<PAGE>   1
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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

      *******************************************************************

DRAFT
-----
                                    FORM 10-Q

          [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                  For the quarterly period ended March 31, 1997

          [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                         COMMISSION FILE NUMBER 0-14992

                          SMITH TECHNOLOGY CORPORATION
                          ----------------------------
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)
             (exact name of registrant as specified in its charter)

             DELAWARE                                    38-2294876
             --------                                    ----------
   (State or other jurisdiction of                     (IRS Employer
   incorporation or organization)                    Identification No.)

             3501 JAMBOREE ROAD, SUITE 304, NEWPORT BEACH, CA 92660
             ------------------------------------------------------
                    (Address of principal executive offices)

       Registrant's telephone number, including area code: (714) 737-7900
                                                           ---------------

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes      No  X
                                       ---     ---

Registrant has not filed its Form 10-K for the twelve month period ended
September 30, 1996.

On May 9, 1997, the registrant had 6,232,464 shares of common stock outstanding.


<PAGE>   2
                          QUARTERLY REPORT ON FORM 10-Q
                        FOR QUARTER ENDED MARCH 31, 1997

                          SMITH TECHNOLOGY CORPORATION
                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION
                                                                                         Page
                                                                                         ----
<S>             <C>                                                                     <C>
       Item 1:  Financial Statements

                Consolidated Balance Sheets (unaudited) as of March 31, 1997
                and September 30, 1996                                                   3-4

                Consolidated Statements of Operations (unaudited)
                for the three and six months ended March 31, 1997 and 1996                5

                Consolidated Statements of Cash Flows (unaudited)
                for the six months ended March 31, 1997 and 1996                          6-7

                Notes to Consolidated Financial Statements (unaudited)                   8-11

       Item 2:  Management's Discussion and Analysis of
                Financial Condition and Results of Operations                            12-18

PART II.  OTHER INFORMATION

       Item 1:  Legal Proceedings                                                        19-20

       Item 3:  Defaults on Senior Securities                                             20

       Item 5:  Other Information                                                         21

                Consolidated Financial Statements as of                                  22-54
                September 30, 1996 (unaudited) and 1995

       Item 6:  Exhibits and Reports on Form 8-K

                Signature

                Exhibit 11 Computation of earnings per share, for the
                three and six months ended March 31, 1997 (unaudited)

                Exhibit 27 Requirements for the format and input
                of financial data schedules (EDGAR version only)
</TABLE>


                                       2
<PAGE>   3
PART I.    FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

                           CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                MARCH 31, 1997    SEPTEMBER 30, 1996
                                                                --------------    ------------------
                                                                  (UNAUDITED)         (UNAUDITED)
<S>                                                             <C>               <C>
ASSETS                                                                                           
                                                                                                 
Current Assets:                                                                                  
         Cash                                                       $   512             $   625  
          Accounts receivable, less allowance for doubtful                                       
               accounts of $848 and $829 (Note 2)                    40,124              40,793  
          Costs and estimated earnings of long-term                                              
                contracts in excess of billings                       2,454               2,025  
          Prepaid expenses and other current assets                   4,155               3,445  
                                                                    -------             -------  
                                                                                                 
               Total current assets                                  47,245              46,888  
                                                                                                 
Property and equipment:                                                                          
          Equipment                                                  19,482              19,330  
          Land and buildings                                          4,017               4,017  
          Leasehold improvements                                      1,107               1,107  
                                                                    -------             -------  
                                                                                                 
                Total property and equipment, at cost                24,606              24,454  
          Less accumulated depreciation and amortization             12,848              11,582  
                                                                    -------             -------  
                                                                                                 
               Property and equipment, net (Note 2)                  11,758              12,872  
                                                                                                 
Other assets:                                                                                    
          Intangible assets, net of accumulated amortization                                     
               of $2,462 and $1,878, respectively                    14,588              15,172  
          Goodwill, net of accumulated amortization                                              
               of $912 and $714, respectively                        14,756              14,953  
          Investment in unconsolidated affiliate                      1,561               1,561  
          Other assets                                                4,082               4,038  
                                                                    -------             -------  
                                                                                                 
TOTAL ASSETS                                                        $93,990             $95,484  
                                                                    =======             =======  
</TABLE>



           See accompanying notes to consolidated financial statements


                                       3
<PAGE>   4
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)
                     CONSOLIDATED BALANCE SHEETS (CONTINUED)
                                 (IN THOUSANDS)                            

<TABLE>
<CAPTION>
                                                                                     MARCH 31,      SEPTEMBER 30,
                                                                                       1997              1996
                                                                                    -----------      -----------
                                                                                    (UNAUDITED)      (UNAUDITED)
<S>                                                                                 <C>             <C>
LIABILITIES, REDEEMABLE PREFERRED STOCK
     AND COMMON STOCKHOLDERS' EQUITY

Current liabilities:
           Accounts and subcontracts payable                                         $ 28,663         $ 22,597
           Accrued expenses and other liabilities:
                       Compensation and related fringes                                 5,457            5,486
                       Severance and office closures                                    3,146            1,688
                       Other                                                            5,887           10,686
           Billings on long-term contracts in excess of
                       costs and estimated earnings                                        94               57
           Current maturities of long-term debt and
                       short-term borrowings                                            4,153            2,866
                                                                                     --------         --------

                  Total current liabilities                                            47,400           43,380

Long-term debt                                                                         24,215           24,881

Other long-term liabilities                                                             8,805            7,804

Convertible Senior Subordinated Note, 10% maturing
           in 2004, convertible into 4,423,171 and 4,210,953
           common shares, respectively at $3.28 per share                              14,508           13,812

Commitments and contingencies (Note 2)

Redeemable Preferred Stock, $0.01 par value; 78,000 shares authorized; 71,128
           and 74,438 shares issued, respectively; 10% cumulative
           dividend; $100 redemption value                                              6,606            6,846


Junior Convertible Preferred Stock; $0.01 par value;
           470,000 shares authorized; none issued                                          --               --

Preference Stock; $0.01 par value, 1,000,000 shares
            authorized; none issued                                                        --               --

Preferred Stock $0.01 par value; 550,500 shares
            authorized; none issued                                                        --               --

Common stockholders' equity:
             Common stock; $0.01 par value; 20,000,000 shares
                       authorized; 6,184,464 and 6,107,440 shares
                       issued and outstanding, respectively                                61               61
              Additional paid in capital                                               17,428           17,379
              Deferred compensation                                                      (404)            (404)
              (Accumulated deficit)                                                   (24,629)         (18,275)
                                                                                     --------         --------

                       Total common stockholders' (deficit) equity                     (7,544)          (1,239)
                                                                                     --------         --------

TOTAL LIABILITIES, REDEEMABLE PREFERRED
     STOCK AND COMMON STOCKHOLDERS' EQUITY                                           $ 93,990         $ 95,484
                                                                                     ========         ========
</TABLE>


           See accompanying notes to consolidated financial statements


                                       4
<PAGE>   5
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

                      CONSOLIDATED STATEMENT OF OPERATIONS
                      (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                    UNAUDITED

<TABLE>
<CAPTION>
                                                                THREE MONTHS ENDED                 SIX MONTHS ENDED
                                                                     MARCH 31,                         MARCH 31,
                                                             -------------------------         -------------------------
                                                               1997             1996             1997             1996
                                                             --------         --------         --------         --------
<S>                                                          <C>              <C>              <C>              <C>
Revenues                                                     $ 39,017         $ 35,136         $ 83,289         $ 81,894

Cost of revenues                                               36,011           32,534           76,088           73,410
                                                             --------         --------         --------         --------

               Gross profit                                     3,006            2,602            7,201            8,484

Selling, general and administrative expenses                    3,461            3,542            6,414            7,391
Amortization of intangible assets, goodwill and
          deferred financing fees                                 506              489            1,012              977
Special items                                                   2,990              200            2,990              593
                                                             --------         --------         --------         --------

           Income from operations                              (3,951)          (1,629)          (3,215)            (477)

Interest expense                                                1,387            1,029            2,649            2,183
                                                             --------         --------         --------         --------

          (Loss) income before share in earnings
                 of unconsolidated affiliate, income
                 taxes and extraordinary charge                (5,338)          (2,658)          (5,864)          (2,660)

Share in (loss) earnings of unconsolidated affiliate               --               --               --              500
                                                             --------         --------         --------         --------

          (Loss) income before income taxes and
              extraordinary charge                             (5,338)          (2,658)          (5,864)          (2,160)

Income tax (benefit) expense                                       24              (63)              49               50
                                                             --------         --------         --------         --------

          (Loss) income before extraordinary
              charge                                           (5,362)          (2,595)          (5,913)          (2,210)

Extraordinary charge on debt refinancing                           --              113               --            1,395
                                                             --------         --------         --------         --------

          Net loss                                             (5,362)          (2,708)          (5,913)          (3,605)

Dividends and accretion Redeemable Preferred
   Stock                                                          220              133              442              270
                                                             --------         --------         --------         --------

          Net loss applicable to common stock                $ (5,582)        $ (2,841)        $ (6,355)        $ (3,875)
                                                             ========         ========         ========         ========

Weighted average number of common and
   common equivalent shares outstanding                         6,167            5,877            6,146            5,880
                                                             ========         ========         ========         ========

Income (loss) per common and common equivalent share:

          (Loss) income before extraordinary charge          $  (0.87)        $  (0.44)        $  (0.96)        $  (0.38)
          Extraordinary charge                                     --            (0.02)              --            (0.24)
                                                             --------         --------         --------         --------

          Net loss                                              (0.87)           (0.46)           (0.96)           (0.61)
                                                                              ========         ========         ========

          Net loss applicable to common stock                $  (0.91)        $  (0.48)        $  (1.03)        $  (0.66)
                                                             ========         ========         ========         ========
</TABLE>


           See accompanying notes to consolidated financial statements


                                       5
<PAGE>   6
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
                                    UNAUDITED

<TABLE>
<CAPTION>
                                                                                   SIX MONTHS ENDED
                                                                                       MARCH 31,
                                                                                ------------------------
                                                                                  1997            1996
                                                                                -------         --------
<S>                                                                             <C>             <C>
OPERATING ACTIVITIES

(Loss) income before extraordinary charge                                       $(5,913)        $ (2,210)

Adjustments to reconcile net (loss) income to cash provided by (used in)
          operating activities:

          Depreciation and amortization                                           2,307            2,207
          (Gain) loss on disposal of equipment                                     (242)            (347)
          Share in earnings of affiliate                                             --             (500)
          Deferred interest                                                         696               --
          Compensation expense                                                       32               --


Changes in operating assets and liabilities:

          Accounts receivable                                                       669           14,104
           Costs and estimated earnings on long-term
                contracts in excess of billings                                    (429)           1,892
          Prepaid expenses and other current assets                                (710)             (12)
          Other assets                                                              (44)             805
          Accounts and subcontracts payable                                       6,066           (7,446)
          Accrued expenses and other liabilities                                 (3,116)          (5,479)
          Billings on long-term contracts in excess of costs
               and estimated earnings                                                37              363
          Other long-term liabilities                                             1,001           (1,926)
          Other net                                                                (400)              --
                                                                                -------         --------

          Net cash used in operating activities                                     (46)           1,451
                                                                                -------         --------
</TABLE>



           See accompanying notes to consolidated financial statements


                                       6
<PAGE>   7
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

                CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
                                 (IN THOUSANDS)
                                    UNAUDITED


<TABLE>
<CAPTION>
                                                                         SIX MONTHS ENDED
                                                                            MARCH 31,
                                                                     ------------------------
                                                                        1997            1996
                                                                     --------         -------
<S>                                                                  <C>              <C>
INVESTING ACTIVITIES

     Capital expenditures                                            $   (185)        $(1,081)
     Advances from affiliates                                              --              --
     Proceeds from sale of fixed assets                                   268             577
                                                                     --------         -------

               Net cash provided by investing activities                   83            (504)
                                                                     --------         -------

FINANCING ACTIVITIES

     Proceeds from revolving line of credit                                            20,649
     Retirement of revolving line of credit                                           (21,537)
     (Repayments) borrowings on revolving line of credit, net          (2,953)         (1,641)
     Proceeds from term loan                                            4,661           6,500
     Retirement of term loan                                                           (3,400)
     Repayments on term loan                                             (962)         (1,161)
     Borrowings from conversion of Senior Note                                          1,675
     Payment of financing fees                                           (100)         (1,096)
     Payment of early debt extinguishment penalty                                        (287)
     Repayments of debt                                                  (470)           (274)
     Proceeds from exercise of stock options                                               14
     Repurchase of Redeemable Preferred Stock                             (34)           (179)
     Dividends paid on Redeemable Preferred Stock                        (292)            (95)
     Other                                                                                 --
                                                                     --------         -------

               Net cash provided by financing activities                 (150)           (832)
                                                                     --------         -------


Net (decrease) increase in cash                                          (113)            115

Cash at beginning of period                                               625             510
                                                                     --------         -------

Cash at end of period                                                $    512         $   625
                                                                     ========         =======

Supplemental Cash Flow Information:
     Issuance of Stock for Bonus Compensation                        $     43         $    47
     Issuance of stock for Defined Contribution Plan                       --         $   107
</TABLE>


           See accompanying notes to consolidated financial statements


                                       7
<PAGE>   8
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)


NOTE 1 - BASIS OF PRESENTATION

                      The accompanying unaudited consolidated financial
statements have been prepared by Smith Technology Corporation, formerly Smith
Environmental Technologies Corporation, (the Company), pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations. The Company believes the
disclosures made herein are adequate to make the information presented not
misleading. The financial statements reflect all material adjustments which are
all of a normal, recurring nature and, in the opinion of management, necessary
for a fair presentation. The financial statements should be read in conjunction
with the unaudited consolidated financial statements and the notes to the
unaudited consolidated financial statements of the Company for the twelve month
period ended September 30, 1996 included herein and the Company's report on Form
8-K filed on January 21, 1997. The Company has not filed its report on Form 10-K
for the twelve month period ended on September 30, 1996.

           The results of operations for the three and six months ended March
31, 1997 are not necessarily indicative of the results that may be expected for
the fiscal year ending September 30, 1997.


NOTE 2 - COMMITMENTS AND CONTINGENCIES

           The Company (previously known as Canonie Environmental Services
Corp.) filed suit in the Circuit Court, Multnomah County, Oregon in February
1995 against NL Industries, Inc., Gould, Inc., Johnson Controls, Inc., Exide,
Inc., AT&T Technologies, Inc., Rhone-Poulenc AG Co., and Burlington Northern
Railroad Co. (the "PRPs" or "PRP Group") for breach of contract dated May 28,
1992 for the remediation of soil on property located near Portland, Oregon (the
"Contract").

           The PRP Group initiated arbitration proceedings and on June 27, 1996
a Construction Industry Arbitration Tribunal of the American Arbitration
Association issued, with one dissenting opinion, a binding award in favor of the
PRPs in the amount of $4.5 million against the Company. The Company's
counterclaim in the arbitration was denied; however, the Company's plant and
equipment at the site was awarded to the Company. The Company filed exceptions
and a motion to vacate the award with the Oregon Circuit Court which were
denied.

           On January 30, 1997, the Company and the PRP Group reached an
agreement for the resolution of the matter. The settlement agreement provides
for payment of the $4.5 million over a period of six years with interest at
twelve percent. The agreement provides semiannual payments which include
interest as follows: $150,000 in 1997; $300,000 in 1998; $584,000 in 1999;
$584,000 in 2000; $1,994,000 in 2001; and $3,786,000 thereafter. The agreement
also allows a discounted prepayment of $2.5 million on or before December 31,
1997 or $2.75 million on or before April 30, 1998 in complete satisfaction of
the obligation. The Company recorded a charge in fiscal 1996 of approximately
$9.7 million consisting of an obligation to the PRP Group of $4.5 million, the
write-off of $1.5 million of accounts receivable and $2.5 million of equipment,
and $1.2 million of related legal and consulting fees. The settlement agreement
provides that any proceeds from the sale of the equipment be applied to payment
of the settlement.


                                       8
<PAGE>   9
           The Company filed notice of a claim with its professional liability,
general liability, and property insurance carriers. The underwriter of the
general liability and professional liability coverage has filed an action in the
Supreme Court of the State of New York, New York County, requesting relief from
the Company's claims of coverage. The Company's claims against its general
liability and professional liability carrier have been resolved with the payment
of $500,000 to the Company.

           Transcontinental Realty Investors, Inc. filed an action against the
Company's subsidiary BCM Engineers Inc. (BCM) and various unrelated parties in
the Superior Court of New Jersey, Burlington County. The action sought to
recover alleged damages exceeding $8 million based on breach of contract and
negligence. An agreement has been reached by the plaintiff and the professional
liability carrier of BCM to resolve all claims. The insurance carrier will pay
the agreed settlement directly to the plaintiff. The Company's obligation is
limited to reimburse the insurance carrier for the balance of the unexpended
portion of a self-insured retention of approximately $215,000 in installments
which is recorded as a liability on the balance sheet. The final payment of any 
remaining balance is due on September 30, 1997.

           U-Max Engineering and Construction Corp. filed claims based on
project delays and defective specifications against the project owner, Stroud
Township. The Township filed a cross-claim against BCM. The United States
District Court for the Middle District of Pennsylvania awarded U-Max a judgment
of $2 million against Stroud Township. The Township has been granted a judgment
of $1 million against BCM. Stroud Township has appealed the judgment against the
Township and the $1 million judgment awarded in favor of the Township against
BCM. BCM's insurance coverage will respond to losses exceeding a $500,000
deductible of which approximately $220,000 has been expended. On November 27,
1996, BCM filed a notice of appeal to the United States Third Circuit Court of
Appeals with a motion to stay execution and/or enforcement on the Township's
judgment and to waive the posting of a supersedeas bond pending BCM's appeal.
The Company's counsel believes there are grounds for reversal or modification of
the judgment on appeal, however, the likelihood of obtaining relief from the
District Court judgment is unknown. The difference between the insurance
deductible and the amount expended of $280,000 is included in other liabilities
in the accompanying balance sheets.

           A settlement agreement of the claim filed in the Court of Common
Pleas of Philadelphia County, Philadelphia has been reached with Mutual
Pharmaceutical Company, Inc. whereby BCM will be required to pay the plaintiff
for site investigation and carrying costs amounting to $207,000. This amount is
to be paid in 13 monthly installments beginning September 12, 1996 of $16,000 in
lieu of exposure to the remaining deductible and further litigation. The claim
is covered by BCM's professional liability coverage which carries a $500,000
deductible. The insurance carrier has approved the settlement agreement.
Additionally, the Company's subsidiary, BCM, will be responsible for performing
certain remediation services at the site to obtain a "No Further Action" letter
from the Pennsylvania Department of Environmental Protection. The estimated cost
of the services is $50,000. If BCM fails to pay the agreed amount or perform
under the agreement, the plaintiff reserves the right to recommence the
litigation and claim additional out-of-pocket costs. The agreement leaves open a
possible claim for diminution of property value up to $420,000 for up to 10
years and requires the Company and BCM to indemnify the plaintiff for any
third-party claims not to exceed $500,000 plus costs of defense until September,
2001. The balance remaining of the payment obligation has been recorded as a
liability on the Company's balance sheet. The costs of services are expensed as
incurred. The Company is unaware of any third-party claims and has not been
notified of any claim of diminution of value of the site.


                                       9
<PAGE>   10
           In November 1993, second amended complaints and initial complaints
were filed in the Circuit Court, County of Jackson, Mississippi, against
multiple defendants including the Company's subsidiary, Riedel Environmental
Services, Inc. (RES) asserting claims in 27 separate civil actions. These civil
actions involved approximately 219 plaintiffs and include two wrongful death
claims. Plaintiffs allege that RES was negligent in transferring and clean-up
activities of the chemical diethylamine released from an overturned tanker.
Settlements of the claims of eighty-seven plaintiffs have been completed without
contribution by RES; those claims will be dismissed leaving one hundred
thirty-two plaintiffs with claims remaining against RES, including the two
wrongful death claims. The special damages of remaining plaintiffs are
approximately $800,000, not including unstated general damages. RES will be
entitled to a credit for payments made by settling defendants allocated against
any remaining plaintiffs. The Company's pollution liability coverage, having an
aggregate of $1 million, is paying the costs of investigation and defense and
will respond to losses up to the coverage balance less those costs. The Company
is vigorously defending the described litigation. 

           In December 1995, BellSouth filed a complaint for unstated damages in
the Circuit Court, Jefferson County, Alabama against the Company, and its
subsidiaries BCM and Canonie Technologies, Inc. The complaint, alleging
professional negligence, fraudulent and negligent misrepresentation,
non-disclosure, innocent misrepresentation and breach of contract, arises out of
BCM's alleged failure to provide oversight and certification of services
performed by BellSouth's asbestos abatement contractors. The plaintiff claims it
has expended an additional $1.6 million to perform asbestos removal which
allegedly was to have been performed by its prior contractor. BCM believes its
services were performed in compliance with all legal requirements, that it has
been released from BellSouth claims, and that a substantial amount of the claims
are barred by statute of limitations. The parties to the lawsuit have entered
into a settlement agreement dated April 21, 1997, which resolved all claims; the
agreement provides for the payment by the Company of $150,000; in monthly
installments, which amount is included as a liability in the Company's balance
sheet.

Stroudsburg Municipal Authority has filed a claim against BCM in the Monroe
County, Pennsylvania, Court of Common Pleas for damages exceeding $500,000
based on allegations of breach of contract and negligent performance of design
services. The Company and its professional liability carrier have retained
counsel to investigate the matter and defend the claim. The Company's insurance
coverage responding to this claim has a $150,000 self-insurance retention.  No
provision for loss, if any, has been recorded in the accompanying balance
sheets.

           BCM is the lessee of improved property formerly used as a laboratory
and office/warehouse space for field service personnel. The lease dated October
23, 1989 terminates May 31, 2000 and contains provisions for the confession of
judgment in favor of Gravers Company (the "Owner") in the event of default. The
Owner has, pursuant to the lease provisions, filed judgments in the Montgomery
County, Pennsylvania Court of Common Pleas providing for ejectment of BCM and a
money judgment against BCM in the amount of $1,094,039. BCM has brought the
lease payments current and is in the process of negotiating an agreement
providing for the deferment by the Owner of any action to retake possession of
the leased property or to take action to collect on the money judgment so long
as BCM remains in compliance with the underlying lease. BCM is attempting to
sublease this space to others. Remaining lease payments have been accrued less
anticipated sublease rent recovery.


                                       10
<PAGE>   11
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                                   (UNAUDITED)

               The Company is currently a party to other litigation and claims
incidental to the performance of services. The Company believes that these
matters are adequately accrued or covered by insurance, are without merit or the
disposition thereof is not anticipated to have a material effect on the
Company's financial position; however these matters, individually or in the
aggregate, could have a material adverse effect on future quarterly or annual
results of operations or cash flow when resolved.



NOTE 3 - INDUSTRY SEGMENT

           The Company operates within a single industry segment in the United
States.



                                       11
<PAGE>   12
ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
         CONDITION AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

                      The following table sets forth, for the periods indicated,
the percentages which certain items from the consolidated statements of
operations bear to the revenues of the Company. This table and the Management's
Discussion and Analysis of Financial Condition and Results of Operations should
be read in conjunction with the unaudited consolidated financial statements and
the notes to the unaudited consolidated financial statements of the Company for
the twelve month period ended September 30, 1996 included herein. The September
30, 1996 unaudited consolidated financial statements have been modified from
those presented in the December 31, 1996 10-Q to reflect reduced profit
recognition of approximately $1.5 million on certain construction and
remediation projects. Similarly, the current fiscal year amounts have been 
reduced by $450,000 for the quarter ended December 31, 1996. The Company has 
not filed its report on Form 10-K for the twelve month period ended on 
September 30, 1996.

<TABLE>
<CAPTION>
                                                  THREE MONTHS ENDED               SIX MONTHS ENDED
                                                       MARCH 31,                       MARCH 31,
                                                ----------------------          ----------------------
                                                 1997            1996            1997            1996
                                                ------          ------          ------          ------
<S>                                             <C>             <C>             <C>             <C>
Revenues                                         100.0%          100.0%          100.0%          100.0%
Cost of Revenues                                  92.3            92.6            91.3            89.6
                                                ------          ------          ------          ------
      Gross profit (loss)                          7.7             7.4             8.7            10.4

Selling, general and administrative                8.9            10.1             7.7             9.0
  expenses
Amortization of intangible assets,
  goodwill and deferred financing fees             1.3             1.4             1.2             1.2

Special items                                      7.6             0.6             3.6             0.7
                                                ------          ------          ------          ------
      Income from operations                     (10.1)           (4.7)           (3.8)           (0.5)

Interest expense                                   3.6             2.9             3.2             2.7
                                                ------          ------          ------          ------
      (Loss) income before share in
           earnings of unconsolidated
           affiliate, income taxes and
           extraordinary charge                  (13.7)           (7.6)           (7.0)           (3.2)

Share in (losses) earnings of
   unconsolidated affiliate                         --              --              --             0.6
                                                ------          ------          ------          ------
      (Loss) income before income taxes
          and extraordinary charge               (13.7)           (7.6)           (7.0)           (2.6)

Income tax (benefit) expense                       0.1             (.2)             .1             0.1
                                                ------          ------          ------          ------
      (Loss) income before extraordinary
          charge                                 (13.8)           (7.4)           (7.1)           (2.7)

Extraordinary charge on debt refinancing            --             (.3)             --            (1.7)
                                                ------          ------          ------          ------
      Net (loss) income                          (13.8)%          (7.7)%          (7.1)%          (4.4)%
                                                ======          ======          ======          ======
</TABLE>


                                       12
<PAGE>   13
GENERAL

           The Company provides a broad range of comprehensive environmental
consulting, engineering, and waste water facility design, and on-site
construction and remediation service for clients in the private and public
sectors in the areas of environmental contamination, water resources and
infrastructure. The timing of the Company's revenues is primarily dependent on
its backlog, contract awards and the performance requirements of each contract.
The Company's revenues are also affected by the timing of its clients'
activities. Additional detail regarding backlog is set forth under "Backlog" in
this section. Due to these changes in demand, the Company's quarterly and annual
revenues fluctuate. Accordingly, quarterly or other interim results should not
be considered indicative of results to be expected for any other quarter or full
fiscal year.

           The Company uses the equity method of accounting for incorporated
joint ventures and affiliated companies where ownership ranges from 20 to 50
percent. The Company also includes its proportionate share in unincorporated
joint ventures entered into on large construction-type remediation contracts.

           Certain amounts from prior periods have been reclassified to conform
to current period presentation.


COMPARISON OF QUARTER ENDED MARCH 31, 1997 AND 1996

           Revenues for the quarter ended March 31, 1997 were $39.0 million
compared with $35.1 million for the same quarter in 1996, an increase of $3.9
million or 11.1 percent. Increased remediation services revenues of $10.2
million were offset by reduced demand for construction and engineering services.
In the prior year quarter, revenues were negatively impacted by delays in the
Federal Government budget approval process affecting revenues under the
Company's EPA ERCS contracts. Revenues from EPA contracts for the quarter ended
March 31, 1997 were approximately $16.0 million compared with $7.0 million in 
the prior year quarter.

           Gross profit for the quarter ended March 31, 1997 was $3.0 million or
7.7 percent of revenues compared with $2.6 million or 7.4 percent of revenues
for the quarter ended March 31, 1996, an increase of approximately $400,000. The
increase in gross profit is due primarily to the aforementioned increase in EPA
ERCS revenues, offset by reduced project profit margins due to an extremely
price competitive environmental construction and remediation market. Indirect
costs have been reduced to partially offset the effects of the decline in
project profit margins.

           Selling, general and administrative expenses for the quarter ended
March 31, 1997 were $3.5 million or 8.9 percent of revenues, compared with $3.5
million or 10.1 percent of revenues for the same quarter in the prior year.
Reduced accounting, business development and other administrative costs as a
result of cost reductions implemented during the second half of fiscal year 1996
and reduced legal fees as a result of the settlement of the NL Industries
arbitration were offset by professional bid and proposal assistance utilized in
the pursuit of Federal Government remediation services contracts. Additionally,
the Company engaged a management consulting firm to assist in its working
capital management and turnaround efforts.

           Amortization of intangible assets, goodwill and deferred financing
fees for the quarter ended March 31, 1997 was $506,000, compared with to 
$489,000 for the same period in the prior fiscal year.


                                       13
<PAGE>   14
           Special items for the quarter ended March 31, 1997 were $3.0 million
and included $3.5 million of costs associated with the implementation of a plan
to reduce facility and equipment leasing obligations and severance and retention
costs associated with a staff reduction plan, reduced by the recovery of
$500,000 in the resolution of claims filed with its insurance carriers related
to the NL Industries arbitration settlement. Special items also related to
office consolidations of $200,000 were recorded in the quarter ended March 31,
1996.

           Interest expense for the quarter ended March 31, 1997 was $1.4
million compared with $1.0 million for the same quarter in 1996. The increase in
interest expense is primarily due to increased bank borrowings and higher
interest rates.

           In the quarter ended March 31, 1997, the Company provided for income
taxes of $24,000 which represents a provision for state income taxes. The
Company has not provided for federal taxes as a result of the loss for the
current quarter. The Company has significant net operating loss carryforwards to
offset future federal tax liabilities. A valuation allowance has been recorded
to reduce the deferred tax asset related to these carryforwards and other
deferred tax assets to zero since the realization of such benefit is not
assured.

           In the quarter ended March 31, 1996, the Company recorded an
extraordinary charge of $113,000 as a result of reversing the FY96 first quarter
tax benefit in connection with the debt refinancing.


COMPARISON OF SIX MONTHS ENDED MARCH 31, 1997 AND 1996

           Revenues for the six months ended March 31, 1997 were $83.3 million
compared with $81.9 million for the same period in 1996, an increase of $1.4
million or 1.7 percent. Increased remediation services revenues of $14.6 million
were offset by reduced demand for construction and engineering services. In the
prior year period, revenues were negatively impacted by delays in the Federal
Government budget approval process affecting revenues under its EPA ERCS
contracts. Revenues from EPA contracts for the six months ended March 31, 1997
were approximately $28.1 million compared with $20.0 million in the prior year
period.

           Gross profit for the six months ended March 31, 1997 was $7.2 million
or 8.7 percent of revenues compared with $8.5 million or 10.4 percent of
revenues for the six months ended March 31, 1996, a decrease of approximately
$1.3 million. The increase in gross profit and decrease in the percentage return
is due primarily to increased EPA ERCS remediation service revenues at
historically lower gross profit margins. Additionally, the environmental
construction and remediation market is extremely price competitive which has
reduced project profit margins. Indirect costs have been reduced to partially
offset the effects of the decline in project profit margins.

           Selling, general and administrative expenses (SG&A) for the six
months ended March 31, 1997 were $6.4 million or 7.7 percent of revenues,
compared with $7.4 million or 9.0 percent of revenues for the same period in the
prior year. The decrease in SG&A is primarily attributable to reduced
accounting, business development and other administrative costs as a result of
cost reductions implemented during the second half of fiscal year 1996 and
reduced legal fees as a result of the settlement of the NL Industries
arbitration offset by increased proposal and management consulting expenses.

           Amortization of intangible assets, goodwill and deferred financing
fees for the six months ended March 31, 1997 was $1.0 million, the same as in 
the prior fiscal year.


                                       14
<PAGE>   15
           Special items for the six months ended March 31, 1997 were $3.0
million and included $3.5 million of costs associated with the implementation of
a plan to reduce facility and equipment leasing obligations and severance and
retention costs associated with a staff reduction plan, reduced by the recovery
of $500,000 in the resolution of claims filed with its insurance carriers
related to the NL Industries arbitration settlement. Special items of $593,000
for severance and relocation costs were recorded in the six months ended March
31, 1996 in connection with office closings and consolidations.

           Interest expense for the six months ended March 31, 1997 was $2.6
million compared with $2.2 million for the same period in 1996. The increase in
interest expense is primarily due to increased bank borrowings and higher
interest rates.

           The Company's share of earnings from an unconsolidated affiliate in
the six months ended March 31, 1996 was $500,000. No activity was conducted by
the joint venture during the current fiscal year.

           In the six months ended March 31, 1997, the Company provided for
income taxes of $49,000 which represents a provision for state income taxes. The
Company has not provided for federal taxes as a result of the loss for the
current quarter. The Company has significant net operating loss carryforwards to
offset future federal tax liabilities. A valuation allowance has been recorded
to reduce the deferred tax asset related to these carryforwards and other
deferred tax assets to zero since the realization of such benefit is not
assured.

           The Company recorded an extraordinary charge of approximately $1.4
million during the six months ended March 31, 1996 as a result of refinancing
its senior credit facility. The charge includes unamortized financing fees and a
prepayment penalty in connection with the refinancing.


LIQUIDITY AND CAPITAL RESOURCES

           The Company is engaged in a business which at times requires
substantial working capital for construction, remediation and engineering
services contracts that require investments of personnel and equipment by the
Company before the Company is permitted to invoice the client. Many of the
Company's contracts also provide for progress or monthly invoices as certain
benchmarks of performance are reached or costs have been incurred. The Company's
working capital and cash have been significantly impacted by the amount of debt
incurred in connection with the acquisition of BCM Engineers, Inc. ("BCM"),
Riedel Environmental Services, Inc. ("RES") and the assets of RESNA Industries,
Inc. ("RESNA") and by costs associated with consolidating the acquired
companies' operations into those of the Company. As a result of these factors
and current market conditions for the environmental industry which reflect lower
government spending, lessened regulatory enforcement and lower project profit
margins the Company has and continues to experience liquidity problems.

           The Company has in place a Loan and Security Agreement (the "Loan
Agreement") with The Chase Manhattan Bank and BTM Capital Corporation
(collectively, the "Senior Lenders"). Effective April 21, 1997, the Company and
its Senior Lenders executed the Fifth Amendment, Waiver and Consent (the "Fifth
Amendment") which waived prior defaults and consented to certain conditions
under the Loan Agreement. The Fifth Amendment restructured the revolving line of
credit (the "Revolver") to be based upon eligible billed accounts receivable
only and eliminated eligible unbilled accounts receivable from the borrowing
base. Advances against eligible unbilled accounts receivable were converted to a
term loan of approximately $4.4 million as of April 21, 1997. The amended Loan
Agreement includes a $24.5 million


                                       15
<PAGE>   16
Revolver and term loans totaling approximately $8.0 million including the 
balance remaining from the original term loan of approximately $3.6 million.
The term loans are being repaid on a weekly and monthly basis and are being
amortized at the rate of approximately $2.9 million per year. Additionally, the
Fifth Amendment provides for an overadvance of $8.0 million against the Revolver
borrowing base. The overadvance provision is reduced to $6.0 million beginning
August 1, 1997 and is eliminated effective October 2, 1997 at which time the
Revolver is reduced to $23.5 million. A mandatory term loan pre-payment or a
further reduction in the overadvance of $500,000 is also required by August 1,
1997. Changes in the borrowing base occur as a result of the magnitude and
timing of the Company's billings and collections for services.

           The Fifth Amendment also amended financial covenants through
September 30, 1997 and increased interest rates to 4.5 percent over the Bank's
ABR rate and contained a fee of $250,000 with payment deferred to October 2,
1997. The Company must also provide the Senior Lenders on or before May 15, 1997
detachable warrants exercisable at a nominal price for 7.5 percent of the fully
diluted common stock of the Company. At March 31, 1997, this represented
approximately 795,000 shares. The Company and its Senior Lenders have verbally
agreed to extend the date of delivery of unaudited financial statements for
the year ended September 30, 1996 and the issuance of the detachable warrants to
June 16, 1997.

           The principal sources of liquidity for the Company's business and
operating needs are internally generated funds from operations and available
revolving credit borrowings under the Chase Facility. For the six months ended
March 31, 1997, operating activities used net cash of approximately $46,000,
primarily due to operating losses offset by increases in accounts and
subcontracts payable. Investing activities provided $83,000 in net cash
principally from the sale of assets. Financing activities utilized net cash of
$150,000 primarily from repayments of debt obligations. Cash generated from the
collection of accounts receivable is used to repay the Revolver and results in
an increase of available borrowings under the Revolver.

           As of March 31, 1997, long term debt, including current maturities of
$4.2 million, was approximately $42.9 million, the components of which were
borrowings of $18.9 million under the Revolver and $8.2 million in term loans,
$14.5 million of convertible senior subordinated notes and $1.3 million of other
notes and capital leases. 

           The Company's inability to make timely payments to certain of its
trade and other creditors has resulted in the filing of multiple lawsuits
against the Company. The Company has disputed the amounts claimed in certain of
these actions and has entered into installment payment agreements or allowed
judgments to be taken against the Company in others. A number of vendors and
subcontractors have also delivered notice of non-payment to the surety company
providing payment bonds on projects being performed by the Company. Outstanding
judgments obtained by trade creditors (exclusive of the Gravers Company and
Winstead Sechrist & Minick judgments discussed in Item 1 of Part II) total
approximately $173,000. In addition, the Company has entered into agreements to
pay on an installment basis approximately $346,000 in settlement of other
creditor claims and judgments, of which approximately $183,000 will come due
during this fiscal year. There are presently seventeen unresolved lawsuits
involving claims exceeding, in the aggregate, $750,000 and claims made against
the Company's surety for non-payment exceeding, in the aggregate, $2.9 million.
All undisputed amounts have been included as liabilities in the Company's 
balance sheet. These claims could also result in the termination of projects 
or jeopardize the ability of the Company to continue performance under 
contracts. Termination of projects would result in the loss of future 
revenues, create potential liability for the Company to its clients and the 
surety company 


                                       16
<PAGE>   17
for increased cost to complete projects and adversely affect the Company's
ability to pursue additional work.

           The Company has attempted to improve cash flow and improve working
capital through cost reduction measures and improved billing and collection
procedures. Through these efforts and the sale of certain real estate,
management believes it will meet the $2.5 million reduction required by its
Senior Lenders as described above. The Company has implemented a strategic
restructuring program and is pursuing capital investment, merger and divestiture
opportunities. These potential transactions may require an increase in the
Common Stock, the Preferred Stock and the Preference Stock currently authorized
by the Company's Certificate of Incorporation. Proceeds from such transactions 
are required to meet the mandatory reduction of the remaining overadvance of 
up to $6.0 million and the $1.0 million reduction in the Revolver required by 
October 2, 1997. Remaining proceeds would be utilized to reduce the Company's 
trade payables and long-term debt subject to the approval of the Senior 
Lenders. In the event the Company fails to improve the management of its 
working capital and conclude a capital investment, merger or divestiture 
transaction on a timely basis, its liquidity and financial position will be 
materially adversely impacted and the Company would be required to consider 
other measures of protecting its assets against creditors.


BACKLOG

           As of March 31, 1997, the Company had a contract backlog of orders of
approximately $84 million compared with approximately $107 million and $114
million at September 30, 1996 and March 31, 1996, respectively. The value of
unfunded or indefinite delivery order contracts ("IDO") was approximately $106
million as of March 31, 1997 compared with approximately $140 million and $147
million at September 30, 1996 and March 31, 1996, respectively. The combined
contract backlog as of March 31, 1997 was approximately $190 million compared
with approximately $247 million and $261 million at September 30, 1996 and March
31, 1996, respectively. The Company has recently received notices of termination
of work on three significant contracts. One termination resulted from the loss
of Company personnel having substantial experience with the contracted services.
Two terminations resulted from a change in technology to be applied to the
specific site requirements. Reductions of projected revenues of approximately
$10 million resulting from these terminations are reflected in the backlog as of
March 31, 1997.

           Subsequent to the end of the quarter, the Company executed a contract
for EPA ERRS Region 4 covering the southeastern portion of the United States to
be performed over a five year period. The EPA contract provides an additional
$50 million to the Company's total backlog increasing the total backlog to
approximately $240 million. The ultimate value of the backlog is subject to
change as the scope of work on projects change. Customers often retain the right
to change the scope of work with an appropriate increase or decrease in contract
price.


OTHER ITEMS AFFECTING OPERATING RESULTS

           The Company generates a substantial portion of its revenues under its
Emergency Response Cleanup Services (ERCS) contracts for the Environmental
Protection Agency ("EPA"). The Company is the prime contractor for removal of
hazardous substances in ERCS Zone 4A, comprising Regions 6, 7 and 8, and ERCS
Region 5. The ERCS Zone 4A contract was extended through March 31, 1997 with
completion of 


                                       17
<PAGE>   18
work by June 30, 1997. The ERCS Region 5 contract has been renewed through
September 30, 1997, the final option year.

           Revenues from EPA contracts for the three and six months ended March
31, 1997 were approximately $16.0 million and $28.1 million, respectively.

           As a federal government contractor, the Company is required to comply
with various regulations and standards regarding its systems and procedures for
the accumulation and billing of contract costs and federal procurement
requirements. As a result of its federal government contract activities, the
Company is subject to audit to assure compliance with these requirements.
Although the Company to date has not experienced any materially negative audit
results, an unfavorable determining could impact the Company's ability to
complete current contracts and compete for future federal government work.

               The EPA procurements of future similar services are referred to
as Emergency Response and Remediation Services (ERRS). The Company has submitted
proposals in competition for award of future ERRS contracts covering Regions 3,
4, 7 and 10. On April 17, 1997, the Company was notified that its was awarded a
contract in Region 4 covering the southeastern portion of the United States. The
contract is estimated at approximately $50 million over a five year performance
period with work scheduled to begin in June 1997. The Company intends to
actively seek the award of the EPA ERRS Region 5 contract and other future EPA
and other federal government agency and department remedial action contracts.


FORWARD LOOKING STATEMENTS AND INFORMATION

               This report and other reports and statements filed by the Company
from time to time with the Securities and Exchange Commission (collectively,
"SEC Filings") contain or may contain certain forward-looking statements and
information that are based on information available to the Company's management
and various estimates, assumptions and predictions made by the Company's
management. When used in SEC Filings, the words "anticipate," "contemplate,"
"estimate," "expect," "future," "intend," "plan," "predict" and similar
expressions are intended to identify forward-looking statements. Such statements
are subject to inherent uncertainties, including, in addition to any
uncertainties specifically identified in the text surrounding such statements,
uncertainties with respect to changes or developments in social, economic,
business, industry, market, legal and regulatory circumstances and conditions
and actions taken or omitted to be taken by third parties, including the
Company's stockholders, customers, suppliers, business partners and competitors,
and legislative, regulatory, judicial and other governmental authorities and
officials. Consequently, actual events, circumstances, consequences, effects and
results may vary significantly from those described in or contemplated by such
forward-looking statements or information.


                                       18
<PAGE>   19
                          SMITH TECHNOLOGY CORPORATION

PART II    OTHER INFORMATION

ITEM 1.    LEGAL PROCEEDINGS


GRAVERS COMPANY VS. BCM ENGINEERS INC.

           The Company's subsidiary, BCM Engineers Inc. (BCM), is the lessee of
improved property formerly used as a laboratory and office/warehouse space for
field service personnel. The lease dated October 23, 1989 terminates May 31,
2000 and contains provisions for the confession of judgment in favor of Gravers
Company (the "Owner") in the event of default. The Owner has, pursuant to the
lease provisions, on March 21, 1997 filed judgments in the Montgomery County,
Pennsylvania Court of Common Pleas providing for ejectment of BCM and a money
judgment against BCM in the amount of $1,094,039. BCM has brought the lease
payments current and is in the process of negotiating an agreement providing for
the deferment by the Owner of any action to retake possession of the leased
property or to take action to collect on the money judgment so long as BCM
remains in compliance with the underlying lease. BCM is attempting to sublease
this space to others.


WINSTEAD SECHREST & MINICK VS. SMITH TECHNOLOGY CORPORATION

           The Company has entered into a settlement agreement to resolve a
lawsuit to collect money due for professional services filed March 11, 1997 in
the 101st Judicial District Court of Dallas County, Texas by Winstead Sechrest &
Minick. The agreement provides for mandatory installment payments of $50,000 per
quarter in payment of a stipulated judgment in the amount of $465,842 which may
be satisfied upon the aggregate payment of $324,459 plus interest on or before
September 30, 1997.


BELLSOUTH TELECOMMUNICATIONS INC. VS. BCM ENGINEERS INC.

           In December 1995, BellSouth filed a complaint for unstated damages in
the Circuit Court, Jefferson County, Alabama against the Company, its
subsidiaries BCM and Canonie Technologies, Inc. The complaint, alleging
professional negligence, fraudulent and negligent misrepresentation,
non-disclosure, innocent misrepresentation and breach of contract, arises out of
BCM's alleged failure to provide oversight and certification of services
performed by BellSouth's asbestos abatement contractors. The plaintiff claims it
has expended an additional $1.6 million to perform asbestos removal which
allegedly was to have been performed by its prior contractor. BCM believes its
services were performed in compliance with all legal requirements, that it has
been released from BellSouth claims, and that a substantial amount of the claims
are barred by statute of limitations. The parties to the lawsuit have entered
into a settlement agreement dated April 21, 1997, which resolved all claims; the
agreement provides for the payment by the Company of $150,000 in monthly
installments.



                                       19
<PAGE>   20
STROUDSBURG MUNICIPAL AUTHORITY VS. BCM ENGINEERS INC. A SUBSIDIARY OF SMITH
TECHNOLOGY CORPORATION

           Stroudsburg Municipal Authority has filed a claim on January 8, 1997
in the Monroe County, Pennsylvania, Court of Common Pleas for damages exceeding
$500,000 based on allegations of breach of contract and negligent performance of
design services. The Company and its professional liability carrier have
retained counsel to defend the claim and investigate the matter. The Company's
insurance coverage responding to this claim has a $150,000 self-insurance
retention.


VENDOR CLAIMS

        The Company's inability to make timely payments to certain of its trade
and other creditors has resulted in the filing of multiple lawsuits against the
Company. The Company has disputed the amounts claimed in certain of these
actions and has entered into installment payment agreements or allowed judgments
to be taken against the Company in others. A number of vendors and
subcontractors have also delivered notice of non-payment to the surety company
providing payment bonds on projects being performed by the Company. Outstanding
judgments obtained by trade creditors (exclusive of the Gravers Company and
Winstead Sechrist & Minick judgments discussed in Item 1 of Part II) total
approximately $173,000. In addition, the Company has entered into agreements to
pay on an installment basis approximately $346,000 in settlement of other
creditor claims and judgments, of which approximately $183,000 will come due
during this fiscal year. There are presently seventeen unresolved lawsuits
involving claims exceeding, in the aggregate, $750,000 and claims made against
the Company's surety for non-payment exceeding, in the aggregate, $2.9 million.
All undisputed amounts have been included as liabilities in the Company's 
balance sheet. In the event the Company fails to achieve the strategic 
restructuring discussed in Item 2. Section 1, Management's Discussion and 
Analysis of Financial Condition and Results of Operations allowing for the 
resolution of the Company's accounts payable, the financial condition and 
operations of the Company will be materially and adversely affected by these 
and other potential vendors claims for unpaid amounts.


OTHER LITIGATION AND CLAIMS

           The Company is currently a party to other litigation and claims
incidental to the performance of services. The Company believes that these
matters are adequately accrued or covered by insurance, are without merit or the
disposition thereof is not anticipated to have a material effect on the
Company's financial position; however, these matters individually or in the
aggregate, could have a material adverse effect on future quarterly or annual
results of operations or cash flow when resolved.


ITEM 3.  DEFAULTS ON SENIOR SECURITIES

           The Company has not made timely payment of dividends accruing on the
Redeemable Preferred Stock. The unpaid dividends are approximately $287,000 at
March 31, 1997, comprised of $178,000 due March 31, 1997 and $109,000 remaining
balance from December 31, 1996. The terms of the preferred stock provide that a
non-payment condition increases the dividend rate to seven and one-half percent
and to ten percent in the event two quarterly payments are not made. The Company
has extended a dividend payment "catch-up" plan to its Redeemable Preferred 
Stockholders  


                                       20
<PAGE>   21
which has reduced the arrearage through December 31, 1996 to $81,000. The Fifth
amendment of the Chase Facility restricts subsequent payments of quarterly
dividends while an over advance condition exists on its revolving line of
credit. These dividends will accrue at the rate of 10%, or approximately
$178,000 per quarter, until all arrearages are fully paid.

ITEM 5. OTHER INFORMATION

           The Company filed a Form 8-K dated February 28, 1997 reporting the
execution of a letter of intent for the sale of assets and accounts receivable
relating to three engineering offices. On April 11, 1997, the Company issued a
press release announcing that the sale of those engineering offices together
with a second sale of assets of three additional offices to a related buyer have
been terminated.

           As of the date of this filing, the Company has not filed its annual
report on Form 10-K for its fiscal year ended September 30, 1996. The Form 10-K
has not been filed because the Company's auditors have not released their audit
report due to the previously existing default condition under the Chase
Facility. All of the financial data for fiscal year ended September 30, 1996
contained herein is unaudited. The Company's annual meeting which was scheduled
for March 20, 1997 has been postponed until such time as the Company's Form 10-K
is filed and a proxy statement and proxy materials can be distributed to the
stockholders of the Company.

Arthur A. Riedel resigned as a member of the Board of Directors effective March
20, 1997. The resignation of E. Brian Smith as President and Chief Executive
Officer and the appointment of Thomas F. Herlihy, a principal in the management
consulting firm of Walker, Truesdell and Associates, as interim President and
Chief Executive Officer of the Company was effective April 14, 1997. Mr. Smith
remains Chairman of the Board of Directors. On April 24, 1997, Frank J. Gorry
was appointed Senior Vice President-Chief Operating Officer and Anthony J. Dury
and William T. Campbell were each elevated to the position of Senior Vice
President.


                                       21
<PAGE>   22
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

                           CONSOLIDATED BALANCE SHEETS
                 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)


                                     ASSETS

<TABLE>
<CAPTION>
                                                                              SEPTEMBER 30,
                                                                        -------------------------
                                                                            1996           1995
                                                                        -----------      --------
                                                                        (UNAUDITED)
<S>                                                                     <C>              <C>
Current Assets:
        Cash .........................................................    $   625        $    686
        Accounts receivable, less allowance for doubtful
           accounts of $829 and $1,502, respectively (Note 3) ........     40,793          52,852
        Costs and estimated earnings on long-term contracts
            in excess of billings (Note 4) ...........................      2,025           2,287
        Prepaid expenses and other current assets ....................      3,445           3,203
                                                                          -------        --------

               Total current assets ..................................     46,888          59,028
                                                                          -------        --------

Property and Equipment:
        Equipment ....................................................     19,330          21,949
        Land, buildings and improvements .............................      4,017           4,007
        Leasehold improvements .......................................      1,107           1,044
                                                                          -------        --------

             Total property and equipment, at cost ...................     24,454          27,000
        Less accumulated depreciation and amortization ...............     11,582          10,062
                                                                          -------        --------

           Property and equipment, net ...............................     12,872          16,938

Other Assets:
      Intangible assets, net of accumulated amortization of $1,878
             and $712, respectively (Note 2) .........................     15,172          16,338
      Goodwill, net of accumulated amortization of $714 and
             $322, respectively (Note 2) .............................     14,953          15,345
      Investment in unconsolidated affiliate (Note 5) ................      1,561           1,502
      Other assets (Note 6) ..........................................      4,038           5,443
                                                                          -------        --------

TOTAL ASSETS .........................................................    $95,484        $114,594
                                                                          =======        ========
</TABLE>


          See accompanying notes to consolidated financial statements.


                                       22
<PAGE>   23
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

                           CONSOLIDATED BALANCE SHEETS
                 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                     LIABILITIES, REDEEMABLE PREFERRED STOCK
                         AND COMMON STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                                                           SEPTEMBER 30,
                                                                                    --------------------------
                                                                                        1996            1995
                                                                                    -----------      ---------
                                                                                    (UNAUDITED)
<S>                                                                                 <C>              <C>
Current Liabilities:
    Accounts and subcontracts payable ..........................................     $ 22,597         $24,733
    Accrued expenses and other liabilities:
        Compensation and related fringes .......................................        5,486           4,973
        Severance and office closures ..........................................        1,688           1,618
        Other ..................................................................       10,686           9,343
    Billings on long-term contracts in excess of costs and
        estimated earnings (Note 4) ............................................           57           1,251
    Current maturities of long-term debt and short-term borrowings (Note 7) ....        2,866           2,110
                                                                                     --------        --------
           Total current liabilities ...........................................       43,380          44,028

Long-term debt (Note 7) ........................................................       24,881          27,403
Other long-term liabilities ....................................................        7,804           6,017
Convertible Senior Subordinated Note; 10%; maturing in 2004, convertible
      into 4,210,953 common shares at  $3.28 per share (Note 8) ................       13,812          10,000

Commitments and contingencies (Notes 9 and 14):

Redeemable Preferred Stock, $0.01 par value; 78,000 shares authorized; 74,438
       and 76,218 shares issued, respectively; 10% cumulative
       dividend; $100 redemption value (Notes 1 and 12) ........................        6,846           6,857

Junior Convertible Preferred Stock, $0.01 par value; 470,000 and 371,500
        shares authorized, respectively; none issued (Note 8) ..................           --              --

Preference Stock, $0.01 par  value; 1,000,000 shares authorized;
        none issued ............................................................           --              --

Common Stockholders' Equity:
   Common stock, $0.01 par value; 20,000,000 shares authorized, 6,107,440
         and 5,850,015 shares issued and outstanding, respectively .............           61              58
   Additional paid-in capital ..................................................       17,379          17,149
   Deferred compensation .......................................................         (404)             --
   (Accumulated deficit) retained earnings .....................................      (18,275)          3,082
                                                                                     --------        --------

               Total common stockholders' equity ...............................       (1,239)         20,289
                                                                                     --------        --------

TOTAL LIABILITIES, REDEEMABLE PREFERRED STOCK
       AND COMMON STOCKHOLDERS' EQUITY                                               $ 95,484        $114,594
                                                                                     ========        ========
</TABLE>


See accompanying notes to consolidated financial statements.


                                       23
<PAGE>   24
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

                      CONSOLIDATED STATEMENTS OF OPERATIONS
                 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

<TABLE>
<CAPTION>
                                                                 YEAR        SEVEN MONTHS
                                                                ENDED            ENDED          YEARS ENDED FEBRUARY 28,
                                                             SEPTEMBER 30,    SEPTEMBER 30,    --------------------------
                                                                 1996             1995            1995            1994
                                                             -----------      -----------      ----------     -----------
                                                             (UNAUDITED)
<S>                                                          <C>             <C>               <C>            <C>
Revenues (Notes 3 and 15) ..............................     $   164,382      $   105,290      $  104,738     $    59,461
Cost of revenues .......................................         152,735           91,932          89,922          56,020
                                                             -----------      -----------      ----------     -----------
       Gross profit ....................................          11,647           13,358          14,816           3,441

Selling, general, and administrative expenses ..........          14,218            9,109          10,285           5,754
Amortization of intangible assets, goodwill
    and deferred financing fees ........................           1,957            1,025             510              --
Special items (Note 15) ................................          11,811              393              --           4,263
                                                             -----------      -----------      ----------     -----------
(Loss) income from operations ..........................         (16,339)           2,831           4,021          (6,576)

Interest expense .......................................           4,417            2,225           1,229             412
                                                             -----------      -----------      ----------     -----------
(Loss) income before share in earnings of unconsolidated
    affiliate, income tax and
       extraordinary item ..............................         (20,756)             606           2,792          (6,988)

Share in earnings (losses) of unconsolidated
    affiliates (Note 5):
        Operating ......................................             375             (173)            539            (221)
        Investment write-off (Note 15) .................              --               --              --          (2,655)
                                                             -----------      -----------      ----------     -----------
(Loss) income before taxes and extraordinary item ......         (20,381)             433           3,331          (9,864)

Income tax (benefit) expense (Note 10) .................            (419)              87             558             135
                                                             -----------      -----------      ----------     -----------
(Loss) income before extraordinary item ................         (19,962)             346           2,773          (9,999)

 Extraordinary item on debt refinancing (Note 6) .......          (1,395)              --              --              --
                                                             -----------      -----------      ----------     -----------

Net (loss) income ......................................         (21,357)             346           2,773          (9,999)
Dividends and accretion on Redeemable
     Preferred Stock ...................................             587              334             218              --
                                                             -----------      -----------      ----------     -----------

Net (loss) income applicable to Common Stock ...........     $   (21,944)     $        12      $    2,555     $    (9,999)
                                                             ===========      ===========      ==========     ===========

Weighted average number of common and
     common equivalent shares outstanding ..............       5,978,084        5,964,250       5,865,782       5,700,783
                                                             ===========      ===========      ==========     ===========

(Loss) earnings per common and common equivalent
      share before extraordinary item ..................     $     (3.44)     $      0.00      $     0.44     $     (1.75)
                                                             ===========      ===========      ==========     ===========

(Loss) earnings per common and common
     equivalent share ..................................     $     (3.67)     $      0.00      $     0.44     $     (1.75)
                                                             ===========      ===========      ==========     ===========
</TABLE>


          See accompanying notes to consolidated financial statements.


                                       24
<PAGE>   25
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' EQUITY
                    (IN THOUSANDS, EXCEPT COMMON SHARE DATA)

<TABLE>
<CAPTION>
                                                    SHARES OF                  ADDITIONAL
                                                     COMMON         COMMON       PAID-IN     DEFERRED     RETAINED
                                                      STOCK          STOCK       CAPITAL   COMPENSATION   EARNINGS       TOTAL
                                                   ----------      --------      --------      -----      --------      --------
<S>                                                <C>             <C>         <C>         <C>            <C>           <C>
Balance, February 28, 1993 ...................      5,700,783      $     57      $ 16,580         --      $ 10,514      $ 27,151
Net loss .....................................             --            --            --         --        (9,999)       (9,999)
Other ........................................             --            --            31         --            --            31
                                                   ----------      --------      --------      -----      --------      --------

Balance, February 28, 1994 ...................      5,700,783            57        16,611         --           515        17,183
Net income ...................................             --            --            --         --         2,773         2,773
Shares issued upon conversion of stock options        106,689             1           359         --            --           360
Dividends and accretion on Redeemable
   Preferred Stock ...........................             --            --            --         --          (218)         (218)
                                                   ----------      --------      --------      -----      --------      --------

Balance, February 28, 1995 ...................      5,807,472            58        16,970         --         3,070        20,098
Net income ...................................             --            --            --         --           346           346
Shares issued upon conversion of stock options         42,543            --           179         --            --           179
Dividends and accretion on Redeemable
    Preferred Stock ..........................             --            --            --         --          (334)         (334)
                                                    ---------      --------      --------      -----      --------      --------
Balance, September 30, 1995 ..................      5,850,015            58        17,149         --         3,082        20,289
Net Loss .....................................                                                             (21,357)      (21,357)
Shares issued upon conversion of stock options          7,625            --            31         --            31
Shares issued to contribute Company match
    to 401 K Plan ............................         88,949             1           210         --            --           211
Shares issued for deferred compensation
    and other obligations ....................        160,851             2           576      $(404)          174
Dividends and accretion on Redeemable
    Preferred Stock ..........................             --            --          (587)        --            --          (587)
                                                   ----------      --------      --------      -----      --------      --------

Balance, September 30, 1996 (unaudited) ......      6,107,440      $     61      $ 17,379      $(404)     $(18,275)     $ (1,239)
                                                   ==========      ========      ========      =====      ========      ========
</TABLE>


          See accompanying notes to consolidated financial statements.


                                       25
<PAGE>   26
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)


<TABLE>
<CAPTION>
                                                          YEAR       SEVEN MONTHS      YEARS ENDED 
                                                          ENDED         ENDED          FEBRUARY 28,
                                                      SEPTEMBER 30,  SEPTEMBER 30,  --------------------
                                                          1996          1995         1995          1994
                                                        --------      --------      -------      -------
                                                       (UNAUDITED)
<S>                                                   <C>            <C>            <C>          <C>
Operating Activities:
Net (loss) income .................................     $(21,357)     $    346      $ 2,773      $(9,999)
Adjustments to reconcile net income (loss)
     to net cash provided by operating activities:
     Write-off of deferred financing fees .........        1,108            --           --           --
     Deferred interest ............................          812            --           --           --
     Compensation expense .........................          404            --           --           --
     Provisions for special items .................        9,795            --           --        4,263
     Depreciation and amortization ................        5,200         2,868        3,360        1,546
     Gain on disposal of equipment ................         (260)           94          168           --
     Share in (earnings) losses of affiliates .....         (375)          173         (539)       2,876
Income tax refund .................................           --            --           --        2,208
Changes in operating assets and liabilities, net of
     effects from acquisitions:
     Accounts receivable ..........................       10,606       (10,464)       4,529        2,749
     Costs and estimated earnings on long-term
            contracts in excess of billings .......         (262)       (1,011)       1,562        2,720
     Prepaid expenses and other current assets ....         (693)          410         (602)         724
     Other assets .................................          997          (357)      (1,959)          --
     Accounts and subcontracts payable ............       (2,136)        6,848        1,130        1,386
     Accrued expenses and other liabilities .......        2,544        (2,374)      (4,983)        (859)
     Billings on long-term contracts in excess of
            costs and estimated earnings ..........       (1,194)          615         (496)         178
     Other long-term liabilities ..................       (3,634)       (3,005)        (845)          --
 Other, net .......................................          226            53         (218)         675
                                                        --------      --------      -------      -------

Net cash provided by (used in) operating activities     $  2,305      $ (5,804)     $ 3,880      $ 8,467
                                                        ========      ========      =======      =======
</TABLE>


          See accompanying notes to consolidated financial statements.


                                       26
<PAGE>   27
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

                CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                               YEAR           SEVEN MONTHS
                                                               ENDED             ENDED         YEARS ENDED FEBRUARY 28,
                                                            SEPTEMBER 30,     SEPTEMBER 30,    ------------------------
                                                                1996              1995           1995            1994
                                                              --------         ---------       --------         ------- 
                                                            (UNAUDITED)
<S>                                                         <C>               <C>            <C>              <C>
INVESTING ACTIVITIES:
    Capital expenditures .............................        $ (1,402)        $(2,172)        $   (689)        $(3,333)
    Advances (to) from affiliates ....................              --             125            1,000          (1,496)
    Proceeds from sale of subsidiary .................              --              --               --             704
    Proceeds from sale of fixed assets ...............             725              --               --              --
    Purchase of BCM Engineers (net of cash acquired) .              --              --           (4,783)             --
    Purchase of Riedel Environmental Services (net
        of cash acquired) ............................              --              --          (18,336)             --
    Other ............................................              --             388              (43)             22
                                                              --------         -------         --------         ------- 
Net cash used in investing activities ................            (677)         (1,659)         (22,851)         (4,103)
                                                              --------         -------         --------         ------- 

FINANCING ACTIVITIES:
    Proceeds from revolving line of credit used to
        fund acquisitions ............................              --              --           19,580              --
    Retirement of acquired companies debt ............              --              --          (10,647)             --
    Proceeds from term loans used to fund acquisitions              --              --            4,500              --
    Proceeds from Senior Note ........................              --              --            2,000              --
    Proceeds from Convertible Senior
         Subordinated Note ...........................              --              --           10,000              --
    Proceeds from new revolving credit facility ......          20,649              --               --              --
    Retirement of former revolving credit facility ...         (21,537)             --               --              --
    (Repayments) borrowings on revolving
        line of credit, net ..........................             747           7,219           (4,800)         (3,200)
    Proceeds from term loan ..........................           6,500              --               --              --
    Retirement of term loan ..........................          (3,400)             --               --              --
    Repayments on term loan ..........................          (2,040)             --               --              --
    Payment of financing fees ........................          (1,096)             --               --              --
    Payment of early debt extinguishment penalty .....            (287)             --               --              --
    Repayment of other notes and capital leases ......            (986)         (1,096)          (1,967)             --
    Proceeds from exercise of stock options ..........              31              50              360              --
    Repurchase of Redeemable Preferred Stock., net ...             (84)           (178)              --              --
    Dividends paid on Redeemable Preferred Stock .....            (186)           (191)              --              --
                                                              --------         -------         --------         ------- 

Net cash provided by (used in) by financing activities          (1,689)          5,804           19,026          (3,200)
                                                              --------         -------         --------         ------- 

Net increase (decrease) in cash ......................             (61)         (1,659)              55           1,164
Cash at beginning of period ..........................             686           2,345            2,290           1,126
                                                              --------         -------         --------         ------- 
Cash at end of period ................................        $    625         $   686         $  2,345         $ 2,290
                                                              ========         =======         ========         =======
</TABLE>


          See accompanying notes to consolidated financial statements.


                                       27
<PAGE>   28
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 1 - BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BUSINESS

           Smith Technology Corporation (formerly Smith Environmental
Technologies Corporation), a Delaware corporation (the Company), provides a
broad range of comprehensive environmental consulting, engineering, and on-site
construction and remediation services for clients, in the private and public
sectors in the areas of environmental contamination, water resources and
infrastructure. During the year ended February 28, 1995, the Company completed
three acquisitions which significantly increased its services, core competencies
and geographic coverage. See Note 2 for description of acquisitions. The
Company's operations are considered to be concentrated in one industry segment
in the United States.

           The financial statements of the Company have been prepared on a
going-concern basis, which contemplates the realization of assets and
satisfaction of liabilities in the normal course of business. Accordingly, the
financial statements do not include any adjustments relating to the
recoverability of recorded assets, or the amounts and classification of
liabilities that might be necessary should the Company be unable to continue as
a going concern.

           The Company incurred a net loss of $19.9 million for fiscal 1996 and
as a result its working capital decreased to $5.0 million and its common
stockholder's equity decreased to $211,000 at September 30, 1996. Further, the
Company was in default of its Loan Agreement as defined herein which has
required the Company to obtain forbearance agreements from its Senior Lenders
and an amended Loan Agreement (see Note 7).

           During January 1997, the Company and its Senior Lenders agreed to an
amended Loan Agreement which waived violations of certain conditions and
financial covenants and established new financial covenants for the remainder of
the Loan Agreement (see Note 7). Also during January 1997, the Company agreed to
a resolution of an arbitration award, which while accounting for approximately
$9.7 million of the Company's fiscal 1996 loss, requires only $150,000 of
payments in fiscal 1997 (see Note 14).

           The Company has developed plans to improve its operating results.
Commencing in fiscal year 1996 and continuing in fiscal year 1997, the Company
implemented measures to lower its operating cost structure and remain
competitive in the markets in which it competes. Such reductions were
principally in personnel and facilities expense, impacting the indirect cost of
revenues and selling and general and administrative expenses. Further, the
Company is continuing its focus on accelerated client billings and increased
collections of accounts receivable in order to improve its cash flow. Management
believes a significant portion of the fiscal 1996 loss can be attributed to
non-recurring events. The Company is also pursuing identified capital investment
and merger opportunities, as well as the divestiture of a portion of its
business. The Company has engaged the services of an environmental financial
consultant and investment banker to actively market certain portions of the
Company's engineering operations. Proceeds from such a capital investment or
divestiture would be utilized to reduce the Company's trade payables, subject to
approval of the Senior Lenders and long-term debt. Accordingly, management
believes operating results and cash flows will improve to a sufficient level in
fiscal year 1997 to allow the Company to meet its amended financial covenants in
the Loan Agreement, to meet its obligations to its various unsecured 


                                       28
<PAGE>   29
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


creditors and the holders of its Redeemable Preferred Stock and enable the
Company to continue as a going concern.

CHANGE IN YEAR END

           Effective March 1, 1995, the Company changed its fiscal year end from
February 28 to September 30. The accompanying consolidated financial statements
include audited financial statements for the seven month transition period ended
September 30, 1995 (transition period; 1995T). Unaudited financial statements
are presented for the seven month period ended September 30, 1994 and the twelve
month period ended September 30, 1995 for comparative purposes only.

PRINCIPLES OF CONSOLIDATION

           The consolidated financial statements include the accounts of the
Company and its subsidiaries. All material intercompany accounts and
transactions are eliminated. The Company uses the equity method of accounting
for incorporated joint ventures and affiliated companies where ownership ranges
from 20 percent to 50 percent. The Company also includes its proportionate share
of unincorporated joint ventures entered into on larger construction-type
remediation projects. Certain amounts in the prior years have been reclassified
to conform to the current year presentation.

USE OF ESTIMATES

           The preparation of consolidated 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 may differ from those
estimates and such differences could be material to the consolidated financial
statements.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

           In March 1995, the Financial Accounting Standards Board (FASB) issued
Statement No. 121 "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of." (SFAS No. 21). SFAS No. 121 prescribes the
accounting for the impairment of long-lived assets such as property, plant and
equipment; identifiable intangibles including assets such as customer lists,
contract backlog and assembled workforce; and goodwill related to those assets.
The Statement is effective for fiscal years beginning after December 15, 1995.
Although the Company has not yet adopted SFAS 121, it believes that there would
be no material impact on its financial position and results of operations upon
application to its fiscal year ended September 30, 1997.

           In October 1995, the FASB issued Statement No. 123 "Accounting for
Stock-Based Compensation" (SFAS No. 123) which will be effective for the
Company's 1997 fiscal year. SFAS No. 123 allows companies which have stock-based
compensation arrangements with employees to adopt a new fair-value basis of
accounting for stock options and other equity instruments, or to continue to
apply the existing accounting rules under APB Opinion 25 "Accounting for Stock
Issued to Employees" but with additional financial statement disclosure. The
Company expects to continue to account for stock-based


                                       29
<PAGE>   30
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)



compensation arrangements under APB Opinion 25 and therefore does not expect
SFAS No. 123 to have a material impact on its financial position, results of
operations and cash flows.


REVENUE AND COST RECOGNITION

           Revenues from engineering and remediation service contracts are
generally recognized as the services are provided, principally under
cost-plus-fee and time and materials contracts. The Company recognizes revenues
on fixed price, long-term contracts on the percentage-of-completion method,
primarily based on contract costs incurred to date compared with total estimated
contract costs. Where appropriate, contracts are divided between engineering and
construction efforts and accordingly, gross margin related to each activity is
recognized as those separate services are rendered. Contract costs include all
direct material, labor, and subcontract costs and other direct costs related to
contract performance. Indirect costs, classified as cost of revenues, and
selling, general, and administrative costs are charged to expense as incurred.
Changes to total estimated contract costs and losses, if any, are recognized in
the period they are determined. Revenues recognized in excess of amounts billed
are classified under current assets as costs and estimated earnings on long-term
contracts in excess of billings. It is anticipated that the incurred costs
associated with contract work in progress at September 30, 1996 will be billed
and collected in fiscal 1997. Amounts received from clients in excess of
revenues recognized to date are classified under current liabilities as billings
on long-term contracts in excess of costs and estimated earnings. An amount
equal to contract costs attributable to claims, if any, is included in revenues
when realization is probable and the amount can be reasonably estimated.


PROPERTY, EQUIPMENT, AND DEPRECIATION

           Property and equipment are stated at cost. Depreciation is provided
primarily on the straight-line method except for process equipment which is
depreciated based on units of production and cost recovery methods. Depreciation
is based on the following estimated useful lives:


<TABLE>
      <S>                                                    <C>
      Building and improvements............................  25-30 years
      Office, process and field equipment..................   3-12 years
</TABLE>


Leasehold improvements are amortized over the shorter of their respective useful
lives or lease terms.


                                       30
<PAGE>   31
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


INCOME TAXES

           The Company utilizes the liability approach to financial accounting
and reporting for income taxes. This method requires recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been included in the financial statements or tax returns. Under this
method, deferred tax assets and liabilities are determined based on the
differences between the financial statement and tax bases of assets and
liabilities using enacted tax rates in effect for the year in which the
differences are expected to reverse.


DIVIDENDS AND ACCRETION ON REDEEMABLE PREFERRED STOCK

           The Company's Redeemable Preferred Stock was recorded at its
estimated fair value at the date of issuance. The original $932,000 excess
redemption value over the carrying value is being accreted using the interest
method so that the carrying value will equal the redemption value on the
scheduled redemption dates. Dividends and accretion on Redeemable Preferred
Stock for the year ended September 30, 1996, the seven months ended September
30, 1995 and for the year ended February 28, 1995 are as follows:

<TABLE>
<CAPTION>
                                       1996             1995T            1995
                                       ----             ----             ----
   <S>                                 <C>              <C>              <C> 
   Dividends                           $419             $222             $163
   Accretion                            168              112               55
                                       ----             ----             ----
                                       $587             $334             $218
                                       ====             ====             ====
</TABLE>

           The Redeemable Preferred Stock carries a stated dividend rate of 5%.
The Company did not make the schedule dividend payments on June 30, 1996 and
September 30, 1996. As a result, the dividend rate was increased to 7.5% for the
quarter ended September 30, 1996 and 10% for the quarters subsequent to
September 30, 1996. The penalty dividend rate of 10% will remain in effect until
such time that all accrued and unpaid dividends are paid in full. At September
30, 1996, there was $232,598 of dividends in arrears.

INCOME (LOSS) APPLICABLE TO COMMON STOCK

           Income (loss) applicable to common stock represents the portion of
the Company's earnings (loss) applicable to its common stockholders. Such amount
is calculated by adjusting net income (loss) for the accretion and dividend
requirements on the Company's Redeemable Preferred Stock.


                                       31
<PAGE>   32
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


(LOSS) EARNINGS PER SHARE

           (Loss) earnings per share are computed on the basis of the weighted
average number of common and common equivalent shares outstanding. The dilutive
effect of the Company's stock options was calculated using the treasury stock
method in 1995T and fiscal 1995. The effect of the Company's stock options was
excluded from the calculation of (loss) earnings per share in fiscal 1996 and
1994 due to their anti-dilutive impact. Other potentially dilutive securities at
September 30, 1996 consist of the Company's Convertible Senior Subordinated Note
and Senior Note (see Note 8). Conversion of the Convertible Senior Subordinated
Note and the Senior Note for all periods presented was not considered since
assumed conversion did not result in significant dilution or was anti-dilutive.

INTANGIBLE ASSETS AND GOODWILL

           Intangible assets are amortized over an estimated useful life of
fifteen years. Goodwill is amortized over forty years. The Company continually
evaluates goodwill and intangible assets to ensure that the goodwill and
intangible assets are fully recoverable from projected undiscounted cash flows
of the acquired business operations. Impairments are recognized in operating
results in the period in which a permanent diminution in value occurs.

STATEMENT OF CASH FLOWS

           Supplemental cash flow information is summarized as follows (in
thousands):

<TABLE>
<CAPTION>
                                         SEVEN MONTHS
                           YEAR ENDED        ENDED         YEARS ENDED FEBRUARY 28,
                          SEPTEMBER 30,   SEPTEMBER 30,   ------------------------
                              1996            1995          1995            1994
                            -------         -------         -----         -------
   <S>                    <C>            <C>              <C>             <C>
   Interest paid .......    $(3,228)        $(1,405)        $(830)        $  (532)
   Interest received ...         86             115            40             100
   Income taxes paid ...        (24)            (22)         (391)             --
   Income tax refund ...         --              --           620           1,981
</TABLE>


NOTE 2 - ACQUISITIONS

           On September 28, 1994, the Company purchased all of the outstanding
common stock of BCM Engineers Inc. (BCM), an environmental consulting and
engineering company, for cash of $5.0 million and 78,000 shares of Redeemable
Preferred Stock with an estimated fair value of $6.9 million on the date of
issuance and a redemption value of $7.8 million. The Redeemable Preferred Stock
has a 5 percent cumulative dividend requirement and is redeemable in equal
installments on the fifth, sixth and seventh anniversaries of its issuance (see
Note 12). The Company also repaid $9.5 million of BCM's indebtedness from the
proceeds under its LaSalle Loan Agreement.

           On November 21, 1994, the Company purchased all of the capital stock
of Riedel Environmental Services, Inc. (RES), an Oregon corporation, from Riedel
Environmental Technologies, Inc. RES is an 


                                       32
<PAGE>   33
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


environmental remediation firm. The purchase price, paid in cash, was
approximately $18.2 million. The RES acquisition was funded by the Company's
issuance of a $10 million Convertible Senior Subordinated Note and a $2 million
Senior Note (see Note 8) and borrowings under the Company's revolving and term
credit facilities.

           On December 30, 1994, the Company entered into an agreement with
RESNA Industries, Inc. (RESNA) to acquire substantially all of RESNA's assets in
exchange for the assumption by the Company of RESNA's debt to its principal bank
lender of $1.5 million, of which $1.1 million was paid at closing with proceeds
from the Company's revolving credit facility. The Company also assumed certain
other liabilities in connection with RESNA's operations. RESNA, based in
California, operated a full service environmental remediation business which
focuses primarily on the soil and groundwater contamination market and cleanups
related to underground storage tanks.

           The transactions were accounted for as purchases; accordingly, the
purchase prices have been allocated to assets and liabilities based on estimated
fair values as of the acquisition dates and the results of operations of the
acquired companies have been included in the Company's statement of operations
since their respective acquisition dates. The cost in excess of estimated fair
value of the net tangible assets acquired upon finalization of the purchase
price, was $32.7 million. Of such amount $15.7 million was recorded as goodwill
and $17.0 million was allocated to intangible assets consisting of approximately
$9.2 million for assembled workforce and $7.8 million for customer lists and
contract backlog.


                                       33
<PAGE>   34
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 3 - ACCOUNTS RECEIVABLE

           Accounts receivable are comprised of the following (in thousands):


<TABLE>
<CAPTION>
                                                                           SEPTEMBER 30,
                                                                    -------------------------
                                                                      1996             1995
                                                                    --------         --------
   <S>                                                              <C>              <C>
   Commercial and non-US government customers:
           Amounts billed ....................................      $ 21,595         $ 25,791
           Unbilled recoverable costs and estimated earnings..         4,052            6,847
           Retention .........................................         1,605            2,829
                                                                      27,252           35,467

   United States Government and agencies:
           Amounts billed ....................................         7,976            9,092
           Unbilled recoverable costs and estimated earnings..         6,015            9,353
           Retention .........................................           379              442
                                                                      14,370           18,887
   All customers .............................................        41,622           54,354

   Allowance for doubtful accounts ...........................          (829)          (1,502)
                                                                    $ 40,793         $ 52,852
                                                                    ========         ========
</TABLE>


           Unbilled recoverable costs and estimated earnings represent revenue
earned and recognized on contracts which are not yet billable according to
contract terms, which usually consider the passage of time, achievement of
certain milestones, or the completion of the project. Retention of approximately
$2.0 million is expected to be substantially collected during fiscal 1997.

           Included within unbilled recoverable costs from the U.S. Government
is approximately $1.2 million of prior year cost adjustments to be recovered
from the EPA under the Company's ERCS contracts. The Company also has an
obligation to the EPA related to a $2.8 million settlement of a contract dispute
associated with the acquisition of RES in November 1994. The Company has not
made the required payments under this settlement on a timely basis, therefore
the $1.3 million due to EPA has been included in current liabilities.

           Due to the nature of the services provided by the Company, it may
derive revenue from a single customer which exceeds 10 percent of its revenues
for the year. For the year ended September 30, 1996, and the seven month period
ended September 30, 1995, the Company derived revenues from the United States
Environmental Protection Agency (EPA) of approximately $43.5 million or 26.3
percent and $29.6 million or 28.1 percent, respectively of revenues for
Emergency Response Cleanup Services (ERCS). There were no significant commercial
customers with revenues in excess of 10 percent during the year ended September
30, 1996 or the seven month period ended September 30, 1995. For the year ended
February 28, 1995, the Company had two commercial customers with revenues of
$12.2 million and $12.1 million respectively. For the year ended February 28,
1994, the Company had two different commercial customers with revenues of $9.9
million and $6.6 million respectively.


                                       34
<PAGE>   35
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 4 - LONG-TERM CONTRACTS AND RECEIVABLES

           Long-term contracts in process accounted for using the
percentage-of-completion method are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                 SEPTEMBER 30,
                                                            ----------------------
                                                              1996           1995
                                                            -------        -------
   <S>                                                      <C>            <C>
   Accumulated expenditures on uncompleted contracts..      $11,138        $82,778
   Estimated earnings thereon ........................          596          9,787
                                                            -------        -------
                                                             11,734         92,565
   Less applicable progress billings .................        9,766         91,529
                                                            -------        -------
   Total .............................................      $ 1,968        $ 1,036
                                                            =======        =======
</TABLE>


           The long-term construction contracts are shown in the accompanying
balance sheets as follows (in thousands):

<TABLE>
<CAPTION>
                                                                  SEPTEMBER 30,
                                                            ----------------------
                                                              1996           1995
                                                            -------        -------
   <S>                                                      <C>            <C>
   Costs and estimated earnings on long-term
         contracts in excess of billings ...........        $ 2,025        $ 2,287
   Billings on long term contracts in excess of 
         costs and estimated earnings ..............            (57)        (1,251)
                                                            -------        -------
   Total ...........................................        $ 1,968        $ 1,036
                                                            =======        =======
</TABLE>


                                       35
<PAGE>   36
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 5 - INVESTMENT IN UNCONSOLIDATED AFFILIATE

           The Company owns a 50 percent interest in Soil Tech ATP Systems, Inc.
(STI). STI is a corporate joint venture that was formed to use its sublicense
rights and its related waste material processing equipment for remediation of
contaminated sites. STI has the sole U.S. license until 2012 of pyrolysis
technology, developed by a Canadian quasi-governmental agency. Under the equity
method of accounting, the investment has been adjusted to reflect the Company's
proportionate share of earnings and losses. The Company's management believes
its investment at September 30, 1996 will be realized through STI's future
undiscounted cash flows.

           In addition, the Company owned a 20 percent interest in LaPosta
Recycling Center, Inc. (LRC). LRC was formed to develop a full service hazardous
waste treatment facility and recycling center. The Company wrote off its
investment in and advances to LRC in fiscal 1994 and has no further financial
commitment to LRC.

           For the year ended September 30, 1996 and the seven months ended
September 30, 1995, STI was not a significant unconsolidated affiliate. A
summary of the unconsolidated affiliates' combined financial position and
results of operations for the years ended February 28, 1995 and 1994,
respectively, is as follows (in thousands):

<TABLE>
<CAPTION>
                                      FOR YEAR ENDED FEBRUARY 28,
                                      ---------------------------
                                         1995            1994
                                        ------        --------
   <S>                                <C>             <C>
   Revenue .......................      $8,252        $  5,166
                                        ------        --------
   Net income (loss) .............         561            (874)
                                        ------        --------
   Current assets ................       1,597           3,117
   Non-current assets ............       2,882           4,001
                                        ------        --------
   Total Assets ..................       4,479           7,118


   Currents liabilities ..........         922           2,722
   Notes payable to stockholders..       6,872           8,432
                                        ------        --------

   Total Liabilities .............      $7,794        $ 11,154
                                        ======        ========
</TABLE>


                                       36
<PAGE>   37
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


           The Company had no material operating transactions with STI during
the year end September 30, 1996 or in the seven months ended September 30, 1995.
The $375,000 in earnings in fiscal 1996 were the result of a claim settlement
won by the Company associated with a contract completed in a prior fiscal year.
The Company derived revenues from services performed for various affiliated
companies, primarily STI for the years ended February 28, 1995 and 1994. In
addition, the Company's cost of revenues include costs associated with services
provided by affiliated companies, primarily STI, as subcontractors on its
remediation contracts. These transactions with affiliates are summarized as
follows (in thousands):

<TABLE>
<CAPTION>
                                                           FOR THE YEAR ENDED FEBRUARY 28,
                                                           -------------------------------
                                                                 1995          1994
                                                                ------        ------
   <S>                                                          <C>           <C>   
   Services provided to affiliates, included in revenues        $  604        $  917
   Subcontract costs, included in cost of revenues .....        $8,015        $4,614
</TABLE>


NOTE 6 - OTHER ASSETS

           Other assets include the following (in thousands):

<TABLE>
<CAPTION>
                                                            SEPTEMBER 30,
                                                     ------------------------
                                                      1996              1995
                                                     ------            ------
   <S>                                               <C>               <C>   
   Trade note receivable ................            $1,539            $1,539
   Deferred financing fees ..............               722             1,173
   Due from officer .....................               105                95
   Other ................................             1,672             2,636
                                                     ------            ------
                                                     $4,038            $5,443
                                                     ======            ======
</TABLE>


           The trade note receivable is secured by real estate located in Santa
Barbara County, California which contains a toxic waste site. The note bears
interest at 1 percent below the prime rate and is due May, 2002. Repayment terms
are accelerated upon a transfer or a modified utilization of the real estate, or
an abandonment of efforts to obtain waste permits.

           Deferred financing fees are carried net of accumulated amortization.
On October 18, 1995, the Company entered into a new Loan Agreement (see Note 7)
and repaid its obligation under the prior loan agreement. Deferred financing
fees, in connection with the prior agreement, of $1.1 million, plus a prepayment
penalty of $287,500 was recorded as an extraordinary item in fiscal 1996.
Amortization expense was $396,000 for the year ended September 30, 1996,
$352,000 for the transition period ended September 30, 1995 and $200,000 for the
year ended February 28, 1995.


                                       37
<PAGE>   38
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 7 - DEBT

           Long-term debt consists of the following (in thousands):

<TABLE>
<CAPTION>
                                                                                SEPTEMBER 30,
                                                                         -------------------------
                                                                           1996             1995
                                                                         --------         --------
   <S>                                                                   <C>              <C>
   Bank borrowings:
           Revolving credit loans ...............................        $ 21,858         $ 21,999
           Term loans ...........................................           4,536            3,476
   Senior Note (Note 8) .........................................              --            2,000
   Capitalized lease obligations at interest rates of 6% to 12%..             779            1,091
   ESOP notes payable to individuals at interest rates of
           7.5% to 11.75% .......................................             453              604
   Other ........................................................             121              343
                                                                         --------         --------
           Total debt ...........................................          27,747           29,513
   Less: current maturities .....................................          (2,866)          (2,110)

   Total long-term debt .........................................        $ 24,881         $ 27,403
                                                                         ========         ========
</TABLE>

           On October 18, 1995, the Company entered into a $35 million credit
facility with The Chase Manhattan Bank (formerly Chemical Bank) and BTM Capital
Corporation (formerly BOT Financial Corporation) (the "Senior Lenders"). The
facility (the "Chase Facility" or the "Loan Agreement") replaced a facility with
another bank. The Chase Facility consists of a three year $28.5 million
revolving line of credit, including a $5 million unbilled account subline, and a
$6.5 million term loan. The Company may choose an interest rate equal to 2.0
percent over the Bank's ABR rate or 3.75 percent over the Bank's Eurodollar loan
rate on revolving credit borrowings and 2.25 percent over the ABR rate or 4.0
percent over the Eurodollar loan rate on the term loan. At September 30, 1996,
all borrowings under the Chase Facility were determined by adding the applicable
margin percent to the Bank's ABR rate, as defined. At September 30, 1996, the
Bank's ABR Rate was 8.25%. At September 30, 1996 there were no letters of credit
issued pursuant to the Chase Facility.

           Borrowings pursuant to the Loan Agreement are secured by
substantially all of the assets of the Company and its subsidiaries. Under the
revolving credit line, the Company may borrow up to 80 percent of eligible
billed accounts receivable, and up to 50 percent of the eligible unbilled
accounts, as defined by the Loan Agreement. The unused credit facility at
September 30, 1996 was $360,000. The term loans are based on eligible property
and equipment at the time of the loans and are being amortized over 48 months
with final payment due on October 18, 1998.

           The Chase Facility requires the Company to meet financial targets,
maintain certain key ratios and comply with numerous financial covenants and
reporting requirements. Additionally, the Loan Agreement places restrictions on
the repayment of debt (Note 8) and other conditions on the payment of dividends
on common and preferred stock.

           During 1996, the Company violated certain covenants and terms of the
Loan Agreement and has operated under forbearance agreements through January 14,
1997.


                                       38
<PAGE>   39
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


           On January 14, 1997, the Company and its Senior Lenders executed the
Fourth Amendment, Waiver and Consent (the "Fourth Amendment") subject to the
execution on January 30, 1997 of the settlement agreement with the PRP Group
(note 14). The Fourth Amendment waived and consented to certain conditions and
actions related to (1) the BCM Employee Stock Ownership Plan, and (2) financial
covenant violations for periods ended June 30, 1996 and September 30, 1996 under
the Loan Agreement. The Fourth Amendment also increased the interest rates to
2.5 percent over the Bank's ABR rate or 4.25 percent over the Bank's Eurodollar
loan rate on revolving credit borrowings and 2.75 percent over the ABR rate or
4.5 percent over the Eurodollar loan rate on the term loan. The Fourth Amendment
also modified certain fees and reduced the Revolving Line of Credit from $28.5
million to $27 million. The Term Loan Maturity date was modified to October 18,
1998, concurrent with the terms of the Revolving Line of Credit. The Fourth
Amendment also established new financial covenants for the remaining term of the
Loan through October 18, 1998.

           Subsequent to the execution of the Fourth Amendment, the Company
determined that its eligible accounts receivable used to calculate its borrowing
base was overstated in calendar months December 1996 and January 1997. As a
result of this determination, the Company is in an over-advance position which
is a default under the terms of the Loan Agreement. The Senior Lenders have
advised the Company that the over-advance must be cured by April 15, 1997, which
cure may include the use of proceeds from a potential sale of a portion of the
Company's engineering operations, and that its Revolver will be reduced to a
maximum of approximately $24.3 million. The Company and its Senior Lenders are
discussing the language of an amendment to the Loan Agreement pending a
determination of the magnitude of the overstatement of the Company's eligible
accounts receivable and method of resolution on the effect on the Company's
borrowing base. In the interim, the Company has agreed to reduce its outstanding
unbilled account subline with repayments to its Senior Lenders of $25,000 per
week.

           The fair value of the Company's long-term debt at September 30, 1996
approximates the carrying value.

           Maturities of long-term debt outstanding at September 30, 1996 based
on the amended Loan Agreement are as follows (in thousands):

<TABLE>
   <S>                                                                <C>
   1997 ..........................................                    $ 2,866
   1998 ..........................................                      1,693
   1999 ..........................................                     23,162
   2000 ..........................................                         13
   2001 ..........................................                         13
   Thereafter ....................................                         --
                                                                      -------
                                                                      $27,747
                                                                      -------
</TABLE>


                                       39
<PAGE>   40
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 8 - CONVERTIBLE SUBORDINATED NOTE

           On November 15, 1994, the Company executed an Amended and Restated
Note Purchase Agreement with 399 Venture Partners, Inc. (the "Investor"), an
affiliate of Citicorp Venture Capital, Ltd., in connection with the purchase of
RES, pursuant to which the Company issued, and the Investor purchased, $10
million aggregate principal amount of a Convertible Senior Subordinated Note
(the "Convertible Senior Subordinated Note") and $2 million aggregate principal
amount of a Senior Note (the "Senior Note", and collectively with the
Convertible Senior Subordinated Note, the "Subordinated Notes"). The Amended and
Restated Note Purchase Agreement provided allocation to various individual
distributees of promissory notes formerly held by 399 Venture Partners, Inc.
(the "Holders"). On October 21, 1995, the Senior Note, including accrued
interest, was not paid and therefore became due and convertible by the holder on
the same basis as the Convertible Senior Subordinated Note. The Subordinated
Notes mature on November 21, 2004 with interest payable semi-annually at 10
percent per annum. As of September 30, 1996, the Notes were convertible by the
holder at any time prior to maturity into approximately 421,095 shares of Junior
Convertible Preferred Stock, par value $.01 per share. The Junior Convertible
Preferred Stock is in turn convertible to Common Stock, par value $.01 per
share, of the Company. Subject to certain adjustments for future below market
stock issuances and similar events, the Subordinated Notes, if fully converted
for Common Stock, would be convertible into approximately 4.2 million shares of
Common Stock.

           Additionally, the Holders previously agreed to defer the payment of
interest due May 21, 1995 and November 21, 1995, and by amendment have also
agreed to defer all interest due through May 21, 1998. The amended agreement
provides for the issuance of additional notes (maturing on November 21, 2004) in
lieu of all such deferred interest payments. The effect as of September 30, 1996
of this deferral was to reclassify approximately $1.8 million of accrued
interest expenses to long-term debt under the Subordinated Notes, which
reclassification is reflected in the Company's financial statements. All of the
interest converted to principal will be subject to conversion rights on the same
terms and conditions as the original principal amount of the Subordinated Notes.


           The Holders are not entitled to voting rights as stockholders of the
Company. Upon conversion of the Subordinated Notes to Junior Convertible
Preferred Stock, the Holders are entitled to participate with Common Stock, on
an as-if converted basis, with respect to dividends, certain voting rights and,
upon liquidation, dissolution and winding up of the Company; provided, however,
that, except as required by law and as to matters which the Junior Convertible
Preferred Stock is entitled to vote separately as a class, the total voting
power of the Junior Convertible Preferred Stock will not represent more than
19.9 percent of the total voting power of the then outstanding Common Stock and
Junior Convertible Preferred Stock, taken together.

           The Company has the right to prepay the Subordinated Notes, subject
to certain provisions in the Company's credit facilities discussed in Note 7.
However, if prepayment occurs prior to November 21, 1999, and prior to the later
of a two year period ending November 21, 1996 or the "Positive Development
Trading Date", which date occurs after the Common Stock of the Company has
traded above $7.00 per share for ninety consecutive days, the Holder is entitled
to a prepayment premium of up to 5% which reduces over time. Additionally, the
Holders retain an exercise right, in the event prepayment occurs prior to the
later of November 21, 1996 and the "Positive Development Trading Date", to
purchase shares of 


                                       40
<PAGE>   41
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


Junior Convertible Preferred Stock, at the same terms as were
provided in the Subordinated Notes, within a one year exercise period. The
Company has filed a designation of a series of Junior Convertible Preferred
Stock of 470,000 shares and has reserved 4,700,000 shares of Common Stock in the
event of conversion of Junior Convertible Preferred Stock.


                                       41
<PAGE>   42
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 9 - LEASES

           The Company leases office space and various equipment under
non-cancelable leases expiring through 2001. For the year ended September 30,
1996, the transition period ended September 30, 1995, and the years ended
February 28, 1995 and 1994 total lease expense charged to operations was
approximately $6.0 million, $4.1 million, $7.1 million and $3.6 million,
respectively and includes rentals under short-term cancelable leases.

           As of September 30, 1996, future minimum rental payments required
under operating leases that have initial or remaining non-cancelable terms in
excess of one year are as follows (in thousands):

<TABLE>
               <S>                      <C>    
               1997                     $ 7,075
               1998                       5,747
               1999                       4,949
               2000                       3,278
               2001                         923
               Thereafter .............   1,996
                                        -------
                                        $23,968
                                        =======
</TABLE>


                                       42

<PAGE>   43
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 10 - INCOME TAXES

           Provision (benefit) for federal and state income taxes are comprised
of the following components (in thousands):

<TABLE>
<CAPTION>
                                                SEVEN MONTHS
                              YEAR ENDED            ENDED         YEARS ENDED FEBRUARY 28,
                             SEPTEMBER 30,      SEPTEMBER 30,     ------------------------
                                 1996               1995            1995             1994
                                -----               ----            ----             ----     
   <S>                       <C>                <C>               <C>                <C>
   Current                                                                                    
      Federal .........         $(519)              $ --            $405             $ --     
       State ..........           100                 87             153              135     
                                -----               ----            ----             ----     
                                 (419)                87             558              135     
                                                                                              
   Deferred:                                                                                  
      Federal .........            --                 --              --               --     
       State ..........            --                 --              --               --     
                                                                                              
   Total ..............         $(419)              $ 87            $558             $135     
                                =====               ====            ====             ====     
</TABLE>



                        (Space intentionally left blank)


                                       43
<PAGE>   44
                          SMITH TECHNOLOGY CORPORATION
             (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)



           Significant components of the Company's deferred tax assets and
liabilities are as follows (in thousands):

<TABLE>
<CAPTION>
                                                          SEPTEMBER 30,
                                                    ------------------------
                                                      1996            1995
                                                    --------         -------
   <S>                                              <C>              <C>    
   Deferred tax assets:
           Bad debt allowance .................     $     26         $   277
           Restructuring and related items ....        1,369           1,976
           Capital loss carryforward ..........        1,331           1,331
           Net operating loss carryforward ....        7,893           3,005
           AMT and other credits ..............          999             999
           Unconsolidated affiliates ..........          370             370
           Accrued liabilities ................        4,294           1,370
           Other ..............................        1,007           1,087
           Valuation allowance ................      (13,427)         (5,434)
                                                    --------         -------
              Total deferred tax assets .......        3,862           4,981
                                                    --------         -------
   Deferred tax liabilities:
           Property and equipment .............       (1,336)         (1,475)
           Cash to accrual ....................         (909)         (1,819)
           Other ..............................          (43)           (113)
           Goodwill ...........................       (1,574)         (1,574)
                                                    --------         -------
              Total deferred tax liabilities ..       (3,862)         (4,981)
                                                    --------         -------
              Net deferred taxes ..............     $     --         $    --
                                                    ========         =======
</TABLE>


           The Company had net operating loss and net capital loss carryforwards
for federal income tax purposes of approximately $19.7 million and $3.3 million,
respectively, at September 30, 1996. If unused, the net operating loss will
expire beginning in fiscal 2008. The capital loss carryforward, if unused, will
expire beginning in fiscal 1999. For financial reporting purposes, a valuation
allowance has been recorded to reduce the deferred tax asset related to these
carryforwards and other deferred tax assets, including approximately $1.3
million of deferred tax assets related to companies acquired during the year
ended February 28, 1995, net of deferred tax liabilities, to zero since the
realization of such amounts is not assured. Future tax benefits from the
carryforwards will reduce income tax expense when realized. Future tax benefits
associated with the unrecognized net deferred tax assets of the companies
acquired in fiscal 1995 will reduce goodwill when realized. Due to a greater
than 50 percent change in ownership of the Company within the past three fiscal
years, use of the preacquisition loss carryforwards to reduce future taxable
income will be limited to approximately $900,000 annually. Postacquisition
losses are not subject to any annual limitations.


                                       44
<PAGE>   45
                          SMITH TECHNOLOGY CORPORATION
            (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

           A reconciliation of income tax expense (benefit) to amounts computed
using federal statutory rates are shown below (in thousands):

<TABLE>
<CAPTION>
                                                              SEVEN MONTHS
                                              YEAR ENDED          ENDED
                                             SEPTEMBER 30,    SEPTEMBER 30,       YEAR ENDED FEBRUARY 28,
                                                                                 ------------------------ 
                                                1996              1995            1995             1994
                                               -------          -------          -------          -------
<S>                                            <C>              <C>              <C>              <C>
Income tax expense (benefit) computed
    at the federal statutory rate              $(7,173)         $    35          $   977          $(2,446)
Loss carryforward for which no benefit
   was provided                                  6,994               --               --            2,446
Utilization of previously unbenefited
   losses                                           --             (372)            (826)              --
Elimination of deferred taxes                       --               --               --
State taxes                                        100               87              100              135
Non-deductible goodwill amortization                97              142               69               --
Other                                             (437)             195              238               --
                                               -------          -------          -------          -------
Income tax expense (benefit)                   $  (419)         $    87          $   558          $   135
                                               =======          =======          =======          =======
</TABLE>


NOTE 11 - EMPLOYEE BENEFIT PLAN

           The Company has a defined contribution plan covering substantially
all employees. Under the plan, employees may make tax deferred voluntary
contributions which, at the discretion of the Company's Board of Directors, are
matched within certain limits by the Company. In addition, the Company may make
additional discretionary contributions to the plan as profit sharing
contributions. All contributions to the plan are limited by applicable Internal
Revenue Code regulations. For the year ended September 30, 1996, the seven
months ended September 30, 1995 and the year ended February 28, 1995, the
Company recorded matching contributions of $169,000, $147,000 and $161,000,
respectively. There were no Company contributions for year ended February 28,
1994. Of the amounts recorded during the year ended September 30, 1996 and the
seven month period ended September 30, 1995, $117,000 and $53,000 were made by
the contribution of Smith Technology Corporation common stock.

NOTE 12 - REDEEMABLE PREFERRED STOCK

           In connection with the acquisition of BCM, the Company authorized and
issued 78,000 shares of Redeemable Preferred Stock (the "Redeemable Preferred
Stock"). Each share has a $100 redemption value, is senior to the Company's
common stock and has a liquidation preference of $100 per share plus accrued and
unpaid dividends. The Redeemable Preferred Stock was recorded at its initial
fair value of $6,868,000 on the date of issuance. The excess of the redemption
value over the carrying value is being accreted to redemption value by periodic
charges to retained earnings using the interest method and an effective annual
rate of return of 7.5 percent. The Redeemable Preferred Stock has a 5.0 percent
per annum cumulative dividend payable quarterly. If the Company fails for any
reason to make a scheduled quarterly dividend payment on the Redeemable
Preferred Stock, the rate of the dividends shall increase from 5 percent per
annum to 7.5 percent per annum per share, and if failure to pay a quarterly
dividend occurs a second consecutive time, the rate of dividends shall increase
to 10 percent per annum per share. When all accrued 



                                       45
<PAGE>   46
                          SMITH TECHNOLOGY CORPORATION
            (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


but unpaid dividends have been paid in full at the adjusted rate, the dividend
rate for future dividends will return to the initial rate of 5 percent per
annum. The Company did not make the required June 30, 1996 or September 30, 1996
dividend payment when due. As a result, the dividend rate for the quarter ended
September 30, 1996 was increased to 7.5% and for quarters subsequent to
September 30, 1996, the dividend rate will be 10% until all accrued but unpaid
dividends are paid in full. The Redeemable Preferred Stock shall not have any
right or power to vote on any question or in any proceeding or to be represented
at any meeting of the Company's stockholders. The Company at its option may
redeem shares of Redeemable Preferred Stock, in whole or in part, at any time.
The Company is required to redeem at a redemption price of $100 per share plus
accrued but unpaid dividends, and to the extent such redemption payments are
permitted in accordance with the covenant set forth therein, no later than each
of the fifth, sixth and seventh anniversaries of the date of issuance of the
shares of Redeemable Preferred Stock, and not less than one-third of the total
shares originally authorized and issued. In the event the Company fails to make
a scheduled redemption payment, the redemption date for all remaining shares of
Redeemable Preferred Stock is accelerated and the rate of dividends increases to
15 percent per annum.

           The Redeemable Preferred Stock issued in connection with the
acquisition of BCM is principally held by the BCM Employee Stock Ownership and
Profit Sharing Plan (the ESOP) for the future benefit of vested participants.
Effective September 28, 1994, the ESOP was amended to fully vest all
participants who were employed by BCM on September 28, 1994 and to provide that
no further contributions are to be made to the ESOP. The Company has entered
into a Trust and Security Agreement which created a trust (the Trust) to provide
partial security for payment of certain current and future obligations of the
Company arising in connection with the acquisition of BCM, principally the
payment of dividends on and the redemption of the Redeemable Preferred Stock.
Participants become eligible for distribution of the Redeemable Preferred Stock
held for their account in the ESOP upon retirement, death, disability or in the
sixth year following termination of employment. The participants can put the
Redeemable Preferred Stock back to the Company at the $100 redemption value in
exchange for cash or cash and a subordinated promissory note. Payments to a
participant by the Company are limited to the greater of 20 percent of the
redemption value of the shares of Redeemable Preferred Stock or $10,000 per
year. Certain insurance policies on the lives of former and present employees of
BCM, with aggregate death benefits of approximately $41 million and an aggregate
cash surrender value (net of policy loans) of approximately $976,000, are held
by the Trust for the benefit of the beneficiaries. The Company is obligated to
contribute $100,000 each fiscal quarter to fund premium payments on the
insurance policies. The Company has not made contributions in the full amount
when due. However, sufficient contributions have been made to enable the trustee
to maintain all insurance policies in force through September 30, 1996. The
Trust will terminate after all secured indebtedness has been satisfied, and any
remaining assets will be returned to the Company.

           The Stock Repurchase Agreement provides that certain shares of the
Company's Redeemable Preferred Stock, put back to the Company, be repurchased
within 30 days of receiving the stock. At September 30, 1996 there was 3,245
shares of Redeemable Preferred Stock with a value of $324,532, which were put
back to the Company that was not repurchased in accordance with the agreement
nor within the cure periods provided therein. Therefore, these amounts have been
included in current liabilities.



                                       46
<PAGE>   47
                          SMITH TECHNOLOGY CORPORATION
            (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 13 - STOCK OPTION PLANS

           The Company has various plans which provide for the grant of
incentive awards to employees, advisors and non-employee directors. During
fiscal 1994, the 1986 Employee Stock Option Plan and the 1992 Non-employee
Directors Stock Option Plans were terminated except as to options then
outstanding. The terminated plans were replaced by the 1994 Stock Incentive Plan
and the 1994 Non-employee Directors Stock Option Plan (1994 Directors' Plan). A
maximum of 1,200,000 and 250,000 shares of the Company's common stock are
issuable in connection with awards granted under the 1994 Stock Option Incentive
Plan and 1994 Directors' Plan, respectively.

           The 1994 Stock Incentive Plan provides for the granting of incentive
stock options and other stock-based awards to key employees and advisors. The
exercise price of options granted under the plan is 100 percent of the fair
market value of common stock on the date the option is granted. Options become
exercisable as determined at the date of grant by a committee of the Board of
Directors and expire ten years after the date of grant unless an earlier
expiration date is set at the time of grant. At September 30, 1996, there were
160,851 shares outstanding pursuant to other stock-based compensation awards
under the plan.



                                       47
<PAGE>   48
                          SMITH TECHNOLOGY CORPORATION
            (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)




           The 1994 Non-employee's Directors' Plan provides for the granting of
options to acquire the Company's common stock to non-employee directors. The
exercise price of options granted under the plan is 100 percent of the fair
market value of common stock on the date the option is granted. Options become
exercisable one to four years after the grant date and expire ten years after
the date of grant unless an earlier expiration date is set at the time of grant.

           On September 19, 1996, the Company approved a plan whereby all option
Holders have the right to receive 1 option at the exercise price of $1.00 for
every 3 options held. The price of reissued stock options was determined by the
price of the Company's stock at the close of business on September 19, 1996.
Under the plan, 362,688 stock options were cancelled at option prices ranging
from $2.25 to $11.00 per share and 120,894 were reissued at $1.00 per share.

           The following table summarizes activity under the Company's stock
plans:

<TABLE>
<CAPTION>
                                                                                           Option Price
                                                     Shares                                 Per Share
                                                    ------------------          ----------------------------

<S>                                                 <C>                         <C>
     February 28, 1993..........................              774,250                     $3.40 -- $15.73
            Granted                                           369,000                     $2.88 -- $ 5.00
            Lapsed or canceled..................             (343,000)                    $2.88 -- $15.73
                                                    ------------------
     February 28, 1994                                        800,250                     $2.88 -- $15.73
            Granted                                           491,456                     $3.25 -- $ 7.00
            Exercised...........................             (106,689)                    $2.88 -- $ 5.00
            Lapsed or canceled..................             (307,862)                    $2.88 -- $15.73
                                                    ------------------
     February 28, 1995 .........................              877,155                     $2.88 -- $15.73
            Granted                                           327,400                     $5.38 -- $ 6.50
            Exercised...........................              (92,799)                    $2.88 -- $ 4.38
            Lapsed or canceled..................             (101,652)                    $2.88 -- $11.00
                                                    ------------------
     September 30, 1995                                     1,010,104                     $2.88 -- $11.00
            Granted                                           258,694                     $1.00 -- $ 5.63
            Exercised ..........................               (7,625)                    $3.75 -- $ 4.88
            Lapsed or canceled..................             (502,846)                    $2.25 -- $11.00
                                                    ------------------
     September 30, 1996                                       758,327                     $1.00 -- $ 7.75
</TABLE>


           At September 30, 1996, 619,322 shares of the Company's Common Stock
were reserved for future grant under the plans. At September 30, 1996, 1995, and
February 28, 1995 and 1994 options for 236,856, 191,247, 358,617 and 700,250
shares, respectively, were exercisable.



                                       48
<PAGE>   49
                          SMITH TECHNOLOGY CORPORATION
            (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)



NOTE 14 - COMMITMENT AND CONTINGENCIES

           The Company (previously known as Canonie Environmental Services
Corp.) filed suit in the Circuit Court, Multnomah County, Oregon in February
1995 against NL Industries, Inc., Gould, Inc., Johnson Controls, Inc., Exide,
Inc., AT&T Technologies, Inc., Rhone-Poulenc AG Co., and Burlington Northern
Railroad Co. (the "PRPs" or "PRP Group") for breach of contract dated May 28,
1992 for the remediation of soil on property located near Portland, Oregon (the
"Contract").

           In the suit, the Company sought recovery for amounts due as a result
of services performed under the Contract, including $1.5 million in accounts
receivable, $2.5 million of plant and equipment at the site, and other damages
resulting in a total claim of $8.5 million. Prior to the Company filing suit,
activity at the site had been suspended pending EPA approval of changes in the
remedial activities proposed by the PRPs and supported by independent
engineering reports which indicated significant differences in the waste
materials at the site from the materials specified in the EPA Record of Decision
and in the initial remedial investigation performed by others at the site. The
PRPs alleged the Contract required the dispute be arbitrated. The Company's
objections were overruled by the court and the court action was abated pending
arbitration before the American Arbitration Association. In the arbitration, the
PRPs sought reimbursement from the Company for amounts ranging from $3.4 million
to $18.0 million, under various damage theories relating to work performed by
the Company under the Contract alleging negligent performance and breach of
contract. The Company filed a counterclaim in the arbitration to recover the
damages claimed in the court action.

           On June 27, 1996 a Construction Industry Arbitration Tribunal of the
American Arbitration Association issued, with one dissenting opinion, a binding
award in favor of the PRPs in the amount of $4.5 million against the Company.
The counterclaim of the Company was denied; however, the Company's plant and
equipment at the site was awarded to the Company. The Company filed exceptions
and a motion to vacate the award with the Oregon Circuit Court which were
denied.

           On January 30, 1997, the Company and the PRP Group reached an
agreement for the resolution of the matter. The settlement agreement provides
for payment of the $4.5 million over a period of six years with interest at
twelve percent. The agreement provides semiannual payments which include
interest as follows: $150,000 in 1997; $300,000 in 1998; $584,000 in 1999;
$584,000 in 2000; $1,994,000 in 2001; and $3,786,000 thereafter. The agreement
also allows a discounted prepayment of $2.5 million on or before December 31,
1997 or $2.75 million on or before April 30, 1998 in complete satisfaction of
the obligation. The Company recorded a charge in fiscal 1996 of approximately
$9.7 million consisting of an obligation to the PRP Group of $4.5 million, the
write-off of $1.5 million of accounts receivable and $2.5 million of equipment,
and $1.2 million of related legal and consulting fees. The settlement agreement
provides that any proceeds from the sale of the equipment be applied to payment
of the settlement.



                                       49
<PAGE>   50
                          SMITH TECHNOLOGY CORPORATION
            (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)




           The Company has filed notice of a claim with its professional
liability, general liability, and property insurance carriers. The underwriter
of the general liability and professional liability coverage has filed an action
in the Supreme Court of the State of New York, New York County, requesting
relief from the Company's claims of coverage. The Company's professional
liability coverage includes a $500,000 self-insured retention requirement which
has been met by the Company through the costs of investigation and defense
related to this matter. The likelihood of recovery is unknown at this time.

           Transcontinental Realty Investors, Inc. filed an action against the
Company's subsidiary BCM Engineers Inc. (BCM) and various unrelated parties in
the Superior Court of New Jersey, Burlington County. The action sought to
recover alleged damages exceeding $8 million based on breach of contract and
negligence. An agreement has been reached by the plaintiff and the professional
liability carrier of BCM to resolve all claims. The insurance carrier will pay
the agreed settlement directly to the plaintiff. The Company's obligation is
limited to reimburse the insurance carrier for the balance of the unexpended
portion of a self-insured retention of approximately $215,000 in installments of
$50,000 payable quarterly beginning September 26, 1996, with final payment of
any remaining balance due on September 30, 1997.

           U-Max was awarded a judgment in the United States District Court for
the Middle District of Pennsylvania of $2 million against Stroud Township. The
Township has been granted a judgment of $1 million against the Company's
subsidiary, BCM Engineers Inc. (BCM). Stroud Township has appealed the judgment
against the Township and the $1 million judgment awarded in favor of the
Township against BCM. BCM's insurance coverage will respond to losses exceeding
a $500,000 deductible of which approximately $220,000 has been expended. On
November 27, 1996, BCM filed a notice of appeal to the United States Third
Circuit Court of Appeals with a motion to stay execution and/or enforcement on
the Township's judgment and to waive the posting of a supersedeas bond pending
BCM's appeal. The Company's counsel believes there are grounds for reversal or
modification of the judgment on appeal, however, the likelihood of obtaining
relief from the District Court judgment is unknown. The difference between the
insurance deductible and the amount expended of $280,000 is included in other
liabilities at September 30, 1996.

           A settlement agreement of the claim filed in the Court of Common
Pleas of Philadelphia County, Philadelphia has been reached with Mutual
Pharmaceutical Company, Inc. whereby BCM Engineers Inc. will be required to pay
the plaintiff for its out-of-pocket costs incurred to date for the site
investigation and carrying costs amounting to $207,000. This amount is to be
paid in 13 monthly installments beginning September 12, 1996 of $16,000 in lieu
of exposure to the remaining deductible and further litigation. The claim is
covered by BCM's professional liability coverage which carries a $500,000
deductible. The insurance carrier has approved the settlement agreement.
Additionally, the Company's subsidiary, BCM, will be responsible for performing
certain remediation services at the site to obtain a "No Further Action" letter
from the Pennsylvania Department of Environmental Protection. The estimated cost
of the services is $50,000. If BCM fails to pay the agreed amount or perform
under the agreement, the plaintiff reserves the right to recommence the
litigation and claim additional out-of-pocket costs. The agreement leaves open a
possible claim for diminution of property value up to $420,000 for up to 10
years and requires the Company and BCM to indemnify the plaintiff for any
third-party claims not to exceed $500,000 plus costs of defense until September,
2001. The Company is unaware of any third-party claims and has not been notified
of any claim of diminution of value of the site.




                                       50
<PAGE>   51
                          SMITH TECHNOLOGY CORPORATION
            (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


           In November 1993, second amended complaints and initial complaints
were filed in the Circuit Court, County of Jackson, Mississippi, which include
RES along with a number of other defendants in claims pending in 27 separate
civil actions. These civil actions involved approximately 219 plaintiffs and
include two wrongful death claims. Plaintiffs allege that RES was negligent in
transferring and clean-up activities of the chemical diethylamine released from
an overturned tanker. Settlements of the claims of eighty-seven plaintiffs have
been completed without contribution by RES; those claims will be dismissed
leaving one hundred thirty-two plaintiffs with claims remaining against RES,
including the two wrongful death claims. The special damages of remaining
plaintiffs are approximately $800,000, not including unstated general damages.
RES will be entitled to a credit for payments made by settling defendants
allocated against any remaining plaintiffs. The Company's pollution liability
coverage, having an aggregate of $1 million, is paying the costs of
investigation and defense and will respond to losses up to the coverage balance
less those costs. The Company is vigorously defending the described litigation.
No provision for loss, if any, has been recorded at September 30, 1996.

           In December 1995, BellSouth filed a complaint for unstated damages in
the Circuit Court, Jefferson County, Alabama against the Company, its subsidiary
BCM Engineers Inc. (BCM) and Canonie Technologies, Inc. The complaint, alleging
professional negligence, fraudulent and negligent misrepresentation,
non-disclosure, innocent misrepresentation and breach of contract, arises out of
BCM's alleged failure to provide oversight and certification of services
performed by BellSouth's asbestos abatement contractors. The plaintiff claims it
has expended an additional $1.6 million to perform asbestos removal which
allegedly was to have been performed by its prior contractor. The matter is
being investigated and discovery is being conducted. BCM believes its services
were performed in compliance with all legal requirements, that it has been
released from BellSouth claims, and that a substantial amount of the claims are
barred by statute of limitations. The Company is vigorously defending the
matter. No provision for loss, if any, has been recorded at September 30, 1996.

           Stroudsburg Municipal Authority has filed a claim in the Monroe
County, Pennsylvania, Court of Common Pleas for damages exceeding $500,000 based
on allegations of breach of contract and negligent performance of design
services. The Company and its professional liability carrier are investigating
the claim.

           The Company is currently a party to other litigation and claims
incidental to its business. The Company believes that these matters are
adequately accrued or covered by insurance, are without merit or the disposition
thereof is not anticipated to have a material effect on the Company's financial
position; however, one or more of these matters, individually or in the
aggregate could have a material adverse effect on future quarterly or annual
results of operations or cash flow when resolved.



                                       51
<PAGE>   52
                          SMITH TECHNOLOGY CORPORATION
            (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)




NOTE 15 - SPECIAL ITEMS

           Special items were $11.8 million for the year ended September 30,
1996 and include a charge associated with the NL Industries arbitration
settlement of $9.7 million (Note 14), additional acquisition legal settlement
and associated defense costs of approximately $900,000 and costs of $1.2 million
associated with the further consolidation of facilities, including related
personnel severance and relocation costs. The Company recorded $10.6 million of
these special items including $8.9 million related to the arbitration settlement
in the fourth quarter of fiscal 1996. In September, 1995, the Company incurred
$393,000 in severance and relocation costs in connection with the Company's
continuing effort to reduce operating costs.

           In the second and fourth quarters of fiscal 1994, the Company
recorded special items aggregating $9.3 million associated with management's
focus on resolving ongoing operational issues, such as project specific claims
issues, investments in non-core business activities, and new information
systems, staff reductions and office closings. Of the $9.3 million of aggregate
special items, $2.3 million was attributable to additional costs and changes in
profit estimates related to construction contracts and is included in cost of
revenues and $2.7 million related primarily to the write-off of the Company's
equity method investment in LRC, a joint venture formed to develop an
incinerator and is included in losses of unconsolidated affiliates. The
remaining $4.3 million in charges is included in special charges. Included in
the special items were $2.4 million of restructuring charges resulting from
office closures and severance costs aggregating $1.8 million and the write-off
of an investment in a non-core business no longer fitting the strategic
direction of the Company of approximately $600,000. The effect of the office
closures and restructuring charges was to eliminate the costs of operating
certain offices in fiscal 1995 and thereafter. These costs, primarily indirect
costs classified in cost of revenues, aggregated $2.3 million in fiscal 1994.
Since the offices were closed and staff reductions occurred in March and April
of 1994, the first two months of the fiscal year, savings were realized
immediately and for virtually all of fiscal 1995. Additionally in 1994, there
were other special charges which included an asset write-off resulting from the
implementation of a new information system of approximately $400,000, a
writedown of process equipment determined to have impaired value of
approximately $500,000, and an accrual of costs associated with litigation of
$1.0 million.



                                       52
<PAGE>   53
                          SMITH TECHNOLOGY CORPORATION
            (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)



NOTE 16 - UNAUDITED CONSOLIDATED STATEMENT OF OPERATION FOR THE TWELVE MONTHS 
          ENDED SEPTEMBER 30, 1995

The table below lists the consolidated statement of operations for the year
ended September 30, 1996, the unaudited twelve month period ended September 30,
1995 and the unaudited seven month period ended September 30, 1994.





<TABLE>
<CAPTION>
                                                              YEAR ENDED             12 MONTHS ENDED          SEVEN MONTHS ENDED 
                                                          SEPTEMBER 30, 1996       SEPTEMBER 30, 1995         SEPTEMBER 30, 1994
                                                              (UNAUDITED)              (UNAUDITED)               (UNAUDITED)
                                                              -----------              -----------               -----------

<S>                                                           <C>                      <C>                       <C>         
 Revenues ...........................................         $   164,382              $   166,257               $    43,771
 Cost of revenues ...................................             152,735                  145,723                    38,006
                                                              -----------              -----------               -----------
        Gross profit ................................              11,647                   20,534                     5,765
                                                                                                                            
 Selling, general, and administrative expenses ......              14,218                   13,327                     4,192
 Amortization of intangibles, goodwill and                                                                                  
       deferred financing fees ......................               1,957                    1,535                        --
 Special items ......................................              11,811                      393                        --
                                                              -----------              -----------               -----------
                                                                                                                            
 (Loss) income from operations ......................             (16,339)                   5,279                     1,573
                                                                                                                            
 Interest expense ...................................               4,417                    3,413                        41
                                                              -----------              -----------               -----------
 Income before share in earnings of unconsolidated                                                                          
          affiliate and income tax ..................             (20,756)                   1,866                     1,532
                                                                                                                            
 Share in earnings of unconsolidated affiliates .....                 375                      103                       263
                                                              -----------              -----------               -----------
 (Loss) income before taxes and extraordinary item ..             (20,381)                   1,969                     1,795
                                                                                                                            
Income tax (benefit) expense ........................                (419)                     310                       335
                                                              -----------              -----------               -----------
(Loss) income before extraordinary item .............             (19,962)                   1,659                     1,460
                                                                                                                            
Extraordinary charge on debt refinancing ............              (1,395)                      --                        --
                                                              -----------              -----------               -----------
                                                                                                                            
Net (loss) income ...................................             (21,357)                   1,659                     1,460
Dividends and accretion on redeemable
         Preferred Stock.............................                 587                      552                        --
                                                              -----------              -----------               -----------
                                                                                                                            
Net (loss) income applicable to Common Stock ........         $   (21,944)             $     1,107               $     1,460
                                                              -----------              -----------               -----------
                                                                                                                            
Weighted average number of common and common                                                                                
        equivalent shares outstanding ...............           5,978,084                5,897,881                 5,782,100
                                                                                                                            
(Loss) earnings per common and common                                                                                       
    equivalent share before extraordinary item ......         $     (3.44)             $       .19               $       .25
                                                              -----------              -----------               -----------
                                                                                                                            
(Loss) earnings per common and common equivalent                                                                            
       share ........................................         $     (3.67)             $       .19               $       .25
                                                              -----------              -----------               -----------
</TABLE>


          See accompanying notes to consolidated financial statements.


                 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS


                                       53
<PAGE>   54
                          SMITH TECHNOLOGY CORPORATION
            (FORMERLY SMITH ENVIRONMENTAL TECHNOLOGIES CORPORATION)

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                                            NET (WRITE-OFFS)        
                                            BALANCE AT                        CHARGED         RECOVERIES       BALANCE AT
                                            BEGINNING         OTHER             TO              CHARGED          END OF
                                            OF PERIOD        RESERVES         EXPENSE       AGAINST RESERVE      PERIOD
                                            ---------------------------------------------------------------------------
<S>                                         <C>              <C>               <C>             <C>             <C> 
ALLOWANCE FOR DOUBTFUL ACCOUNTS:
Year-Ended September 30, 1996 ............    $1,502         $   --            $  118          $ (791)         $  829
Seven Months Ended September 30, 1995.....     1,312            442(b)            124            (376)          1,502
Year Ended February 28, 1995 .............       485          1,188(a)            165            (526)          1,312
Year Ended February 28, 1994 .............     1,300             --              (122)           (693)            485
</TABLE>

-----------

(a) Additional reserves recognized with the acquisitions of BCM Engineers $(777)
    and Riedel Environmental Services $(411)

(b) Additional reserves recognized as a result of the finalization of the
    purchase price allocation.


                                       54
<PAGE>   55
ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

             (a)  Exhibits

                      10.36         Fifth Amendment, Waiver and Consent dated as
                                    of April 21, 1997 by and among the
                                    Registrant, BCM Engineers Inc. (a
                                    Pennsylvania corporation), BCM Engineers
                                    Inc. (an Alabama corporation) Riedel
                                    Environmental Services, Inc. and The Chase
                                    Manhattan Bank (formerly known as Chemical
                                    Bank), as agent for the lenders.

                      11            Statement regarding computation of earnings
                                    per share.

                      27            Requirements for the format and input of
                                    financial data schedules (EDGAR version
                                    only).


               (b)  Reports on Form 8-K

                      Form 8-K dated October 30, 1996 was filed on January 9,
                      1997 in connection with (i) the Execution of the Fifth
                      Amendment to the Forbearance Agreement dated June 7, 1996
                      by and among the Registrant, BCM Engineers Inc., a
                      Pennsylvania corporation, BCM Engineers Inc., an Alabama
                      corporation, Riedel Environmental Services, Inc., and
                      Chemical Bank, as Agent for the Lenders, (ii) the
                      execution of the Sixth Amendment to the Forbearance
                      Agreement dated June 7, 1996 by and among the Registrant,
                      BCM Engineers Inc., a Pennsylvania corporation, BCM
                      Engineers Inc., an Alabama corporation, Riedel 
                      Environmental Services, Inc., and Chemical Bank, as 
                      Agent for the Lenders.

                      Form 8-K dated December 30, 1996 was filed on January 21,
                      1997 in connection with (i) the execution of the Fourth
                      Amendment and Waiver to the Loan and Security Agreement
                      dated as of January 14, 1997 by and among the Registrant,
                      BCM Engineers Inc., a Pennsylvania corporation, BCM
                      Engineers Inc., an Alabama corporation, Riedel
                      Environmental Services, Inc., and Chemical Bank, as Agent
                      for the Lenders, (ii) the Third Amended and Restated Note
                      Purchase Agreement effective January 13, 1997 between the
                      Registrant and 399 Venture Partners, Inc., (iii) the
                      Seventh Amendment to the Forbearance Agreement made as of
                      December 30, 1996 by and among the Registrant, BCM
                      Engineers Inc., a Pennsylvania corporation, BCM Engineers
                      Inc., an Alabama corporation, Riedel Environmental
                      Services, Inc., and Chase Manhattan Bank, as Agent for the
                      Lenders, and (iv) an announcement of the Company's delay
                      in filing its Form 10-K which filing was due on December
                      29, 1996 and extended to January 14, 1997. The Company has
                      not filed its Form 10-K for the twelve month period ended
                      September 30, 1996.

                      Form 8-K dated February 28, 1997, was filed on March 10,
                      1997, in connection with the execution of a letter of
                      intent for the sale of accounts receivable and other
                      assets related to the Company's operations conducted in
                      Mobile, Alabama; Panama City, Florida; and Dallas, Texas.



                                       55
<PAGE>   56
                                   SIGNATURES



Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.


                           Smith Technology Corporation  
                            (Registrant)

                           By:  /s/  William T. Campbell
                                ------------------------------------
                                     William T. Campbell
                                     Senior Vice President - Finance

Date:  May 15, 1997



                                       56