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================================================================================

                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

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

                                   FORM 10-K

[X]   ANNUAL REPORT ON FORM 10-K PURSUANT TO SECTION 13 OR 15 (D)
                    OF THE SECURITIES EXCHANGE ACT OF 1934

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

                                      OR

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

                         COMMISSION FILE NO. 33-97722

                          NEUROMEDICAL SYSTEMS, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

                DELAWARE                                  13-3526980
     (STATE OR OTHER JURISDICTION OF                   (I.R.S. EMPLOYER
     INCORPORATION OR ORGANIZATION)                   IDENTIFICATION NO.)

   TWO EXECUTIVE BOULEVARD, SUITE 306
           SUFFERN, NEW YORK                               10901-4164
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                   (ZIP CODE)


                                (914) 368-3600
             (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

       SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE

          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

                        COMMON STOCK, $0.0001 PAR VALUE
                               (TITLE OF CLASS)

                        PREFERRED STOCK PURCHASE RIGHTS
                               (TITLE OF CLASS)

  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 [X] No [_]

  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [_]

  The aggregate market value of the common stock, $0.0001 par value, of the
registrant (the "Common Stock") held by nonaffiliates as of March 1, 1998 was
approximately $58,265,800. For purposes of the foregoing calculation only, all
directors and officers of the registrant, and Goldman, Sachs & Co. and its
related affiliates, have been deemed affiliates of the Company. As of March 1,
1998 an aggregate of 31,055,846 shares of Common Stock were outstanding.

  This Annual Report on Form 10-K incorporates by reference Part III of the
registrant's 1998 Definitive Proxy Statement filed pursuant to Regulation 14A.

================================================================================
<PAGE>

                           NEUROMEDICAL SYSTEMS, INC.

                               TABLE OF CONTENTS
     ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

<TABLE>
<CAPTION>
                                                                            PAGE
                                                                            ----
 <C>      <S>                                                               <C>
 PART I
 Item  1. Business.......................................................     3
 Item  2. Properties.....................................................    19
 Item  3. Legal Proceedings..............................................    20
 Item  4. Submission of Matters to a Vote of Security Holders............    21
 Executive Officers of the Registrant.....................................   21
 PART II
 Item  5. Market for Registrant's Common Equity and Related Stockholder
           Matters.......................................................    24
 Item  6. Selected Financial Data........................................    25
 Item  7. Management's Discussion and Analysis of Financial Condition and
           Results of Operations.........................................    25
 Item  8. Financial Statements and Supplementary Data....................    33
 Item  9. Changes in and Disagreements with Accountants on Accounting and
           Financial Disclosure..........................................    34
 PART III
 Item 10. Directors and Executive Officers...............................    34
 Item 11. Executive Compensation.........................................    34
 Item 12. Security Ownership of Certain Beneficial Owners and Management.    34
 Item 13. Certain Relationships and Related Transactions.................    34
 Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
           8-K............................................................   34
 Signatures...............................................................
</TABLE>

                                       2
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                                    PART I

ITEM 1. BUSINESS

OVERVIEW

  Neuromedical Systems, Inc., a Delaware corporation (the "Company") is a
healthcare technology company focused on bringing intelligent vision to
medicine. It is the Company's objective to become the premier supplier of
cytology screening and anatomic pathology diagnostic equipment and services to
laboratories. The Company's first and, to date, only product, the PAPNET(R)
Testing System, is a sophisticated interactive computer assisted system that
assists the laboratory professional in the detection of abnormal cells on
cervical cytology specimens (also known as Pap smears). Since its inception,
the Company has been primarily engaged in the development, manufacturing and
marketing of the PAPNET Testing System, and the scanning of Pap smears at its
slide processing facilities.

  In the United States, the PAPNET Testing System is promoted to assist the
cytology professional in the examination of conventionally prepared smears
that have first been assessed by standard manual microscopic review to be
"negative," "within normal limits", or evidencing "benign cellular changes."
Outside of the U.S., some of the Company's laboratory customers use the PAPNET
Testing System in a variety of modes, including to assist in the
interpretation of liquid-based Pap specimens, and Pap smears that have not
first been assessed by manual microscopic review.

  As discussed in greater detail below, the PAPNET system may be purchased or
leased by the laboratory customer in its entirety or individual components, or
accessed on a patient-by-patient basis.

THE CERVICAL PAP SMEAR OPPORTUNITY

  Background. Cancer of the uterine cervix is preceded by a series of curable
stages that may progress without symptoms over a period of years until
reaching an invasive stage. Treating uterine cervical cancer after it has
reached the invasive stage becomes more difficult and expensive, and by then
it is not always curable. The Pap test, developed in the 1940s by Dr. George
N. Papanicolaou, is an effective manual screening procedure for the early
detection of precancerous and cancerous conditions of the uterine cervix. The
Pap test's goal is to reveal early changes in cervical cells that precede or
indicate the development of cancer, thereby facilitating timely medical
intervention to prevent or treat cervical cancer.

  With early detection, treatment is relatively inexpensive and almost always
successful. According to the American Cancer Society, the Pap test has been
the primary factor in a 70% reduction in the death rate from cervical cancer
over the past 40 years in the United States.

  Pap smears are widely used in North America, Europe and other developed
areas to aid in the early detection of cervical cancer and precancerous
conditions. The Company estimates that there are more than 50 million Pap
smears screened annually in the United States alone, and at least that number
screened annually outside the United States.

  The Company estimates that American laboratories diagnose more than
2,000,000 cases of cervical abnormalities each year. The American Cancer
Society ("ACS") estimates that there will be approximately 13,700 new cases of
invasive cervical cancer diagnosed in the United States in 1998. The Company
estimates that there will be approximately 65,000 cases of cervical carcinoma
in situ in 1998. In situ cancers are localized lesions which have not yet
invaded the surrounding underlying tissues. If treated at this stage,
carcinoma in situ will not progress and metastasize (spread beyond the local
area) into other parts of the body. Women diagnosed with carcinoma in situ
typically are treated by ablative therapy, conization (removal of a portion of
the cervix) or hysterectomy, and women diagnosed with invasive cervical cancer
are treated with hysterectomy and/or radiation. According to ACS,
approximately 4,900 women are expected to die of the disease in the United
States in 1998. Outside of the United States, where cervical cancer screening
is less prevalent, more than 450,000 new

                                       3
<PAGE>

cases of cervical cancer are diagnosed each year. Almost all deaths--and much
of the morbidity--due to cervical cancer could be prevented by early-stage
detection and treatment.

  Pap smear preparation and evaluation. To prepare a conventional Pap smear, a
gynecologist, general practitioner or other healthcare provider scrapes the
surface of a woman's uterine cervix to collect a sample of cells. The specimen
is smeared onto a 1 (inch) X 3 (inch) slide and preserved with a fixative agent
such as alcohol. The Pap smear, along with patient information, is then sent to
a laboratory for staining, cover-slipping, screening and diagnosis.

  At the laboratory, a cytotechnologist (a healthcare professional with
special training in the examination and interpretation of human cells)
conducts a microscopic review of the Pap smear to determine the adequacy of
the sample and the presence of any abnormal cells. In determining sample
adequacy, cytotechnologists classify each slide as (i) satisfactory for
evaluation; (ii) satisfactory but limited by certain characteristics; or (iii)
unsatisfactory for evaluation.

  After determining the adequacy of the sample, the cytotechnologist manually
screens each Pap smear slide with a microscope to differentiate abnormal cells
from normal cells on the basis of size, shape and structural details of the
cells and their nuclei. Each Pap smear slide is then classified, typically in
accordance with the Bethesda System for Reporting Cervical/Vaginal Cytologic
Diagnoses (the "Bethesda System") into one of the following categories: (i)
"within normal limits"; (ii) "benign cellular changes"; (iii) Atypical
Squamous Cells of Undetermined Significance/Atypical Glandular Cells of
Undetermined Significance ("ASCUS/AGUS"); (iv) Low Grade Squamous
Intraepithelial Lesions ("LGSIL"); (v) High Grade Squamous Intraepithelial
Lesion ("HGSIL"); and (vi) carcinoma. Any slide classified as other than
within normal limits or benign cellular changes is considered abnormal and may
reflect cell changes that precede the onset of cancer, or cancer itself.
Abnormal slides are typically referred to a senior cytotechnologist and
pathologist for further review and final diagnosis.

  Treatment following an abnormal Pap smear report. Women with abnormal Pap
smears are usually notified to return to their clinician's office for a repeat
Pap smear (generally in the case of "ASCUS" reports) or to undergo colposcopy
and biopsy procedures (generally in the case of all other classifications). To
perform a colposcopy, a clinician uses a device called a colposcope to
visually examine the surface of the cervix. If the clinician sees evidence of
an abnormal condition (a "lesion"), the clinician usually will take a sample
of tissue (a "biopsy") for review by a pathologist. The pathologist's biopsy
report constitutes the definitive diagnosis of the abnormal condition, and
guides subsequent treatment.

  Treatment of early-stage non-invasive cervical cancer may be accomplished by
simple or involved procedures to remove the lesion, depending on its size,
nature and location. Once the cancer reaches the invasive stage, the patient's
chances for recovery may be reduced and more radical treatment is typically
required, such as a hysterectomy and/or radiation. These procedures may expose
the patient to risk and result in significant physical and psychological
stress.

  False negative and false positive Pap smear results. A "negative" Pap smear
result predicts the absence of cervical disease. An abnormal (or "positive")
Pap smear predicts the presence of cervical disease. Definitive diagnosis of
the presence of abnormality is confirmed by colposcopy and/or biopsy.

  As discussed in greater detail below, a negative Pap smear result does not
perfectly predict the absence of disease. When it does not, the Pap smear
result is a "false negative." Similarly, a positive Pap smear result does not
perfectly predict the presence of disease that will be confirmed on colposcopy
and biopsy. When it does not, the Pap smear result is a "false positive."

  False negative results pose the greatest health risk for the female patient,
because the lesion that is present inside her may grow and spread undetected,
and thereby progress from an easily treatable condition to a life-

                                       4
<PAGE>

threatening condition. By the time the disease is symptomatic, treatment will
be more invasive, more expensive, and less likely to succeed.

  False positives generally do not pose a significant health risk to the
patient, although they may lead to inconvenience and anxiety that could have
been avoided. In addition, overtreatment associated with false positives may
adversely impact fertility and competence of the cervix.

  Generally speaking, the relative magnitude of economic impact to the health
care system is greater with respect to false positives than false negatives,
because false positives often lead to a large number of expensive, but
ultimately unnecessary, medical procedures.

  Unfortunately, conventional methods to reduce false negatives (erring on the
side of conservativism in Pap smear diagnoses, for example), can increase the
number of false positives. Similarly, conventional methods to reduce false
positives (reducing the number of ambiguous smears reported as "ASCUS," for
example), can increase the number of false negatives. This tension has sparked
a sometimes passionate debate between those who would commit more resources to
avoid false negatives, and those who would reduce false positives in order to
conserve funds for other uses (including the recruitment of women who do not
regularly receive a regular Pap smear). As discussed in greater detail below,
the Company believes that its technology can contribute to a resolution of the
tension between the adverse medical consequences of false negatives, and the
adverse financial consequences of false positives.

  The causes and consequences of false negative Pap smear results. There is
enormous controversy within the healthcare community over the causes of false
negative Pap smear results, the correct way to define false negatives, the
best way to measure the number and magnitude of false negatives, and the
actual health consequences that flow from false negatives. Notwithstanding the
controversy, the Company believes that there is substantial consensus in the
scientific literature on the causes of false negatives, and considerable
evidence that false negative Pap smear results can result in substantial
adverse health consequences, including death, for the patients who are
affected by them.

  False negative results derive from deficiencies in sampling, screening, and
interpretation. There is no agreement as to which of these causes is the most
significant. However, cytopathologists generally agree that both sampling and
screening deficiencies are a significant source of false negatives, and that
errors of interpretation constitute a less common source of false negatives.

  Sampling deficiencies occur as a consequence of either (i) a deficient
transfer of cells or (ii) deficient preparation. A deficient transfer of cells
means that either abnormal cells do not transfer from the cervix to the
clinician's sampling device, or abnormal cells of the lesion on the sampling
device do not transfer to the slide. Deficiencies in slide preparation can
result for several reasons: the clinician deposits cells on to the slide in
thick clumps (which are difficult for the cytotechnologists to analyze), the
clinician deposits too few cells on the slide, or the smear dries in the air
before the clinician fixes it in alcohol. Air drying can cause an artificial
distortion of the size and shape of cells, which makes it more difficult to
determine whether abnormalities exist.

  The medical literature and industry participants define sampling false
negatives in different ways. Some commentators and participants believe that a
sampling false negative occurs when very few abnormal cells exist on the Pap
smear slide, or when those cells are obscured by blood or mucus. Others
believe that a sampling false negative occurs when there is a complete absence
of abnormal cells on the slide, notwithstanding the presence of a lesion in
the patient's cervix.

  PAPNET-assisted screening can help the laboratory prevent the first type of
sampling false negative, since in some cases a cytotechnologist using the
PAPNET technology can locate abnormal cells present on the specimen even when
they are scarce or obscured. Manufacturers of liquid-based preparation systems
hold that their products can potentially address both types of sampling false
negatives, and can substantially eliminate the distortions of air-drying.

                                       5
<PAGE>

  A screening false negative occurs when abnormal cells are present on the
slide, but the laboratory does not detect their presence. Screening false
negatives are the inevitable consequence of manual microscopic cytology
screening.

  Unlike most other high-volume laboratory tests (which have become
automated), the cytological examination of the Pap smear is performed manually
through visual examination of cells. Cytotechnologists screen up to 100 Pap
smears per day using standard light microscopes, usually at 100x
magnification. Each of these Pap smears may contain hundreds of thousands of
normal cells. The relatively few Pap smears that are abnormal may contain only
a very small number of abnormal cells (sometimes fewer than 100) scattered
among the vast number of normal cells. The manual screening of Pap smears has
been appropriately characterized as a taxing and challenging task. Given
inevitable lapses in vigilance and the effects of habituation,
cytotechnologists will eventually overlook some evidence of abnormality while
screening. As a result, manual screening false-negative rates ranging from 5%
to 40% of true positives have been commonly reported in the medical literature
over the last 20 years.

  There is enormous controversy over the extent of the adverse health
consequences that flow from false negative Pap smear results. On the one hand,
those that are concerned about the impact of negative results on individual
patients argue that false negatives can have extremely serious adverse health
consequences to particular affected women. On the other hand, those who
consider the issue from a population perspective argue that the majority of
false negatives are not of great consequence because most lesions will regress
spontaneously, or the disease will not progress significantly before it is
detected in a subsequent Pap smear.

  The National Cancer Institute has reported that as many as 40% of the women
who suffer from invasive cervical cancer had a Pap smear within the previous
five years. Since it is generally believed five years is less than the usual
time for cervical cancer to develop, many of these women may have had an
abnormality that went undetected.

  PAPNET-assisted screening can significantly reduce screening false
negatives, as discussed in greater detail below. Indeed, in 1996 the Food and
Drug Administration (the "FDA") approved the additional product claim that
PAPNET testing of routine presumed negative Pap smears can be conservatively
expected to identify seven times more false negatives when compared with
manual quality-control rescreening of the same number of smears. Other studies
have confirmed that PAPNET-assisted rescreening of presumed negative smears
can detect more false negatives than manual screening alone, although at
different proportionate increases.

  The causes and consequences of false positive Pap smear results. False
positive Pap smear results occur in part because cytology screening is
inherently subjective and does not generate perfectly reproducible results.
False positives occur in great numbers because many smears may appear abnormal
but do not necessarily predict the presence of a precancerous lesion in the
cervix. Many of these smears are reported as indicating "atypical squamous
cells of uncertain significance," or "ASCUS" (industry sources estimate that
every year as many as 2,000,000 smears are diagnosed as ASCUS or the
equivalent in the United States alone). The medical literature suggests that
only 20-30% of ASCUS smears will be associated with a detectable lesion on
biopsy. Many clinicians are of the opinion that the reason that the rate of
ASCUS reporting is so high is because laboratories would rather err by
reporting false positive results than by reporting false negative results.

  An ASCUS report from the laboratory imposes a serious dilemma on the
treating clinician. If the clinician decides to colposcope and/or biopsy all
patients with ASCUS smear reports, a great deal of economic resources will be
used to find a relatively small amount of cervical disease. However, if the
clinician elects to follow patients with ASCUS results with less aggressive
treatment (such as more frequent gynecological examinations and Pap smears),
the clinician and the patient run the risk that a lesion will go undetected
and progress to the point that treatment is more invasive and/or less likely
to be successful. The Company estimates that over $1 billion is spent every
year in the United States alone to colposcope or otherwise follow patients who
have had ASCUS Pap smear reports.


                                       6
<PAGE>

  The Company believes that in those parts of the world where laboratories may
use the PAPNET system to assist in the primary screening of cervical
specimens, PAPNET-assisted screening can help laboratories lower their ASCUS
rates by assisting in the detection of precancerous or cancerous lesions that
then allows the laboratory to report the results with a more definitive
classification than ASCUS or its equivalent. Indeed, three separate and
independent studies have shown that PAPNET-assisted review of supposed ASCUS
cases can detect evidence of squamous intraepithelial lesions (LGSIL and
HGSIL) on 18% to 35% of such smears. These studies suggest that PAPNET-
assisted screening may be a useful means for determining the manner of follow-
up treatment of ASCUS smears. However, it is not expected that use of the
PAPNET system with ASCUS smears will be approved by the FDA for the Company's
customers in the United States until the PAPNET system is approved, if it is
approved, for the primary screening of Pap smears.

THE PAPNET TESTING SYSTEM--ITS USE BY THE LABORATORY

  In General. The PAPNET Testing System is a computerized image processing
system, which can be purchased by the laboratory as a service through one of
the Company's central Scanning Centers, or outside of the United States as
equipment for installation in the laboratory (under the brand name PAPNET-on-
Cyte(TM)). Laboratories may use PAPNET on a reflexive, patient-specific basis
(that is, at the request of the particular patient's clinician) or routinely
(that is, for every patient as a standard part of the laboratory's screening
process). In the United States, the system is approved only for review of
conventional Pap smears previously assessed as "negative," "within normal
limits," or evidencing "benign cellular changes." Outside of the United
States, the system is generally available for use by the laboratory customer
in accordance with the professional judgment of its supervising pathologists,
and can therefore be used for the primary screening of cervical smears,
including both conventional and liquid-based preparations.

  Slides designated for PAPNET-assisted screening are first scanned on a
PAPNET Scanning Station, which may reside in the laboratory (in the case of
PAPNET-on-Cyte systems) or at an NSI Scanning Center. The PAPNET Scanning
Stations' proprietary image processing and neural network computers are
designed to scan the hundreds of thousands of cells on the typical Pap smear
in order to select color images of 128 potentially abnormal cells and cell
clusters from each slide (whether or not such cells are, in fact, abnormal).
These 128 images from each slide are recorded on a digital tape cassette or
CD-ROM, or downloaded directly from the Scanning Station to the Review Station
in the case of PAPNET-on-Cyte systems.

  At the customer laboratory, a certified cytotechnologist specially trained
in PAPNET-assisted screening uses the PAPNET Review Station to evaluate the
128 color images from each slide. The PAPNET Review Station's software ensures
that the cytotechnologist displays each image at 200x magnification (twice
normal screening power) and permits the cytotechnologist to expand any image
to 400x magnification. If all of the images appear normal, the
cytotechnologist classifies the slide as "negative," and no further
examination is required. Customers and independent investigators have reported
that cytotechnologists experienced in the use of the PAPNET Review Station can
review cases in substantially less time than it takes to perform a
conventional manual microscopic review.

  If any one of the 128 images appears to be abnormal, the cytotechnologist
classifies the slide as requiring "review." The cytotechnologist then refers
to the "x, y" coordinates provided with each PAPNET image and uses the
coordinates as a reference point to re-examine the slide directly through the
microscope. If, after direct microscopic inspection, the cytotechnologist
continues to believe that the slide contains abnormal cells, he or she refers
the slide to the laboratory's pathologist for a final diagnosis. In no case
does the PAPNET Testing System make a diagnosis of a slide or smear.

  In the United States. The PAPNET Testing System is used in the United States
as a supplement to current practice and does not require alteration of the
clinician's procedure for the taking of Pap smears, or the laboratory's method
of staining or applying the cover slip. The system provides an additional and
complementary level of screening for the purpose of decreasing false negative
Pap smear diagnoses.


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<PAGE>

  The clinical trial conducted to support the Company's FDA premarket approval
application involved a study of more than 10,000 Pap smears originally
classified as "negative" and retrieved from laboratory archives. The trial
measured the ability of PAPNET testing to assist in the detection of missed
abnormalities on Pap smears previously diagnosed as "negative" from a
population of women who nevertheless subsequently developed high grade lesions
or invasive cervical cancer (the "Case" group). The system was also used to
re-examine "negative" Pap smears from arbitrarily selected women who were not
known to have developed cervical lesions or cancer (the "Control" group). The
trial results indicated that, when used as an adjunct to manual screening,
PAPNET testing can increase the aggregate cervical abnormality detected by up
to 30% when compared with the combination of manual screening and routine
manual quality control rescreening. The trial results also demonstrated that
PAPNET testing assisted in the detection of abnormality which had been
originally missed by manual screening for 31.6% of the Case group. For 91.7%
of such women, PAPNET testing would have found the abnormality more than a
year prior to the biopsy that confirmed the patient's disease, and, for 38.9%
of such women, more than two years earlier.

  In 1996, the Company received an additional claim from the FDA that shows
that PAPNET testing of routine presumed negative Pap smears can be
conservatively expected to identify seven times more false negatives when
compared with manual quality control rescreening of the same number of smears.

  During 1998, the Company plans to initiate a multi-site prospective clinical
trial designed to support an application to the FDA for approval to promote
the PAPNET system for primary screening in the United States.

  Outside the United States. Outside of the United States, the Company's
customer laboratories use the PAPNET system in a variety of different ways,
including as a reflexive rescreening device (as in the United States) and as a
primary screening device that is fully integrated into the laboratory's
processes. The United Kingdom's National Health Service is sponsoring two
clinical trials, entirely independent of the Company, that are designed to
assess the clinical and cost-effectiveness of PAPNET-assisted primary
screening of Pap smears. A multi-center primary screening clinical trial is
expected be completed in Australia during 1998. Finally, the Company is
sponsoring a multi-site, multi-nation European clinical trial to assess the
clinical effectiveness of PAPNET-assisted primary screening.

THE PAPNET TESTING SYSTEM -- THE TECHNOLOGY

  The PAPNET Testing System utilizes both algorithmic and adaptive computer
technologies, including neural networks. Neural networks represent a
relatively new computer technology. Instead of the serial (single) path of
programming utilized by conventional computers, neural network computers have
thousands of adaptively-formed paths linked in parallel, comprising a network
conceptually similar to the network of neurons in the human brain. Neural
networks can process immense quantities of information while mimicking the
neurological ability to learn from experience. After training on images of a
series of "abnormal" and "normal" cells, a neural network can recognize
abnormal cells even though they differ considerably from the training set of
images. Neural networks excel at solving complex pattern-recognition problems.
Because the PAPNET Testing System includes neural networks, it can
differentiate potentially abnormal cells from the overlapping normal cells,
debris, lymphocytes, blood and neutrophils commonly found on the
conventionally prepared Pap smear slide.

  The PAPNET Testing System includes two major subsystems: the PAPNET Scanning
Station (and related equipment) and the PAPNET Review Station. The PAPNET
Scanning Stations can be located at Scanning Centers owned and operated by the
Company, or they can be installed directly into customer laboratories. The
PAPNET Review Stations are always located at the customers' laboratories.

  The PAPNET Scanning Station is the principal component of the PAPNET Testing
System. It scans each bar-coded and labeled slide in order to select color
images of 128 cells and cell clusters deemed by the Scanning Station's
algorithmic and neural network computers to be among the most potentially
abnormal (whether or not such cells are, in fact, abnormal). The images are
recorded on a digital tape cassette or CD-ROM and returned

                                       8
<PAGE>

with the slides to the laboratory to be reviewed on the PAPNET Review Station,
or downloaded directly to the Review Station in the case of PAPNET-on-Cyte
systems.

  The PAPNET Review Station is based upon personal computer technology and
includes a large, high-resolution monitor, digital tape or CD-ROM drive and
the Company's proprietary PAPNET Review Station software. The images produced
by the PAPNET Scanning Station are reviewed and evaluated on the Review
Station by one of the laboratory's certified cytotechnologists specially
trained in PAPNET-assisted screening.

MARKETING AND SALES--OVERVIEW

  The Company originally expected that its business would develop primarily as
a service to laboratories, and that most of its laboratory customers would
elect to send smears on a patient-by-patient basis for scanning at the
Company's centralized Scanning Centers. This strategy turned out to be
expensive to support because of the high cost of sales and high marketing and
sales expenses, and for a number of reasons it was only moderately successful
at generating sales. Accordingly, the Company is refocusing its strategy
toward selling and leasing the PAPNET Testing System directly to laboratories,
with the goal that the Company will become the premier supplier of cytology
screening and anatomic pathology diagnostic equipment and services to
laboratories. As discussed below, the Company relaunched the PAPNET system in
Europe in September under the brand name PAPNET-on-Cyte. In the United States,
the Company is laying the groundwork to make the same transition that it has
already made in Europe and that it plans to make in Asia during 1998. However,
due to differences in the laboratory marketplace, reimbursement and regulatory
requirements, the Company expects that the transition in the United States
will extend at least until the end of 1999.

 Marketing and Sales--Europe

  During the fourth quarter of 1997, management implemented a shift in the
direction of its marketing and sales efforts in Europe with the introduction
of sales and leasing of PAPNET equipment under the brand name PAPNET-on-Cyte.
Under the PAPNET-on-Cyte program, a PAPNET Scanner, Review Station and
additional support equipment are placed directly into customer laboratories.
The laboratory customer has complete control of the PAPNET testing process,
including those functions that were previously performed by Company personnel
at Scanning Centers. On the basis of initial fourth quarter 1997 responses
from the cytopathology community, the Company believes that PAPNET-on-Cyte
will be an attractive alternative for pathologists and laboratory
professionals in Europe. However, the Company expects most PAPNET-on-Cyte
sales to come from the public sector in European countries where budgetary
cycles tend to be slow and unpredictable. Therefore, there can be no assurance
as to the magnitude of such sales within the foreseeable future.

  The Company provides customers with a range of options to facilitate
financing for the acquisition of PAPNET-on-Cyte Systems. Such options include
cash purchase, leasing (financial and operational) and rental programs. In
addition to the acquisition price for PAPNET-on-Cyte, the Company assesses a
"click charge" to be invoiced on a monthly basis in an amount corresponding to
the number of slides scanned. The click charge covers the royalty for the use
of the Company's proprietary cell classification software, upgrades of
software and hardware for Review Stations, training of cytotechnologists, and
a field servicing program that covers routine maintenance and repairs. NSI
Europe also recently concluded an agreement with IBM Europe whereby IBM became
the preferred financing partner in countries where IBM has a financial
division present.

  NSI Europe has subsidiaries in the U.K., Germany, Italy and the Benelux
countries, and a branch office in Spain. A pan-European Company sales force of
16 persons works in small teams operating out of Company offices. The Company
is considering the use of third party agents and/or distributors to widen
sales coverage, and expects to make a determination in this regard during
1998.

  The Company believes that the ability to offer a quality field service
program is important to the success of PAPNET-on-Cyte. Since servicing is not
the Company's core expertise, the Company has outsourced servicing in each
country where PAPNET-on-Cyte systems are placed. The first service partner has
been contracted in the

                                       9
<PAGE>

United Kingdom and additional service partnering contracts for other countries
are expected to be signed during 1998. The Company will supervise and
coordinate the PAPNET-on-Cyte field service outsourcing though its core
European Lab Support Group headquartered in Amsterdam. The Company believes
that outsourcing servicing permits the Company to deliver quality service in
each customer's local language with rapid response time.

  Several recent technical improvements have already increased the usefulness
of PAPNET-on-Cyte in laboratories. The Company recently announced the
introduction of new software for scanners that allows them to operate with
greater independence, and a dedicated network link between scanners and Review
Stations.

  In connection with the restructuring of the Company's European sales
strategy and the initiation and promotion of PAPNET-on-Cyte, the Company has
ceased marketing programs related to sales of slide scanning services through
the Amsterdam Scanning Center. The Company expects to close its scanning
facility in Amsterdam during the second quarter of 1998 as existing customers
shift to PAPNET-on Cyte systems in their own laboratories or at reference
laboratories. The Amsterdam office is expected to remain open as regional
management headquarters for European strategic development, budget control and
planning, and also to provide support operations for the Company's European
medical, marketing and financing programs.

  The equipment included in PAPNET-on-Cyte carries the CE Mark, which
indicates that the equipment complies with European regulations. The European
Union is developing medical device directives that may apply to the PAPNET
system. See "--Government Regulation."

 Marketing and Sales--United States

  In the United States, the Company is preparing to make the same transition
that it has already made in Europe, and that it plans to make in Asia during
1998. However, due to differences in the laboratory marketplace, reimbursement
and regulatory requirements, the Company expects that the transition in the
United States will extend until at least the end of 1999.

  The Company believes that the demand for adjunctive PAPNET-assisted
rescreening in the United States is limited, and does not expect significant
sales growth until the FDA permits the Company to sell the PAPNET system for
the primary screening of Pap smears. The Company believes that demand for
PAPNET-assisted rescreening is limited because (i) there is no consensus among
practicing pathologists that they should perform any Pap smear rescreening,
manual or otherwise (beyond required quality control rescreening), (ii)
PAPNET-assisted rescreening is perceived as an expensive method of
rescreening, even among those pathologists who support rescreening, and (iii)
for many patients, there is no source of incremental reimbursement to the
laboratory for PAPNET-assisted rescreening, so laboratories that offer PAPNET-
assisted rescreening run the risk that it will not be profitable.

  Notwithstanding the limited demand for PAPNET-assisted rescreening, the
Company believes that it can continue to generate U.S. revenues while it
awaits approval to promote PAPNET testing for primary screening. The Company
has developed a two-prong strategy that focuses on (i) segments of the market
where the clinical value of adjunctive PAPNET-assisted rescreening may be
greater than for typical healthy women, and (ii) laboratories that can commit
to rescreen a specified percentage of their negative smears at a substantial
discount to the list price for patient-by-patient adjunctive testing. The
marketing and communications strategy that supports both aspects of this
approach recognizes the laboratory as a key part of the channel of
distribution. The selling effort will attempt to enlist the laboratory in an
integrated sale that will include the clinician, rather than focus directly on
the clinician.

  Targeted adjunctive testing. The Company will emphasize that adjunctive
PAPNET-assisted rescreening may be particularly valuable to those patients who
may be at increased risk for cervical disease. This group may include women
with a history of cervical abnormality, sexually active women who have not
been screened in two or more years, women who have had multiple children and
who use oral contraceptives, women who had first sexual intercourse at an
early age, and women who smoke. The Company believes that clinicians who

                                      10
<PAGE>

recommend PAPNET-assisted rescreening on a patient-by-patient basis will be
more likely to recommend the test to women who fall into one or more of these
categories than for women generally.

  Targeted laboratories. The Company also will offer PAPNET testing at much
reduced prices to laboratories that commit to rescreen a specified percentage
of their negative smears for PAPNET-assisted rescreening. The Company believes
that such pricing arrangements will be attractive to laboratories that are
particularly supportive of PAPNET testing, and that have a greater than
average ability to obtain additional reimbursement for a significant
percentage of their Pap smears.

  The Company has also revised its strategy for communicating with
pathologists, clinicians and patients. Through the first four months of 1997,
the Company directed advertising toward all three segments, in the hope that
interest from women would motivate clinicians to request PAPNET-assisted
rescreening and pathologists to perform it. However, the Company has concluded
(for the foreseeable future) that continued large expenditures for advertising
are not likely to produce commensurate sales. Accordingly, during the second
half of 1997 the Company implemented a major shift in its medical
communications strategy. The Company now provides information and education to
patients primarily through laboratories and clinicians, rather than through
direct-to-consumer advertising, and communicates with both laboratories and
clinicians through channels other than advertising. The goal of the strategy
is to enlist the cooperation and support of key laboratory personnel,
including pathologists, cytotechnologists and laboratory business managers, in
the dissemination of educational and informational programs to clinicians and
their patients.

  United States marketing and sales expenses during 1998 are expected to be
substantially less than in 1997 and 1996, because direct selling to
laboratories and their clinician clients costs much less than the national
direct-to-consumer campaign waged by the Company in 1996 and 1997.

 Marketing and Sales--Asia Pacific

  In the Asia Pacific region, PAPNET Testing System is promoted as a high
standard semi-automated tool to improve accuracy and cost effectiveness of
primary and secondary screening of Pap Smears. In response to divergent market
conditions in the Asia Pacific region and unique factors affecting various
local environments, the Company has formulated a series of country-specific
sales and marketing programs.

 Hong Kong

  Cytology in Hong Kong is well established, although the Company estimates
that only about 20% of the adult female population undergo annual Pap smear
screening. Such rates of screening also appear to be the norm in most other
Asian cities, however, available data indicate a generally increasing trend of
Pap smear screening of about 10% each year in Hong Kong. Approximately half of
Pap smears are read by government-owned laboratories and the other half by
private laboratories. During the past three years, Company marketing efforts
have been directed at the private market to provide vertically integrated
PAPNET screening services. As a result, approximately 30% of the privately
screened slides in Hong Kong now undergo PAPNET-assisted screening through the
Company's wholly-owned cytology laboratory, Compuscreen Medical Diagnostic
Centre. The Company believes there is a high degree of support among Hong Kong
private laboratories with respect to the benefits of computer-assisted Pap
smear screening and further believes that this private sector acceptance will
facilitate adoption of PAPNET in the public sector over the long term.
Accordingly, the Company is preparing for implementation of a marketing
program to sell scanning equipment and scanning services to Hong Kong
government institutions.

 Taiwan

  As in Hong Kong, cytology is well established in Taiwan. The Company
estimates that approximately 1.2 million Pap smears are screened in Taiwan
each year, representing about 20% of the adult female population. Cervical
cancer is considered the number one cause of cancer death among women in
Taiwan and the

                                      11
<PAGE>

government has indicated a strong interest in taking action to lower mortality
from this disease, including implementing a free Pap smear screening program
for women 40 years and older. The government also recognizes the importance of
reducing false-negative smears and has undertaken programs to improve the
accuracy of screening. PAPNET is marketed as supplemental screening in Taiwan
and is a self-paid test. Three of the largest laboratories in Taiwan are now
PAPNET certified and are able to offer PAPNET Testing. At present, slides are
scanned at the Company's Hong Kong Scanning Center.

 China

  Unlike Hong Kong and Taiwan, China's cytology is substantially
underdeveloped, with only a small number of adequately trained cytologists and
cytopathologists. Although data are limited, available information indicates
that Pap smear screening, once popular and mandatory, has been neglected in
the past decade. The Company believes that use of PAPNET as a primary
screening application best addresses women's public health issues in China by
improving both accuracy and efficiency of existing Pap smear practice. All
slides are currently sent to the Company's processing center in Hong Kong for
PAPNET scanning. There are now three PAPNET certified cytology laboratories in
China, and more than forty hospitals and laboratories send at least some of
their Pap smears for PAPNET-assisted screening. Following PAPNET scanning,
approximately half of the slides are reviewed on PAPNET Review Stations by the
Company's Compuscreen cytology laboratory, while the other half are returned
to the certified laboratories for local review on PAPNET Review Stations. The
Company anticipates that business in China during 1998 will continue to be
predominantly service oriented, with equipment sales following in future
periods as the market expands, however there can be no assurance in this
regard.

  Pursuant to the existing treaty between the Government of the United Kingdom
and the People's Republic of China, Hong Kong reverted to and become part of
China in July 1997. The Company is uncertain as to the long-term impact, if
any, that such a change in government will have on its business operations in
the Asia Pacific region.

THIRD-PARTY REIMBURSEMENT

  Some private third-party medical insurance payers and government agencies
offer reimbursement for laboratory testing associated with routine medical
examinations, including Pap smears. In the United States, many Pap smears are
currently paid for by the patient, and the level of reimbursement by third-
party payers that do provide reimbursement varies considerably. Third-party
payers (including, but not limited to, Medicare/Medicaid, private health
insurance plans, health administration authorities in foreign countries and
other organizations) may affect the pricing or relative attractiveness of the
Company's products and services by regulating or limiting the amount of
reimbursement for PAPNET testing provided by such payers or by not providing
any reimbursement at all. Restrictions on reimbursement may limit the price
which the Company can charge for its services or reduce the demand for PAPNET
testing. In addition, if Medicare and Medicaid do not provide for
reimbursement of PAPNET testing, or, if the level of reimbursement is
significantly below the amount laboratories charge for performing PAPNET
testing, the size of the potential market available to the Company may be
reduced. By early 1998, the Company was aware of only one state Medicaid payer
that reimbursed for PAPNET-assisted rescreening, and Medicare reimbursement
was significantly below the amount that laboratories charge for performing
PAPNET-assisted rescreening. There can be no assurance that costs associated
with PAPNET testing will ever attain general widespread reimbursement or that
the level of reimbursement to clinical laboratories for PAPNET testing will
achieve or be maintained at levels necessary to permit the Company to generate
substantial revenues. In the international market, reimbursement by third-
party medical insurance payers, including governmental insurers and providers,
varies from country to country. In certain countries, the Company's ability to
achieve significant market penetration may depend upon whether private third-
party or governmental reimbursement is available.

MANUFACTURING; RESEARCH AND DEVELOPMENT

  The Company's subsidiary, Neuromedical Systems Israel, Ltd. ("NSIL"), based
in Rehovot, Israel, manufactures the Scanning Stations, related equipment and
software. NSIL assembles components, optically

                                      12
<PAGE>

aligns the automated microscope, installs all software (including the
Company's proprietary image processing algorithm and neural network-based
classifier) and tests the completed system. Components of the Scanning
Stations are either purchased "off-the-shelf" or are manufactured by
subcontractors to the Company's specifications.

  NSIL has been designated as an "Approved Enterprise" by the Investment
Center, a government agency of the Ministry of Industry and Commerce and the
Ministry of Finance of the Government of Israel. Such status makes NSIL
eligible to receive government guaranteed loans under certain terms and
conditions. The outstanding amount as of December 31, 1997 under long-term
loans derived from this program was approximately $1.9 million.

  The PAPNET Review Station is based on "off-the-shelf" personal computer
technology manufactured by third-party vendors and shipped to laboratories.
Final assembly is done at the laboratories by Company personnel who install
software, affix applicable labels and align the laboratory's microscope to the
"x, y" coordinates associated with the PAPNET Testing System.

  The Company expended approximately $8,362,000, $6,785,000 and $5,172,000 in
the years ended 1997, 1996 and 1995, respectively, on research and development
related to the PAPNET Testing System. In early 1998, the Company announced
plans to consolidate product development in the United States by the end of
1998. The purpose of the consolidation is to bring product development closer
to the customer base and to manage product development more effectively. Since
the engineers principally responsible for the Company's proprietary cell
classification technology already work in the United States operation, the
Company expects that it will not suffer extensive development delays as a
consequence of the consolidation.

PATENTS AND PROPRIETARY RIGHTS

  The Company's first U.S. patent issued on October 23, 1990. The Company's
patents cover various technologies applicable to the Company's current and
planned businesses. Some of the technologies covered by the Company's patents
include the application of neural networks, adaptive processing, and non-
algorithmic processing to the classification of cytological specimens
generally. In addition, the Company owns patents which cover interactive
screening of specimens in which certain cells from a specimen are
automatically selected and displayed for focused human review. The Company's
PAPNET Testing System is specifically disclosed and claimed.

  The Company has nine issued United States patents and several pending patent
applications. The Company's issued United States patents do not begin to
expire until at least 2008. The Company also has been issued patents in
several foreign countries, including certain European countries, Canada and
Australia, and has applied for patent protection in numerous other foreign
countries, including Japan and certain European countries.

  The Company is not aware of any patents held by others that would prevent
the Company from manufacturing and commercializing, in the United States and
abroad, the PAPNET Testing System as it currently exists. Nevertheless, one of
the Company's competitors, NeoPath, Inc. ("Neopath"), has sued the Company in
the United States District Court for the Western District of Washington for
patent infringement. In addition, the Company has sued Neopath for patent
infringement and other claims in the United States District Court for the
Southern District of New York. See "Legal Proceedings" under Item 3 of Part I
herein.

  The Company has trademark/service mark registrations for "Neuromedical
Systems," "NSI," "PAPNET," "Advancing the Vision of Cytology," "PAPNET-on-
Cyte," and the Company's logo design and other marks in the United States.
Applications to register several of these marks have been filed in several
foreign countries, and the registrations for many of these have already
issued.


                                      13
<PAGE>

  In May 1995, a competitor of the Company filed with the U.S. Patent Office
requests, which the Patent Office granted, for re-examination of three of the
Company's issued United States patents which relate to technology on which the
PAPNET Testing System is based. The re-examination process was completed in
1996 for each of the re-examined patents and Re-examination Certificates have
been received by the Company from the Patent Office confirming or finding
patentable all claims of the re-examined patents. The Company also added
claims to one patent during the re-examination process.

TERRITORIAL LICENSES

  From 1989 through 1991, the Company entered into various license agreements
for the states of Ohio, Kentucky, Nevada, Missouri, Georgia, North Carolina,
Utah, Arizona and the metropolitan area of Chicago and San Diego County, which
in the aggregate account for approximately 20% of the population of the United
States (the "License Agreements" and each licensee thereof, a "Licensee"). The
Company received net proceeds of approximately $3.5 million from the sale of
the License Agreements. The Company estimates that its royalty obligation will
amount to an expense of approximately 10% of the Company's United States
revenues over the term of the License Agreements, however, the actual expense
of such royalties may differ from the estimated percentage depending on
variation in geographical origin of Company revenues. In 1997, the Company's
royalty obligation was equal to approximately 18.9% of the Company's United
States revenues, because a disproportionate share of revenues came from
certain licensed territories.

  In December 1995, the Company and the Licensees entered into a settlement
agreement (the "Settlement Agreement") and a warrant exercise agreement, the
effect of which included the clarification of previously disputed elements of
prior license agreements. In accordance with the Settlement Agreement, the
Company will enter into new licenses with the respective Licensees (or their
successors-in-interest, as the case may be) pursuant to which the rights and
obligations of the Licensees will be clarified but with respect to which the
economic terms of the License Agreements will not be materially altered (each,
a "Restated License"). Each Restated License will provide, however, that a
slide received from multistate national laboratories will be deemed to have
been received from licensed territories pro rata according to each territory's
population as a percentage of United States population. The Restated Licenses
will expire on December 31, 2025. In 1996, the Licensees that held the
licenses to Ohio, Kentucky, Missouri, Georgia, North Carolina and the
metropolitan area of Chicago consolidated into NetMed, Inc., an Ohio
corporation the common stock of which is traded publicly under the ticker
symbol NMD. Also in 1996, the Licensees that held the licenses to Nevada,
Arizona, Utah and San Diego County consolidated into Cytology West, Inc.
("CWI"), a privately-held Nevada corporation. The president of CWI is Carl
Genberg, a director of the Company.

  In addition, the provisions of an agreement, dated October 3, 1990, granted
certain rights to be the Company's sole licensee for distribution of the
PAPNET system in Canada. The agreement provides that such "licensee shall be
entitled to terms which are at least as favorable as those in any domestic
United States of America licenses." A license has not been negotiated. There
can be no assurance that the terms of such license, when it is negotiated, or
the activities of the licensee thereunder, will not have material consequences
on the profitability of the Company's business in Canada. Joseph Salamon, a
former director of the Company, is the agent of the record holder of the
rights to the Canadian license.

DISTRIBUTION AGREEMENTS AND OTHER EXCLUSIVE ARRANGEMENTS; ASIA PACIFIC
ACQUISITIONS AND ROYALTY ARRANGEMENT

  Until June 1, 1997, the Company was a party to an exclusive representation
agreement with Papnet (Far East) Ltd. ("PFEL") for the distribution of the
Company's PAPNET Testing System in Asia Pacific markets. In addition, the
Company paid certain management fees in connection with assistance rendered by
PFEL with respect to the establishment of the Company's Asia Pacific
operations center in Hong Kong. Dr. Stephen Ng is the president and an 18.3%
stockholder of PFEL and was member of the Company's Board of Directors from
1994 until the Company's 1997 Annual Meeting of Stockholders when his term of
office expired and he did not stand for reelection. In a stock purchase
agreement effective June 1, 1997, NSI Asia Pacific Ltd., a wholly-owned

                                      14
<PAGE>

subsidiary of the Company, acquired New System International, Ltd. ("New
System International"), a Hong Kong corporation and the former operating
subsidiary of PFEL. Dr. Ng served as president of New System International
prior to its acquisition and continues in such capacity for the Company, as
well as serving as Vice-President, Asia Pacific. In a related transaction,
effective August 1, 1997, the Company acquired all of the assets of its former
distributor of PAPNET in Taiwan. As part of the acquisition of New System
International and the Taiwan distributor, PFEL entered into a royalty
arrangement with the Company pursuant to which it paid the Company $800,000
for the right to receive 3% to 4% of Company sales revenues in Hong Kong,
China and Taiwan over a 15 year period.

  From time to time in certain foreign markets, the Company has agreed to do
business exclusively with one or two local laboratories for a limited period
of time. The Company has entered into such commitments to secure certain
minimum quantities of business from such laboratories and investment from such
laboratories in local marketing and sales efforts.

GOVERNMENT REGULATION

  United States. The PAPNET Testing System is a medical device subject to
extensive regulation in the United States by the FDA and by other federal,
state and local authorities. The FDA regulates the research, development,
clinical studies, manufacturing, processing, packaging, labeling,
distribution, promotion and post-market surveillance of medical devices in the
United States.

  Preclinical and clinical trials of medical devices must be conducted in
conformity with all applicable FDA regulations, including, with respect to
preclinical trials, Good Laboratory Practice regulations. In addition, state
and local permits may be required under regulations relating to clinical
activities.

  Under the Federal Food, Drug and Cosmetic Act, the PAPNET Testing System is
a Class III medical device, subject to the most stringent FDA review of any
medical devices to ensure that the device is safe and effective before
commencement of marketing, sales and distribution for clinical use in the
United States. A maker of Class III devices (such as the Company) must
generally subject its product to clinical trials, and thereafter submit to the
FDA an application supported by extensive data, including clinical trial data,
to prove the safety and effectiveness of the product. As part of the FDA
application, the device maker must submit a full description of the device and
its components, a full description of the methods, facilities and controls
used for manufacturing, and proposed labeling.

  The Company is required to register with the FDA and to submit device
listing information for products in commercial distribution, and is subject to
periodic reinspection by the FDA for compliance with Quality System
regulations with respect to manufacturing, testing, distribution, storage and
control activities. Labeling and promotional activities are also regulated by
the FDA. The Company is required to provide the FDA with periodic reports
containing safety and effectiveness information.

  Although the Company has received approval for the PAPNET Testing System
from the FDA for the rescreening of conventional Pap smears that have been
previously assessed as "negative," "within normal limits" or "evidencing
benign cellular changes," there can be no assurance that the Company will
obtain the required regulatory approval for any future product that it may
develop or other indications for the PAPNET system (including primary
screening), on a timely basis, if at all. Furthermore, additional regulatory
requirements could be imposed by legislation or regulation. If the FDA
believes that the Company is not in compliance with the law or related
regulations, the FDA can take one or more actions, including the following:
withdraw previously approved applications; require notification to users
regarding newly found, unreasonable risks; request repair, refund or
replacement of faulty devices; request corrective advertisements, formal
recalls or temporary marketing suspension; or institute legal proceedings to
detain or seize products, enjoin future violations or assess criminal
penalties against the Company, its officers or employees. Civil penalties for
Food, Drug and Cosmetic Act violations may be assessed by the FDA in lieu of
or in addition to instituting legal action. Any such action by the FDA could
result in disruption of the Company's operations for an indeterminate period
of time. Various

                                      15
<PAGE>

states in which the Company's products are sold or may be sold in the future
may impose additional regulatory requirements.

  In May 1996, the FDA issued a "warning letter" to Papnet of Ohio, Inc.
(subsequently merged and consolidated with certain other Licensees of the
Company into NetMed, Inc.) concerning certain material posted on Papnet of
Ohio's site on the World Wide Web. Papnet of Ohio responded to the warning
letter. Papnet of Ohio is unrelated to the Company other than as a Licensee.
Although the warning letter was addressed to Papnet of Ohio, the Company has
modified certain of its promotional materials in response to the warning
letter. See "--Territorial Licenses."

  From time to time, the Company has received "untitled" letters from the
Office of Compliance of the Center for Devices and Radiological Health of the
Food and Drug Administration ("FDA Compliance"), relating to the Company's
promotional activities. In addition, in 1994, prior to the approval of the
pre-market approval application for the PAPNET Testing System, the Company
received a "warning letter" with respect to certain alleged pre-approval
promotional activities. In each case, the Company has responded to the FDA's
concerns and no enforcement action has been taken. The Company believes that
each of these letters from FDA Compliance were in response to complaints
lodged with FDA by the Company's competitors.

  International. The Company's products are subject to a variety of
regulations in certain international markets, including Europe. Some European
countries have established national regulations relating to in vitro
diagnostic medical devices, such as the PAPNET system. These regulations do
not typically require premarket approval, but may impose other requirements.

  In vitro diagnostic medical devices such as the PAPNET system are not
currently subject to medical device directives issued by the European Union
("EU"). The Company anticipates, however, that the EU will soon propose a
directive for in vitro diagnostic medical devices that would establish a basis
for harmonized regulation of such devices among EU member states. Such a
directive would likely establish a deadline for compliance. If enacted, the
directive would apply only to member states of the EU and the European
Economic Area. Other European countries, however, may enact national laws that
would conform to the directive. There can be no assurance that the PAPNET
Testing System or any other product that the Company may develop will obtain
any required regulatory clearance or approval on a timely basis, if at all.

REGULATION OF CERVICAL PAP SMEAR ANALYSIS

  In 1988, Congress adopted the Clinical Laboratory Improvement Amendments of
1988 ("CLIA"). CLIA directed the Department of Health and Human Services to
promulgate regulations to improve the quality of biomedical analytic services,
particularly the examination of Pap smears. The CLIA regulations require
laboratories to rescreen slides from at least 10% of the laboratory's Pap
smears interpreted to be "negative" on initial manual screening. Such
rescreened slides must include negative cases selected at random from the
total caseload and from patients or groups of patients that are identified as
having a high probability of developing cervical cancer based on available
patient information.

  In addition, the Company's direct clients, clinical laboratories, are
subject to state regulation, inspection and licensing. In recent years, a
number of states, including New York and California, have adopted regulations
limiting the number of slides which can be manually examined by a
cytotechnologist in a given period. To the Company's knowledge, none of these
regulations explicitly limits the number of slides that may be examined in
connection with PAPNET rescreening. There can be no assurance, however, that
such states or other states will not limit the number of slides which may be
examined using PAPNET testing during any particular time period, or that any
such limitations will not have an adverse effect on the acceptance of the
PAPNET Testing System in the marketplace or the ability of the Company to
generate substantial revenues.

COMPETITION

  The Company is currently aware of four principal competitors which are
engaged in efforts to automate one or more aspects of cervical smear
screening. Three competitors, Cytyc Corporation ("Cytyc"), AutoCyte Inc.

                                      16
<PAGE>

("AutoCyte", formerly a unit of Hoffman-La Roche's Roche Image Analysis
Systems) and Morphometrix Technologies Inc. ("Morphometrix") are focused on
the development of devices for the production of monolayer slides, an
alternative to the conventional Pap smear method of specimen collection and
preparation. In addition, AutoCyte and Morphometrix have announced that they
are each developing imaging and automated analysis systems for use with
monolayer slide preparations. AutoCyte has stated that it expects to receive
FDA premarket approval of its PREP(R) monolayer slide preparation system in
1998 and that it expects to file during 1998 a premarket approval application
for its AutoCyte SCREEN(R) automated interactive cervical cancer screening
system. Morphometrix has stated that it expects clinical trials to begin
during the first quarter of 1998 with respect to CYMET, its automated image
analysis system, with a view to obtain regulatory approval and product launch
in the first half of 1999. Morphometrix intends CYMET to be employed using
CYPREP, a fluid-based monolayer Pap sample system, which Morphometrix has
announced that it is developing using the ThinPrep(R) monolayer technology.
Cytyc received approval from the FDA in May 1996 to market its ThinPrep(R)
preparation to laboratories, for the purpose of filtering out blood, mucus and
other material from the specimen for cervical cancer screening as a
replacement for the conventional Pap smear method. In addition, Cytyc received
FDA approval in November 1996 to expand its product labeling to include the
claim that the ThinPrep(R) System is significantly more effective in detecting
Low Grade Squamous Intraepithelial Lesions and more severe lesions in various
populations than the conventional Pap smear method. Cytyc labeling may also
indicate that the specimen quality using the ThinPrep System(R) is
significantly improved over that of the conventional Pap smear method.

  The Company estimates that conventionally prepared Pap smears account for
approximately 90% of the Pap smears analyzed in the United States and
Australia, and virtually all of the Pap smears screened in Europe and greater
China, the Company's other major markets. However, liquid-based preparations
(including particularly the ThinPrep(R) Pap Test(TM)) are rapidly gaining in
popularity in the United States and Australia, and the Company expects that
such preparations could account for a significant portion of the market in the
United States within two years. The leading manufacturer of such preparations,
Cytyc, has announced the formation of a European business unit for the purpose
of selling its ThinPrep(R) Pap Test(TM) in that market, but the Company is not
aware of material sales to date in Europe.

  The PAPNET system is not currently approved by FDA for the rescreening of
ThinPrep(R) Pap Test(TM) slides or other liquid-based preparations, so a
decision by a clinician or laboratory to use the ThinPrep(R) preparation for a
particular patient precludes PAPNET-assisted rescreening for that patient.
However, the Company has announced its intention to include liquid-based
preparations in its clinical trial designed to establish the safety and
effectiveness of the PAPNET system for the primary screening of Pap smears. If
the Company is successful in such trial and receives FDA approval for this
expanded use, the Company believes that the ability of its PAPNET system to be
used with both conventional and liquid-based preparations without modification
or adjustment will be a significant competitive advantage.

  The other competitor of which the Company is aware, NeoPath, has developed a
device for automated primary screening of conventional Pap smears, for which
it submitted to the FDA a pre-market approval supplemental application. The
FDA Hematology and Pathology Devices Panel (the "Panel") held a public meeting
on January 28, 1998 to consider recommending approval of such supplement. The
Panel recommended approval of such supplement, subject to certain enumerated
conditions. NeoPath has stated that it expects FDA approval within the next
few months. In addition, on September 29, 1995, the FDA granted approval to
NeoPath for the AutoPap(R) QC System to be used as part of a laboratory's
quality control procedures.

  According to NeoPath, the AutoPap(R) QC System is designed to sort Pap smear
slides into two groups, one classified as "negative" and one classified for
"review." The group of slides classified for review, which constitutes a
specified percentage of the whole, is again reviewed manually by the
cytotechnologist through a conventional microscope. In contrast,
cytotechnologists trained in the use of the PAPNET Testing System evaluate the
128 color images from each slide on the PAPNET Review Station. If all of the
images appear normal, the cytotechnologist classifies the slide as "negative,"
and no further examination is required. If any

                                      17
<PAGE>

one of the 128 images appears to the cytotechnologist to be abnormal, the
cytotechnologist classifies the slide as "review" and then re-examines the
slide manually under the microscope. Every slide screened using the PAPNET
system receives a directed, professional human analysis, either of the PAPNET
images or of both the images and the slide.

  The Company believes that at present it is still too early to determine the
competitive effects resulting from an FDA advisory panel's recommendation that
FDA approve Neopath's primary screening system. The Company believes that FDA
approval of NeoPath's system may lend credibility to the use of computer-
assisted screening systems generally, and such approval would not necessarily
be adverse to the Company's long term interests. The Company has placed a high
priority during 1998 on initiating clinical trials with respect to the use of
the PAPNET(R) Testing System as a primary screening device to support a
premarket approval supplemental application to the FDA, however there can be
no assurance of such approval on a timely basis, or at all.

  The Company's known competitors or other companies may develop new products
and technologies that prove to be more effective than the PAPNET Testing
System or that may be viewed by clinical laboratories as reducing operating
costs (for example, by reducing the number of cytotechnologists used in
screening). In addition, competitive products and technologies may be
manufactured and marketed more successfully than the PAPNET Testing System.
Such developments could render the PAPNET Testing System less competitive or
possibly obsolete, and could have a material adverse effect on the Company.
The Company will be required to compete with respect to product effectiveness,
price, manufacturing and slide processing efficiency, marketing capabilities
and customer service and support, areas in which it currently has limited
experience.

  In addition to competitors attempting to develop fully automated or semi-
automated systems for the screening or rescreening of Pap smears or
alternative forms of Pap smears (such as liquid-based preparations), there may
in the future be alternate techniques or technologies for the detection or
prevention of cervical cancer, including in vivo devices and vaccines for
human papilloma virus ("HPV"), which is implicated in most cases of cervical
cancer. Although no such technique has been demonstrated to be useful as a
substitute for the Pap smear, there can be no assurance that new techniques or
technologies will not one day supplant or replace the Pap smear in medical
practice.

EMPLOYEES

  As of February 28, 1998, the Company employed 241 persons, including 32
persons in product development and engineering, 13 persons in medical and
regulatory affairs, 52 persons in slide processing operations, 20 persons in
manufacturing and quality assurance, 71 persons in marketing, sales and
customer training and 53 persons in administrative capacities. The Company is
not subject to any collective bargaining agreements and believes that its
relationship with its employees is good.

CUSTOMERS

  Although the Company's customer base is broadly diversified, one customer,
Laboratory Corporation of America, did account for more than 10% of the
Company's revenues during fiscal 1997.

SEGMENTS; SEASONALITY; ENVIRONMENTAL COMPLIANCE

  The Company is a single segment business. The Company believes that Pap
smear testing is not subject to any material degree of seasonality. See Items
6, 7 and 8 of Part II herein for financial information regarding the Company.

  The Company believes that compliance with federal, state and local rules and
regulations which have been enacted or adopted regulating the discharge of
materials into the environment, or otherwise relating to the protection of the
environment, will not have a material effect on capital expenditures,
operations or competitive

                                      18
<PAGE>

position of the Company and its subsidiaries. The Company does not anticipate
any material expenditure for environmental control facilities for the
remainder of its current fiscal year or in the succeeding fiscal year.

CAUTIONARY STATEMENT

  Investment in the Company's securities involves a high degree of risk. In
evaluating an investment in the Company's securities, Company stockholders and
prospective investors should carefully consider the risk factors discussed in
Exhibit 99.1, which is attached hereto, and the information detailed in this
Form 10-K under Item 1 Business and Item 7 Management's Discussion and
Analysis of Financial Condition and Results of Operations, as well as
information contained in the Company's other filings with the Securities and
Exchange Commission.

  This Form 10-K, the Company's Annual Report to Stockholders, any Form 10-Q
or any Form 8-K of the Company or any other written or oral statements made by
or on behalf of the Company may include forward-looking statements within the
meaning of Section 21E of the Securities Exchange Act of 1934 which reflect
the Company's current views with respect to further events and financial
performance. These forward-looking statements are subject to certain risks and
uncertainties that could cause actual results to differ materially from
historical results or those anticipated. For information regarding these risks
and uncertainties, see the Cautionary Statement set forth in Exhibit 99.1 and
Item 1 Business and Item 7 Management's Discussion and Analysis of Financial
Condition and Results of Operations included in this Annual Report on Form 10-
K. The words "believe", "expect", "anticipate", and similar expressions
identify forward-looking statements, which speak only as of their dates. The
Company undertakes no obligation to publicly update or revise any forward-
looking statements, whether as a result of new information, future events or
otherwise.

ITEM 2. PROPERTIES

  The Company's executive offices are located in Suffern, New York, in
approximately 23,500 square feet of leased space. The Company believes that
such facilities will be sufficient for the Company's executive office needs
during the foreseeable future.

  The Company's United States Scanning Center is located in New Jersey in
approximately 26,500 square feet of leased space. Additional Company
administrative offices are also located at this site. The Company believes
that the New Jersey Scanning Center slide processing operations facilities
will be adequate to meet demand for PAPNET testing through 1998. The Company
also anticipates that its administrative offices at the New Jersey facility
will be sufficient to meet foreseeable Company demand.

  The European Scanning Center and the Company's European sales and marketing
staff are located in approximately 16,300 square feet of leased space in
Amsterdam, The Netherlands. The Company expects to close the scanning
operations at this facility during 1998. The Company believes that the
facility will be adequate to meet PAPNET slide processing requirements through
such anticipated closing and continue to be sufficient for administrative
office space needs thereafter. The Company also maintains small sales offices
in the United Kingdom, Germany and Italy, which the Company believes will be
sufficient to meet its needs during the foreseeable future.

  NSIL's manufacturing facility occupies an aggregate of approximately 25,900
square feet of leased space at Kiryat Weizmann, Rehovot, Israel. The Company
believes that its existing facility is adequate to meet the anticipated demand
for PAPNET scanners and related equipment through 1998. The Company believes
that, based on current market conditions, any additional manufacturing space
that could be required will be readily available on terms similar to those of
the current facility. Any new or expanded manufacturing facility is subject to
regulation by the Food and Drug Administration and may require a facility
inspection before it can be used to manufacture medical devices for use in the
United States.

  The Company's Asia Pacific operations are headquartered in the Hong Kong
Institute of Biotechnology, an affiliate of the Chinese University of Hong
Kong in Shatin, the New Territories, Hong Kong. The Hong Kong

                                      19
<PAGE>

center occupies an aggregate of 8,264 square feet of leased space. This
facility accommodates the administrative offices of NSI Asia Pacific Ltd. and
New System International Ltd. The facility also houses NSI Hong Kong Ltd.,
which operates the Company's Asia Pacific Scanning Center, and Compuscreen
Medical Diagnostic Centre which is the Company's wholly-owned cytology
laboratory. The Company anticipates that its Asia Pacific facilities will be
sufficient to meet requirements during the foreseeable future.

  The Company's Australian office occupies approximately 800 square feet which
the Company believes will be sufficient through 1998.

ITEM 3. LEGAL PROCEEDINGS

  On December 4, 1995, the Company was served with a Summons and Complaint in
an action entitled Herbst et al. v. Neuromedical Systems, Inc. et al., in the
Supreme Court of the State of New York. The plaintiffs in this suit allege,
among other things, that pursuant to written contracts, which they claim the
Company has breached, they were entitled to be issued warrants exercisable for
the purchase of approximately 128,000 shares of common stock at various
prices. They further allege that the Company and certain of its officers and
directors made fraudulent misrepresentations and took other allegedly improper
actions that diminished the value of the warrants they claim they are entitled
to under these contracts. On January 31, 1996, the plaintiffs served the
Company with an Amended Complaint alleging legal claims similar to those in
the original Summons and Complaint served on the Company, but adding one of
the Company's former directors as a defendant and specifying that the
plaintiffs are seeking compensatory damages from the Company and one of its
former officers and a former director totaling $114 million and punitive
damages totaling $175 million. On February 23, 1996, the defendants moved to
dismiss the Amended Complaint and on November 27, 1996, the New York State
Supreme Court issued an opinion dismissing all of the plaintiff's claims that
the Company and certain officers and directors committed fraud and other
improper actions that allegedly diminished the value of the warrants
plaintiffs claim they are entitled to receive. The Court denied the Company's
motion to dismiss plaintiffs' breach of contract claim, and plaintiffs
continue to seek $39 million in compensatory damages and $75 million in
punitive damages. The Company intends to continue to vigorously defend this
action. The Company believes that, in any event, the damages claimed bear no
relation to the harm alleged and believes an adverse judgment in this case
would not have a material adverse effect on the Company's operations,
financial position or cash flows.

  On July 15, 1996, the Company filed a lawsuit against NeoPath Inc., a
competitor of the Company, in the United States District Court for the
Southern District of New York, seeking damages and injunctive relief for
patent infringement, false advertising, unfair competition, intentional
interference with business relations and damage to business reputation. In the
lawsuit, the Company alleges that NeoPath willfully misappropriated the
Company's patented technology and used such technology in NeoPath's AutoPap(R)
300 QC System. The Company also alleges that NeoPath falsely characterized and
made misleading comparisons to consumers and securities analysts of the
AutoPap(R) 300 QC System and the Company's PAPNET Testing System. NeoPath has
denied all allegations and, in addition, it has filed counterclaims against
the Company seeking damages and injunctive relief for false advertising and
unfair competition. In the counterclaims, NeoPath alleges that statements made
by the Company characterizing the performance of the PAPNET Testing System,
and its effectiveness relative to NeoPath's AutoPap(R) 300 QC System, as well
as other statements, are false and misleading and constitute
misrepresentations. The Company believes that NeoPath's assertions are without
merit. In the second half of 1997, the Company filed, briefed and argued a
motion for a preliminary injunction against further manufacture of the
AutoPap(R) 300 QC System. That motion is still pending. Although the duration,
costs and ultimate outcome of this lawsuit are unknown, the Company expects
that the costs of pursuing this lawsuit will be significant during 1998.

  On March 28, 1997, Neopath, Inc. filed a patent infringement lawsuit against
the Company in the United States District Court for the Western District of
Washington. The lawsuit seeks to enjoin the Company from allegedly infringing
three of Neopath's patents. Neopath is seeking preliminary and permanent
injunctive relief as well as compensatory damages, including treble damages.
On March 18, 1998, NeoPath and the Company filed a stipulated dismissal of two
of the three NeoPath patents asserted against the Company in this case. Also

                                      20
<PAGE>

on March 18, 1998, the Company filed a motion for summary judgment of non-
infringement on the remaining NeoPath patent. NeoPath has yet to respond to
the Company's motion for summary judgment and the Court has not yet decided
whether to grant or deny the Company's motion. Also on March 18, 1998, NeoPath
filed a motion for leave to amend its Complaint to add an allegation of
infringement of a further NeoPath patent. The Company has yet to respond to
NeoPath's motion for leave to amend and the Court has not yet decided whether
to grant or deny NeoPath leave to amend its complaint. The Company believes
that it has valid legal and factual defenses to NeoPath's allegations of
infringement of the patent currently in the lawsuit as well as to NeoPath's
allegations of infringement of the patent it seeks to add to the lawsuit
through amendment of the Complaint. The Company intends to continue to
vigorously defend this action. The Company also believes that an adverse
judgment in this case would not have a material effect on the Company's
operations, financial position or cash flow.

  On March 18, 1998, NeoPath also filed an additional patent infringement
lawsuit against the Company in the United States District Court for the
Western District of Washington. The lawsuit seeks to enjoin the Company from
allegedly infringing two additional NeoPath patents. NeoPath is seeking
preliminary and permanent injunctive relief as well as compensatory damages,
including treble damages. The Company has not yet filed an answer to the
Complaint in the lawsuit and is still evaluating NeoPath's allegations. Based
on its initial review, however, the Company believes that it has valid legal
and factual defenses and intends to vigorously defend this action.

  On April 15, 1997, the Company was served with a lawsuit filed by Cytyc
Corporation in the United States District Court for the District of
Massachusetts against the Company, certain of its officers and others,
alleging false and misleading advertising, unfair and deceptive trade
practices, theft of trade secrets, unfair competition, interference with
relationships and defamation. On June 23, 1997, the court dismissed the
Massachusetts lawsuit on the basis of lack of jurisdiction. On June 24, 1997,
Cytyc filed suit against the Company, Mark Rutenberg and Dr. Mango in the
United States District Court for the Southern District of New York, alleging
causes of action for (1) violation of the Lanham Act, (2) misappropriation of
trade secrets, (3) defamation, (4) violations of Sections 349 and 350 of New
York General Law and (5) unfair competition. In this action, Cytyc seeks in
excess of $11,000,000 in damages, costs and attorneys' fees, as well as
injunctive relief prohibiting the Company from making false, misleading and
defamatory statements regarding Cytyc and its ThinPrep Pap Test. The Company
moved to dismiss the complaint on the basis that it failed to state a claim
upon which relief could be granted, which motion was denied by the Court on
September 5, 1997. The Company subsequently filed a counterclaim in this
matter on October 3, 1997, alleging causes of action for (1) violation of the
Lanham Act, (2) violation of Sections 349 and 350 of New York General Law, (3)
defamation and (4) unfair competition. The Company filed an amended
counterclaim on November 10, 1997. By way of its amended counterclaim, the
Company seeks damages and injunctive relief against Cytyc. The Company is
contesting the case vigorously. The Company believes that the damages proposed
bear no relation to the harm alleged, and believes that it is probable that
this case will not have a material adverse effect on the Company's operations,
financial position or cash flows, although there can be no assurance in this
regard. Notwithstanding the foregoing, although the duration, costs and
ultimate outcome of this lawsuit are unknown, the Company expects that the
costs of defending this lawsuit will be significant during 1998.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS

  No matters were submitted to a vote of the security holders of the Company
during the fourth quarter of 1997.

EXECUTIVE OFFICERS OF THE REGISTRANT

  As of March 27, 1998, the following individuals are executive officers of
the Company serving in the respective capacities indicated.


                                      21
<PAGE>

  PAUL R. SOHMER, M.D., age 49, has served as President, Chief Executive
Officer and a director of the Company since November 1997. Prior to joining
the Company, from 1993 to 1996 he served as President of Genetrix, Inc., the
largest privately-owned U.S. genetics services company. From 1996 until
November 1997, Dr. Sohmer provided consulting services to the investment
community and industry, and evaluated investment and strategic opportunities
in early and mid-stage technology and specialty care companies. From 1991
through 1992, Dr. Sohmer served as the Corporate Vice President of
Professional Services and President of the Professional Services Organization
for the Nichols Institute, a clinical laboratory company where he was
responsible for marketing, sales, information services and clinical studies.

  JOHN B. HENNEMAN, III, age 36, is Executive Vice President of US Operations,
Secretary and Chief Legal Officer. Mr. Henneman joined the Company in February
1994 and has served the Company in several executive capacities, including as
Co-Chief Executive Officer of the Company from July 1997 until November 1997.
For more than seven years prior to joining the Company, Mr. Henneman practiced
law with the Chicago office of Latham & Watkins. Mr. Henneman received his
A.B. in Politics from Princeton University and his J.D. from the University of
Michigan Law School.

  UZI ISH-HURWITZ, age 54, is Executive Vice President, Chief of Technical
Operations of the Company and President of Neuromedical Systems Israel, Ltd.,
a subsidiary of the Company, and he has served as a director of the Company
since June 1996. Mr. Ish-Hurwitz joined the Company in April 1993 and has
served in several executive capacities, including as Co-Chief Executive
Officer of the Company from July 1997 until November 1997. Mr. Ish-Hurwitz was
the co-founder of Indigo Graphic Systems, Ltd. (Rehovot, Israel), and served
as its President from 1987 to 1992. From 1973 to 1986, Mr. Ish-Hurwitz served
as Vice President--Operations of Scitex Corporation, Ltd. (Israel). Mr. Ish-
Hurwitz is a graduate of the Technion-Israeli Institute of Technology with a
B.Sc. in Electrical Engineering and has completed fellowship programs at the
London Business School and the Harvard Business School Advanced Management
Program.

  ELISE A. ECANOW, age 32, is Vice President and General Counsel. She served
as Assistant General Counsel for the Company from November 1995 to March 1998.
Prior to joining the Company, Ms. Ecanow served from 1993 to 1995 as Corporate
Counsel at Caremark International, Inc., and was with the law firm of Mayer,
Brown & Platt in Chicago from 1990 to 1993. Ms. Ecanow received her B.A. in
Organizational Behavior and Management from the University of Michigan and her
J.D. from Stanford Law School.

  ZEEV HADASS, PH.D., age 64, is Vice President Product Development and Lab
Support and has served as an executive of the Company since March 1994. From
1991 to 1994, Mr. Hadass was Executive Project Director of MedLink Europe, BV,
a master distribution company that establishes and manages European
distribution networks for medical companies based in the United States. From
1990 to 1991, Mr. Hadass was President of Abiomed, Inc., a maker of cardiac
assist and periodontal screening devices. Mr. Hadass received his Ph.D. in
Aeronautical Engineering from Stanford University, his M.Sc. in Nuclear
Engineering from INSTN, France, and his B.Sc. in Mechanical Engineering from
the Technion-Israeli Institute of Technology.

  LAURIE J. MANGO, M.D., age 35, is Vice President and Chief Medical Officer
of the Company. Prior to joining the Company in 1990, Dr. Mango was a resident
in anatomic pathology at the University of California, San Francisco and
served as a Cytology Fellow at Montefiore Medical Center under Dr. Leopold G.
Koss. Dr. Mango graduated from Rice University with a B.S. in electrical
engineering and received her M.D. from Baylor College of Medicine.

  STEPHEN K.C. NG, M.D., age 48, is Vice President, Asia. Dr. Ng joined the
Company as an executive in June 1997. Dr. Ng served as a director of the
Company from January 1994 until May 1997, during which time he also served as
President of Papnet (Far East) Ltd., a licensee of the Company's PAPNET
Testing System in Hong Kong, China and Taiwan. Prior to his affiliation with
the Company and PFEL, Dr. Ng served Columbia University in various capacities
as an epidemiologist. He has also served as Chief, Division of Epidemiology of
the American Health Foundation.

                                      22
<PAGE>

  ANDREW C. PANAGY, age 47, is Vice President, Marketing and Sales of the
Company. Prior to joining the Company in February 1994, Mr. Panagy served as
Executive Vice President and Chief Operating Officer of the MEDED Healthcare
Group, a healthcare marketing and consulting company. Mr. Panagy has held
numerous marketing and sales positions with Ayerst Laboratories, a
pharmaceutical division of American Home Products Corp., including as head of
the female healthcare marketing group. Mr. Panagy received his B.S. in Biology
from Wagner College, and has participated in post-graduate business programs
at Long Island University in New York.

  MARK L. SMITH, age 36, is Vice President of Finance and Administration, and
Chief Financial Officer of the Company. Prior to accepting his appointment at
the Company in March 1998, Mr. Smith served in various executive capacities at
Genzyme Corporation of Cambridge, Massachusetts. From 1996 until June 1997,
Mr. Smith served as Vice President of Finance for Genzyme Genetics. From June
1997 until March 1998, Mr. Smith served as Group Controller for Genzyme
Genetics, Genzyme Pharmaceuticals and Genzyme Diagnostic Products. He also
supervised the finance functions for all the Genzyme manufacturing activities
and genetic services in the United States, the United Kingdom and Switzerland.
From 1993 until 1996, Mr. Smith served as Vice President of Finance and
Administration and Chief Financial Officer of Genetrix, Inc. Before joining
Genetrix, Mr. Smith practiced with the accounting firm of Price Waterhouse in
both Australia and the United States. He is a Certified Public Accountant (US)
and a member of the Institute of Chartered Accountants in Australia.

  HENK SNYMAN, M.D., age 39, is Vice President, Europe. He has been with the
Company since November 1996. From April 1995 until November 1996, Dr. Snyman
was General Manager of Serono Benelux, a subsidiary of Ares-Serono, a
multinational pharmaceutical company. From April 1993 until April 1995, Dr.
Snyman was European Business Director of Ares-Serono. Dr. Snyman obtained his
medical degree in South Africa at Orange Free State, Bloemfontein and
qualified as a surgeon at each of the Royal Colleges of Surgeons of Edinburgh
and Glasgow, respectively. Dr. Snyman has attended various business school
programs in London, Paris and Boston.

  HOWARD M. SOLOMON, M.D., F.C.A.P., age 41, is Vice President of Medical
Operations. Dr. Solomon joined the Company in March 1997. From 1994 to 1997,
Dr. Solomon was Vice President of Clinical Affairs of London International
U.S. Holdings, Inc., a medical products manufacturer. In 1993 Dr. Solomon was
Director of Regulatory Affairs at Becton Dickinson Cellular Imaging Systems.
Prior to such affiliations, Dr. Solomon was an Obstetric and Gynecologic
Pathology Fellow at St. John's Mercy Medical Center (St. Louis, Missouri). Dr.
Solomon graduated from University of Missouri with a B.S. in Chemical
Engineering and received his M.D. from the University of Missouri School of
Medicine. Dr. Solomon is a diplomate of the American Board of Pathology in
combined anatomic and clinical pathology.

                                      23
<PAGE>

                                    PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

(A) MARKET INFORMATION

  The principal market on which the Common Stock of the Company is traded is
the Nasdaq National Market System, under the symbol "NSIX."

  The high and low sales price for the Company's Common Stock during each
quarterly period in which the Common Stock has been publicly traded is set
forth in the table below:

<TABLE>
<CAPTION>
                                                               HIGH       LOW
                                                             --------- ---------
      <S>                                                    <C>       <C>
      1997
        4th Quarter......................................... $ 5 5/8   $ 2 5/8
        3rd Quarter.........................................   5 13/16   2 13/16
        2nd Quarter.........................................  10 5/8     5
        1st Quarter.........................................  13 3/4     7 3/8
      1996
        4th Quarter......................................... $19 1/4   $11 3/4
        3rd Quarter.........................................  20 1/8    10 3/4
        2nd Quarter.........................................  23 3/8    14
        1st Quarter.........................................  26 7/8    18 5/8
</TABLE>

  As of March 13, 1998, the high and low sales prices for the Company's Common
Stock during the first quarter 1998 were $4 1/4 and $2 3/8, respectively.

  During fiscal year 1997, no sales of unregistered securities were made by
the Company.

(B) HOLDERS

  As of March 13, 1998, there were approximately 361 holders of record of the
Company's Common Stock, including Goldman, Sachs & Co. and its related
affiliates, who, as of February 27, 1998, beneficially owned 8,337,395 shares,
or approximately 26.8% of total shares outstanding. In addition to the holders
of record, 17,519,952 shares of Common Stock were held beneficially in
approximately 6,000 nominee accounts as of the close of business on March 13,
1998.

(C) DIVIDENDS

  The Company has not paid and does not anticipate paying any cash dividends
in the foreseeable future and intends to retain future earnings for the
development and expansion of its business. Any future determination to pay
dividends will be at the discretion of the Company's Board of Directors and
subject to certain limitations under the General Corporation Law of the State
of Delaware and will depend upon the Company's results of operations,
financial condition, other contractual restrictions and other factors deemed
relevant by the Board of Directors.

                                      24
<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

  The following selected consolidated financial data of the Company are
qualified by reference to and should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the consolidated financial statements and notes thereto included herein.

<TABLE>
<CAPTION>
                                             YEAR ENDED DECEMBER 31,
                         -------------------------------------------------------------------
                             1997          1996          1995          1994         1993
                         ------------  ------------  ------------  ------------  -----------
<S>                      <C>           <C>           <C>           <C>           <C>
Total revenues.......... $  9,374,000  $  4,729,000  $  2,475,000  $  1,238,000  $   502,000
Net loss................  (36,581,000)  (34,158,000)  (29,428,000)  (13,819,000)  (6,782,000)
Basic and diluted net
 loss per share*........        (1.18)        (1.17)        (1.80)        (1.00)         --
Total assets............   66,344,000   104,204,000   127,348,000    13,173,000   12,863,000
Long-term debt and
 capital
 lease obligations......    8,345,000    11,166,000     6,050,000     4,190,000      695,000
</TABLE>
--------
* Basic and diluted net loss per share amounts for 1995 and 1994 are on a pro
  forma basis.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS

OVERVIEW

  Neuromedical Systems, Inc., a Delaware corporation (the "Company") is a
healthcare technology company focused on bringing intelligent vision to
medicine. It is the Company's objective to become the premier supplier of
cytology screening and anatomic pathology diagnostic equipment and services to
laboratories. The Company's first and, to date, only product, the PAPNET
Testing System, is a sophisticated interactive system that assists the
laboratory professional in the detection of abnormal cells on cervical
cytology specimens (also known as Pap smears). Since its inception, the
Company has been primarily engaged in the development, manufacturing and
marketing of the PAPNET Testing System, and the scanning of Pap smears at its
slide processing facilities. The Company's revenues are currently being
derived from sales of PAPNET testing services, equipment sales and interest
income.

  In the United States, the PAPNET Testing System is promoted to assist the
cytology professional in the examination of conventionally prepared smears
that have first been assessed by standard manual microscopy to be "negative,"
"within normal limits", or evidencing "benign cellular changes." Outside of
the United States, some of the Company's laboratory customers use the PAPNET
Testing System in a variety of different modes, including to assist in the
interpretation of liquid-based Pap specimens and Pap smears that have not
first been assessed by manual microscopic review.

  The PAPNET system may be purchased or leased by the laboratory customer in
its entirety or individual components, or accessed on a patient by patient
basis.

  The PAPNET Testing System was approved by the United States Food and Drug
Administration (the "FDA") for commercial use in the United States on November
8, 1995. Prior to that time, the PAPNET Testing System was permitted to be
utilized in the United States on an investigational basis only, and the
Company was permitted to derive revenue with respect thereto only to recover
certain of its costs. However, during that time the Company was selling PAPNET
testing services for commercial use outside of the United States. The Company
established three scanning facilities (the "Scanning Centers"), one each in
the United States, The Netherlands and Hong Kong. The Netherlands Scanning
Center has scanned slides primarily from customers in Europe while the Hong
Kong Scanning Center has scanned slides from Asia and Australia. During the
third quarter of 1997, the Company announced a strategic shift in its European
business approach from being a supplier of scanning services via a centralized
scanning center to selling and leasing the PAPNET Testing System equipment to
laboratories under the PAPNET-on-Cyte trade name. As a consequence of this
change, the Company has announced the signing of a number of European sales
and lease contracts and delivered the first PAPNET-on-Cyte system to a
customer in the fourth quarter of 1997. In addition, the Company recently

                                      25
<PAGE>

announced plans to close its Netherlands Scanning Center and lease or sell its
existing PAPNET Systems to laboratory customers. In the United States, the
Company is preparing to make the same transition that it has made in Europe.
However, due to differences in the laboratory marketplace, reimbursement and
regulatory requirements, the Company expects that the transition in the United
States will extend until at least the end of 1999. In addition to slide
scanning services, the Company's Asia Pacific operations provide PAPNET-
assisted screening for customers in Hong Kong, China and Taiwan through the
Company's wholly-owned Hong Kong cytology laboratory, Compuscreen Medical
Diagnostic Centre. The Company is also preparing a marketing program to sell
and lease scanning equipment to Hong Kong government institutions. See Note 5
of Notes to Consolidated Financial Statements for the year ended December 31,
1997 for information regarding the Company's revenues, net loss and
identifiable assets by geographic area.

  The Company has incurred net losses since inception through December 31,
1997 of $131,089,000 and has to date generated only limited commercial
revenues. Since the approval of the PAPNET Testing System by the FDA, the
Company has been increasing the scale of its operations to commercial levels
in the United States and internationally. Management believes that its
existing cash resources will be sufficient to fund operations and to meet its
cash requirements through 1999, although there can be no assurance in this
regard. The Company's past results of operations reflect its developmental or
early commercial stage and are not necessarily indicative of the results from
operations that may be expected in the future.

  Statements in this discussion which are not historical facts, including
statements about the Company's confidence and strategies and its expectations
about demand for and acceptance of the PAPNET Testing System, are forward
looking statements that involve risks and uncertainties. The forward looking
statements are made pursuant to the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Actual results may differ materially
due to a variety of factors which include, but are not limited to, the
Company's continuing negative cash flow, reliance on a single product,
competition, dependence on key personnel, the impact on the Company of its
territorial license agreements, dependence on patents and proprietary
technology, government regulation of both products and advertising, limited
marketing and sales history, the impact of third party reimbursement
decisions, risk of litigation and other risks detailed in the Company's
Securities and Exchange Commission filings, including Exhibit 99.1 filed
herewith.

RESULTS OF OPERATIONS

  The Company's results of operations have fluctuated significantly from year
to year and quarter to quarter, principally due to variations in the level of
expenditures relating to its clinical trials, research projects, marketing and
sales programs and international expansion. The Company's results of
operations are expected to continue to fluctuate significantly and may
continue to result in substantial losses.

  The Company believes that significant revenue growth during 1998 is
dependent on the success of the strategic shift of its European business
strategy to sell PAPNET-on-Cyte equipment to laboratories. The Company does
not expect significant revenue growth in the United States until it obtains
FDA approval for use of the PAPNET Testing System for interactive primary
screening of Pap smears.

  From inception through December 31, 1997, the Company has experienced
negative gross margins due to the significant underutilization of its scanning
and manufacturing operations. Improvement in the Company's future gross
margins will be dependent upon the level of commercial acceptance of the
PAPNET Testing System and, in particular during 1998, the degree of success of
PAPNET-on-Cyte sales in Europe.

  The Company's costs and expenses increased substantially during 1996 and
1997, compared to earlier years, as the Company expanded its commercial
operations both in the United States and internationally. The Company,
however, anticipates that aggregate costs and expenses will decrease in 1998
compared to 1997, following the Company's decision to focus sales and
marketing efforts on laboratory customers and opinion leading clinicians, sell
equipment in Europe and consolidate product development activities in the
United States. Despite these cost reduction programs, however, the Company
does not expect total costs and expenses to decline significantly in 1998
because of the expected increased costs of clinical studies for a primary
screening indication in the United States, increased costs associated with the
Company's operation of its Hong Kong, China and Taiwan acquisitions for a full
year in 1998 versus a partial year in 1997, uncertainty over the level of
costs associated

                                      26
<PAGE>

with ongoing litigation, and higher royalty payments in the sales territories
of the Company's territorial licensees ("Licensees") that will increase
proportionate to increases in the Company's revenues in those territories.

  Interest expense is expected to decline in 1998, compared to 1997, due to
the reduced need to borrow funds for the expansion of the Company's
manufacturing, slide processing and marketing capabilities, including the
installation of additional PAPNET Scanning Stations at the Company's Scanning
Centers, and the scheduled repayment of existing debt. Interest income from
the Company's investment of excess funds are expected to offset interest
expense in 1998. The Company expects that interest income will decline in
1998, compared to 1997, because of the significant use of cash during 1997 and
the anticipated use of cash in 1998.

  The impact of inflation on the Company's revenues and costs has not been
significant.

 Comparison of the Years Ended December 31, 1997 and 1996

  Revenues in 1997 were $9,374,000, an increase of 98% from $4,729,000 during
1996. This increase was due to a significant increase in unit volume, higher
average unit pricing, including the favorable pricing impact of the
acquisition of operations in Hong Kong, China and Taiwan, and increased
revenue from the sale of equipment, primarily PAPNET-on-Cyte Systems and
Review Stations in Europe.

  An increase in slide scanning unit volume accounted for approximately 40% of
the revenue increase over 1996. For United States operations (includes Canada
and South America), slide scanning unit volume increased by 87% over 1996,
while in international markets, slide scanning unit volume increased by 14%
over 1996. Worldwide average unit pricing during 1997 increased by
approximately 31% compared to 1996 and accounted for approximately 42% of the
revenue increase. This increase was primarily due to a higher proportion of
unit volume being generated in the United States and to the acquisition of a
laboratory and the marketing operations in Hong Kong and China of New Systems
International Ltd., and the operations in Taiwan of Papnet Far East Ltd.
(Taiwan). Revenue from the sale of equipment, primarily PAPNET-on-Cyte
systems, accounted for the remaining 18% of the revenue increase.

  Total costs and expenses for 1997 were $47,776,000 compared to $42,266,000
in 1996, an increase of $5,510,000. This increase was due primarily to
increases in general and administrative expenses, research and development
expenses, and cost of sales, partially offset by lower sales and marketing
expenses.

  The Company's cost of sales increased to $12,111,000 in 1997, compared to
$8,178,000 during 1996, an increase of $3,933,000. This increase was primarily
associated with the expansion of the Company's slide processing and
manufacturing capacity, increased royalty expenses as a result of increases in
the Company's revenues in the sales territories of the Licensees, the
acquisition of the laboratory business of New System International Ltd. in
June 1997 and the cost associated with the sale of equipment.

  Sales and marketing expenses decreased to $17,884,000 during 1997 from
$20,328,000 during 1996, a decrease of $2,444,000. The decrease in sales and
marketing expenses was due primarily to the reduction in sales and marketing
expenses in the United States, primarily in advertising and promotion
expenses, as a result of the Company's decision to suspend advertising and
channel communications through its laboratory customers. This decrease was
partially offset by higher marketing expenses in Europe and the acquisition of
new marketing operations in Hong Kong and China in June of 1997 and Taiwan in
August of 1997.

  The Company's research and development expenses increased to $8,362,000 in
1997, compared to $6,785,000 during 1996, an increase of $1,577,000. This
increase was due primarily to the expansion of the product development and
medical departments of the Company to support working toward obtaining
expanded clinical claims and indications, and future enhancements of the
PAPNET Testing System.

  The Company's general and administrative expenses increased to $9,419,000
during 1997 compared to $6,975,000 in 1996, an increase of $2,444,000. This
increase was due primarily to higher legal expenses, primarily for litigation,
increased recruiting costs associated with the search for a new CEO and costs
associated with the revised employment agreement of the former CEO.

                                      27
<PAGE>

  Interest income decreased to $3,514,000 during 1997 compared to $5,208,000
during 1996, a decrease of $1,694,000. This decrease was due primarily to the
lower level of cash, cash equivalents and short-term securities balances that
the Company held during 1997 as a result of the Company's continuing losses in
1996 and 1997.

  Interest expense during 1997 increased to $1,635,000 compared to $1,095,000
in 1996, an increase of $540,000. This increase was due primarily to higher
average levels of debt and capital lease obligations.

  The Company incurred a net loss during 1997 of $36,581,000, or $1.18 per
share, compared to a net loss of $34,158,000, or $1.17 per share during 1996.
The increased net loss was due primarily to the increase in general and
administrative and research and development expenses and to the reduction in
interest income in 1997. These items were partially offset by an improved
gross margin and lower sales and marketing expenses.

 Comparison of the Years Ended December 31, 1996 and 1995

  Revenues for the year ended December 31, 1996 were $4,729,000, compared to
$2,475,000 for 1995, an increase of $2,254,000 or 91%. This increase was due
primarily to significantly higher selling prices in 1996 compared to 1995 and
to higher unit volume in the United States, offset partially by slightly lower
unit volume in international markets.

  Total costs and expenses for the year ended December 31, 1996 were
$42,266,000 compared to $31,687,000 in 1995, an increase of $10,579,000. This
increase was primarily the result of higher sales and marketing expenses,
which increased to $20,328,000 in 1996 from $6,268,000 in 1995. The increase
in sales and marketing expenses of $14,060,000 was due primarily to costs
associated with the launch of the PAPNET Testing System in the United States,
including salaries for additional personnel and advertising and promotion
costs required to initiate the PAPNET direct-to-consumer campaign. In
addition, the Company's cost of sales, research and development and general
and administrative expenses also increased during 1996, although at a slower
rate than sales and marketing expenses. These increases were due primarily to
the expansion of the technical and administrative infrastructure of the
Company to support commercial activities in both the United States and
internationally, and the additional costs of being a public company. These
increases in expenses during 1996, compared to 1995, were partially offset by
the absence in 1996 of two non-cash charges that occurred in 1995, totaling
$7,752,000, resulting from the terms of a settlement agreement entered into
with the Licensees in December 1995 and the vesting of 568,058 employee
performance stock options upon the completion of the Company's initial public
offering (the "IPO") in December 1995.

  Interest income for the year ended December 31, 1996 was $5,208,000 compared
to $548,000 during 1995. This increase was due primarily to the Company's
significantly higher cash and cash equivalent balances in 1996 as a result of
the Company's IPO, equity sales to private investors during the third quarter
of 1995 and the exercise of certain warrants by investors in December 1995.

  Interest expense during 1996 was $1,095,000 compared to $924,000 during
1995. This increase was due to higher levels of debt and capital lease
obligations, which the Company entered into in late 1996, incurred to finance
capital equipment additions, primarily related to the Company's PAPNET
Scanning Stations.

  The Company incurred a foreign exchange loss of $734,000 during the year
ended December 31, 1996 compared to foreign exchange gain of $160,000 during
1995. The 1996 loss and the 1995 gain were caused primarily by fluctuations in
exchange rates on dollar denominated intercompany loans.

  The Company incurred a net loss during the year ended December 31, 1996 of
$34,158,000, or $1.17 per share, compared to a net loss of $29,428,000, or
$1.80 per share (on a pro forma basis), for 1995. The increased net loss
during 1996, compared to 1995, was due primarily to an increase in marketing
and sales expenses associated with the launch of the PAPNET Testing System in
the United States, following approval by the FDA in November 1995, including
the cost of the direct-to-consumer advertising campaign. In addition, the
Company's cost of sales, research and development and general and
administrative expenses also increased during 1996, although at a slower rate
than sales and marketing expenses. These increases in expenses during

                                      28
<PAGE>

1996, compared to 1995, were partially offset by the absence in 1996 of the
two non-cash charges, referred to above, that were recognized in the fourth
quarter of 1995. The reduction in net loss per share in 1996 reflects the net
effect of the increased loss in 1996 offset by an increase in the weighted-
average shares outstanding. The increase in the weighted-average shares
outstanding resulted from the issuance of shares in the IPO in December 1995
and the exercise of certain common stock warrants and options in late 1995 and
1996.

LIQUIDITY AND CAPITAL RESOURCES

  The Company has financed its operations since its inception primarily by the
issuance of equity securities; sales of PAPNET Testing System services; funds
received for the territorial license agreements (prior to 1992); interest
earned on cash, cash equivalents and short-term securities; and proceeds from
notes, bank loans and equipment leasing agreements. In addition, in the fourth
quarter of 1997, the Company generated its first revenues from the sale of
PAPNET-on-Cyte systems to laboratories in Europe. The Company expects to
generate increased revenue from the sale and rental of PAPNET-on-Cyte systems
to European customers in 1998.

  The Company's combined cash, cash equivalents, and short-term securities
totaled $45,936,000 at December 31, 1997, a decrease of $37,455,000 from
December 31, 1996. During 1997, the Company used $32,589,000 for operating
activities; $5,032,000 for investing activities (net of the net purchase of
$30,094,000 of short-term securities) offset by net cash provided by financing
activities of $214,000.

  The uses of cash and cash equivalents during 1997 were $36,581,000
(inclusive of $5,278,000 of non-cash items) to finance the Company's net loss;
$30,094,000 for the net purchase of short-term securities; $3,276,000 to
purchase capital equipment, primarily for the manufacture of PAPNET Scanning
Stations and related equipment, to support the expansion of the Company's
scanning capacity; $1,156,000 to acquire the Company's new operations in Hong
Kong, China and Taiwan; $600,000 for a non-recourse loan to the Company's
former CEO in connection with his revised employment agreement; $3,986,000 to
repay notes, bank loans and capital lease obligations; and $1,344,000 for
changes in operating assets and liabilities.

  The sources of cash and cash equivalents during 1997 were proceeds of
$1,737,000 from notes and bank loans, proceeds of $1,672,000 from capital
lease financing transactions (sale/leaseback), a reduction in restricted cash
of $431,000 and proceeds of $360,000 from the issuance of common stock,
associated with the exercise of stock options and warrants.

  The significant increase in cash used for operations during 1996 and 1997,
when compared with earlier years, is primarily the result of higher expenses
for the initiation and expansion of the Company's sales and marketing programs
in the United States and internationally, higher expenses for research and
development to support product enhancements and the Company's FDA premarket
approval application, other FDA related activities, expansion of the Company's
slide processing and manufacturing capabilities in the United States, The
Netherlands and Hong Kong, expansion of the Company's manufacturing
capabilities in Israel, and expansion of the administrative infrastructure
needed to support commercial activities following approval of the PAPNET
Testing System by the FDA and the additional costs of being a public company.

  As of December 31, 1997, the Company's debt and capital lease obligations
totaled $13,474,000. The amount of combined payments of the outstanding debt
and capital lease obligations, including related interest on capital leases,
for the five years succeeding December 31, 1997 is approximately $5,797,000 in
1998, $3,901,000 in 1999, $2,516,000 in 2000, $2,169,000 in 2001 and $441,000
in 2002. The Company's commitments for payments under non-cancelable operating
leases for the five years succeeding December 31, 1997 are approximately
$2,324,000 in 1998, $2,153,000 in 1999, $1,669,000 in 2000, $698,000 in 2001
and $563,000 in 2002.

  The Company anticipates that its use of cash will be substantial for the
foreseeable future. In particular, the Company anticipates that expenditures
will continue to be substantial in 1998 due to the cost of marketing and sales
in the United States and internationally, the expansion of research and
development programs for additional

                                      29
<PAGE>

clinical indications and claims, and the cost of ongoing litigation. The
Company anticipates that during 1998 it will invest approximately $3.0 million
for working capital purposes and approximately $2.0 million for capital
expenditures and leasehold improvements. Although funding for these capital
expenditures is expected to be available out of the Company's cash resources,
management of the Company believes that it may be desirable for the Company to
finance certain of such capital expenditures through additional debt or
capital lease obligations. There can be no assurance, however, that such
funding can be obtained or, if obtained, that the terms thereof will be
reasonable.

  In an agreement effective as of June 1, 1997, the Company acquired New
System International Ltd., a Hong Kong corporation, for a net purchase price
of $1,564,000. New System International Ltd. was previously the operating
subsidiary of Papnet (Far East) Ltd. a Hong Kong corporation ("PFEL"), a
distributor of the Company's PAPNET Testing System in Hong Kong and China. New
System International Ltd. also provides clinical laboratory services through
its Hong Kong-based Compuscreen Medical Diagnostic Centre. Dr. Stephen Ng, a
former director of the Company, served as president of New System
International Ltd. prior to its acquisition and in the third quarter of 1997
entered into an employment agreement with the Company providing for his
continuation in such capacity.

  In an agreement effective as of August 1, 1997, the Company acquired the
assets of the Taiwan PAPNET distributor, Papnet Far East Ltd. (Taiwan) through
the Company's acquisition subsidiary, New System Ltd., for a purchase price of
$392,000. In a related transaction, the Company executed a license and
management services agreement with Papnet Far East Ltd. (Taiwan) for operation
of the Company's assets in Taiwan.

  Related to each of the foregoing acquisitions, on September 30, 1997, PFEL
entered into an Amended and Restated Representation Agreement with the
Company, and a Sublicense Agreement with the Company's subsidiary, NSI Asia
Pacific Ltd., pursuant to which the Company received $800,000 from PFEL for
the right of PFEL to receive a royalty of 3% to 4% based on sales in Hong
Kong, China and Taiwan over a fifteen year period (the "Royalty Arrangement").
Under the terms of the Royalty Arrangement, commencing September 2001 and
ending September 2005, PFEL may, at its option, require the Company to
repurchase its rights under the Royalty Arrangement for an aggregate purchase
price equal to five times the trailing year's royalty due (the "Repurchase
Option"). The Repurchase Option is payable at the election of the Company in
either cash or in Company Common Stock. If the Repurchase Option is exercised
by PFEL and made payable by the Company in Common Stock, (i) the price of the
Common Stock will be determined based on the average publicly quoted closing
price of the most recent 30 day period prior to exercise of the Repurchase
Option, and (ii) the Company will provide registration rights with respect to
such Common Stock. The Royalty Arrangement contains a provision providing that
in the event of cessation of the Company's Asia Pacific operations, a
termination fee shall be due and payable to PFEL in an amount equal to
$800,000 less the sum of all royalty payments previously paid. No payments
were made during 1997 to PFEL in regard to the Royalty Arrangement. There can
be no assurance that payments made by the Company in respect of the Royalty
Arrangement will not have material consequences on the profitability of the
Company's Asia Pacific business. In addition, in the event PFEL exercises its
Repurchase Option and if the consideration is paid in Common Stock, such
payment will result in dilution of the Company's outstanding Common Stock, and
the registration and sale of such stock may adversely affect the market for
other publicly traded shares of the Company's Common Stock.

  During 1996 and 1997, the Company entered into loan and equipment lease
agreements with two equipment financing companies to provide the Company with
lines of credit to finance certain of the Company's equipment purchases. These
loans and lease commitments expired on December 31, 1997. Under the terms of
these loan agreements, the loans are secured by a perfected first priority
interest in the financed equipment. During 1996 and 1997, the Company borrowed
approximately $12,876,000 under these agreements. The agreements require the
Company to maintain certain financial covenants throughout the duration of the
repayment period. The Company anticipates that during 1998 it will be
required, under these financial covenants, to provide the lenders with letters
of credit or restricted cash estimated to be approximately $3.7 million as
additional collateral under these agreements.

                                      30
<PAGE>

  The Company anticipates that its current cash, cash equivalents, and short-
term securities will be sufficient to enable the Company to meet its future
operating requirements through 1999, although there can be no assurance in
that regard. The Company does not expect to generate a positive internal cash
flow in the foreseeable future due to continued working capital requirements
and capital expenditures, repayment of debt and capital lease obligations and
ongoing losses from operations during the next year. The Company may need to
arrange additional equity or debt financing for the future operation of its
business. There can be no assurance that such financing can be obtained or, if
it is obtained, that the terms thereof will be reasonable. The Company plans
to invest excess funds in short-term instruments, including money market
funds.

  During 1997, the Company's operating results reflect foreign exchange losses
of $58,000 and its financial position as of December 31, 1997 reflects a
foreign currency translation effect of $335,000. As discussed in detail below,
the Company is subject to foreign currency exchange rate risk because (i) it
has investments in its foreign subsidiaries, (ii) it derives a significant
portion of its revenues and incurs a significant portion of its costs and
expenses in the local currencies of the countries in which its subsidiaries
are transacting business and (iii) it finances the operations of such
subsidiaries substantially through dollar denominated intercompany loans which
are recorded on the books of the subsidiaries in their respective local
currencies. Fluctuations in exchange rates have not had a material impact on
the Company's revenues or costs and expenses, but have affected the value of
its equity investments and intercompany loans.

  From inception through December 31, 1997, a significant proportion of the
Company's sales have been derived from foreign sources, and the Company
anticipates that international sales will continue to represent a significant
proportion of its net sales as it executes its plan to sell PAPNET-on-Cyte
systems in Europe. In addition, the Company has provided a significant portion
of the financing required for the operation of its subsidiaries in The
Netherlands, Australia, Israel and Hong Kong through intercompany loans and
equity investments denominated in United States dollars. As a result of its
international operations and its current financing approach, the Company's
operating results are subject to the impact of fluctuations in exchange rates
of the currencies in which its foreign operations conduct business versus the
United States dollar. The Company is exposed to gains and losses with respect
to several European currencies (predominately Dutch guilders) and Australian
dollars because the Company's subsidiaries invoice for equipment sales and
slide processing services and incur costs and expenses in local currencies. In
addition, although the Company's Israeli subsidiary maintains its books in
U.S. dollars, certain of its expenses are incurred in Israeli shekels and are
subject to exchange fluctuations. The revenues and expenses of the Company's
Hong Kong subsidiary are in Hong Kong dollars, the value of which is presently
tied to the United States dollar and, therefore, are not currently subject to
material fluctuations. There can be no assurance, however, that the exchange
rate between the United States dollar and the Hong Kong dollar will not
fluctuate in the future.

  To date, the Company has not implemented a program to hedge its foreign
currency risk, but may do so in the future.

  At December 31, 1997, the Company had available United States net operating
loss carry forwards of approximately $88,000,000 that will expire in the years
2004 through 2012 and cumulative deductible temporary differences of
approximately $7,800,000. The Company also has foreign net operating losses of
approximately $14,000,000 that are available to offset the separate taxable
incomes of certain foreign subsidiaries. These losses may be carried forward
indefinitely. In addition, at December 31, 1997, the Company also had
approximately $1,300,000 of United States research and development credits
available which will expire in the years 2004 through 2012. The Tax Reform Act
of 1986 enacted a complex set of rules limiting the potential utilization of
United States net operating loss carry forwards and tax credit carry forwards
in periods following a corporate "ownership change." In general, an ownership
change is deemed to occur if the percentage of stock of a loss corporation
owned (actually, constructively and, in some cases, deemed) by one or more "5%
Stockholders" has increased by more than 50 percentage points over the lowest
percentage of such stock owned during a three year testing period. As a result
of changes in the Company's ownership, the utilization of a substantial
portion of the Company's available United States net operating loss carry
forwards and tax credit carry forwards will be subject to annual limitations.
It is management's belief, however, that since such annual limitations are

                                      31
<PAGE>

determined based on the value of the Company immediately prior to the
ownership changes, a significant portion of the carry forwards will be
available annually should the Company become profitable in future tax years.

  The Company has an ongoing program to review, test and insure that its
computer systems will not suffer catastrophic failures in connection with the
change in the calendar on January 1, 2000. The Company believes that the cost
of year 2000-related corrections will not have a material effect on the
Company's business, operation or financial condition. The Company licenses
most of the software it uses in various functions other than in its slide
processing operations and slide processing related functions. Although this
practice has minimized the Company effort and cost needed to make the Company
year 2000 compliant, it does place greater reliance on the outside firms that
provide the software. Because most of the Company's software is licensed, the
Company's main internal compliance tasks are auditing hardware and software,
reviewing internal and external applications, prioritizing applications by
risk, creating a communications program to raise awareness levels and enable
correction of all existing application solutions, and installation of vendor
provided year 2000 software fixes. The Company believes that the majority of
the major software applications it uses are either year 2000 compliant or
contain only minor problems, and only a few need significant modification.
Some of the applications, including the applications in its slide processing
operations and slide processing related functions, are still under evaluation
by the Company.

  At present, the recent downturns in various Asia Pacific economies have not
had a material impact on the Company's financial condition in the region;
however, there can be no assurance that Asian economic difficulties will not
adversely affect the Company's Asia Pacific sales and operations.

  The Company is involved in several lawsuits. See "Legal Proceedings" under
Item 3 of Part I herein for a complete discussion of legal proceedings in
which the Company is involved, which discussion is incorporated herein by
reference thereto.

                                      32
<PAGE>

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                           PAGE
                                                                           ----
<S>                                                                        <C>
Report of Independent Auditors............................................ F-2
Consolidated Balance Sheets at December 31, 1997 and 1996................. F-3
Consolidated Statements of Operations for the years ended December 31,
 1997, 1996 and 1995...................................................... F-4
Consolidated Statements of Cash Flows for the years ended December 31,
 1997, 1996 and 1995...................................................... F-5
Consolidated Statements of Stockholders' Equity for the years ended
 December 31, 1997, 1996 and 1995......................................... F-6
Notes to Consolidated Financial Statements................................ F-7
</TABLE>

                                       33
<PAGE>

ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

  No changes in and/or disagreements on accounting or financial disclosure
occurred during the fiscal years 1997 or 1996.

                                   PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS

  The information called for by Item 10 of this Form with respect to Company
directors and compliance with Section 16(a) of the Exchange Act is hereby
incorporated by reference from the registrant's 1998 definitive proxy
statement filed pursuant to Regulation 14A which has been, or will be, filed
with the Commission within 120 days after the end of the fiscal year covered
by this Form 10-K. The information called for by Item 10 of this Form
regarding executive officers is set forth above in Part I above under the
caption, "Executive Officers of the Registrant" and is hereto incorporated by
reference from such section.

ITEM 11. EXECUTIVE COMPENSATION

  The information called for by Item 11 of this Form is hereby incorporated by
reference from the registrant's 1998 definitive proxy statement filed pursuant
to Regulation 14A which has been, or will be, filed with the Commission within
120 days after the end of the fiscal year covered by this Form 10-K.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

  The information called for by Item 12 of this Form is hereby incorporated by
reference from the registrant's 1998 definitive proxy statement filed pursuant
to Regulation 14A which has been, or will be, filed with the Commission within
120 days after the end of the fiscal year covered by this Form 10-K.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  The information called for by Item 13 of this Form is hereby incorporated by
reference from the registrant's 1998 definitive proxy statement filed pursuant
to Regulation 14A which has been, or will be, filed with the Commission within
120 days after the end of the fiscal year covered by this Form 10-K.

                                    PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(A)1. FINANCIAL STATEMENTS

  See Index to Consolidated Financial Statements included on page 33.

  2. FINANCIAL STATEMENT SCHEDULES

  The following consolidated Financial Statement Schedule of the Company is
included herein at the page indicated:

      Schedule II--Valuation and Qualifying Accounts: page F-23.

  All other schedules have been intentionally omitted either because they are
not required or because the information has been included in the Notes to the
Consolidated Financial Statements included in this Report on Form 10-K.

                                      34
<PAGE>

(B) REPORTS ON FORM 8-K

  October 30, 1997: Announcement of Third Quarter 1997 and Nine Months 1997
Financial Results.

  November 5, 1997: Announcement of appointments of Paul Sohmer, M.D. as
President and Chief Executive Officer, and C. Raymond Larkin, Jr. as Chairman
of the Board of Directors.

(C) LIST OF EXHIBITS

  Reference is made below to exhibits indicated with the following footnotes
which are incorporated herein by reference thereto:

    (1) Filed with the U.S. Securities and Exchange Commission (the
  "Commission") as an exhibit to the Registration Statement on Form S-1 of
  the Company (No. 33-97722), filed with the Commission on October 3, 1995,
  as amended by Amendment No. 1 thereto filed on November 13, 1995, by
  Amendment No. 2 thereto filed on November 22, 1995, by Amendment No. 3
  thereto filed on November 29, 1995, by Amendment No. 4 thereto filed on
  December 5, 1995, by Amendment No. 5 thereto filed on December 7, 1995, by
  Post-Effective Amendment No.1 thereto filed on September 30, 1996, and
  Post-Effective Amendment No. 2 thereto on Form S-3 filed on April 21, 1997.

    (2) Filed with the Commission as an exhibit to the Company's Form 10-Q
  for the quarterly period ended June 30, 1997.

    (3) Filed with the Commission as an exhibit to the Company's Form 10-Q
  for the quarterly period ended September 30, 1997.

  Exhibits indicated with footnote (4) are an executive contract or
compensatory plan or arrangement filed pursuant to Item 14 of Form 10-K.

<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                        DESCRIPTION OF DOCUMENT
 -------                       -----------------------
 <C>     <S>
   3.1   Amended and Restated Certificate of Incorporation (1)
   3.2   By-Laws (1)
   4.1   Form of Rights Agreement (1)
   4.2   Form of Stock Certificate (1)
  10.1   Neuromedical Systems, Inc. 1993 Stock Incentive Plan as Amended and
         Restated October 25, 1995 (1)(4)
  10.2   Employment Agreement, dated November 19, 1993, between Neuromedical
         Systems, Inc. and Mark R. Rutenberg (1)(4)
  10.3   Employment Agreement, dated November 18, 1993, between Neuromedical
         Systems, Inc. and Uzi Ish-Hurwitz (1)(4)
  10.4   Employment Agreement, dated November 10, 1994, between Neuromedical
         Systems, Inc. and David Duncan, Jr. (1)(4)
  10.5   Employment Agreement, dated April 1, 1994, between Neuromedical
         Systems, Inc. and Zeev Hadass (1)(4)
  10.6   Employment Agreement, dated March 1, 1994, between Neuromedical
         Systems, Inc. and John B. Henneman, III (1)(4)
  10.7   Employment Agreement, dated November 19, 1993, between Neuromedical
         Systems, Inc. and James M. Herriman (1)(4)
  10.8   Employment Agreement, dated November 19, 1993, between Neuromedical
         Systems, Inc. and Laurie J. Mango, M.D. (1)(4)
  10.9   Employment Agreement, dated February 14, 1994, between Neuromedical
         Systems, Inc. and Andrew C. Panagy (1)(4)
</TABLE>

                                      35
<PAGE>

<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                          DESCRIPTION OF DOCUMENT
 -------                         -----------------------
 <C>     <S>
  10.10  Amendment to Employment Agreement between Neuromedical Systems, Inc.
         and Mark R. Rutenberg, dated as of October 25, 1995 (1)(4)
  10.11  Amendment to Employment Agreement between Neuromedical Systems, Inc.
         and Uzi Ish-Hurwitz, dated as of October 25, 1995 (1)(4)
  10.12  Amendment to Employment Agreement between Neuromedical Systems, Inc.
         and David Duncan, Jr., dated as of October 25, 1995 (1)(4)
  10.13  Amendment to Employment Agreement between Neuromedical Systems, Inc.
         and Zeev Hadass, dated as of October 25, 1995 (1)(4)
  10.14  Amendment to Employment Agreement between Neuromedical Systems, Inc.
         and John B. Henneman, III, dated as of October 25, 1995 (1)(4)
  10.15  Amendment to Employment Agreement between Neuromedical Systems, Inc.
         and James M. Herriman, dated as of October 25, 1995 (1)(4)
  10.16  Amendment to Employment Agreement between Neuromedical Systems, Inc.
         and Laurie J. Mango, M.D., dated as of October 25, 1995 (1)(4)
  10.17  Amendment to Employment Agreement between Neuromedical Systems, Inc.
         and Andrew C. Panagy, dated as of October 25, 1995 (1)(4)
  10.18  Employee Stock Bonus Plan (1)(4)
  10.19  Form of Rutenberg Nonqualified Stock Option Agreement (1)(4)
  10.20  Form of Indemnification Agreement between the Company and its
         directors and officers (1)(4)
  10.21  Exclusive Representation Agreement between Neuromedical Systems, Inc.
         and Papnet (Far East) Ltd. (1)
  10.22  Territorial License Agreement between Neuromedical Systems, Inc. and
         Papnet of Ohio, Inc. (for the Territory of Ohio) (1)
  10.23  Territorial License Agreement between Neuromedical Systems, Inc. and
         Papnet of Ohio, Inc. (for the Territories of Kentucky, Indiana and
         Chicago) (1)
  10.24  Territorial License Agreement between Neuromedical Systems, Inc. and
         ER Group, Inc. (1)
  10.25  Territorial License Agreement between Neuromedical Systems, Inc. and
         Carolina Cytology, Inc. (1)
  10.26  Territorial License Agreement between Neuromedical Systems, Inc. and
         Cytology West, Inc. (1)
  10.27  Territorial License Agreement between Neuromedical Systems, Inc. and
         I-A Cytology (1)
  10.28  Settlement Agreement, dated as of December 4, 1995, among Neuromedical
         Systems, Inc. and Papnet of Ohio, Inc., Cytology Indiana, Inc.,
         Indiana Cytology Review Company, ER Group, Inc., Cytology West, Inc.,
         Carolina Cytology Licensing Company, Papnet Utah, Inc., Carolina
         Cytology Warrant Partnership and GRK Partners (1)
  10.29  Warrant Exercise Agreement, dated as of December 4, 1995, among
         Neuromedical Systems, Inc. and Papnet of Ohio, Inc., Cytology Indiana,
         Inc., Indiana Cytology Review Company, ER Group, Inc., Carolina
         Cytology Warrant Partnership and GRK Partners (1)
  10.30  Restated Employment Agreement between the Company and Mark R.
         Rutenberg, dated June 29, 1997 (2)(4)
  10.31  Secured Non-Recourse Promissory Note between the Company and Mark R.
         Rutenberg, dated July 9, 1997 (2)
  10.32  Form of Employee Replacement Option Agreement, dated July 28, 1997
         (3)(4)
  10.33  Form of Executive Employment Agreement, dated July 1, 1997 (3)(4)
  10.34  Employment Agreement, between Neuromedical Systems, Inc., and Stephen
         K.C. Ng, M.D., dated as of June 1, 1997 (3)(4)
  10.35  Employment Agreement, between NSI Netherlands B.V. and Henk Snyman,
         M.D., dated as of October 8, 1996, as amended July 1, 1997 (3)(4)
</TABLE>

                                       36
<PAGE>

<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                          DESCRIPTION OF DOCUMENT
 -------                         -----------------------
 <C>     <S>
  10.36  Stock Purchase Agreement, dated as of June 1, 1997 among NSI Asia
         Pacific Ltd., Papnet (Far East) Ltd. ("PFEL") and the PFEL
         Stockholders (3)
  10.37  Asset Purchase Agreement, dated as of August 1, 1997 among New System
         Ltd., Papnet Far East Ltd. (Taiwan), and the stockholders of Papnet
         Far East Ltd. (Taiwan) (3)
  10.38  License and Management Services Agreement, dated as of August 1, 1997,
         between New System Ltd. and Papnet Far East Ltd. (Taiwan) (3)
  10.39  Amended and Restated Representation Agreement, dated September 30,
         1997, between Neuromedical Systems, Inc. and Papnet (Far East) Ltd.
         (3)
  10.40  Sublicense Agreement between NSI Asia Pacific Ltd. and Papnet (Far
         East) Ltd., dated September 30, 1997 (3)
  10.41  Employment Agreement between the Company and Paul Sohmer, dated as of
         November 4, 1997 (3)(4)
  10.42  Option Agreement (A) between the Company and Paul Sohmer, dated as of
         November 4, 1997 (3)(4)
  10.43  Option Agreement (B) between the Company and Paul Sohmer, dated as of
         November 4, 1997 (3)(4)
  10.44  Form of Amendment to Company Stock Option Agreements, dated September
         18, 1997, between the Company and Employee Participants in the
         Company's 1993 Stock Option Plan (the "Plan") and/or the Plan as
         amended and restated on October 25, 1995 (3)(4)
  21.1   Subsidiaries of the Registrant
  23.1   Consent of Independent Auditors
  24.1   Powers of Attorney
  27.1   Financial Data Schedule
  99.1   Cautionary Statements for Purposes of the Safe Harbor Provisions of
         the Private Securities Litigation Reform Act of 1995
</TABLE>

  A copy of any of the exhibits included in this Annual Report on Form 10-K,
other than those as to which confidential treatment is pending or has been
granted by the Securities and Exchange Commission, upon payment of a fee to
cover the reasonable expenses of furnishing such exhibits, may be obtained by
written request to the Company, at the address set forth on the front cover,
attention General Counsel.

                                      37
<PAGE>

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                           PAGE
                                                                           ----
<S>                                                                        <C>
Report of Independent Auditors............................................ F-2
Consolidated Balance Sheets at December 31, 1997 and 1996................. F-3
Consolidated Statements of Operations for the years ended December 31,
 1997, 1996 and 1995...................................................... F-4
Consolidated Statements of Cash Flows for the years ended December 31,
 1997, 1996 and 1995...................................................... F-5
Consolidated Statements of Stockholders' Equity for the years ended
 December 31, 1997, 1996 and 1995......................................... F-6
Notes to Consolidated Financial Statements................................ F-7
</TABLE>

                                      F-1
<PAGE>

                        REPORT OF INDEPENDENT AUDITORS

To the Stockholders and the Board of Directors
 Neuromedical Systems, Inc.:

  We have audited the accompanying consolidated balance sheets of Neuromedical
Systems, Inc. and subsidiaries as of December 31, 1997 and 1996, and the
related consolidated statements of operations, stockholders' equity and cash
flows for each of the three years in the period ended December 31, 1997. Our
audits also included the financial statement schedule listed in the Index at
Item 14(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

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

  In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Neuromedical
Systems. Inc. and subsidiaries at December 31, 1997 and 1996, and the
consolidated results of their operations and their ash flows for each of the
three years in the period ended December 31, 1997 in conformity with generally
accepted accounting principles. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.

                                                              Ernst & Young LLP

Hackensack, New Jersey
February 6, 1998

                                      F-2
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                      DECEMBER 31,
                                               ---------------------------
                                                   1997           1996
                                               -------------  ------------
<S>                                            <C>            <C>           <C>
                           Assets
Current assets:
  Cash and cash equivalents................... $  15,842,000  $ 83,391,000
  Short-term securities.......................    30,094,000           --
  Accounts receivable, net of allowance.......     2,119,000     1,650,000
  Inventories.................................     2,942,000           --
  Prepaid expenses............................       617,000       803,000
  Other current assets........................       525,000       732,000
                                               -------------  ------------
Total current assets..........................    52,139,000    86,576,000
Restricted cash...............................       638,000     1,000,000
Property and equipment........................    12,092,000    16,388,000
Intangible assets, net of accumulated
 amortization (1997-$753,000, 1996-$492,000)..       817,000       166,000
Note receivable from employee.................       600,000           --
Other assets..................................        58,000        74,000
                                               -------------  ------------
                                               $  66,344,000  $104,204,000
                                               =============  ============
            Liabilities and Stockholders' Equity
Current liabilities:
  Current portion of notes and bank loans
   payable.................................... $   2,705,000  $  1,200,000
  Current portion of capital lease
   obligations................................     2,424,000     1,972,000
  Accounts payable............................     1,149,000     2,256,000
  Accrued liabilities.........................     4,247,000     4,082,000
                                               -------------  ------------
Total current liabilities.....................    10,525,000     9,510,000
Notes and bank loans payable, long-term.......     3,762,000     4,704,000
Notes payable-stockholder.....................           --        600,000
Capital lease obligations, less current
 portion......................................     4,583,000     5,862,000
Commitments and contingencies
Stockholder's equity
  Preferred stock, $.0001 par value;
   authorized--10,000,000 shares; none issued
   and outstanding............................
  Common stock, $.0001 par value; authorized--
   100,000,000 shares; issued and outstanding
   31,049,510 shares in 1997 and 29,795,049
   shares in 1996.............................         3,000         3,000
  Additional paid-in capital..................   178,801,000   177,559,000
  Deferred compensation.......................      (576,000)          --
  Accumulated deficit.........................  (131,089,000)  (94,508,000)
  Foreign currency translation................       335,000       474,000
                                               -------------  ------------
                                                  47,474,000    83,528,000
                                               -------------  ------------
Total stockholders' equity.................... $  66,344,000  $104,204,000
                                               =============  ============
</TABLE>

                            See accompanying notes.

                                      F-3
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                             YEAR ENDED DECEMBER 31,
                                      ----------------------------------------
                                          1997          1996          1995
                                      ------------  ------------  ------------
<S>                                   <C>           <C>           <C>
Revenues:
  Slide processing and equipment
   sales............................. $  9,374,000  $  4,729,000  $  2,475,000
                                      ------------  ------------  ------------
    Total revenues...................    9,374,000     4,729,000     2,475,000
                                      ------------  ------------  ------------
Costs and Expenses:
  Cost of sales......................   12,111,000     8,178,000     6,478,000
  Sales and marketing................   17,884,000    20,328,000     6,268,000
  Research and development...........    8,362,000     6,785,000     5,172,000
  General and administrative.........    9,419,000     6,975,000     6,017,000
  Stock issued pursuant to a settle-
   ment agreement....................          --            --      1,652,000
  Vesting of performance options at
   initial public
   offering..........................          --            --      6,100,000
                                      ------------  ------------  ------------
    Total costs and expenses.........   47,776,000    42,266,000    31,687,000
                                      ------------  ------------  ------------
Loss from operations.................  (38,402,000)  (37,537,000)  (29,212,000)
Other income (expense):
  Interest income....................    3,514,000     5,208,000       548,000
  Interest expense...................   (1,635,000)   (1,095,000)     (924,000)
  Foreign exchange...................      (58,000)     (734,000)      160,000
                                      ------------  ------------  ------------
    Other income (expense)--net......    1,821,000     3,379,000      (216,000)
                                      ------------  ------------  ------------
Net loss............................. $(36,581,000) $(34,158,000) $(29,428,000)
                                      ============  ============  ============
  Basic and diluted net loss per
   share (1995 on a proforma basis).. $      (1.18) $      (1.17) $      (1.80)
                                      ============  ============  ============
  Shares used in computation of net
   loss per share....................   30,928,000    29,277,000    16,340,000
                                      ============  ============  ============
</TABLE>


                            See accompanying notes.

                                      F-4
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                              YEAR ENDED DECEMBER 31,
                                       ----------------------------------------
                                           1997          1996          1995
                                       ------------  ------------  ------------
<S>                                    <C>           <C>           <C>
OPERATING ACTIVITIES
Net Loss.............................  $(36,581,000) $(34,158,000) $(29,428,000)
Adjustments to reconcile net loss to
 net cash used in
 operating activities:
  Depreciation and amortization......     4,972,000     3,415,000     2,936,000
  Non-cash compensation related to
   issuance of
   common stock warrants and options.       306,000       341,000       210,000
  Foreign exchange loss..............        58,000       737,000           --
  Stock issued pursuant to a settle-
   ment agreement....................           --            --      1,652,000
  Vesting of performance options at
   initial public
   offering..........................           --            --      6,100,000
Changes in operating assets and lia-
 bilities:
  Increase in accounts receivable....      (274,000)     (750,000)     (252,000)
  Increase in inventory..............      (445,000)          --            --
  Decrease (increase) in prepaid
   expenses and other assets.........       434,000      (375,000)      199,000
  (Decrease) increase in accounts
   payable...........................    (1,219,000)      211,000      (110,000)
  Increase in accrued liabilities....       160,000       759,000     1,894,000
                                       ------------  ------------  ------------
  Net cash used in operating activi-
   ties..............................   (32,589,000)  (29,820,000)  (16,799,000)
                                       ------------  ------------  ------------
INVESTING ACTIVITIES
Purchase of short-term securities....   (35,094,000)          --            --
Proceeds from maturing short-term se-
 curities............................     5,000,000           --            --
Purchases of property and equipment..    (3,276,000)   (8,643,000)   (5,008,000)
Acquisition of businesses, net of
 cash acquired.......................    (1,156,000)          --            --
Loan to officer......................      (600,000)          --            --
                                       ------------  ------------  ------------
Net cash used in investing activi-
 ties................................   (35,126,000)   (8,643,000)   (5,008,000)
                                       ------------  ------------  ------------
FINANCING ACTIVITIES
Restricted cash......................       431,000    (1,250,000)    1,016,000
Issuance of stock pursuant to exer-
 cise of warrants....................       143,000         8,000    18,500,000
Issuance of stock pursuant to exer-
 cise of options.....................       217,000     1,745,000           --
Issuance of common stock in initial
 public offering.....................           --            --     94,725,000
Issuance of convertible preferred
 stock...............................           --            --     19,325,000
Repayments to licensees..............           --            --        (97,000)
Proceeds from notes and bank loans...     1,737,000     3,144,000     1,774,000
Proceeds from sale lease-back trans-
 actions.............................     1,672,000     6,323,000     1,354,000
Payments of notes and bank loans.....    (1,764,000)   (1,250,000)   (1,082,000)
Payments on capital leases...........    (2,222,000)   (1,045,000)     (565,000)
                                       ------------  ------------  ------------
Net cash provided by financing activ-
 ities...............................       214,000     7,675,000   134,950,000
                                       ------------  ------------  ------------
EFFECT OF EXCHANGE RATE CHANGES ON
 CASH................................       (48,000)       36,000      (235,000)
                                       ------------  ------------  ------------
Net (decrease) increase in cash and
 cash equivalents....................   (67,549,000)  (30,752,000)  112,908,000
Cash and cash equivalents, beginning
 of period...........................    83,391,000   114,143,000     1,235,000
                                       ------------  ------------  ------------
Cash and cash equivalents, end of pe-
 riod................................  $ 15,842,000  $ 83,391,000  $114,143,000
                                       ============  ============  ============
Supplemental disclosures:
  Cash paid for interest.............  $  1,576,000  $  1,042,000  $    893,000
Non-cash investing activities:
  Transfer of property and equipment
   to inventory......................  $  2,497,000           --            --
</TABLE>

                             See accompanying notes

                                      F-5
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                         COMMON STOCK    CONVERTIBLE    ADDITIONAL                                FOREIGN       TOTAL
                       -----------------  PREFERRED      PAID-IN      DEFERRED    ACCUMULATED    CURRENCY   STOCKHOLDERS'
                         SHARES   AMOUNT    STOCK        CAPITAL    COMPENSATION    DEFICIT     TRANSLATION    EQUITY
                       ---------- ------ ------------  ------------ ------------ -------------  ----------- -------------
<S>                    <C>        <C>    <C>           <C>          <C>          <C>            <C>         <C>
Balance at January 1,
 1995................   4,131,447        $ 30,442,000  $  4,286,000              $ (30,922,000)             $  3,806,000
Sale of 7,782,634
 shares of Series G
 Convertible
 Preferred Stock plus
 a related share
 grant issuance cost
 of 119,092 shares,
 net of cash
 expenses............                      17,890,000                                                         17,890,000
Compensation expense
 related to stock
 options.............                                        17,000                                               17,000
Sale of 610,574
 shares of Series H
 Convertible
 Preferred Stock plus
 a related share
 grant issuance cost
 of 17,018 shares,
 net of cash
 expenses............                       1,435,000                                                          1,435,000
Exercise of
 15,500,000 Series E
 Preferred Stock
 warrants............                      15,500,000                                                         15,500,000
Shares issued
 pursuant to
 executive
 compensation........      27,679                           193,000                                              193,000
Exercise of stock
 warrants............     750,000                         3,000,000                                            3,000,000
Initial public
 offering, net of
 expenses............   6,900,000 $1,000                 94,724,000                                           94,725,000
Shares issued
 pursuant to a
 settlement agreement
 and cashless
 exercise of stock
 warrants............     834,300                         1,652,000                                            1,652,000
Vesting of
 performance options
 at initial public
 offering............                                     6,100,000                                            6,100,000
Conversion of
 preferred stock to
 common at initial
 public offering.....  16,161,402  2,000  (65,267,000)   65,265,000                                                  --
Net loss for the year
 December 31, 1995...                                                              (29,428,000)              (29,428,000)
Foreign currency
 translation.........                                                                            $(223,000)     (223,000)
                       ---------- ------ ------------  ------------  ---------   -------------   ---------  ------------
Balance at December
 31, 1995............  28,804,828  3,000          --    175,237,000        --      (60,350,000)   (223,000)  114,667,000
Shares issued
 pursuant to exercise
 of stock warrants...     619,641                             8,000                                                8,000
Value of options and
 warrants issued for
 services rendered...                                       569,000                                              569,000
Share issued pursuant
 to exercise of stock
 options.............     370,580                         1,745,000                                            1,745,000
Net loss for the year
 ended December 31,
 1996................                                                              (34,158,000)              (34,158,000)
Foreign currency
 translation.........                                                                              697,000       697,000
                       ---------- ------ ------------  ------------  ---------   -------------   ---------  ------------
Balance at December
 31, 1996............  29,795,049  3,000          --    177,559,000        --      (94,508,000)    474,000    83,528,000
Shares issued
 pursuant to exercise
 of stock warrants...   1,207,031                           143,000                                              143,000
Shares issued
 pursuant to exercise
 of stock options....      47,430                           217,000                                              217,000
Value of options and
 warrants issued for
 services rendered...                                       882,000  $(782,000)                                  100,000
Amortization of
 deferred
 compensation........                                                  206,000                                   206,000
Net loss for the year
 ended December 31,
 1997................                                                              (36,581,000)              (36,581,000)
Foreign currency
 translation.........                                                                             (139,000)     (139,000)
                       ---------- ------ ------------  ------------  ---------   -------------   ---------  ------------
Balance at December
 31, 1997............  31,049,510 $3,000 $        --   $178,801,000  $(576,000)  $(131,089,000)  $ 335,000  $ 47,474,000
                       ========== ====== ============  ============  =========   =============   =========  ============
</TABLE>

                            See accompanying notes.

                                      F-6
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

  Nature of Operations. Neuromedical Systems, Inc., a Delaware corporation
(the "Company") is a healthcare technology company focused on bringing
intelligent vision to medicine. The Company was organized in 1988 and
commenced operations January 1, 1989. It is the Company's objective to become
the premier supplier of cytology screening and anatomic pathology diagnostic
equipment and services to laboratories. The Company's first and, to date, only
product, the PAPNET(R) Testing System, is a sophisticated interactive system
that assists the laboratory professional in the detection of abnormal cells on
cervical cytology specimens (also known as Pap smears). Since its inception,
the Company has been primarily engaged in the development, manufacturing and
marketing of the PAPNET(R) Testing System, and the scanning of Pap smears at
its slide processing facilities. The Company's revenues are currently being
derived from sales of PAPNET(R) testing services, equipment sales and interest
income.

  Basis of Presentation. The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

  Principles of Consolidation. The consolidated financial statements include
the accounts of Neuromedical Systems, Inc. and all of its wholly-owned
subsidiaries. All intercompany transactions have been eliminated in
consolidation.

  Revenue Recognition. To date, the Company's revenues have been earned
principally from the processing of PAPNET(R) tests and cytology services on a
fee per slide basis, sales of equipment and, prior to 1992, the sale of
territorial licenses. Slide processing and cytology service revenue is
recognized upon delivery of processed slides to third-party common carriers or
shipping services since the earning process is completed upon the performance
of these processing services. Equipment sales revenue is recognized upon
acceptance of the equipment by the customer.

  Research and Development Costs. Research and development costs are expensed
as incurred.

  Advertising and Promotion Costs. Advertising and promotion costs are
expensed as incurred. During 1997 and 1996, the Company expensed approximately
$6,912,000 and $11,625,000 of such costs, respectively.

  Cash Equivalents. Cash equivalents consist of highly liquid investments with
a maturity of three months or less when purchased. As of December 31, 1997,
the Company had approximately $13,000,000 in two money market mutual funds.

  Short-Term Securities. Short-term securities consist of investments in U.S.
government agency debt obligations with an original maturity greater than
three months but less than one year. The Company's policy is to hold short-
term securities until maturity and record the securities at cost which
approximates fair value.

  Concentration of Credit Risk. The Company provides equipment, slide
processing and cytology services to laboratory customers. Revenues are from
all regions of the United States as well as many foreign countries. The
Company performs periodic credit evaluations of its customers' financial
condition. Credit losses have been minimal and within management's
expectations. There is no significant concentration of the Company's accounts
receivable portfolio in any customer or geographical region that presents a
material risk to the Company based on that concentration. The Company
currently does not require collateral from any of its customers.

                                      F-7
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  Inventories. Inventories are stated at the lower of cost or market, using
the first in first out (FIFO) method and consist of the following major
classes as of December 31, 1997:

<TABLE>
        <S>                                                           <C>
        Raw Materials................................................ $1,124,000
        Work in process..............................................    202,000
        Finished goods...............................................  1,616,000
                                                                      ----------
        Total........................................................ $2,942,000
                                                                      ==========
</TABLE>

Until 1997, the Company only manufactured scanning equipment for its own
internal use. During 1997, the Company announced plans to sell and lease
scanning equipment to customers in selected geographic regions. As a result,
the Company has accounted for PAPNET systems and related equipment as
inventory at December 31, 1997.

  Property and Equipment. Property and equipment are stated at cost.
Depreciation is computed using the straight line method over the estimated
useful lives of the assets normally ranging from 2.5 to 5 years. PAPNET
Testing Systems held for internal use are depreciated over their useful life,
generally 5 years. Assets acquired pursuant to capital lease arrangements are
generally amortized over the estimated useful life of the asset. Leasehold
improvements are amortized over the term of the related lease.

  Intangibles. Goodwill is amortized over 5 years using the straight line
method. Effective January 1, 1995, additions to patent and patent application
costs are amortized over a twelve-month period. The net book value of patent
and patent application costs at January 1, 1995 is being amortized over 3
years using the straight-line method.

  Foreign Exchange. Each of the Company's foreign subsidiaries (with the
exception of its Israeli subsidiary, whose functional currency is the United
States dollar) uses its local currency as the functional currency and
translates all assets and liabilities at current exchange rates and all income
and expenses at average exchange rates. The adjustment resulting from this
translation is included in a separate component of stockholders' equity. Gains
or losses resulting from foreign currency transactions are included in the
consolidated statement of operations.

  Net Loss Per Share. Net loss per share is computed using the weighted-
average number of shares of common stock outstanding. Historical net loss per
share information through December 31, 1995 is not considered meaningful due
to the significant changes in the Company's capital structure which occurred
upon the closing of the Company's initial public offering. Accordingly, such
per share information is not presented. In 1997, the Company adopted FASB
Statement No. 128 "Earnings per share". Implementation of this pronouncement
did not change the reported net loss per share for 1997 and 1996. Basic and
diluted net loss per share are the same for all years presented.

  Pro Forma Net Loss Per Share. Pro forma net loss per share has been restated
to conform with the requirements of FASB Statement No. 128 "Earnings per
share." Pro forma net loss per share in 1995 is computed using the weighted-
average number of shares of common stock outstanding amounting to 5,657,000
and includes the effect of common shares issuable upon conversion of
convertible preferred stock outstanding since January 1, 1995 or from the date
of issuance, if later, amounting to 10,683,000.

  Employee Stock Based Compensation. The Company follows Accounting Principles
Board Statement No. 25 with regard to the accounting for stock issued as
compensation for employees.

  Income Taxes. The liability method is used in accounting for income taxes.
Under this method, deferred tax assets and liabilities are determined based on
differences between financial reporting and tax bases of assets and
liabilities and are measured using the enacted tax rates and laws that will be
in effect when the differences are expected to reverse.


                                      F-8
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 2.BALANCE SHEET

  The allowance for doubtful accounts at December 31, 1997 and 1996 was
$439,000 and $210,000, respectively. No amounts were charged to the reserve in
1997 and 1996.

  Included in other current assets is $181,000 and $250,000 of restricted cash
at December 31, 1997 and 1996, respectively.

  Accrued liabilities consist of the following:

<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                          ---------------------
                                                             1997       1996
                                                          ---------- ----------
        <S>                                               <C>        <C>
        Compensation..................................... $1,665,000 $1,698,000
        Advertising and promotion........................    196,000    859,000
        Professional fees................................    927,000    549,000
        Taxes............................................    268,000    328,000
        Other liabilities................................  1,191,000    648,000
                                                          ---------- ----------
          Total.......................................... $4,247,000 $4,082,000
                                                          ========== ==========
</TABLE>

 3.PROPERTY AND EQUIPMENT

  Property and equipment consists of the following:

<TABLE>
<CAPTION>
                                                            DECEMBER 31,
                                                       ------------------------
                                                          1997         1996
                                                       -----------  -----------
        <S>                                            <C>          <C>
        PAPNET(R) systems and related equipment......  $19,629,000  $18,228,000
        PAPNET(R) systems and related equipment under
         construction................................          --     2,497,000
        Furniture, fixtures and related equipment....    6,683,000    5,291,000
                                                       -----------  -----------
                                                        26,312,000   26,016,000
        Accumulated depreciation and amortization....  (14,220,000)  (9,628,000)
                                                       -----------  -----------
                                                       $12,092,000  $16,388,000
                                                       ===========  ===========
</TABLE>

  Until 1997, the Company only manufactured scanning equipment for its own
internal use. During 1997, the Company announced plans to sell and lease
scanning equipment to customers. As a result, the Company has recorded
PAPNET(R) systems and related equipment not designated for internal use as
inventory at December 31, 1997.

  A substantial portion of the Company's property and equipment has been
pledged as collateral in connection with outstanding borrowings or is subject
to capital lease arrangements.

  Equipment under capital leases totaled approximately $8,456,000 and
$7,716,000 at December 31, 1997 and 1996, respectively, and consists
principally of PAPNET systems and related equipment. Included in accumulated
depreciation and amortization is approximately $2,994,000 and $1,698,000
related to assets under capital leases at December 31, 1997 and 1996,
respectively.

                                      F-9
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

 4.LEASES

  The Company leases facilities and certain equipment under agreements
accounted for as operating leases. Rent expense for the years ended December
31, 1997, 1996 and 1995 approximated $2,532,000, $1,849,000, and $1,099,000,
respectively.

  Minimum future lease payments under capital leases and non-cancelable
operating leases at December 31, 1997, are as follows:

<TABLE>
<CAPTION>
                                                           CAPITAL   OPERATING
                                                            LEASES     LEASES
                                                          ---------- ----------
        <S>                                               <C>        <C>
        1998............................................. $3,092,000 $2,324,000
        1999.............................................  2,301,000  2,153,000
        2000.............................................  1,678,000  1,669,000
        2001.............................................  1,178,000    698,000
        2002.............................................    108,000    563,000
        Thereafter.......................................        --     235,000
                                                          ---------- ----------
        Total minimum lease payments.....................  8,357,000 $7,642,000
                                                                     ==========
        Less amount representing interest................  1,350,000
                                                          ----------
        Present value of minimum lease payments.......... $7,007,000
                                                          ==========
</TABLE>

  The facility leases include escalation clauses for operating expenses and
real estate taxes. Certain of the facility leases include renewal options for
terms ranging from two to four year periods.

  During 1997, the Company obtained $1,622,000 of equipment lease financing
under a master lease agreement. Under the agreement the Company is required to
maintain certain financial covenants throughout the duration of the lease
period. The Company anticipates that during 1998 it will be required, under
these financial covenants, to provide the lessor with letters of credit or
restricted cash of approximately $800,000 as additional collateral for these
lease borrowings.

                                     F-10
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

 5. BUSINESS SEGMENTS

  The Company operates in a single industry segment. The Company's operations
by geographic area for the years ended December 31, 1997, 1996 and 1995 are
presented below:

<TABLE>
<CAPTION>
                                                                   IDENTIFIABLE
                                      TOTAL REVENUES   NET LOSS       ASSETS
                                      -------------- ------------  ------------
<S>                                   <C>            <C>           <C>
Year ended December 31, 1997
  United States......................   $5,219,000   $(22,903,000) $ 98,231,000
  Europe.............................    1,847,000     (6,855,000)    5,261,000
  Israel.............................    3,057,000     (3,913,000)    4,102,000
  Asia and Australia.................    2,308,000     (2,695,000)    5,338,000
  Interarea eliminations.............   (3,057,000)      (215,000)  (46,588,000)
                                        ----------   ------------  ------------
                                        $9,374,000   $(36,581,000) $ 66,344,000
                                        ==========   ============  ============
Year ended December 31, 1996
  United States......................   $2,440,000   $(23,372,000) $119,427,000
  Europe.............................    1,070,000     (5,201,000)    5,140,000
  Israel.............................    7,163,000     (1,827,000)    6,121,000
  Asia and Australia.................    1,219,000     (1,860,000)    2,883,000
  Interarea eliminations.............   (7,163,000)    (1,898,000)  (29,367,000)
                                        ----------   ------------  ------------
                                        $4,729,000   $(34,158,000) $104,204,000
                                        ==========   ============  ============
Year ended December 31, 1995
  United States......................     $760,000   $(21,445,000) $133,399,000
  Europe.............................      969,000     (3,976,000)    4,828,000
  Israel.............................    2,133,000     (2,294,000)    4,341,000
  Asia and Australia.................      740,000     (1,213,000)    2,111,000
  Interarea eliminations.............   (2,127,000)      (500,000)  (17,331,000)
                                        ----------   ------------  ------------
                                        $2,475,000   $(29,428,000) $127,348,000
                                        ==========   ============  ============
</TABLE>

  Transfers between geographic areas are accounted for at amounts which are
generally above cost and consistent with rules and regulations of governing
tax authorities. Such transfers are eliminated in the Consolidated Financial
Statements. Substantially all revenues, with the exception of those
originating in Israel which are interarea, are from unaffiliated customers.
One customer accounted for 18% and 16% of total revenues in the year ended
December 31, 1997 and 1996, respectively. Another customer accounted for 11%
of revenue in the year ended December 31, 1996. Interarea eliminations
associated with identifiable assets substantially relate to the U.S.

                                     F-11
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

 6.DEBT

  The Company's debt consists of the following:

<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                           ---------------------
                                                              1997       1996
                                                           ---------- ----------
   <S>                                                     <C>        <C>
   Notes:
     Note payable at 12.2% due in monthly installments of
      $25,000, including interest, with the final payment
      of approximately $122,000 due in August 2002.......  $1,133,000        --
     Note payable at 12.4% due in monthly installments of
      $44,000, including interest, with the final payment
      of approximately $210,000 due in December 2001.....   1,720,000 $2,098,000
     Note payable at 18.1% due in monthly installments of
      $37,000, including interest, with a final payment
      of $188,000 due July 1998..........................     380,000    720,000
     Note payable at 16.0% due in monthly installments of
      $15,000, including interest, with a final payment
      of $77,000 due March 1999..........................     264,000    389,000
     Note payable-stockholder at 10.0%, with interest
      payable monthly, principal due in March 1998.......     300,000    300,000
     Note payable-stockholder at 10.0%, with interest
      payable monthly, principal due in June 1998........     300,000    300,000
     Note payable to private foundation at 8% due in
      semi-annual installments over a variable period
      estimated through February 2000....................     379,000    399,000
   Bank loans:
     Foreign loans payable at annual rates between 8.1%
      and 8.9%, guaranteed by the State of Israel and
      linked to the United States dollar, payments due
      quarterly through 2003.............................   1,917,000  2,193,000
     Foreign note payable at 7.8% with interest and
      principal due in quarterly installments of
      approximately $11,000, through September 1998......      28,000     76,000
     Other borrowings....................................      46,000     29,000
                                                           ---------- ----------
                                                            6,467,000  6,504,000
   Less current portion..................................   2,705,000  1,200,000
                                                           ---------- ----------
                                                           $3,762,000 $5,304,000
                                                           ========== ==========
</TABLE>

                                      F-12
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  During 1996, the Company entered into an agreement with an equipment
financing company to provide the Company with a $5,000,000 line of credit to
finance certain of the Company's equipment purchases, primarily PAPNET
scanners and related equipment. Through December 31, 1997, the Company
borrowed an aggregate of $3,322,000 under the agreement in two loans with loan
terms of 60 months and with final payments in an amount equal to 10% of the
original principal amount of each such loan. The loans are secured by a
perfected first priority interest in the financed equipment. The Company is
required to maintain certain financial covenants throughout the duration of
the loans. The Company anticipates that during 1998 it will be required, under
these financial covenants, to provide the lender with letters of credit or
restricted cash estimated to be of approximately $2,900,000 as additional
collateral on these loans. The loan commitment expired on December 31, 1997.

  Foreign loans payable represent borrowings at LIBOR plus 2.4% to 3.1%.
Payment terms vary from payment commencing two years after issuance and then
payable quarterly over a two-year period until maturity to five years in equal
quarterly installments.

  Each of the $300,000 notes payable-stockholder is convertible into common
stock at a conversion rate of $12.00 per share at the option of the
noteholder.

  The proceeds from the note payable to private foundation were received
during 1996 and 1995 to finance certain product development projects. The note
is repayable over a variable period of 2 to 6 years at approximately 8.0% per
annum.

  Maturities of the outstanding debt for the five years succeeding December
31, 1997 are $2,705,000 in 1998, $1,600,000 in 1999, $838,000 in 2000,
$991,000 in 2001, and $333,000 in 2002.

  The fair value of the Company's long term debt which approximates its
carrying value is estimated using discounted cash flow analysis based on the
Company's current incremental borrowing rates for similar type borrowing
arrangements.

7. TERRITORIAL LICENSE AGREEMENTS

  From 1989 through 1991, the Company entered into various long-term
territorial license agreements (the "License Agreements") for the PAPNET
testing system. Territories covered by these licenses account for
approximately 20% of the population of the United States. The Company received
net proceeds of approximately $3,500,000 from the sale of these territorial
licenses. Each license expires on the later of (i) 17 years after its
execution or (ii) the expiration of the initial patent granted for the PAPNET
system, and is renewable for an additional 17-year term at the licensee's
option. The Company does not expect to enter into any additional territorial
license agreements.

  Pursuant to the License Agreements, as amended, each licensee is obligated
to use its best efforts to promote the use of the PAPNET (R) testing system,
in its territory at the licensee's expense. Each licensee is entitled to
receive royalties equal to the greater of (i) 50% of the territory's net slide
revenue (as defined) generated from participating laboratories within its
territory, not to exceed the licensee's share of a specified number of slides
annually (ranging from 175,000 to 3,000,000, and aggregating 12,175,000 among
all of the licensees); or (ii) a specified percentage (ranging from 0. 15% to
1.0%, and aggregating 4.15% for all the licensees) of the net annual slide
revenues (as defined) up to specified annual monetary limits for each licensee
(aggregating $23,000,000 for all its licensees). Royalty expense under these
agreements amounted to $988,000 and $286,000 in 1997 and 1996, respectively.


                                     F-13
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  In December 1995, the Company and the entities which hold the United States
licenses (the "Licensees") entered into a Settlement Agreement and a Warrant
Exercise Agreement (the "Territorial Agreements"), the effect of which
included the clarification of previously disputed elements of prior license
agreements, the requirement for the Company to make payments of stock having a
fair market value equivalent to approximately $1,652,000 and the irrevocable
election by the Licensees and acceptance by the Company for the cashless
exercise of 826,032 outstanding warrants into 715,894 shares of common stock
in connection with the closing of the Company's initial public offering.

  Pursuant to the Settlement Agreement, the Company consented to the merger of
all the Licensees and related parties. In 1996, the licensees and related
parties merged into two territorial entities, Netmed, Inc. ("Netmed") and
Cytology West, Inc. ("Cytology West"). Under the Settlement Agreement, the
Licensees and the Company agreed to enter into new licenses pursuant to which
the rights and obligations of the parties will be clarified but, with respect
to which, the economic terms of the License Agreements will not be materially
altered. The Company and the Licensees have also executed mutual general
releases, which include, among other things, the release of claims previously
made by the Licensees. The Company is currently negotiating the new licenses
which will expire on December 31, 2025.

  Provisions of a promissory note, dated October 3, 1990 (which was later
converted to Series A Convertible Preferred Stock), granted the holder of the
note certain rights to be the Company's sole licensee for distribution of the
PAPNET system in Canada. Such promissory note provided that the licensee shall
be entitled to terms which are at least as favorable as those in any domestic
United States of America licenses. No agreement has been reached on the terms
of the license with the holder.

  One of the Company's directors also holds beneficial interests in entities
which hold United States territorial licenses.

8. CAPITAL STOCK

  General. The authorized capital stock of the Company consists of 100,000,000
shares of common stock, par value $.0001 per share, and 10,000,000 shares of
preferred stock, par value $.0001 per share.

  Initial Public Offering Conversion of Preferred Stock. In December 1995, the
Company completed an initial public offering of 6,900,000 shares of common
stock at $15.00 per share and converted all shares of its then outstanding
Series A through H Convertible Preferred Stock into 16,161,402 shares of
common stock. As a result of the Company's recapitalization in connection with
its initial public offering, the number of authorized shares of preferred
stock was reduced to 10,000,000, none of which are issued or outstanding as of
December 31, 1997.

  Registration Rights. Certain of the former preferred stockholders have
registration rights under an agreement which continues to apply to the shares
of common stock into which such preferred stock was converted or which may be
issued upon the exercise of warrants. In addition, certain holders of common
stock issued upon conversion of preferred stock have limited rights to require
the Company to register their shares in a public offering.

  Stockholder Rights Plan. The Board of Directors has adopted a Stockholder
Rights Plan, pursuant to which there has been issued with respect to each
share of common stock issued and outstanding one Preferred Stock Purchase
Right (a "Right"). Each Right entitles the registered holder to purchase from
the Company one one-hundredth of a share of Series A Preferred Stock at a
price of $60.00 per one one-hundredth of a share, subject to adjustment. These
Rights may have the effect of discouraging a tender offer or other takeover
attempts not previously approved by the Board of Directors.

                                     F-14
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  Common Shares Reserved. As of December 31, 1997, the Company had reserved
shares of common stock for issuance as follows:

<TABLE>
<CAPTION>
                                                                       NUMBER OF
                                                                        SHARES
                                                                       ---------
        <S>                                                            <C>
        Exercise of common stock options.............................. 4,721,990
        Exercise of common stock warrants.............................   257,624
</TABLE>

  Warrants. As of December 31, 1997, the Company had 257,624 outstanding
common stock warrants at exercise prices ranging from $4.00 to $14.63 per
share, all of which were exercisable. The following summarizes these
outstanding common stock warrants, exercise prices and expiration dates:

<TABLE>
<CAPTION>
                            NUMBER OF   EXERCISE   WEIGHTED-AVERAGE EXPIRATION
                            WARRANTS     PRICE      EXERCISE PRICE     DATE
                            --------- ------------ ---------------- ----------
   <S>                      <C>       <C>          <C>              <C>
   Warrants issued in
    connection with
    preferred stock........   51,876  $       4.00      $ 4.00           7/98
   Warrants issued in
    connection with
    equipment financing
    arrangements...........   70,348  $ 4.71-$8.00      $ 6.93      4/98-3/00
   Other warrants issued...  135,400  $4.00-$14.63      $10.46      1/98-2/02
                             -------  ------------      ------      ---------
     Total warrants          257,624                    $ 8.19
      outstanding..........  =======                    ======
</TABLE>

  Most of the Company's outstanding warrants contain provisions allowing for
the conversion of such warrants into a lesser number of shares without the
payment of cash to the Company (so-called "cashless exercise" provisions).
Accordingly, there can be no assurance that, even if all of such warrants are
exercised, the Company will receive the proceeds from their exercise.

  During 1997, 1,241,586 warrants were exercised, of which 1,167,897 warrants
were exercised under cashless exercise provisions. During 1997, the Company
issued 20,276 warrants, primarily for consulting services, at a fair value of
$100,000 and a weighted-average exercise price of $10.00 per share. Warrants
of 6,392 with a weighted average exercise price of $1.80 expired in 1997.

 9. STOCK OPTIONS

  On November 17, 1993, the Board of Directors of the Company adopted the
Neuromedical Systems, Inc. 1993 Stock Option Plan which was amended and
restated October 25, 1995 as the Neuromedical Systems, Inc. 1993 Stock
Incentive Plan (the "Plan"). This amendment and restatement increased the
maximum number of shares with respect to which awards can be granted under the
Plan to 4,140,000 shares, subject to adjustment in the event of a change in
capitalization, with no more than one-third of the total number of authorized
shares to be issued as grants of restricted stock and, provided that, over the
term of the Plan, the maximum number of shares with respect to which awards
may be granted to any individual is 2,000,000 and the maximum award per
individual of dollar-denominated performance units is $5,000,000. The Plan
provides for award grants in the form of non-qualified or incentive stock
options, non-discretionary director options, stock appreciation rights,
dividend equivalent rights, restricted stock, performance units and
performance shares.

  Under the terms of the Plan, a committee of the Company's Board of Directors
may grant options to purchase shares of the Company's common stock to
employees, directors and consultants of the Company at such prices as may be
determined by the Committee, principally equal to or greater than fair value
at date of grant. Options granted under the Plan vest over periods from
immediate vesting to five years at various rates and expire after ten years.

                                     F-15
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  During the third quarter of 1997, the Company entered into Replacement
Option Agreements, (collectively, the "Replacement Options") each dated as of
July 28, 1997, with certain Company employees participating in the stock
option plan. Pursuant to the terms of the Replacement Options, the Company
canceled 1,015,570 employee stock options at exercise prices ranging from
$5.56 to $17.63 per share and issued 942,904 replacement options, each at an
exercise price of $4.00 per share, representing the fair market value of the
common stock on July 28, 1997. The Replacement Options provide for a 1 for 1
exchange of options granted on or after October 1, 1996, except for certain
members of senior management who received Replacement Options covering shares
equal only to 80% of their respective original option grant amounts received
on or after such date. The Replacement Options vest over a four year period
and will become exercisable beginning in 1998 at a rate of 25% per year. If
the holder of the Replacement Options is terminated by the Company without
cause prior to July 28, 1998, 25% of the holders options will vest and become
exercisable as of the termination date.

  Also in 1997, the Company modified the terms of all outstanding employee
stock option agreements (with the exception of those executed by interim Co-
CEOs) to allow employees to exercise their vested stock options for a period
of two years from the date of their termination if one of the following two
conditions are met: (i) the employee remains in the employment of the Company
for a period of six months after the employment of the new CEO of the Company,
or (ii) the employee is terminated by the Company without cause prior to the
date set forth in (i) above. The foregoing modifications as applied to the
interim Co-CEOs extends their respective exercise period to three years
provided that they meet the conditions of clauses (i) or (ii) above.

  On November 4, 1997, the Company entered into an employment agreement with
Paul Sohmer, M.D. to become President and Chief Executive Officer of the
Company. Dr. Sohmer's employment agreement provides for a grant of options to
acquire 750,000 shares of Company Common Stock at an exercise price of $4.56
per share (the fair market value of the Common Stock on the grant date), and
options for an additional 250,000 shares of Common Stock at an exercise price
of $10.00 per share. All of such options, which were granted outside of the
Plan, vest and become exercisable at a rate of 25% of the total grant on each
anniversary of the grant date.

  The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" (APB 25) and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FASB
Statement No. 123, "Accounting for Stock-Based Compensation," requires use of
option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, because the exercise price of the Company's
employee stock options equals the market price of the underlying stock on the
date of grant, no compensation expense is recognized.

  Pro forma information regarding net loss and net loss per share is required
by Statement 123, and has been determined as if the Company had accounted for
its employee stock options under the fair value method of that Statement. The
fair value for these options was estimated at the date of grant using a Black-
Scholes option pricing model for 1997 and 1996 and the Minimum Value Method
for 1995, prior to becoming a public company in December 1995. The following
assumptions were made: (i) weighted-average assumptions for risk-free interest
rates of approximately 5.78% for 1997 and 6.38% for 1996, (ii) weighted-
average volatility factor of the expected market price of the Company's common
stock of .74 for 1997 and .42 for 1996, (iii) weighted-average expected life
of the options of 5 years for 1997 and 6 years for 1996 and (iv) no dividends
will be declared.

  The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's

                                     F-16
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
employee stock options have characteristics significantly different from those
of traded options, and because changes in the subjective input assumptions can
materially affect the fair value estimate, in management's opinion, the
existing models do not necessarily provide a reliable single measure of the
fair value of its employee stock options.

  For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The
Company's pro forma information follows:

<TABLE>
<CAPTION>
                                       1997           1996           1995
                                   ------------   ------------   ------------
   <S>                             <C>            <C>            <C>
   Pro forma net loss............. $(37,988,000)  $(34,595,000)  $(29,305,000)
   Pro forma net loss per share...  $     (1.23)   $     (1.18)   $     (1.79)
</TABLE>

  The Company's stock option activity is as follows:

<TABLE>
<CAPTION>
                                 1997                 1996                1995
                          -------------------- ------------------- -------------------
                                      WEIGHTED            WEIGHTED            WEIGHTED
                                      AVERAGE             AVERAGE             AVERAGE
                            NUMBER    EXERCISE  NUMBER    EXERCISE  NUMBER    EXERCISE
                          OF SHARES    PRICE   OF SHARES   PRICE   OF SHARES   PRICE
                          ----------  -------- ---------  -------- ---------  --------
<S>                       <C>         <C>      <C>        <C>      <C>        <C>
Options outstanding,
 beginning of year......   2,759,118   $8.74   2,920,648   $ 7.49  1,712,000   $ 4.18
Options granted.........   2,879,474    6.43     235,000    17.65  1,218,898    12.11
Options exercised.......     (47,430)   4.58    (370,580)    4.71        --       --
Options cancelled.......  (1,169,712)   9.67     (25,950)    6.12    (10,250)    4.00
                          ----------   -----   ---------   ------  ---------   ------
Options outstanding, end
 of year................   4,421,450   $7.04   2,759,118   $ 8.74  2,920,648    $7.49
                          ==========   =====   =========   ======  =========   ======
Options exercisable at
 year end...............   1,549,839   $5.10   1,508,279   $ 4.70  1,747,375   $ 4.23
                          ==========   =====   =========   ======  =========   ======
</TABLE>

  The number and weighted-average fair value of options granted during 1997,
1996 and 1995 is as follows:

<TABLE>
<CAPTION>
                                  1997                 1996                 1995
                          -------------------- -------------------- --------------------
                                     WEIGHTED             WEIGHTED             WEIGHTED
                                     AVERAGE              AVERAGE              AVERAGE
                                    FAIR VALUE           FAIR VALUE           FAIR VALUE
                          NUMBER OF OF OPTIONS NUMBER OF OF OPTIONS NUMBER OF OF OPTIONS
                           SHARES    GRANTED    SHARES    GRANTED    SHARES    GRANTED
                          --------- ---------- --------- ---------- --------- ----------
<S>                       <C>       <C>        <C>       <C>        <C>       <C>
Stock price equal to
 exercise price.........  2,629,474   $3.38     235,000    $7.68     400,625    $2.02
Stock price equal to
 exercise price-
 performance based
 option.................        --      --          --       --      813,273    $0.49
Stock price greater than
 exercise price.........        --      --          --       --        5,000    $3.26
Stock price less than
 exercise price.........    250,000   $2.37         --       --          --       --
</TABLE>

  The weighted average fair value of options granted in 1997 includes the
value of the options granted in 1997 and the incremental value associated with
the replacement options issued in July 1997, concurrent with the cancellation
of 1,015,570 stock options.

  The following table summarizes information about fixed price stock options
outstanding at December 31, 1997:

<TABLE>
<CAPTION>
                               OPTIONS OUTSTANDING               OPTIONS EXERCISABLE
                        --------------------------------- ----------------------------------
  RANGE OF              WEIGHTED AVERAGE                       NUMBER
  EXERCISE    NUMBER OF    REMAINING     WEIGHTED AVERAGE  EXERCISABLE AT   WEIGHTED AVERAGE
   PRICES      SHARES   CONTRACTUAL LIFE  EXERCISE PRICE  DECEMBER 31, 1997  EXERCISE PRICE
  --------    --------- ---------------- ---------------- ----------------- ----------------
<S>           <C>       <C>              <C>              <C>               <C>
$  4.00-4.56  2,874,664      8 years          $ 4.15          1,265,160           $4.00
   6.00-7.25    363,513      7 years            6.39            198,013            6.36
       10.00    250,000     10 years           10.00                --              --
 15.00-18.38    930,773      8 years           15.40             84,166           18.06
       22.63      2,500      8 years           22.63              2,500           22.63
              ---------                                       ---------
$ 4.00-22.63  4,421,450                         7.04          1,549,839            5.10
============  =========                       ======          =========          ======
</TABLE>

                                     F-17
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  During 1995, the Company granted to its former CEO, a performance-based
option, under the Plan, for 813,273 shares of common stock at a per share
exercise price of $15.00. The grant was designed to produce an option value of
$12.5 million if at any time during the option's ten-year term either of the
following events (the "performance goal") occurs: (i) the Company's share
price over any 90 consecutive day period reaches a target price of $30.37 or
(ii) all or substantially all of the Company's shares are acquired at or above
the target price. The option provides for equitable adjustments to the
performance goal, the number of shares subject to the option and the exercise
price in the event of a change in capitalization as defined in the Plan. The
exercisability of the option will not accelerate upon the occurrence of a
change in control, and the option will terminate in connection with a change
in control if the performance goal is not attained prior to or in connection
with the change in control.

  The Company and its former CEO entered into a revised and restated
employment agreement, (the "Revised Agreement") on June 30, 1997 effective
with his resignation as CEO. Subject to the terms of the Revised Agreement,
the options held by the former CEO to purchase company stock were extended so
as to expire eight and one half years after the expiration of the Revised
Agreement. In connection with the extension of the exercise period of the
options the Company recorded $782,000 of non-cash deferred compensation. This
amount is being amortized to expense over the term of the Revised Agreement.

10.INCOME TAXES

  The Company's pre-tax income (loss) is made up of the following:

<TABLE>
<CAPTION>
                                          1997          1996          1995
                                      ------------  ------------  ------------
   <S>                                <C>           <C>           <C>
   U.S. ............................. $(23,000,000) $(25,270,000) $(21,945,000)
   Foreign...........................  (13,581,000)   (8,888,000)   (7,483,000)
                                      ------------  ------------  ------------
                                      $(36,581,000) $(34,158,000) $(29,428,000)
                                      ============  ============  ============

  A reconciliation of the Company's income tax expense (benefit) computed at
U.S. federal statutory tax rates to recorded income tax expense (benefit) is as
follows:

<CAPTION>
                                          1997          1996          1995
                                      ------------  ------------  ------------
   <S>                                <C>           <C>           <C>
   Tax at U.S. statutory rate........ $(12,437,000) $(11,614,000) $(10,005,000)
   State income taxes................   (1,374,000)   (1,402,000)   (1,290,000)
   Effect of lower foreign effective
    tax rates........................    2,382,000     1,760,000     1,435,000
   Other.............................          --       (175,000)          --
   Valuation allowance recorded......   11,429,000    11,431,000     9,860,000
                                      ------------  ------------  ------------
   Recorded tax provision............ $        --   $        --   $        --
                                      ============  ============  ============

  The components of the Company's deferred tax assets are as follows:

<CAPTION>
                                          1997          1996          1995
                                      ------------  ------------  ------------
   <S>                                <C>           <C>           <C>
   Deferred tax assets:
     Cash (tax) versus accrual basis
      of accounting.................. $    115,000  $    229,000  $    340,000
     Employee stock options..........    1,561,000     1,358,000     2,500,000
     Research and development
      credits........................    1,358,000     1,060,000       950,000
     Tax benefit of net operating
      loss carryforwards.............   39,791,000    29,004,000    17,245,000
   Other.............................    1,270,000     1,015,000       200,000
                                      ------------  ------------  ------------
   Total deferred tax assets.........   44,095,000    32,666,000    21,235,000
   Less valuation allowance..........  (44,095,000)  (32,666,000)  (21,235,000)
                                      ------------  ------------  ------------
   Net deferred tax asset............ $        --   $        --   $        --
                                      ============  ============  ============
</TABLE>


                                     F-18
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  At December 31, 1997, the Company had available U.S. net operating loss
carryforwards of approximately $88,000,000 that will expire in the years 2004
through 2012 and cumulative deductible temporary differences of approximately
$7,800,000. For financial reporting purposes, a valuation allowance has been
recognized to offset the deferred tax asset related to these carryforwards and
temporary differences.

  The Company also has foreign net operating losses of $14,000,000 which are
available to offset the separate company taxable incomes of certain foreign
subsidiaries. These losses may be carried forward indefinitely. For financial
reporting purposes a valuation allowance has been recorded for these credits.
Certain foreign subsidiaries qualify for tax incentives in the countries of
incorporation. In order to realize these benefits, these foreign subsidiaries
will need to be profitable in future tax years.

  In addition, as of December 31, 1997, the Company also had approximately
$1,300,000 of U.S. research and development credits available, which will
expire in 2004 through 2012. For financial reporting purposes, a valuation
allowance has been established for the full amount of the deferred tax asset
recorded for these credits.

  The Tax Reform Act of 1986 enacted a complex set of rules limiting the
potential utilization of United States net operating loss carryforwards and
tax credit carryforwards in periods following a corporate "ownership change."
In general, an ownership change is deemed to occur if the percentage of stock
of a loss corporation owned (actually, constructively and, in some cases,
deemed) by one or more "5% stockholders" has increased by more than 50
percentage points over the lowest percentage of such stock owned during a
three-year testing period. As a result of changes in the Company's ownership,
the utilization of a substantial portion of the Company's available United
States net operating loss carryforwards, and tax credit carryforwards will be
subject to annual limitations. It is management's belief, however, that, since
this annual limitation is determined based on the value of the Company
immediately prior to the ownership change, a significant portion of these
carryforwards will be available annually should the Company become profitable
in future tax years.

11.COMMITMENTS AND CONTINGENCIES

  The Company entered into an employment agreement with its new President and
CEO, dated November 4, 1997 (the "Agreement"), which has a term of three years
and is renewable automatically for additional one year terms thereafter unless
notice is given by either party ninety days prior to the end of the then-
current term. The material provisions of the Agreement provide for his
employment, annual salary, guaranteed bonus in the first year and bonus
eligibility thereafter. In addition, the Agreement and related option
agreements provide for a grant of options to him as described in Note 9.

  During 1997, each of the Company's other executive officers entered into
three-year employment agreements with the Company. Each of the employment
agreements provide that, in the event that an employee is terminated other
than for "cause" or "disability" (as those terms are defined in the applicable
agreement), a portion of the employee's stock options will become vested and
exercisable to the extent that it would have had the employee remained
employed by the Company for a one year period following his termination of
employment, and, subject to the employee's compliance with restrictive
covenants in his employment agreement, options held by the employee as of the
date of the termination of employment will remain exercisable (to the extent
those options either are vested on termination of employment or vest over the
succeeding year) until the earlier of the date one year following the
termination of employment or the expiration of the option's term. In addition,
the employment agreements provide for the continuation of salary for one year
after termination other than for cause.

  On December 4, 1995, the Company was served with a Summons and Complaint in
an action entitled Herbst et al v. Neuromedical Systems, Inc. et al., in the
Supreme Court of the State of New York. The plaintiffs in this

                                     F-19
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

suit alleged, among other things, that pursuant to written contracts, which
they claim the Company has breached, they were entitled to be issued warrants
exercisable for the purchase of approximately 128,000 shares of common stock
at various prices. They further alleged that the Company and certain of its
officers and directors made fraudulent misrepresentations and took other
allegedly improper actions that diminished the value of the warrants they
claim they are entitled to under these contracts. On January 31, 1996, the
plaintiffs served the Company with an Amended Complaint alleging legal claims
similar to those in the original Summons and Complaint served on the Company,
but adding one of the Company's former directors as a defendant and specifying
that the plaintiffs are seeking compensatory damages from the Company and one
of its former officers and a former director totaling $114 million and
punitive damages totaling $175 million. On February 23, 1996, the defendants
moved to dismiss the Amended Complaint and on November 27, 1996, the New York
State Supreme Court issued an opinion dismissing all of the plaintiffs' claims
that the Company and certain officers and directors committed fraud and other
improper actions that allegedly diminished the value of the warrants
plaintiffs claim they are entitled to receive. The Court denied the Company's
motion to dismiss plaintiffs' breach of contract claim, and plaintiffs
continue to seek $39 million in compensatory damages and $75 million in
punitive damages. The Company intends to continue to vigorously defend this
action. The Company believes that, in any event, the damages claimed bear no
relation to the harm alleged and believes an adverse judgement in this case
would not have a material adverse effect on the Company's operations,
financial position or cash flows.

  On July 15, 1996, the Company filed a lawsuit against NeoPath, a competitor
of the Company, in the United States District Court for the Southern District
of New York, seeking damages and injunctive relief for patent infringement,
false advertising, unfair competition, intentional interference with business
relations and damage to business reputation. In the lawsuit, the Company
alleges that NeoPath willfully misappropriated the Company's patented
technology and used such technology in NeoPath's AutoPap System. The Company
also alleges that NeoPath falsely characterized and made misleading
comparisons to consumers and securities analysts of the AutoPap System and the
Company's PAPNET Testing System. NeoPath has denied all allegations and, in
addition, it has filed counter-claims against the Company seeking damages and
injunctive relief for false advertising and unfair competition. In the
counter-claims, NeoPath alleges that statements made by the Company
characterizing the performance of the PAPNET Testing System, and its
effectiveness relative to NeoPath's AutoPap System, as well as other
statements, are false and misleading and constitute misrepresentations. The
Company believes that NeoPath's assertions are without merit. Although the
duration, costs and ultimate outcome of this lawsuit are unknown, the Company
expects that the costs of pursuing this lawsuit will be significant during
1998.

  On March 28, 1997, Neopath, Inc. filed a patent infringement lawsuit against
the Company in the United States District Court for the Western District of
Washington. The lawsuit seeks to enjoin the Company from allegedly infringing
three of Neopath's patents. Neopath is seeking preliminary and permanent
injunctive relief as well as compensatory damages, including treble damages.
The Company believes that it has valid legal and factual defenses to NeoPath's
allegations of infringement. The Company intends to continue to vigorously
defend this action. The Company also believes that an adverse judgment in this
case would not have a material effect on the Company's operations, financial
position or cash flow.

  On April 15, 1997, the Company was served with a lawsuit filed by Cytyc
Corporation in the United States District Court for the District of
Massachusetts against the Company, certain of its officers and others,
alleging false and misleading advertising, unfair and deceptive trade
practices, theft of trade secrets, unfair competition, interference with
relationships and defamation. On June 23, 1997, the court dismissed the
Massachusetts lawsuit on the basis of lack of jurisdiction. On June 24, 1997,
Cytyc filed suit against the Company, Mark Rutenberg and Dr. Mango in the
United States District Court for the Southern District of New York, alleging
causes of action for (1) violation of the Lanham Act, (2) misappropriation of
trade secrets, (3) defamation, (4) violations

                                     F-20
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

of Sections 349 and 350 of New York General Law and (5) unfair competition. In
this action, Cytyc seeks in excess of $11,000,000 in damages, costs and
attorneys' fees, as well as injunctive relief prohibiting the Company from
making false, misleading and defamatory statements regarding Cytyc and its
ThinPrep Pap Test. The Company moved to dismiss the complaint on the basis
that it failed to state a claim upon which relief could be granted, which
motion was denied by the Court on September 5, 1997. The Company subsequently
filed a counterclaim in this matter on October 3, 1997, alleging causes of
action for (1) violation of the Lanham Act, (2) violation of Sections 349 and
350 of New York General Law, (3) defamation and (4) unfair competition. The
Company filed an amended counterclaim on November 10, 1997. By way of its
amended counterclaim, the Company seeks damages and injunctive relief against
Cytyc. The Company is contesting the case vigorously. The Company believes
that the damages proposed bear no relation to the harm alleged, and believes
that it is probable that this case will not have a material adverse effect on
the Company's operations, financial position or cash flows, although there can
be no assurance in this regard. Notwithstanding the foregoing, although the
duration, costs and ultimate outcome of this lawsuit are unknown, the Company
expects that the costs of defending this lawsuit will be significant during
1998.

12.RELATED PARTY TRANSACTIONS

  Through June 1, 1997, the Company was a party to an exclusive representation
agreement ("the Agreement") with Papnet (Far East) Ltd., a Hong Kong
corporation, ("PFEL") for the distribution of the Company's PAPNET Testing
System in Asia Pacific markets. Dr. Stephen Ng is the president and an 18.3%
stockholder of PFEL and was a member of the Company's Board of Directors from
1994 until the Company's 1997 Annual Meeting of Stockholders when his term of
office expired. In addition, PFEL is the record holder of approximately
231,000 shares of the Company's stock.

  During 1997 and 1996, the Company paid commissions of $28,000 and $67,000,
respectively, under the terms of the Agreement. In addition, the Agreement
provided that the Company would pay PFEL fees for management assistance in
connection with the establishment of its Asia-Pacific Scanning Center. The
Company paid PFEL $25,000 during 1997, and $75,000 in 1996 and 1995 in
consideration of such assistance.

  In an agreement effective as of June 1, 1997, the Company acquired New
System International Ltd., a Hong Kong corporation and the former operating
subsidiary of PFEL, for a net purchase price of $1,564,000. New System
International Ltd. also provides clinical laboratory services through its Hong
Kong based Compuscreen Medical Diagnostic Centre. Dr. Stephen Ng served as
president of New System International Ltd. prior to its acquisition and in the
third quarter of 1997 entered into an employment agreement with the Company
providing for his continuation in such capacity.

  During 1997 and 1996 the Company recorded revenue amounting to $211,000 and
$531,000, respectively, from Compuscreen prior to its acquisition by the
Company.

  In an agreement effective August 1, 1997, the Company acquired the assets of
the Taiwan PAPNET (R) distributor, Papnet Far East Ltd. (Taiwan) through the
Company's acquisition subsidiary, New System Ltd. for a purchase price of
$392,000. In a related transaction, the Company executed a license and
management services agreement with Papnet Far East Ltd. (Taiwan) for operation
of the Company's business in Taiwan.

  Related to each of the foregoing acquisitions, on September 30, 1997 PFEL
entered into an Amended and Restated Representation Agreement with the
Company, and a Sublicense Agreement with the Company's subsidiary, NSI Asia
Pacific Ltd., pursuant to which the Company received a $800,000 license fee
from PFEL for the right of PFEL to receive a royalty of 3% to 4% based on
sales in Hong Kong, China and Taiwan over a fifteen year period (the "Royalty
Agreement"). Under the terms of the Royalty Agreement, commencing

                                     F-21
<PAGE>

                  NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

September 2001 and ending September 2005, PFEL, may, at its option, require
the Company to repurchase its rights under the Royalty Agreement for an
aggregate purchase price equal to five times the trailing years royalty due
(the "Repurchase Option"). The Repurchase Option is payable at the election of
the Company in either cash or in Company Common Stock. If the Repurchase
Option is exercised by PFEL and made payable by the Company in Common Stock
(i) the price of the Common Stock will be determined based on the average
publicly quoted closing price of the most recent 30 day period prior to the
exercise of the Repurchase Option, and (ii) the Company will provide
registration rights with respect to such Common Stock. The Royalty Agreement
contains a provision providing that in the event of cessation of the Company's
Asia Pacific operations, a termination fee shall be due and payable to PFEL in
an amount equal to $800,000 less the sum of all royalty payments previously
paid. No payments were made during 1997 to PFEL in regard to the Royalty
Agreement.

  The above acquisitions were accounted for by the purchase method and their
results of operations have been included in the Company's consolidated
operating results since their respective dates of acquisition. The Company
acquired aggregate net assets of approximately $270,000, primarily
representing laboratory equipment, and recorded goodwill of approximately
$900,000, net of the license fee received.

  On June 30, 1997, the former President and CEO entered into a revised and
restated employment agreement (the "Revised Agreement") which will remain
effective until November 19, 1998. The material provisions of the Revised
Agreement provide for continuation of employment with the Company and
participation in the Company's executive benefit plans. In addition, the
Revised Agreement provides for a non-recourse loan from the Company in an
amount of $600,000 which is secured by his pledge of 100,000 shares of Company
common stock. The loan is due on the earlier of November 30, 1999 or the date
which is ten days after termination of his employment for any reason. The
Revised Agreement may be terminated for "Cause" (as defined in the Revised
Agreement) or by either party to the Revised Agreement upon thirty days
written notice. The Revised Agreement provides that in the event of his
voluntary termination prior to November 19, 1998 or if terminated for Cause,
he shall receive $598,000; and if terminated for reasons other than Cause, he
shall receive in addition to such amount, the equivalent of his remaining base
salary as measured from such termination date until the expiration date of the
Revised Agreement.

13.EMPLOYEE SAVINGS PLAN

  The Company established a defined contribution savings plan (401k plan) for
its domestic employees retroactive to January 1, 1995. The plan allows
participating employees to contribute up to 15% of their salary, subject to
annual limits. The Board may, at its sole discretion, approve Company
contributions. Through December 31, 1997, the Company has made no
contributions to the plan.

                                     F-22
<PAGE>

                   NEUROMEDICAL SYSTEMS, INC. & SUBSIDIARIES

                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS

                  YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

<TABLE>
<CAPTION>
              COL. A                  COL. B     COL. C     COL. D     COL. E
              ------               ------------ --------- ---------- ----------
                                                ADDITIONS
                                                 CHARGED
                                     BALANCE    TO COSTS             BALANCE AT
                                   AT BEGINNING    AND                 END OF
                                    OF PERIOD   EXPENSES  DEDUCTIONS   PERIOD
                                   ------------ --------- ---------- ----------
<S>                                <C>          <C>       <C>        <C>
1997
  Against trade receivables for
   doubtful accounts..............   $210,000   $229,000     --       $439,000
1996
  Against trade receivables for
   doubtful accounts..............   $114,000   $ 96,000     --       $210,000
1995
  Against trade receivables for
   doubtful accounts..............        --    $114,000     --       $114,000
</TABLE>

                                      F-23
<PAGE>

                                  SIGNATURES

  PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, AS
AMENDED, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF
BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED ON THE 30TH DAY OF MARCH, 1998,
IN SUFFERN, NEW YORK.

                                          NEUROMEDICAL SYSTEMS, INC.

                                                  /s/ John B. Henneman, III
                                            By: _______________________________
                                                    JOHN B. HENNEMAN, III
                                                EXECUTIVE VICE PRESIDENT OF US
                                               OPERATIONS, SECRETARY AND CHIEF
                                                        LEGAL OFFICER

  PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, AS
AMENDED, THIS ANNUAL REPORT ON FORM 10-K HAS BEEN SIGNED BELOW BY THE
FOLLOWING PERSONS IN THE CAPACITIES AND ON THE DATES INDICATED.

              SIGNATURE                      TITLE                   DATE
              ---------                      -----                   ----

     /s/ C. Raymond Larkin, Jr.*       Chairman of the          March 30, 1998
-------------------------------------   Board
       C. RAYMOND LARKIN, JR.

       /s/ Mark R. Rutenberg*          Non-Executive Vice-      March 30, 1998
-------------------------------------   Chairman of the
          MARK R. RUTENBERG             Board

       /s/ Paul Sohmer, M.D.*          Director; President      March 30, 1998
-------------------------------------   and Chief Executive
          PAUL SOHMER, M.D.             Officer

          /s/ Mark L. Smith            Vice President,          March 30, 1998
-------------------------------------   Finance and
            MARK L. SMITH               Administration,
                                        Chief Financial
                                        Officer and
                                        Principal
                                        Accounting Officer

   /s/ Elizabeth Cogan Fascitelli*     Director                 March 30, 1998
-------------------------------------
     ELIZABETH COGAN FASCITELLI

        /s/ Stuart M. Essig*           Director                 March 30, 1998
-------------------------------------
           STUART M. ESSIG

          /s/ Carl Genberg*            Director                 March 30, 1998
-------------------------------------
            CARL GENBERG

     /s/ Arthur L. Herbst, M.D.*       Director                 March 30, 1998
-------------------------------------
       ARTHUR L. HERBST, M.D.

        /s/ Uzi Ish-Hurwitz*           Director                 March 30, 1998
-------------------------------------
           UZI ISH-HURWITZ

      /s/ John B. Henneman, III
*By: ________________________________
        JOHN B. HENNEMAN, III
          ATTORNEY-IN-FACT