143)      (554,018)
   Acquisition of other assets                                                    (108,240)        (91,521)       (37,645)
   Acquisition of short-term investments                                        (2,432,725)       (958,354)      (973,884)
   Maturities of short-term investments                                            688,154         523,032        634,765
   Sales of short-term investments                                                 625,690         432,047        347,771
   Proceeds from sale of equity investment                                              --              --         62,245
   Payments for acquisitions, net of cash acquired                                (130,300)       (244,020)       (22,958)
-------------------------------------------------------------------------------------------------------------------------
Net cash used by investing activities                                           (2,096,128)     (1,168,959)      (543,724)
-------------------------------------------------------------------------------------------------------------------------
Cash flow from financing activities:
   Issuance of stock, net of repurchases                                           142,596          71,975         52,969
   Acquisition of treasury stock                                                  (358,434)       (284,396)      (456,090)
   Proceeds from employee stock purchase plans                                     115,699          93,581         81,313
   Proceeds (reduction) of short-term borrowings, net                              (15,523)        (92,967)        51,769
   Repayment of receivable purchase agreement                                           --              --       (125,000)
   Proceeds (reduction) of note payable and other                                  (38,362)         16,351        (35,009)
-------------------------------------------------------------------------------------------------------------------------
Net cash used by financing activities                                             (154,024)       (195,456)      (430,048)
-------------------------------------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents                                          266,705         162,097        131,316
Cash and cash equivalents, beginning of year                                       822,267         660,170        528,854
-------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year                                          $1,088,972      $  822,267      $ 660,170
-------------------------------------------------------------------------------------------------------------------------

Supplemental disclosures of cash flow information:
   Cash paid during the period for:
   Interest                                                                          $ 836           $ 905       $ 15,126
   Income taxes                                                                  $ 138,596       $ 334,550       $380,814

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                                                 $ 305,242      $  301,415            $--
   Cash paid for assets                                                           (134,895)       (249,806)            --
   Stock issued                                                                   (144,483)             --             --
-------------------------------------------------------------------------------------------------------------------------
   Liabilities assumed                                                            $ 25,864       $  51,609            $--
-------------------------------------------------------------------------------------------------------------------------
</TABLE>

See accompanying notes.


<PAGE>   22

--------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                        COMMON STOCK       ADDITIONAL                            TREASURY STOCK
THREE YEARS ENDED JUNE 30, 1999                     --------------------      PAID-IN       RETAINED          ---------------------
(In thousands, except share amounts)                  SHARES      AMOUNT      CAPITAL       EARNINGS          SHARES         AMOUNT
<S>                                                 <C>            <C>    <C>            <C>            <C>             <C>
Balances at June 30, 1996                           852,640,236    $ 72   $ 1,164,349    $ 1,662,355    (108,711,752)   $  (596,910)
Net income                                                   --      --            --        762,420              --             --
Currency translation adjustments and other                   --      --            --             --              --             --

Total comprehensive income                                   --      --            --             --              --             --
Issuance of stock, net of repurchases                   (20,000)     --            --        (14,710)     20,756,230        137,574
Treasury stock purchased                                     --      --            --             --     (32,145,238)      (456,090)
Exercise of warrants                                  8,451,536       1         1,611             --              --             --
Tax benefit of employee stock transactions
   and other                                                 --      --        63,837             --              --             --
Issuance of common stock dividend                            --     215            --           (215)             --             --
------------------------------------------------------------------------------------------------------------------------------------
Balances at June 30, 1997                           861,071,772     288     1,229,797      2,409,850    (120,100,760)      (915,426)
Net income                                                   --      --            --        762,862              --             --
Currency translation adjustments and other                   --      --            --             --              --             --

Total comprehensive income                                   --      --            --             --              --             --
Issuance of stock, net of repurchases                  (448,890)     --            (2)       (21,777)     25,276,768        196,631
Treasury stock purchased                                     --      --            --             --     (13,191,740)      (284,396)
Tax benefit of employee stock transactions
   and other                                                 --      --       115,713             --              --             --
------------------------------------------------------------------------------------------------------------------------------------

Balances at June 30, 1998                           860,622,882     288     1,345,508      3,150,935    (108,015,732)    (1,003,191)
Net income                                                   --      --            --      1,031,334              --             --
Currency translation adjustments and other                   --      --            --             --              --             --

Total comprehensive income                                   --      --            --             --              --             --
Issuance of stock, net of repurchases                 6,631,846       2       144,483        (57,371)     27,506,499        315,664
Treasury stock purchased                                     --      --            --             --      (9,409,904)      (358,434)
Tax benefit of employee stock transactions
   and other                                                 --      --       252,661             --              --             --
Issuance of common stock dividend                            --     291            --           (291)             --             --
------------------------------------------------------------------------------------------------------------------------------------
Balances at June 30, 1999                           867,254,728    $581   $ 1,742,652    $ 4,124,607     (89,919,137)   $(1,045,961)
------------------------------------------------------------------------------------------------------------------------------------
</TABLE>

<TABLE>
<CAPTION>
                                                       ACCUMULATED
                                                             OTHER                 TOTAL
THREE YEARS ENDED JUNE 30, 1999                      COMPREHENSIVE         STOCKHOLDERS'
(In thousands, except share amounts)                  INCOME (LOSS)               EQUITY
<S>                                                       <C>                <C>
Balances at June 30, 1996                                 $ 21,620           $ 2,251,486
Net income                                                      --               762,420
Currency translation adjustments and other                  (4,192)               (4,192)
                                                                           -------------
Total comprehensive income                                      --               758,228
Issuance of stock, net of repurchases                           --               122,864
Treasury stock purchased                                        --              (456,090)
Exercise of warrants                                            --                 1,612
Tax benefit of employee stock transactions
   and other                                                    --                63,837
Issuance of common stock dividend                               --                    --
----------------------------------------------------------------------------------------
Balances at June 30, 1997                                   17,428             2,741,937
Net income                                                      --               762,862
Currency translation adjustments and other                   2,660                 2,660
                                                                           -------------
Total comprehensive income                                      --               765,522
Issuance of stock, net of repurchases                           --               174,852
Treasury stock purchased                                        --              (284,396)
Tax benefit of employee stock transactions
   and other                                                    --               115,713
----------------------------------------------------------------------------------------

Balances at June 30, 1998                                   20,088             3,513,628
Net income                                                      --             1,031,334
Currency translation adjustments and other                 (30,187)              (30,187)
                                                                           -------------
Total comprehensive income                                      --             1,001,147
Issuance of stock, net of repurchases                           --               402,778
Treasury stock purchased                                        --              (358,434)
Tax benefit of employee stock transactions
   and other                                                    --               252,661
Issuance of common stock dividend                               --                    --
----------------------------------------------------------------------------------------
Balances at June 30, 1999                                 $(10,099)          $ 4,811,780
----------------------------------------------------------------------------------------
</TABLE>

See accompanying notes.

<PAGE>   23
Notes to Consolidated Financial Statements

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

DESCRIPTION OF BUSINESS
--------------------------------------------------------------------------------
Sun Microsystems, Inc. (the Company or Sun) is a provider of products, services,
and support solutions for building and maintaining network computing
environments. Sun sells scalable computer systems, high-speed microprocessors,
and a line of high-performance software for operating networks, computing
equipment, and storage products. Sun also provides a full range of services
including support, education, and professional services. The Company markets its
products primarily to business, government, and education customers and operates
in various product segments 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 and tax-exempt securities 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 were classified as either trading or
available-for-sale and are carried at fair value. All of the Company's cash
equivalents and short-term investments were classified as available-for-sale at
June 30, 1999 and 1998. Realized and unrealized gains and losses are computed on
the specific identification method based upon actual sales prices 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 the consolidated balance sheet caption "Accumulated
other comprehensive income (loss)." The change in net unrealized gains and
losses on investments, net of income taxes, included in stockholders' equity at
June 30, 1999 and 1998, was not material.

     The Company maintains certain trading assets to generate returns that
offset changes in certain liabilities related to deferred compensation
arrangements. The trading assets consist of marketable equity securities and are
stated at fair value. Both realized and unrealized gains and losses generally
offset the change in the deferred compensation liability and have not been
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 records inventory write downs for potentially excess and
obsolete inventory based on backlog and forecasted demand. However, such backlog
and forecasted demand is subject to revisions, cancellations, and rescheduling.
Actual demand will inevitably differ from such backlog and forecasted demand,
and such differences may be material to the financial statements. Inventories
consist of:

<TABLE>
<CAPTION>

(in thousands)                              1999               1998
<S>                                       <C>                <C>
Raw materials                             $113,070           $ 92,197
Work in progress                            51,183             58,765
Finished goods                             143,620            195,484
                                          --------           --------
Total                                     $307,873           $346,446
                                          ========           ========

</TABLE>

<PAGE>   24

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

OTHER ASSETS
--------------------------------------------------------------------------------
Other assets consist primarily of 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 1999, 1998, and 1997 was $78 million, $42 million, and $27
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 sheet caption
"Accumulated other comprehensive income (loss)." Currency transaction gains or
losses are recognized in current operations and have not been significant to the
Company's operating results in any period. The effect of foreign currency rate
changes on cash and cash equivalents is not material.

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 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, 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 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.

<PAGE>   25

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 expense was
$246 million, $235 million, and $272 million for fiscal years 1999, 1998, and
1997, respectively.

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

WARRANTY EXPENSE
--------------------------------------------------------------------------------
The Company provides currently for the estimated costs that may be incurred
under warranties for product shipped. Accrued warranty liability of $166 million
and $116 million at June 30, 1999 and 1998, respectively, is included in the
consolidated balance sheet caption "Accrued liabilities and other."

NET INCOME PER COMMON SHARE
--------------------------------------------------------------------------------
Basic earnings per common share is calculated by dividing net income by the
weighted average number of common shares outstanding during the period and
excludes any dilutive effects of options, warrants, and convertible securities.
Dilutive earnings per common share is calculated by dividing net income by the
weighted average number of common shares used in the basic earnings per common
share calculation plus the dilutive effect of options, warrants, and convertible
securities.

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
(In thousands, except per share amounts)            Years Ended June 30,
--------------------------------------------------------------------------------
NET INCOME PER COMMON SHARE                       1999       1998         1997
<S>                                         <C>          <C>          <C>
Net income                                  $1,031,334   $762,862     $762,420
--------------------------------------------------------------------------------
Shares used to compute net income
   per common share--basic                     765,853    747,456      736,852
Effect of dilutive securities                   48,388     41,092       41,082
--------------------------------------------------------------------------------
Shares used to compute net income
   per common share--diluted                   814,241    788,548      777,934
--------------------------------------------------------------------------------
Net income per common share--basic          $     1.35   $   1.02     $   1.03
--------------------------------------------------------------------------------
Net income per common share--diluted        $     1.27   $   0.97     $   0.98
--------------------------------------------------------------------------------
</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, 1999 and 1998. 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 1999, the Company
provided approximately $18 million for doubtful accounts ($23 million and $20
million in 1998 and 1997, respectively).

<PAGE>   26

STOCK DIVIDEND
--------------------------------------------------------------------------------
The Company announced a two-for-one stock split (in the form of a stock
dividend) on January 21, 1999, which was distributed at the close of business on
April 8, 1999. The Company also effected a two-for-one stock split (in the form
of a stock dividend) to stockholders of record as of the close of business on
November 18, 1996. All earnings per common share amounts, as well as references
to common stock and stockholders' equity amounts have been restated as if these
stock dividends had occurred as of the earliest period presented.

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
Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock
Issued to Employees," and has provided in Note 9 pro forma disclosures of the
effect on net income and earnings 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
--------------------------------------------------------------------------------
In fiscal 1999, the Company adopted 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." Comprehensive income is defined as the change in equity of a
company during a period from transactions and other events and circumstances
excluding transactions resulting from investment by owners and distributions to
owners. The primary difference between net income and comprehensive income for
the Company is due to currency translation adjustments. Comprehensive income is
reflected in the consolidated statements of stockholders' equity. FAS 131
supersedes Financial Accounting Standards No. 14, "Financial Reporting for
Segments of a Business Enterprise," replacing the "industry segment" approach
with the "management" approach. The management approach designates the internal
organization that is used by management for making operating decisions and
assessing performance as the source of the Company's reportable segments. FAS
131 also requires disclosures about products and services, geographic areas, and
major customers. See Note 10 for these disclosures.

     In June 1998, Financial Accounting Standards No. 133 (FAS 133), "Accounting
for Derivative Instruments and Hedging Activities" was issued and was effective
for all fiscal years beginning after June 15, 1999. FAS 133 was subsequently
amended by Financial Accounting Standards No. 137, "Accounting for Derivative
Instruments and Hedging Activities--Deferral of the Effective Date of FASB
Statement No. 133" and will now be effective for fiscal years beginning after
June 15, 2000, with early adoption permitted. FAS 133, as amended, requires the
Company to recognize all derivatives as either assets or liabilities and measure
those instruments at fair value. It further provides criteria for derivative
instruments to be designated as fair value, cash flow, and foreign currency
hedges and establishes respective accounting standards for reporting changes in
the fair value of the derivative instruments. Upon adoption, the Company will be
required to adjust hedging instruments to fair value in the balance sheet and
recognize the offsetting gains or losses as adjustments to be reported in net
income or other comprehensive income, as appropriate. The Company has not
completed its assessment of the impact of FAS 133, as amended, on its
consolidated financial position or results of operations and is in the process
of determining when it will adopt FAS 133.

     The Company also adopted Statement of Position (SOP) 98-1, "Accounting for
the Costs of Computer Software Developed or Obtained for Internal Use" effective
July 1, 1998. The adoption of SOP 98-1 did not have a material effect on the
Company's consolidated financial position or operating results.

<PAGE>   27

2. ACQUISITIONS

During the three years ended June 30, 1999, the Company completed ten
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.

     On August 28, 1998, the Company completed its acquisition of NetDynamics,
Inc. (NetDynamics), a company conducting development, engineering, and testing
activities associated with the completion of a new enterprise application
platform product. Sun 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 based upon an agreed-upon exchange ratio which was calculated using
an agreed-upon average market price for Sun common stock. The Company issued
5,493,570 shares of Sun common stock (with a fair market value of $24.13 per
share) as consideration for the acquisition. Additionally, Sun issued
approximately 1,136,000 stock options in exchange for NetDynamics stock options
previously outstanding, including approximately 344,000 Sun options in exchange
for vested NetDynamics stock options, with terms similar to Sun stock options.
The fair value of the Sun stock options exchanged for rights to vested
NetDynamics stock options at the time of the acquisition was included as part of
the purchase price. The excess purchase price over the estimated fair value of
net tangible assets has been allocated to various intangible assets, primarily
consisting of developed technology ($20 million), goodwill ($36.2 million),
customer base ($10 million), and assembled work force ($2 million). In addition
to the intangible assets acquired, an $80 million charge representing the
write-off of purchased in-process research development (IPRD) was recorded.

     On January 22, 1999, the Company acquired all of the outstanding capital
stock of Maxstrat Corporation (Maxstrat), by means of a merger transaction
pursuant to which all of the shares of Maxstrat capital stock were converted
into the right to receive cash for total consideration of $101.5 million, net of
cash received of $18.7 million and including $2.5 million associated with vested
stock options. The excess purchase price over the estimated fair value of net
tangible assets has been allocated to various intangible assets, primarily
consisting of developed technology of $8.6 million and goodwill and
goodwill-like assets totaling $61.5 million. In addition to the intangible
assets acquired, the Company recorded a $28.7 million charge, representing the
write-off of IPRD.

     On September 28, 1998, the Company completed its acquisition of i-Planet,
Inc. (i-Planet), a company conducting development, engineering, and testing
activities associated with the completion of a new Java technology based remote
Internet access product. Sun acquired all of the outstanding capital stock of
i-Planet by means of a merger transaction pursuant to which all the shares of
i-Planet capital stock were converted into the right to receive cash for total
consideration of $30 million, including $1.2 million associated with vested
stock options. The excess purchase price over the estimated fair value of net
tangible assets has been allocated to various intangible assets, primarily
consisting of developed technology of $3.3 million and various goodwill and
goodwill-like assets totaling $18.3 million. In addition to the intangible
assets acquired, an $8.4 million charge representing the write-off of IPRD was
recorded.

     On October 16, 1998, the Company completed its acquisition of Beduin
Communications Incorporated (Beduin), a company conducting development,
engineering, and testing activities associated with the completion of a suite of
smart device products. Sun acquired all of the outstanding capital stock of
Beduin by means of a share purchase transaction pursuant to which all the shares
of Beduin capital stock were converted into the right to receive cash for total
consideration of $8.4 million. The excess purchase price over the estimated fair
value of net tangible assets has been allocated to various intangible assets,
primarily consisting of developed technology of $3.1 million and various
goodwill and goodwill-like assets totaling $1.7 million. In addition to the
intangible assets acquired, a $3.6 million charge was recorded, representing the
write-off of IPRD.

<PAGE>   28

     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-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 that 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 Java Card(TM) 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 that will offer improved performance 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 Java virtual machine for the Microsoft 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.

     A summary of the Company's purchase transactions that included IPRD charges
is included in the following table (in millions):

<TABLE>
<CAPTION>
Entity Name   Consideration       Date         IPRD Charge     Form of Consideration & Other Notes

FISCAL 1999
-----------
<S>               <C>       <C>                   <C>          <C>
NetDynamics       $148.2    August 28, 1998       $80.0        $140.8 in common stock and $7.4 in assumed liabilities; developed
                                                               technology of $20.0; goodwill and other intangibles of $48.2

Maxstrat          $101.5    January 22, 1999      $28.7        $99.0 in cash and $2.5 in common stock; developed technology of $8.6;
                                                               goodwill and other intangibles of $61.5

i-Planet          $ 30.0    September 28, 1998    $ 8.4        $28.6 in cash, $1.2 in common stock, and $0.2 in assumed liabilities

Beduin            $  8.4    October 16, 1998      $ 3.6        Cash

FISCAL 1998
-----------

Red Cape          $ 16.7    May 29, 1998          $14.1        Cash

Encore            $186.2    November 24, 1997     $97.0        Cash; developed technology of $56; goodwill and other intangibles
                                                               of $6.7

Chorus            $ 26.5    October 21, 1997      $13.1        Cash

Integrity Arts    $ 30.2    September 22, 1997    $29.9        Cash

Diba              $ 29.7    August 22, 1997       $22.3        $25.6 in cash and $4.1 in assumed liabilities

FISCAL 1997
-----------

Long View         $ 23.0    February 14, 1997     $23.0        Cash
</TABLE>

<PAGE>   29

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 Company computed its
valuations of purchased IPRD for certain of the above acquisitions, specifically
NetDynamics, Maxstrat, i-Planet, Beduin, Red Cape, Integrity Arts, and Diba, as
well as certain technology acquired from Chorus, using a discounted cash flow
analysis on the anticipated income stream to be generated by the purchased
technologies. The Company computed its valuations of IPRD related to certain of
the acquisitions, specifically, Encore and Long View, as well as certain
technology acquired from Chorus, using an income approach that is based on the
assumption that in lieu of ownership, a company would be willing to pay for the
right to exploit the related benefits of the acquired technology. This method
utilizes revenue related to the acquired technology, an appropriate rate for the
use of such technology, expected technology life cycles, amortization cost of
the asset acquired, and an appropriate discount rate.

     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 work force. The values assigned to developed
technologies related to each acquisition were based upon future discounted cash
flows related to the existing products' 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 work forces. Amounts
allocated to goodwill and other intangibles are amortized on a straight-line
basis over periods ranging from two to five years.

3. STRATEGIC DEVELOPMENT AND MARKETING AGREEMENT WITH AMERICA ONLINE, INC.

On November 23, 1998, Sun and America Online, Inc. (AOL) entered into a
Strategic Alliance consisting of several agreements between the parties,
including a Strategic Development and Marketing Agreement (SDMA). The SDMA has a
term of three years which commenced on March 17, 1999 in accordance with its
terms upon the consummation of AOL's acquisition of Netscape Communications,
Inc. (Netscape).

     Under the terms of the SDMA, AOL and Sun are committed to collaboratively
develop, market, and sell client and server software, and collaboratively
develop an AOL-specific Java environment that will enable AOL services to be
accessed through a variety of hardware devices. The SDMA provides that over its
term, AOL will develop and market, together with Sun, client software and
network application and server software based in part on Netscape code, on Sun
code and technology, and on certain AOL services features to business
enterprises. In addition, AOL and Sun have agreed to coordinate their sales
efforts with respect to designated AOL, Netscape, Sun, and collaboratively
developed client software and network application and server software and
associated services.

     Under the terms of the SDMA, Sun has committed that the total revenue
earned by AOL from certain existing Netscape contracts, the sale or license by
Sun or AOL of certain AOL, Netscape, and collaboratively developed software
products and services will not be less than $312 million, $330 million, and $333
million in the first, second, and third years of the SDMA. In addition, the
terms of the SDMA require Sun to pay AOL approximately $275 million over the
term of the SDMA for software and trademark rights granted to Sun by AOL. The
long-term portion of this contractual obligation of $165 million is reflected in
the consolidated balance sheet caption "Deferred income taxes and other
obligations."

4. FAIR VALUE OF FINANCIAL INSTRUMENTS

Fair values of cash equivalents and short-term investments approximate cost due
to the short period of time to maturity. The fair value of long-term debt was
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.

<PAGE>   30

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

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------
(In thousands)                                            At June 30, 1999
--------------------------------------------------------------------------------------------
                                                        GROSS           GROSS
FAIR VALUE OF CASH EQUIVALENTS                     UNREALIZED       UNREALIZED     ESTIMATED
AND SHORT-TERM INVESTMENTS               COST           GAINS           LOSSES    FAIR VALUE
<S>                                <C>                    <C>            <C>      <C>
State and local government debt    $  236,644             $--            $195     $  236,449
Corporate and other
  non-governmental debt             1,024,320              --              72      1,024,248
U.S. government debt                  332,993              --             234        332,759
Floating rate notes                   229,540              --              15        229,525
Money market fund                     184,600              --              --        184,600
Other investments                      26,771              --              --         26,771
--------------------------------------------------------------------------------------------
Total                              $2,034,868              $--           $516     $2,034,352
--------------------------------------------------------------------------------------------
</TABLE>

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------
(In thousands)                                            At June 30, 1999
--------------------------------------------------------------------------------------------
                                                        GROSS           GROSS
FAIR VALUE OF CASH EQUIVALENTS                     UNREALIZED       UNREALIZED     ESTIMATED
AND SHORT-TERM INVESTMENTS               COST           GAINS           LOSSES    FAIR VALUE
<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>

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

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------
(In thousands)                                                         At June 30, 1999
--------------------------------------------------------------------------------------------
                                                                                  ESTIMATED
CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS                             COST     FAIR VALUE
<S>                                                               <C>            <C>
Maturing in one year or less                                      $1,805,328     $1,804,827
Maturing after one year                                              229,540        229,525
-------------------------------------------------------------------------------------------
Total                                                             $2,034,868     $2,034,352
-------------------------------------------------------------------------------------------
</TABLE>


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

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------
(In thousands)                              At June 30, 1999                At June 30, 1999
------------------------------------------------------------------------------------------------
FAIR VALUE OF BORROWING ARRANGEMENTS        ASSET (LIABILITY)               ASSET (LIABILITY)

                                        CARRYING            FAIR        CARRYING           FAIR
                                          AMOUNT           VALUE          AMOUNT          VALUE
<S>                                      <C>             <C>            <C>            <C>
10.18% mortgage loan                     $    --         $    --        $(40,000)      $(41,495)
Forward foreign exchange contracts         4,640           4,640           4,265          4,265
Foreign currency option contracts             --           8,574              --          7,531
Short-term borrowings                     (1,646)         (1,646)         (7,169)        (7,169)
Interest-rate swap agreement                  --              --              --            292
------------------------------------------------------------------------------------------------
</TABLE>

<PAGE>   31

5. DERIVATIVE FINANCIAL INSTRUMENTS

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

<TABLE>
<CAPTION>
---------------------------------------------------------------------------
(In thousands)
---------------------------------------------------------------------------
NOTIONAL AMOUNTS FOR DERIVATIVES                          1999      1998
<S>                                                   <C>          <C>
Swaps hedging debt                                    $     --     $ 40,000
Forward foreign exchange contracts                     844,551      930,155
Foreign currency option contracts                      476,260      241,861
</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 Note 1.

     At June 30, 1999 and 1998, the Company had forward foreign exchange
contracts of less than three months duration, to exchange principally Japanese
yen, British pounds, French francs, and German marks for U.S. dollars in the
total gross notional amount of $845 million and $930 million, respectively. Of
these notional amounts, forward contracts to purchase foreign currency
represented $126 million and $139 million, and forward contracts to sell foreign
currency represented $719 million and $791 million, at June 30, 1999 and 1998,
respectively. The Company also has purchased foreign currency options of less
than two months duration, to exchange principally Japanese yen, British pounds,
German marks, and French francs for U.S. dollars.

6. BORROWING ARRANGEMENTS

As of June 30, 1998, the Company had a $40 million mortgage loan which was
secured by real property and a building. The loan agreement provided for
interest at a fixed interest rate of 10.18%. However, the Company maintained an
interest-rate swap agreement with a third party (receive fixed, pay variable)
that resulted in the Company paying a rate based on three-month LIBOR over the
life of the loan. The Company settled this mortgage in full in May 1999. The
related interest-rate swap agreement matured 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 Euro 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, 1999.
There were no borrowings outstanding under this facility at June 30, 1999.

     At June 30, 1999, Sun's international subsidiaries had uncommitted lines of
credit aggregating approximately $740 million, of which approximately $1.6
million, denominated in British pound and Euro, had been drawn. The average
interest rate at June 30, 1999 was 4.06%.

     On October 16, 1997, the Company filed a shelf registration statement with
the Securities and Exchange Commission (SEC) relating to the registration 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, this
shelf registration statement became effective, so that the Company may 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.

     On June 18, 1999, the Company filed an additional shelf registration
statement with the SEC relating to the registration of additional senior and
subordinated debt securities and common and preferred stock with an aggregate
initial public offering price of up to $3 billion. See Note 12--"Subsequent
Events (unaudited)."

<PAGE>   32

7. INCOME TAXES

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

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------
(In thousands)                                     Years Ended June 30,
------------------------------------------------------------------------------------
                                            1999              1998              1997

Income before income taxes:
<S>                                   <C>               <C>               <C>
  United States                       $  975,394        $  589,387        $  566,554
  Foreign                                630,295           586,779           554,653

Total income before income taxes      $1,605,689        $1,176,166        $1,121,207

Provision for income taxes:
  Current:

    United States federal             $  384,563        $  349,095        $  303,537
    State                                 41,517            47,270            46,894
    Foreign                              129,794           106,192            67,234

    Total current income taxes           555,874           502,557           417,665

Deferred:

    United States federal                 (2,563)          (81,319)          (66,027)
    State                                  7,432            (6,492)           (5,231)
    Foreign                               13,612            (1,442)           12,380

    Total deferred income taxes           18,481           (89,253)          (58,878)

Provision for income taxes            $  574,355        $  413,304        $  358,787
</TABLE>

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>
---------------------------------------------------------------------------
(In thousands)                                            At June 30,
---------------------------------------------------------------------------
                                                       1999           1998
<S>                                                <C>            <C>
Deferred tax assets:

  Inventory valuation                              $ 79,565       $ 67,006
  Reserves and other accrued expenses               215,489        165,724
  Fixed asset basis differences                      74,672         81,926
  Compensation not currently deductible              39,958         41,407
  State income taxes                                 18,089         15,468
  Other                                              55,864         68,687

Gross deferred tax assets                           483,637        440,218

Deferred tax liabilities:

  Net undistributed profits of subsidiaries        (171,839)      (124,777)
  Other                                             (14,410)           428
Gross deferred tax liabilities                     (186,249)      (124,349)
Net deferred tax assets                            $297,388      $ 315,869
</TABLE>

<PAGE>   33

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>
--------------------------------------------------------------------------------------------
(In thousands)                                            Years Ended June 30,
--------------------------------------------------------------------------------------------
                                                         1999            1998           1997
<S>                                                  <C>             <C>            <C>
Expected tax rate at 35%                             $561,991        $411,658       $392,423
State income taxes, net of federal tax benefit         31,817          26,506         27,081
Foreign earnings permanently reinvested in
  foreign operations                                  (82,150)        (49,600)       (63,550)
Acquired in-process research and development           44,498          25,194             --
Other                                                  18,199            (454)         2,833
Provision for income taxes                           $574,355        $413,304       $358,787
</TABLE>


As of June 30, 1999, the Company has unrecognized deferred tax liabilities of
approximately $265 million related to cumulative net undistributed earnings of
foreign subsidiaries of approximately $824 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 were $222 million, $111 million, and $60 million in fiscal
1999, 1998, and 1997, respectively, and were credited to stockholders' equity.

     The Company's United States income tax returns for fiscal years ended June
30, 1993 through 1996 are under examination, and the Internal Revenue Service
has proposed certain adjustments. Management believes that adequate amounts have
been provided for any adjustments that may ultimately result from these
examinations.

8. COMMITMENTS AND CONTINGENCIES

The Company leases certain facilities and equipment under noncancelable
operating leases. The future minimum annual lease payments are approximately
$145 million, $116 million, $92 million, $73 million, and $61 million for fiscal
years 2000, 2001, 2002, 2003, and 2004, respectively, and approximately $195
million for years following fiscal 2004. Rent expense under the noncancelable
operating leases was $166 million in 1999, $139 million in 1998, and $113
million in 1997.

     From time to time and in the ordinary course of business, the Company may
be subject to various claims, charges, and litigation. In the opinion of
management, final judgments from such pending claims, charges, and litigation,
if any, against the Company would not have a material adverse effect on its
consolidated financial position, results of operations, or cash flows.

9. 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 $150, 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.

<PAGE>   34

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. Additionally, in connection with the acquisition of
Lighthouse Design, Ltd., in fiscal year 1996, former shareholders who are
employees of the Company were entitled to receive up to approximately 1,300,000
shares of stock upon achievement of specific performance criteria over a three
year period. As of June 30, 1999 all outstanding performance shares related to
Lighthouse Design, Ltd., had vested.

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

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------
(In thousands, except per share amounts)                         Outstanding Options/Rights
-----------------------------------------------------------------------------------------------
                                  SHARES                                              WEIGHTED
                                 AVAILABLE        NUMBER                               AVERAGE
                                 FOR GRANT     OF SHARES       PRICE PER SHARE  EXERCISE PRICE
<S>                           <C>              <C>         <C>                          <C>
Balance at June 30, 1996       90,556          95,512         $0.0025-$15.0625          $ 5.42
Additional shares reserved        600              --                       --              --
Grants                        (26,578)         26,578      $0.000335-$16.96875          $13.45
Exercises                          --         (14,734)        $0.005-$ 15.0625          $ 3.50
Cancellations                   3,680          (4,638)        $0.005-$ 16.6875          $ 6.66
-----------------------------------------------------------------------------------------------
Balance at June 30, 1997       68,258         102,718       0.000335-$16.96875          $ 7.72
Additional shares reserved     10,344              --                       --              --
Grants                        (29,762)         29,762        $0.0003-$ 23.6875          $18.91
Exercises                          --         (18,526)       $0.0003-$16.96875          $ 4.27
Cancellations                   3,982          (3,982)        $0.675-$ 23.6875          $10.63
-----------------------------------------------------------------------------------------------
Balance at June 30, 1998       52,822         109,972      $0.000335-$ 23.6875          $11.14
Additional shares reserved     37,053              --                       --              --
Grants                        (22,995)         22,995       $0.00067-$ 62.1891          $40.07
Exercises                          --         (22,156)      $0.00067-$ 31.4688          $ 6.51
Cancellations                   6,469          (6,469)          $0.01-$ 54.375          $15.07
Balance at June 30, 1999       73,349         104,342         $0.005-$ 62.1891          $17.96
-----------------------------------------------------------------------------------------------
</TABLE>

<PAGE>   35

The following table summarizes significant ranges of outstanding and exercisable
options at June 30, 1999:

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------
(In thousands,
 except per share amounts)      Outstanding Options                  Options Exercisable
-----------------------------------------------------------------------------------------
                                      WEIGHTED       WEIGHTED                    WEIGHTED
                                       AVERAGE        AVERAGE                     AVERAGE
RANGE OF                             REMAINING       EXERCISE                    EXERCISE
EXERCISE PRICES         SHARES   LIFE IN YEARS          PRICE       SHARES          PRICE
<S>                    <C>                 <C>         <C>          <C>            <C>
$  0.005-$ 6.2189       26,649             3.9         $ 3.84       18,835         $ 3.60
$  6.219-$12.4378       12,154             5.0         $11.28        4,827         $11.31
$12.4379-$18.6567       24,135             6.0         $14.27        7,206         $14.18
$18.6568-$24.8756       23,203             7.1         $20.64        3,674         $20.42
$24.8757-$31.0946          330             8.0         $26.43           --         $   --
$31.0947-$37.3135        5,284             7.2         $31.47            5         $31.47
$37.3136-$43.5324          525             7.9         $39.94           --         $39.94
$43.5325-$49.7513          450             7.6         $48.75           --         $   --
$49.7514-$55.9702       10,338             8.2         $50.13            7         $50.13
$55.9703-$62.1891        1,274             8.3         $58.91           --         $   --
-----------------------------------------------------------------------------------------
                       104,342             5.9         $17.96       34,554         $ 8.69
-----------------------------------------------------------------------------------------
</TABLE>

At June 30, 1999, options to purchase 34,554,000 shares were exercisable at
prices from $0.01 to $50.13 with a weighted average and aggregate exercise price
of $8.69 and $300,146,000, respectively, (29,920,000 shares at an aggregate
price of $190,505,000 at June 30, 1998). At June 30, 1999, the Company retained
repurchase rights to 181,000 shares issued pursuant to stock purchase agreements
and other stock plans.

     The weighted average fair value at date of grant for options granted during
1999, 1998, and 1997 was $24.93, $13.09, and $8.94 per option, respectively.

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 5,579,000, 7,010,000, and 5,857,000 shares of common stock
in fiscal 1999, 1998, and 1997, respectively. At June 30, 1999, approximately
33,956,000 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
1999, the Company repurchased 4,738,000 shares at a cost of approximately $199
million under this program (5,883,000 shares at a cost of approximately $127
million in 1998).

     In August 1996, the Board of Directors approved a systematic common stock
repurchase program related to the 1990 Incentive Plan. In June 1999, the Board
renewed this repurchase plan for an additional three years. In fiscal 1999, the
Company repurchased 4,672,000 shares at a cost of approximately $159 million
under this program (7,309,000 shares at a cost of approximately $157 million in
1998).

     In June 1995, the Board of Directors approved a plan to repurchase
approximately 96 million shares of the Company's common stock. In July and
August 1996, the Company repurchased 17,809,000 shares at a cost of
approximately $236 million under this program.

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

<PAGE>   36

STOCK-BASED COMPENSATION
--------------------------------------------------------------------------------
FAS 123 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 applies the existing accounting rules under APB 25 and
provides pro forma net income and pro forma earnings per common share
disclosures for stock-based awards made during the year as if the
fair-value-based method defined in FAS 123 had been applied. For employee stock
options, the fair value of the stock options was estimated as of the date of
grant using the Black-Scholes option pricing model. Input variables used in the
model include a weighted average risk-free interest rate using the 6.63 year
Treasury Yield as of the date of grant ranging from 4.26% to 5.95% for fiscal
year 1999.

     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,
----------------------------------------------------------------
                           1999            1998           1997
<S>                       <C>             <C>            <C>
Expected life               6.6             7.8            8.1
Interest rate              5.06%           5.73%          6.06%
Volatility                49.51%          49.60%         46.60%
Dividend yield               --              --             --
</TABLE>

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
$194,777,000, $132,985,000, and $76,033,000 in 1999, 1998, and 1997,
respectively ($130,135,000, $89,374,000, and $51,703,000 after tax and $0.15,
$0.09, and $0.04 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
1999, 1998, and 1997 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>
------------------------------------------------------------------------------------------------
(In thousands, except per share amounts)
------------------------------------------------------------------------------------------------
                                                               1999          1998          1997
<S>                                                        <C>           <C>           <C>
Pro forma net income                                       $901,199      $673,488      $710,717
------------------------------------------------------------------------------------------------
Basic:
Pro forma shares used in the calculation of pro forma
  net income per common share--basic                        765,853       747,456       736,852
------------------------------------------------------------------------------------------------
Pro forma net income per common share--basic               $   1.18      $   0.90      $   0.96
------------------------------------------------------------------------------------------------
Diluted:
Pro forma shares used in the calculation of pro forma
  net income per common share--diluted                      805,253       766,754       754,576
------------------------------------------------------------------------------------------------
Pro forma net income per common share--diluted             $   1.12      $   0.88      $   0.94
------------------------------------------------------------------------------------------------
</TABLE>

<PAGE>   37

10. INDUSTRY SEGMENT, GEOGRAPHIC, AND CUSTOMER INFORMATION

In fiscal 1999 the Company adopted FAS 131, which establishes standards for
reporting information about operating segments and related disclosures about
products, geographic information, and major customers. Operating segment
information for 1998 and 1997 is also presented in accordance with FAS 131.

     Sun designs, manufactures, markets, and services network computing systems
and software solutions that feature networked desktops and servers. The Company
is organized by various product divisions including Computer Systems and
Storage, Enterprise Services, and various other divisions. Each division has a
divisional president who reports to the President of the Company. The President
of the Company allocates resources to each of these divisions using information
regarding their respective revenues and operating income. The President of the
Company has been identified as the Chief Operating Decision Maker as defined by
FAS 131.

     In addition to the aforementioned divisions, finance and administration, as
well as certain other corporate groups, report to the Chief Executive Officer of
the Company. Expenses of these groups are not allocated to the operating
segments and are included in the operating results of the Other segment reported
below.

     Although the Company has various divisions, only Computer Systems and
Storage and Enterprise Services are considered reportable segments under the
criteria of FAS 131. Products in the Computer Systems and Storage segment
include a broad range of desktop systems, servers, storage, and network
switches, incorporating the UltraSPARC processors and Solaris operating
environment. In the Enterprise Services segment, the Company provides a full
range of services and support to existing and new customers, including
education, professional services, and systems integration. The Other segment
consists of various software and other miscellaneous divisions, such as
corporate, which did not meet the requirements individually for a reportable
segment as defined in FAS 131.

     The Company does not identify or allocate depreciation by operating
segments, nor does the President of the Company evaluate divisions on
depreciation expense. Additionally, the Company does not allocate interest and
other income, interest expense, charges related to IPRD, or taxes to operating
segments. The accounting policies for segment reporting are the same as for the
Company taken as a whole. See "Summary of Significant Accounting Policies" in
Note 1.

<PAGE>   38
     Information on reportable segments for the three years ended June 30, 1999
is as follows:
<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------
(In thousands)
--------------------------------------------------------------------------------------------
                                     COMPUTER      ENTERPRISE
1999                      SYSTEMS AND STORAGE        SERVICES           OTHER          TOTAL
<S>                                <C>             <C>             <C>           <C>
Revenues                           $9,553,098      $1,635,251      $  537,948    $11,726,297
Interdivision revenues                     --         321,388        (321,388)            --
Operating income                    1,644,234         219,716        (342,185)     1,521,765
Capital additions                     204,003          33,686         501,018        738,707
Accounts receivable                 1,746,028         447,377          93,506      2,286,911
Inventory                             287,425           4,787          15,661        307,873
Total assets                       $4,316,120      $  723,807      $3,380,425    $ 8,420,352
</TABLE>

<TABLE>
<CAPTION>
                                     COMPUTER      ENTERPRISE
1998                      SYSTEMS AND STORAGE        SERVICES           OTHER          TOTAL
<S>                                <C>             <C>             <C>           <C>
Revenues                           $8,251,490      $1,187,581      $  351,769    $ 9,790,840
Interdivision revenues                106,543         265,826        (372,369)            --
Operating income                    1,377,331          87,247        (334,504)     1,130,074
Capital additions                     255,310          38,995         535,838        830,143
Accounts receivable                 1,412,414         357,429          75,922      1,845,765
Inventory                             312,743           7,115          26,588        346,446
Total assets                       $3,127,849      $  531,197     $ 2,052,016    $ 5,711,062
</TABLE>

<TABLE>
<CAPTION>
                                     COMPUTER      ENTERPRISE
1997                      SYSTEMS AND STORAGE        SERVICES           OTHER          TOTAL
<S>                                <C>             <C>             <C>           <C>
Revenues                           $7,406,193      $  851,231      $  340,922    $ 8,598,346
Interdivision revenues                270,881         192,653        (463,534)            --
Operating income                    1,167,617          96,490        (237,589)     1,026,518
Capital additions                     222,349          22,758         308,911        554,018
Accounts receivable                 1,385,282         213,647          67,594      1,666,523
Inventory                             370,243             805          66,930        437,978
Total assets                       $2,884,569      $  340,390      $1,472,315    $ 4,697,274
</TABLE>


One customer accounted for 14% of revenues in both fiscal 1999 and 1998. No
customer accounted for 10% or more of revenues in fiscal 1997. The Company's
significant operations outside the United States include manufacturing
facilities, design centers, and sales offices in Europe, Japan, and Rest of
World.

     Transfers between operating segments and geographic areas are primarily
accounted for at prices that approximate arm's length transactions. In fiscal
1999, sales from Computer Systems and Storage to Enterprise Services are at
cost. In addition, United States export sales approximated 2.5%, 2.3%, and 3.0%
of net revenues during fiscal 1999, 1998, and 1997, respectively.

     Information regarding geographic areas at June 30, 1999, 1998, and 1997,
and for each of the years then ended, is as follows:

<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------------------------
(In thousands)               UNITED STATES          EUROPE           JAPAN   REST OF WORLD   ELIMINATIONS             TOTAL
---------------------------------------------------------------------------------------------------------------------------
<S>                             <C>             <C>             <C>             <C>             <C>             <C>
June 30, 1999, and for the
year then ended:
Sales to unaffiliated
customers                       $6,210,865      $3,418,412      $1,047,253      $1,049,767      $      --       $11,726,297
---------------------------------------------------------------------------------------------------------------------------
Long-lived assets               $2,041,514      $  403,949      $   54,135      $   88,515      $(284,111)      $ 2,304,002
---------------------------------------------------------------------------------------------------------------------------
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
---------------------------------------------------------------------------------------------------------------------------
Long-lived assets               $1,426,183      $  331,422      $   45,187      $   69,303      $(308,558)      $ 1,563,537
---------------------------------------------------------------------------------------------------------------------------
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
---------------------------------------------------------------------------------------------------------------------------
Long-lived assets               $  885,224      $  225,548      $   46,223      $   55,719      $(243,890)      $   968,824
---------------------------------------------------------------------------------------------------------------------------
</TABLE>

<PAGE>   39

11. QUARTERLY FINANCIAL DATA (UNAUDITED)

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------
(In thousands, except per share amounts)                Fiscal 1999 Quarter Ended
-------------------------------------------------------------------------------------------------
                                          June 30        March 28     December 27   September 27
<S>                                    <C>             <C>             <C>            <C>
Net revenues                           $3,514,645      $2,936,028      $2,784,440     $2,491,184
Gross margin                            1,826,356       1,539,504       1,437,230      1,274,847
Operating income                          563,833         383,808         374,145        199,979
Net income                                395,170         261,203         261,087        113,874
Net income per common share--diluted   $     0.48      $     0.32      $     0.32     $     0.15
</TABLE>


<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------
(In thousands, except per share amounts)                Fiscal 1998 Quarter Ended
-------------------------------------------------------------------------------------------------
                                          June 30        March 29     December 28   September 28
<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   $     0.35      $     0.29      $    0.19      $     0.14
</TABLE>

12. SUBSEQUENT EVENTS (UNAUDITED)

On August 5, 1999, the Company acquired all of the outstanding capital stock of
Star Division Corporation (Star Division), by means of a merger transaction
pursuant to which all of the shares of Star Division were converted into the
right to receive cash for total consideration of approximately $54 million.
Simultaneous with the acquisition of Star Division, Sun acquired certain assets
and liabilities of Star Division Software-Entwicklung und Vertriebs GmbH, a
related party of Star Division, for total cash consideration of approximately
$14 million. These transactions will be accounted for as purchases, and the
purchase prices will be allocated to tangible and intangible assets and
in-process research and development.

     On July 14, 1999, the shelf registration statement that Sun filed with the
SEC on June 18, 1999, relating to the registration of senior and subordinated
debt securities and common and preferred stock with an aggregate initial
offering price of up to $3 billion, became effective. The securities registered
by Sun were in addition to the $1 billion of securities previously registered
and declared effective under a different shelf registration statement filed with
the SEC. On August 4, 1999, the Company issued $1.5 billion of unsecured senior
debt securities in four tranches. Each tranche is comprised of the following
notes (the Senior Notes): $200 million (due on August 15, 2002 and bearing
interest at 7%), $250 million (due on August 15, 2004 and bearing interest at
7.35%), $500 million (due on August 15, 2006 and bearing interest at 7.5%), and
$550 million (due on August 15, 2009 and bearing interest at 7.65%). Interest on
the Senior Notes will be payable semi-annually. Sun may redeem all or any part
of any tranche of the Senior Notes at any time at a price equal to 100% of the
principal plus accrued and unpaid interest and an amount as determined by a
quotation agent, which represents the present value of the remaining scheduled
payments. Sun anticipates that the net proceeds from this offering will be used
to fund expansion of the Company's business, including additional working
capital, capital expenditures, acquisition of products, technologies, and
businesses and general corporate matters. Sun also entered into various interest
rate swap agreements to modify the interest characteristics of the Senior Notes
such that the interest associated with these Senior Notes becomes variable.

     In August 1999, the Company signed a definitive agreement (the Agreement)
to acquire Forte Software, Inc. (Forte), a publicly held enterprise tools
software company, by means of a stock-for-stock merger. Under terms of the
Agreement, each share of Forte common stock will be converted into 0.3 shares of
Sun common stock. Additionally, Sun will assume the remaining outstanding Forte
stock options, which will be converted to options to purchase Sun common stock
based on the exchange ratio used for the common shares exchanged. The merger is
subject to certain regulatory approvals, the approval of Forte's shareholders,
and other customary closing conditions. The transaction is expected to be
accounted for as a pooling of interests, and it is anticipated that it will
close in the second quarter of fiscal 2000. The historic results of operations
of Forte are not expected to be material to the financial position or results of
operations of the Company.

<PAGE>   40


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, 1999 and 1998, and the related consolidated
statements of income, stockholders' equity, and cash flows for each of the three
years in the period ended June 30, 1999. 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, 1999 and 1998, and the consolidated results of
their operations and their cash flows for each of the three years in the period
ended June 30, 1999, in conformity with generally accepted accounting
principles.


                                       [ERNST & YOUNG LLP]


Palo Alto, California
July 21, 1999