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

                                   FORM 10-K

               [x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934
                    For the fiscal year ended July 31, 1998
                                      or
             [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934
                      for the transition period from   to

                        commission file number: 0-27772

                                METROWERKS INC.
            (exact name of registrant as specified in its charter)




       Securities registered pursuant to Section 12(b) of the Act: None

          Securities registered pursuant to Section 12(g) of the Act:
                          Common Stock, No par value
                               (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 of 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. [x]

       The aggregate market value of the voting stock by non-affiliates 
           of the registrant as of OCTOBER 15, 1998 WAS $33,111,474.

Number of shares of common stock outstanding as of OCTOBER 15, 1998: 12,919,030
                                        
 This Annual Report on Form 10-K contains 72 Pages of which this is number 1.
                    The Index to exhibits begins on page 28.
                                        

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<TABLE>
<S>           <C>                                                            <C>
Part I                                                                         
                                                                               
  Item 1.     Business                                                        3
                                                                               
  Item 2.     Properties                                                     18
                                                                               
  Item 3.     Legal Proceedings                                              18
                                                                               
  Item 4.     Submission of Matters to a Vote of Security Holders            18
                                                                               
                                                                               
Part II                                                                        
                                                                               
  Item 5      Market for Registrant's Common Equity and                        
              Related Stockholder Matters                                    19
                                                                               
  Item 6.     Selected Consolidated Financial Data                           20
                                                                               
  Item 7.     Management's Discussion and Analysis of                          
              Financial Condition and Results of Operations                  21
                                                                               
  Item 7a.    Quantitative and Qualitative Disclosures About Market Risk     27
                                                                               
  Item 8.     Financial Statements and Supplementary Data                    27
                                                                               
  Item 9.     Changes in and Disagreements with Accountants                    
              on Accounting and Financial Disclosure                         27
                                                                               
                                                                               
Part III                                                                       
                                                                               
  Item 10.    Directors and Executive Officers of the Registrant             27
                                                                               
  Item 11.    Executive Compensation                                         27
                                                                               
  Item 12.    Security Ownership of Certain Beneficial Owners                  
              and Management                                                 27
                                                                               
  Item 13.    Certain Relationships and Related Transactions                 27
                                                                               
                                                                               
Part IV                                                                        
                                                                               
  Item 14.    Exhibits, Financial Statement Schedules, and                     
              Reports on Form 8-K                                            28
                                                                               
              Signatures                                                     30 
</TABLE> 

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Except for the historical information contained herein, the discussion in this
Form 10-K contains forward-looking statements that involve risks and
uncertainties. The Company's actual results could differ materially from those
discussed here. Factors that could cause or contribute to such differences
include, but are not limited to, those discussed below, as well as under the
captions "Additional Risk Factors" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

ITEM 1.   Business

Metrowerks Inc. ("Metrowerks" or "the Company") was amalgamated on January 1,
1990 under the Canada Business Corporations Act and the information contained
herein includes that of the Company and its wholly owned subsidiary, Metrowerks
Corporation, a Texas corporation, which was formed in June 1994, and Metrowerks
Corporation's wholly owned subsidiary, Metrowerks Co. Ltd., a Japanese
corporation, which was formed in August 1996. Metrowerks is a computer software
development company that designs, develops, markets and supports software
development tools. The Company's products are used primarily by professional
software programmers and by programmers in the academic community to create
software applications. The Company's principal product line, Metrowerks(R)
CodeWarrior,(R) consists of a suite of programming tools used to develop
software in the C, C++, Java,/TM/ Pascal and low-level (assembly) programming
languages.

CodeWarrior is hosted on Windows(R) 95/98/NT(R)-based, Solaris-based and
Macintosh(R) computers and is used to develop software for platforms using a
variety of operating systems ("OS") including desktop operating systems Windows
95/98/NT and Mac(R) OS and commercial off-the-shelf embedded operating systems,
such as VxWorks, QNX, Nucleus OS and Windows CE.  CodeWarrior is also the
primary tools solution for many proprietary platforms such as 3Com's Palm
Computing platform, Sony PlayStation, Nintendo 64 and AG Communications', a
Lucent subsidiary, GTD-5 operating system.

The Company's principal line of products, known as CodeWarrior, includes an
Integrated Development Environment ("IDE") which includes: native and two-
machine debuggers, which use a common user interface and which provide source-
level debugging capabilities for a variety of operating systems, including those
listed above; a text editor for editing source code; class browsers used for
developing and editing programs in object-oriented languages such as C++ and
Java; a state-of-the-art project manager which obsoletes "make" files; computer
language compilers for compiling source code written in C, C++, Pascal, Java,
and assembly programming languages into machine code for a variety of
microprocessors, including the 68K, PowerPC,(R) x86, and MIPS(R) families of
microprocessors; and linkers, which permit compiled object code to be linked to
create "executable object code," more commonly known as software programs.

The Company believes that CodeWarrior has become the industry standard for
developing Macintosh programs, and that its CodeWarrior products have been used
to program over 75% of all software applications that run native on the Power
Macintosh computer. Since the introduction of CodeWarrior in January 1994, the
number of registered users of CodeWarrior has grown to over 130,000 users in 75
countries.


                                                                      BACKGROUND

                                             PROGRAMMING LANGUAGES AND COMPILERS

Microprocessors operate based on electrical impulses, with each character or
"bit" consisting of "on" (current or "1") and "off" (no current or "0"). Each
keystroke on the computer keyboard is represented by one "byte," which is
composed of a unique sequence of eight bits. This programming language is known
as machine language or object code. Because it is difficult and cumbersome to
program in object code, programming languages that use the standard 26-letter
alphabet have been devised. Programming languages are divided into two basic
types: low-level and high-level. Low-level languages, known as assembly
languages, map the logic of the instructions that a microprocessor processes on
a one-for-one basis. Programs written in assembly language are very efficient in
their use of microprocessor memory. However, because of this one-to-one mapping
to a particular microprocessor's instruction set, there is not "one" assembly
language but rather one for every kind of 

                                       3
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microprocessor. In order for a program written in assembly language for a
particular kind of microprocessor to operate on a different kind of
microprocessor, the program must be rewritten. Therefore, programming in
assembly languages takes longer, is expensive and requires a great deal of
technical training and skill.

The problems inherent in low-level languages led to the development of high-
level languages. From the perspective of the programmer, these high-level
languages are easier to use and understand. Currently, the dominant high-level
programming languages are:

     C and C++ - the dominant programming languages used for developing "shrink-
     wrapped" Windows and Macintosh applications software, and used increasingly
     to develop software for 32-bit embedded systems; and

     Java - used for networking-based applications where Java-optimized
     bytecodes can run on a variety of hardware, and do not need to be rewritten
     in native mode to run on each specified platform.

     Pascal - used for education purposes;
     
     BASIC - used for database application front-end development and in
     education;

     COBOL - used for programming mainframe-based applications;
     
Because high-level languages use their own logic to solve problems and do not
match the microprocessor's instruction set on a one-for-one basis, their "source
code" must be translated, or compiled, into object code. This task is performed
by software programs, known as compilers, which convert a software application
written in source code into object code that a particular microprocessor can
understand. Development of all software applications requires that source code
be compiled into object code, and thus one of the most important tools a
programmer uses is a compiler.


                                                            TECHNOLOGICAL TRENDS

The continuing evolution of computer technology has dramatically impacted the
environment in which computer programmers must operate. The development of new
programming languages, new operating systems, new types of microprocessors and
the increased focus by developers and companies on time-to-market issues have
all created new demands on programmers.

One of the most significant changes has been the increasing number of 32-bit
microprocessors used in desktop and embedded systems. This shift has resulted in
the development of new operating systems for the desktop and embedded systems
markets, the creation of major new microprocessors, such as Intel's Pentium(R)
family of processors, the increased use of object-oriented programming
languages, most notably C++ and Java, and the importance of networking and
communications technology. Prior to the invention in the 1980's of relatively
low-cost Dynamic Random Access Memory ("DRAM"), programmers went to great
lengths to "optimize" their software to use as little memory as possible,
resulting in relatively longer product development times. Today's competitive
environment for desktop and embedded applications software requires that
reliable software applications be developed with a wide variety of features and
brought to market quickly and in a cost-effective manner. Today's programmer
must balance optimization and use of memory and systems resources with time-to-
market considerations.

The introduction and increasing use of Reduced Instruction Set Computing
("RISC") technology, such as the PowerPC microprocessors now used in the Power
Macintosh computer and the modified RISC architectures of the Pentium, Pentium
Pro and Pentium II microprocessors, has also affected the applications software
market. RISC-based microprocessors utilize different instruction sets than the
traditional complex instruction sets utilized in other common microprocessors
such as Intel's X86 or Motorola's 68K family of microprocessors. Because of
their relatively low cost, 32-bit RISC-based microprocessors are being utilized
in embedded systems applications in 

                                       4
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consumer electronics products, hand-held computers, set-top boxes, game
machines, telecommunications products, automotive products and other electronic
systems. These 32-bit microprocessors permit more features and functionality
than can be programmed into 4-, 8- or 16-bit microprocessors, which have lower
computing power and memory capability.


                                                            NEEDS OF PROGRAMMERS

The Company believes that software companies and their programmers regard the
following as critical attributes of programming tools:

 .  BUILD TIME. The Company believes that today, programmers are concerned with
   not only creating the most highly optimized code, but also with the time
   required to build code and the speed with which a reliable product can be
   brought to market. Therefore, "build time," the time it takes to convert a
   set of source code instructions into a finished application, has become
   critically important to programmers. Shorter build times allow programmers
   more time to add features to an application and to test and debug the
   software more thoroughly.

 .  SPEED, SIZE AND QUALITY OF OBJECT CODE. In general, application developers
   prefer to have applications whose code is smaller and faster than their
   competitor's application. Faster code execution usually maximizes customer
   satisfaction regarding performance, and smaller code size minimizes the use
   of memory which can reduce hardware system requirements. This is true for
   both desktop and embedded applications. Some applications, particularly in
   the embedded systems market, are time-critical and/or memory constrained and
   demand code that is optimized for speed and/or size.

 .  EASE OF USE. Because of the sophisticated nature of software development, the
   large number and geographic dispersion of programmers and the increasing
   number of microprocessors and operating systems being targeted by developers,
   software development tools must be easy to use. Extensive training
   requirements and learning curves associated with complicated development
   tools can result in increased costs and extended development cycles.

 .  FREQUENCY OF UPDATES. Due to the increased pace of microprocessor innovation,
   changes in operating systems and evolving standards for programming
   languages, programming tools must be updated frequently. Programmers must
   keep current with these changes so that the development process is not
   delayed by requiring programmers to spend time modifying their software
   applications to reflect such changes.

 .  SOPHISTICATED DEBUGGING. Because of the increasing complexity of software,
   programming tools must provide debugging capabilities sophisticated enough to
   permit programmers to test software quickly and thoroughly to identify and
   correct "bugs" in the software being developed. This need is particularly
   critical for developers of embedded applications, which are usually burned
   into read-only memory ("ROM").


                                                                        STRATEGY

The Company's vision is to be the leading high-volume provider of cost-
effective, standardized programming tools for software developers in the desktop
development market, the embedded development market and the Java technology
market. The Company has focused on providing developers with a single IDE that
allows them to write software applications in a variety of programming languages
targeted at a variety of microprocessors and operating systems used in these
markets. The key elements of the Company's strategy are as follows:

                                       5
<PAGE>
 
SALES PENETRATION IN THE EMBEDDED MARKET.  The Company has expanded its sales
strategy to better target the embedded market.  The Company intends to sell
into the embedded market through direct sales to end customers and through
original equipment manufacturer ("OEM") licensing arrangements.  OEMs as defined
by the Company includes semiconductor vendors and systems vendors.

     Direct Sales to End Customers.  The Company has historically sold most of
     its products indirectly through third party distributors.  These types of
     distribution channels have not been utilized in the embedded market, and in
     fiscal 1998 the Company focused on strengthening its direct sales team for
     its anticipated growth in the embedded market.  The Company's direct sales
     force has increased from 11 employees at the end of fiscal 1997 to 26
     employees at the end of fiscal 1998. The Company anticipates that it will
     need to increase the number of employees in its direct sales force in
     fiscal 1999 to properly address the sales opportunities that the Company
     believes exist in the embedded market.

     OEM Licensing Arrangements.  Metrowerks has targeted semiconductor vendors
     and systems vendors as potential licensees of the CodeWarrior IDE and other
     CodeWarrior technologies. Semiconductor vendors typically ship hardware and
     software development tools to potential customers for evaluating their
     microprocessors for potential platforms. By providing developers with an
     easy-to-use product that is customized for their boards, semiconductor
     vendors increase the potential for design wins by reducing the customer's
     development costs and improving the time to market for the new product.

     The Company entered into several OEM arrangements in fiscal 1998 including 
     agreements with Applied Microsystems Corporation, Be, Inc., 3Com
     Corporation and QNX Software Systems, Ltd., and anticipates that OEM
     arrangements, as described above, will be a significant percentage of
     revenue for fiscal 1999. However, there can be no assurance that the
     Company will be able to enter into future agreements or that the existing
     or future agreements will result in sales of the CodeWarrior products.

     Systems vendors (primarily providers of integrated development solutions
     including off-the-shelf operating systems, proprietary operating systems
     and hardware platforms) need traditional embedded tools for initial
     platform development (pre-platform development) that are compatible with
     the tools used for application development (post-platform development).
     System vendors need to provide developers with post-platform development
     tools that are easy-to-use, desktop-like tools. Management believes that
     the Company is well positioned for this market, as CodeWarrior products are
     unique in that they benefit from development experience in both the desktop
     and embedded markets.  The Company does not believe that any of their
     competitors have similar product experience.

BROADEN PRODUCT OFFERINGS. The Company believes that its future success is
highly dependent on its ability to market CodeWarrior products that have a
variety of front-ends (for new programming languages) and back-ends (for new
platforms or operating systems) in order to reach as large a group of potential
customers as possible. In fiscal 1998, the Company released four new products
with ten additional products scheduled for release through the end of calendar
1998. In continuing to execute on this element of its strategy, the Company
intends to:

     Expand by Developing Back-Ends for Embedded Platforms. The Company's
     initial products had back-ends for Motorola 68K and PowerPC microprocessors
     used by the Macintosh computer. The Company has since developed back ends
     for the x86 family of microprocessors (including optimizations for Intel
     MMX, AMD K6 and AMD K6-2 with 3D Now! instruction sets), the MIPS families
     of microprocessors, the NEC V800 and Vr Series of microprocessors and
     Motorola's 56800 family of DSP microprocessors. The Company is in the
     process of developing back ends for Motorola's MCore microprocessor and
     Hitachi SuperH families of microprocessors which are popular in the
     embedded systems market.

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     Increase Support for a Variety of Operating Systems. The Company currently
     supports development for desktop operating systems such as Windows 95/98/NT
     and Mac OS; commercial off-the-shelf embedded operating systems such as
     VxWorks, QNX, Nucleus OS and Windows CE, and proprietary embedded operating
     systems such as PlayStation OS, Palm OS, and Nintendo. The Company
     anticipates supporting additional multi-purpose, commercial off-the-shelf
     embedded operating systems and proprietary embedded operating systems in
     the future. The Company's intention is to provide developers with the
     ability to target a variety of operating systems and the related
     microprocessors from the CodeWarrior IDE.

     Partnering Agreements. The Company has entered into product development
     agreements with various companies.  The details of these arrangements vary,
     but generally they provide for the porting of Metrowerks' programming tools
     to a specific platform, for payments to Metrowerks for its porting efforts
     and for either ownership of, or a license to market, the ported programming
     tools. The other party to these agreements is generally permitted to
     utilize the ported tools for its own internal use, or in certain instances,
     to bundle the tools with hardware developed by such party. These partnering
     agreements have provided the Company with a significant amount of revenue,
     constituting approximately 21% of its revenue for fiscal 1998 and 26% for
     fiscal 1997. As a result, the Company is able to devote more of its
     financial resources to research and development than it would otherwise be
     able to do. There can be no assurance that the Company will be able to
     continue to enter into these arrangements in the future.

CONTINUED ENHANCEMENTS TO THE COMPANY'S WINDOWS 95/98/NT DEVELOPMENT TOOLS. In
fiscal 1997, the Company released CodeWarrior Professional, which combined the
Company's Windows 95/98/NT-hosted and Mac-hosted tools for developing
applications for the desktop market. The Company has focused on adding features
to the CodeWarrior Professional product to make the product more competitive
with other tools in the Windows development market.  The Company added several
new features in fiscal 1998 including fully integrated debug support and support
for Intel MMX, AMD K6 and AMD K6-2 with 3D Now! instruction sets. In September
1998, Metrowerks shipped CodeWarrior Professional Release 4 which included a
resource editor and, in the Company's opinion, one of the most highly optimized
x86 compilers in the market. The Company plans to add several functions to these
tools in the near future the most important of which is Rapid Application
Development ("RAD") tools scheduled to be released with CodeWarrior Professional
Release 5 in the third quarter of fiscal 1999. Although Microsoft dominates this
market, the Company feels that the market is large enough for the Company to
increase market share in certain niches. These niches include:

          Cross-Platform Development - Developers who program for Windows as
          well as other targets such as Mac OS, Solaris and Linux, which
          Microsoft does not support.

          Academic Development - Educational institutions have a variety of
          installed systems and benefit from the ability to deploy a common
          solution across platforms. See Strategy - Target the Educational
          Market below.

          Game Development - Developers in this market benefit from the
          multimedia extension support provided by CodeWarrior for Intel and AMD
          processors.  Developers also benefit from CodeWarrior's support of
          multiple gaming platforms, including Sony PlayStation and Nintendo 64.

          High-Performance Development - The x86 compiler in CodeWarrior
          Professional is, in the Company's opinion, one of the most highly
          optimized compilers in the market.  Additionally, the Company recently
          released the CodeWarrior Analysis Tools, a suite of low-priced tools
          for analyzing code performance. The code performance tools are
          compatible with code generated by either CodeWarrior or Microsoft's
          Visual C++.

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<PAGE>
 
TARGET THE EDUCATIONAL MARKET. The Company currently markets its CodeWarrior
Academic products to universities, colleges and high schools, many of which have
standardized on CodeWarrior for computer programming classes. Educational
institutions have a variety of installed computers and operating systems in
their labs that may or may not be compatible with the student's home computer.
Because CodeWarrior is a multi platform solution (runs on Windows 95/98/NT,
Solaris and Mac OS and allows students to write code for platforms), all of
these institutions can eliminate the need for different sets of development
tools for each platform. Additionally, CodeWarrior allows students and
professors to share code bases that are written on different platforms.
CodeWarrior's multiple language support also offers greater flexibility in
language choice to these institutions.

MAINTAIN LEADERSHIP IN THE MACINTOSH COMPUTER MARKET. The Company believes that
its CodeWarrior products have become the industry standard for Macintosh-
hosted programming tools and that its CodeWarrior products have been
used to program over 75% of all commercially available software applications for
the Power Macintosh computer. The Company's intention is to maintain this
position through continued enhancements to its Macintosh tools.


PRODUCTS

  The following is a listing of the Company's products which represent over 90
  percent of the Company's total product revenues:


Desktop Products

  CODEWARRIOR PROFESSIONAL: CodeWarrior Professional is Metrowerks' flagship
  product. It is an integrated development tools suite for creating applications
  that run on the Windows 95/98/NT or Mac OS operating systems. CodeWarrior
  Professional supports the development of applications in C, C++, Java, and
  Pascal.  On the Windows platform, it includes support for 3DNow! extensions on
  AMD K-6 processors, and MMX extensions on Pentium processors. On the Macintosh
  platform, it includes support for AltiVec extensions on PowerPC processors.

  CODEWARRIOR PROFESSIONAL ACADEMIC: This product is identical to CodeWarrior
  Professional and is marketed to the academic community. This product is
  limited to non-commercial use.

  DISCOVER PROGRAMMING FOR WINDOWS AND DISCOVER PROGRAMMING FOR MACINTOSH: These
  are entry-level products designed for individuals who want to learn
  programming. These products contain the CodeWarrior IDE hosted on Windows
  95/98/NT or MacOS for developing C, C++, Java and Pascal applications. The
  products contain books and materials specifically designed for people who want
  to learn how to program.

  VISUAL SOURCESAFE FOR MACINTOSH: This product is a version control tool that
  is used by developers on Macintosh computers to manage large software
  projects. It is fully compatible with Microsoft's Windows-based Visual
  SourceSafe.

The Company has released or is currently planning to release the following
CodeWarrior desktop tools in fiscal 1999:

  CODEWARRIOR PROFESSIONAL (SOLARIS): CodeWarrior Professional (Solaris) is the
  version of the CodeWarrior Professional product hosted on the Solaris
  operating system and running on workstations from Sun Microsystems Inc. This
  product allows developers to create C/C++ applications using command-line
  adapters for GNU compilers and Java applications using Metrowerks bytecode
  compilers.

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<PAGE>
 
  CODEWARRIOR ANALYSIS TOOLS(TM): This CodeWarrior product which was introduced
  in October 1998, is a combination hierarchical profiler and visual code
  coverage tool. Developers use these tools to analyze and verify program
  execution in order to assure the highest performance and quality in their
  programs. The tools can be used with code generated by CodeWarrior or
  Microsoft Visual C++.


Embedded Systems Products

  MICROPROCESSOR SPECIFIC:

     The following embedded products all include the CodeWarrior IDE hosted on
     Windows 95/98/NT operating systems with C/C++ and assembly language
     support:

     CODEWARRIOR FOR POWERPC(TM) EMBEDDED SYSTEMS: For designing applications 
     running on MIPS (ISA level I, II, III, IV) RISC microprocessors.

     CODEWARRIOR FOR MIPS(R) EMBEDDED SYSTEMS: For designing applications
     running on MIPS (ISA level I, II, III, IV) RISC microprocessors.

     CODEWARRIOR FOR NEC(R) V800 SERIES: For designing applications running on
     the NEC V8xx Series of RISC microprocessors.

     CODEWARRIOR FOR NEC(R) VR SERIES: For designing applications running on the
     NEC Vr Series of RISC microprocessors (MIPS ISA levels I, II, III and IV).

     DISCOVER PROGRAMMING FOR MOTOROLA(R) DSP: Entry level product designed as a
     starter kit and development solution for the Motorola 56811 and 56824
     Digital Signal Processors ("DSPs"). Discover Programming for Motorola DSP
     supports application development in C or assembly language only.

  PLATFORM SPECIFIC:

     CODEWARRIOR FOR SONY PLAYSTATION(TM): This product includes the CodeWarrior
     IDE hosted on Windows 95/98/NT and Mac OS operating systems with C, C++ and
     assembly language support for developing applications that run on the Sony
     PlayStation and Sony PlayStation Development System.

     CODEWARRIOR FOR PALM COMPUTING PLATFORM: This product includes the
     CodeWarrior IDE hosted on Windows 95/98/NT and Mac OS operating systems
     with C language support for developing applications that run on the 3Com
     Palm Computing platform. The Company has entered into an OEM agreement with
     3Com that grants to 3Com the exclusive right to market CodeWarrior for
     Palm Computing platform throughout fiscal 1999 on a per unit royalty basis.

     CODEWARRIOR FOR NUCLEUS PLUS(R) EMBEDDED DEVELOPMENT KIT: This product
     features kernel-aware debugging support for the Nucleus PLUS(R) real-time
     operating system from Accelerated Technology Inc.  It is used in
     conjunction with CodeWarrior tools targeting a particular microprocessor to
     create a complete solution for Nucleus PLUS development.

The Company has released or is currently planning to release the following
CodeWarrior desktop tools in fiscal 1999:

  CODEWARRIOR FOR QNX(R) 4.2: This product is a Windows 95/98/NT-hosted version
  of the CodeWarrior IDE which can be used to develop legacy QNX applications
  running on x86-based hardware. This product supports application development
  in C, C++ and assembly language.

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<PAGE>

  CODEWARRIOR FOR QNX(R)/NEUTRINO: This product is a Windows 95/98/NT-hosted
  version of the CodeWarrior IDE which can be used to develop applications
  running under the QNX/Neutrino operating system. This product supports
  application development in C, C++ and assembly language. These tools support
  Neutrino development for hardware that is based on x86, PowerPC, and MIPS
  microprocessors.

  CODEWARRIOR FOR VXWORKS(R)/TORNADO(TM) EMBEDDED DEVELOPMENT KIT: This product
  features kernel aware debugging support for the VxWorks(R) real-time operating
  system from Wind River Systems(R). It is used in conjunction with CodeWarrior
  tools targeting a particular microprocessor to create a complete development
  solution for VxWorks development.

  WINDOWS(R) CE/X86 EMBEDDED DEVELOPMENT KIT: This embedded toolkit supports
  Windows CE development for x86-based hardware. The embedded toolkit is used in
  conjunction with x86 core development tools to create a complete package for
  Windows CE application development for x86-based platforms.

  WINDOWS(R) CE/MIPS EMBEDDED DEVELOPMENT KIT: This embedded toolkit supports
  Windows CE development for MIPS-based hardware. The embedded toolkit is used
  in conjunction with MIPS core development tools to create a complete package
  for Windows CE application development for MIPS-based platforms.

  CODEWARRIOR FOR M-CORE(TM) EMBEDDED SYSTEMS: This product will include the
  CodeWarrior IDE and hosted on Windows 95/98/NT, back-ends for developing
  software applications to run on Motorola's M-CORE family of microprocessors.

  CODEWARRIOR FOR HITACHI SUPERH EMBEDDED SYSTEMS: This product will include the
  CodeWarrior IDE hosted on Windows 95/98/NT, C, C++, and Assembly front-ends
  and back-ends for developing software applications to run on Hitachi SuperH
  microprocessors.

Note:  All products that support C++ development also support EC++ development
as defined by the EC++ Technical Committee.

There can be no assurance that any of these new platforms, operating systems or
programming languages or that any of the Company's proposed programming tools
will be completed or achieve commercial success. Failure of a particular
platform for which the Company has developed a back-end or a programming
language for which the Company has developed a front-end would result in reduced
demand for software applications that run on the platform or in the programming
language, which in turn could adversely affect the Company's business, financial
condition and results of operations. See "Additional Risk Factors-Importance of
New Products and Technological Change."


                                                        RESEARCH AND DEVELOPMENT

The Company continues to make substantial investments in research and
development. While the Company believes that its future performance will depend
upon the success of its research and development efforts, it also believes that
the modular design of its CodeWarrior products provides it with the ability to
incrementally add a new back-end (for a new platform or operating system) or a
new front-end (for a new programming language). This architecture significantly
reduces both the cost and the time-to-market required to release new tools for a
new platform, operating system or programming language, that it would otherwise
face if it had to develop an entirely new set of programming tools.

The Company has a program, "Metrowerks Permanent Testing Partners," which helps
supplement the Company's product testing efforts. The Company has a testing
group of over 1,300 CUSTOMERS. This testing group is provided with product
updates or new releases in advance of their release to the public. The members
of this group utilize the product and notify the Company of any errors they
encountered, which are subsequently corrected prior to the general release of
the product. The Company believes that its Metrowerks Permanent Testing Partners
program provides it with additional product testing and quality control
capabilities at very little additional cost.

                                       10
<PAGE>
 
The Company has also supplemented its internal product development efforts
through external product development agreements. Such funding is generally
pursuant to agreements with third parties which provide for the Company to
develop programming tools from existing CodeWarrior technology for a specific
platform designed by the third party. The Company receives product development
fees, generally to be paid subject to the Company meeting performance standards
and development milestones, which are usually sufficient to cover all or a
substantial portion of the Company's research and development costs. The Company
either owns, or is generally granted a license to market, these programming
tools with its products. The Company recorded revenues of approximately US$2.3
million, US$4.7 million and US$3.9 million pursuant to these product development
agreements for fiscal 1996, 1997 and 1998, respectively. The Company has shifted
its focus towards selling and marketing its existing product line and,
accordingly, product development agreements were a smaller percentage of total
revenues in fiscal 1998.  While the Company anticipates that these revenues will
not increase significantly as a percentage of total revenue in fiscal 1999, they
will remain an important factor in the Company's ongoing operations.  There can
be no assurance that the Company will continue to be able to enter into such
software development arrangements.

Because of the need to develop new products and enhance its current product
offerings, the Company has invested, and continues to invest, substantial
resources in its research and development efforts. At July 31, 1998, the
Company's research and development staff constituted approximately 56% of the
Company's employees, having grown from 90 employees at July 31, 1997 to 141
employees at July 31, 1998. The Company also relies on independent contractors
for some of its research and development projects. The Company incurred costs of
approximately US$3.3 million, US$6.5 million and US$10.0 million on research and
development activities for fiscal 1996, 1997 and 1998. Such expenditures
constituted 31%, 35% and 52% of revenue, respectively, for such periods.

The Company generally releases new versions of, or updates for, its CodeWarrior
products twice a year. The success of new product introductions and updates
depends upon several factors, including recognition of market requirements,
product cost, timely completion and introduction of new products and the
targeted platform, operating system or programming languages, and quality of new
products and such platforms, operating systems or programming languages. There
can be no assurance that the Company will not encounter delays in the
development and introduction of future products. Software products as complex as
those offered by the Company may also contain undetected errors when first
introduced or as updates are released. Although the Company has not experienced
any material errors in its products, there can be no assurance that, despite
testing by the Company and its testing partners, errors will not be found in new
products after commencement of commercial shipments, resulting in a loss of or
delay in market acceptance. There can also be no assurance that the Company will
successfully identify new product opportunities and develop and bring new
products to market in a timely manner, that the Company's products will be
accepted by its targeted customers or utilized in connection with its targeted
applications or that products or technologies developed by other companies will
not render the Company's products or technologies obsolete or noncompetitive.
Further, the success of certain of the Company's new tools will depend in part
on the amount of software applications developed for a new platform, operating
system or programming language, which in turn will depend upon the commercial
success of such platform, operating system or programming language introduced by
other companies. The failure of the Company's new product development efforts or
the lack of market acceptance for the Company's new tools would have a material
adverse effect on the Company's business, financial condition and results of
operations. The failure of any new platform, operating system or programming
language for which the Company may have devoted substantial resources in
developing new tools would also have a material adverse effect on the Company's
business, financial condition and results of operations. See "Additional Risk
Factors-Importance of New Products and Technological Change" and "Risk Factors-
Software Defects."

                                                             SALES AND MARKETING

                                       11
<PAGE>
 
SALES.  The Company sells its products through a combination of direct and
indirect selling methods.  A majority of the Company's desktop product sales and
a small percentage of its embedded product sales are made through major
distributors such as Ingram Micro, Inc., and Merisel Americas, Inc., which sell
to retail stores and mail-order catalogs in the United States and Canada and
through distributors that sell to academic institutions. CodeWarrior
Professional is listed in a variety of mail-order catalogs, including
PC/MacConnection and MacWarehouse, two of the largest mail-order software
distribution catalogs specializing in the North American computer market. The
Company believes that desktop software programmers frequently utilize mail-order
channels rather than retail stores because of the lower prices offered through
such mail order companies. Accordingly, the Company continues to emphasize mail-
order distribution as a method of marketing.

The Company's direct sales force is the primary source for its embedded product
sales as well as site license sales of its desktop products.  The Company
increased the number of direct sales personnel from 11 people at July 31, 1997
to 26 people at July 31, 1998 in anticipation of the introduction of several new
embedded products. The Company's direct sales team sells directly to end-users
worldwide.

In fiscal 1998, the Company expanded its sales efforts to include the
establishment of OEM relationships with various semiconductor vendors and system
vendors ("OEM partners").  Through these OEM relationships the Company typically
licenses certain CodeWarrior technologies to the OEM partner for exclusive and
non-exclusive distribution to their customers. The Company established an OEM
sales team in fiscal 1998 which is now comprised of 4 employees to develop and
monitor these relationships exclusively. See "Strategy".

Outside of the United States and Canada, the Company sells directly and through
distributors in 73 countries. In fiscal 1996, 1997 and 1998, sales outside of
North America were US$1.9 million, US$4.4 million and US$4.3 million,
respectively. Approximately 22% of the Company's registered users are located
outside the United States. The Company relies primarily on distributors to
generate international product sales. The Company generally enters into
distribution agreements with these distributors for a one or two year term, with
provisions for annual renewals thereafter. Product localization (such as
translation of user interface prompts and packaging) is performed for the
Company by third parties and by the Company's Japanese subsidiary.

The Company also offers a toll free telephone number for orders which are
processed and filled by the Company's operations center in Austin, Texas. With
the emergence of new distribution channels such as on-line services and other
electronic distribution, the Company is exploring other cost-effective methods
of distribution.

MARKETING. The Company markets its products through trade show exhibits and
conferences, presentations to large groups of end-users and advertisements in
various software catalogs and magazines. All marketing, advertising and public
relations activities are performed by the Company's marketing group with
assistance from the Company's creative advisors.


                                                                       CUSTOMERS

As of July 31, 1998, the Company had over 130,000 registered users of its
CodeWarrior products. Most of the Company's desktop customers are small
independent software vendors who generally purchase one copy of the Company's
products. The Company's embedded customers range from one and two person
developer teams to large corporate developer teams. A large number of students,
researchers in academia and university computer science labs use the Company's
academic product line.

                                       12
<PAGE>

                                         CUSTOMER AND TECHNICAL SUPPORT SERVICES

The Company believes in providing timely, high quality technical support, which
it believes is critical to maintaining customer satisfaction and is an important
element of the value it provides to customers. The Company provides telephone,
electronic mail and fax-based customer support from 8:00 a.m. to 7:00 p.m., CST,
five days per week and has a staff of 15 technical support individuals. Members
of the Company's technical support staff typically have several years of
experience in areas such as software engineering, software testing or tools
development. Most customer support services for the Company's customers outside
North America are provided through its international distributors; however, the
Company provides the distributors with any needed technical assistance.

                                                                     COMPETITION

The marketplace for professional programming tools is intensely competitive.
Given the variety of platforms and operating systems on or for which the
Company's products operate, the Company faces competition from many companies.
While many of the Company's competitors are software vendors or other technology
companies who offer products for sale to the public, the Company also faces
competition, particularly in the embedded systems market, from platform
manufacturers who develop software applications and programming tools
internally, and who are therefore less inclined to purchase programming tools
from a third party. See "Additional Risk Factors - Competition." The Company
believes that it must continue to develop new products and introduce
enhancements to its existing products in a timely manner to remain competitive.
Even if the Company introduces new and enhanced products, it may not be able to
compete effectively because of the significantly larger resources available to
many of its competitors. The Company's ability to compete successfully also
depends on a number of other factors both within and outside of its control,
including: product pricing; product quality and performance; its ability to
attract and retain key employees; effectiveness of its sales and marketing;
timing of new product introductions by the Company, its competitors and creators
of new hardware platforms; general market and economic conditions; and
government actions throughout the world. There can be no assurance that the
Company will be able to compete successfully or that competition will not have a
material adverse effect on the Company's business, financial condition and
results of operations.

  EMBEDDED SYSTEMS. The market for programming tools for the embedded systems
  market is fragmented, highly competitive and characterized by rapid technology
  advances. The Company's success will depend on the continued enhancement of
  its current products and execution of the Company's sales strategy in the
  embedded market. The Company's products compete with tools developed
  internally by companies and tools offered by third parties. Many platform
  manufacturers, telecommunications companies and automotive manufacturers, to
  name a few, develop software applications and programming tools internally
  (proprietary systems), and accordingly, the Company believes they are less
  inclined to purchase tools from a third party. In addition, the Company faces
  competition from third-party embedded software providers of operating systems
  and tools such as WindRiver Systems, Inc., Integrated Systems, Inc., Microsoft
  Corporation, Green Hills Software, Inc. and Cygnus Solutions. Many of the
  Company's existing and potential competitors have substantially greater
  financial, technical, marketing and sales resources than the Company.

  WINDOWS 95/98/NT PROGRAMMING TOOLS. The Company's PC-hosted tools are new to
  the market and will need to add additional features to compete with other PC-
  hosted programming tools. The Company faces significant and intense
  competition from Microsoft, Inprise and Watcom in this market. All of these
  companies are well established, have strong brand name recognition, and have
  substantially greater financial, technical and marketing resources than the
  Company. There can be no assurance that the Company will be able to compete
  successfully with these companies.

                                       13
<PAGE>

  MACINTOSH PROGRAMMING TOOLS. With respect to its programming tools for the Mac
  OS and any next generation operating system from Apple, the Company faces
  competition from Symantec's Java-based tools and from Apple Computer. Symantec
  and Apple Computer have substantially greater financial, technical and
  marketing resources than the Company. The Company estimates that over 75% of
  the Power Macintosh applications available today were built with CodeWarrior.

                                                           INTELLECTUAL PROPERTY

The Company regards its software as proprietary and attempts to protect it with
copyrights, trademarks, license agreements, trade secret laws, restrictions on
disclosure and transferring title and other methods, rather than patents.
Despite these precautions, it may be possible for unauthorized third parties to
copy certain portions of the Company's products and obtain and use information
the Company regards as proprietary. While the Company's competitive position may
be affected by its ability to protect its proprietary information, the Company
believes that copyright protections are less significant to the Company's
success than other factors, such as trade secret protection, the knowledge,
ability and experience of the Company's personnel, name recognition and ongoing
product development and support.

The Company licenses its products primarily under "shrink wrap" licenses (that
is, licenses included as part of the product packaging). Shrink wrap licenses
are not negotiated with or signed by individual licensees and purport to take
effect upon the opening of the product package. Certain provisions of such
licenses, including provisions protecting against unauthorized use, copying,
transfer and disclosure of the licensed program, may be unenforceable under the
laws of certain jurisdictions. In keeping with industry standards, the Company
does not copy protect its software. Accordingly, it may be possible for
unauthorized parties to copy or reverse engineer the Company's products or
otherwise obtain and use information that the Company regards as proprietary.
Furthermore, there can be no assurance that the Company's competitors will not
independently develop technologies that are substantially equivalent or superior
to the Company's products. Policing unauthorized use of the Company's products
is difficult, and while the Company is unable to determine the extent of
software piracy of its products, software piracy can be expected to be a
persistent problem. In addition, the laws of some foreign countries do not
protect the Company's proprietary rights to the same extent, as do the laws of
the United States and Canada.

As the number of software products in the industry increases and the
functionality of these products further overlaps, the Company believes that
software programs will increasingly become subject to infringement claims. There
can be no assurance that third parties will not assert infringement claims
against the Company in the future with respect to current or future products.
Any such assertion could require the Company to enter into license or royalty
arrangements or result in costly litigation. There can be no assurance that such
license or royalty agreements will be available on reasonable terms or at all.

Although the Company believes that it currently owns or has adequate rights to
utilize all material technologies relating to its existing products, as it
develops new back-ends and front-ends for its CodeWarrior products, it
anticipates that it may find it desirable or necessary to obtain other licenses
from third parties entitling it to use certain technologies. There can be no
assurance that such licenses would be available to the Company on acceptable
terms, if at all. The Company currently has non-exclusive licenses to certain
software programs from Microsoft, a competitor of the Company. The licensed
technologies are incorporated in the Company's Windows 95/98/NT hosted products.
The Company pays Microsoft a royalty based upon the number of CodeWarrior
products sold that incorporate these programs. These licenses will expire upon
the next major release of Windows 95/98/NT. The Company licenses operating
system software from Apple pursuant to a non-exclusive license. The Company pays
a license fee to Apple for this licensed technology. The agreement has a term of
one year and is automatically renewable for successive one-year terms, subject
to earlier termination by Apple upon nine month's written notice. In connection
with the development of its programming tools for the Java programming language,
the Company has a non-exclusive license with Sun Microsystems ("Sun") to use or
modify the Java programming

                                       14
<PAGE>
 
language for the purpose of developing a Java-based CodeWarrior product. This
license is for an initial five-year term and is renewable by the Company for up
to five successive one-year terms. The Company pays Sun a royalty based upon the
number of CodeWarrior products sold that incorporate the Java technology.
Termination by Microsoft, Apple or Sun or the lapse of these agreements would
require product redesign and could significantly increase research and
development costs or would require the Company to obtain licenses from third
parties, which may not be available to the Company on acceptable terms, if at
all. The Company's loss or inability to obtain necessary or desirable licenses
from third parties could have a material adverse effect on the Company's
business, financial condition or results of operations. See "Additional Risk
Factors-Proprietary Technology."

                                                          PRODUCTION AND BACKLOG

The Company's manufacturing operations consist of assembling, packaging and
shipping the software products and documentation needed to fulfill each order.
All fulfillment and shipping is currently performed in Austin, Texas. The
Company's products are CD-ROM based. The Company produces its own CD-ROM master
disks, with disk duplication performed by third parties. Other than software
user documentation, the Company does not ship documentation such as user manuals
with its product, although a copy of such documentation is available on the CD-
ROM disk and a printed version is available to users for an additional fee.

The Company does not believe that backlog is a meaningful indicator of sales
that can be expected in future periods, particularly in view of the fast pace of
technological change in the software industry. The Company generally ships its
products within a few days after acceptance of a customer purchase order and,
therefore, has insignificant product backlog. Product development agreement
revenue backlog was approximately US$250,000, US$780,000 and US$1.2 million as
of July 31, 1996, 1997 and 1998, respectively.

                                                                       EMPLOYEES

As of July 31, 1998, the Company employed 250 full-time personnel, including 141
in research and development; 15 in technical support; 68 in sales and marketing;
and 26 in management and administration. The Company's employees are not
represented by any collective bargaining organization, and the Company has never
experienced a work stoppage. The Company believes its success will depend in
part on its continued ability to attract and retain highly qualified personnel
in a competitive market for experienced and talented software engineers and
sales and marketing personnel. See "Additional Risk Factors - Dependence on Key
Personnel."

                                                         ADDITIONAL RISK FACTORS

FLUCTUATIONS IN QUARTERLY RESULTS. The Company has experienced significant
period-to-period fluctuations in revenues and operating results and anticipates
that such fluctuations will continue. These fluctuations may be attributable to
a number of factors, including the volume and timing of orders received during
the quarter, the timing and acceptance of new products and product enhancements
by the Company or its competitors, stages of product life cycles, purchasing
patterns of customers and distributors, market acceptance of products sold by
the Company's customers, competitive conditions in the industry, business cycles
affecting the markets in which the Company's products are sold, extraordinary
events, such as acquisitions, including related charges, and economic conditions
generally or in specific geographic areas. The future operating results of the
Company may fluctuate as a result of these and other factors, including the
Company's ability to continue to develop innovative and competitive products. In
addition, the Company has not entered into long-term product development
agreements with its customers, and the timing of product development agreement
fees is difficult to predict. The procurement process of the Company's customers
is often several months or longer from initial inquiry to order and may involve
competing considerations. Further, as licensing of the Company's products
increasingly becomes a more strategic decision made at higher management levels,
there can be no assurance that sales cycles for the Company's

                                       15
<PAGE>
 
product will not lengthen. Product revenue in any quarter depends on the volume
and timing of orders received in that quarter. Because the Company's staffing
and operating expenses are based on anticipated total revenue levels and a high
percentage of the Company's costs are fixed in the short term, small variations
between anticipated orders and actual orders, as well as non-recurring or large
orders, could cause disproportionate variations in the Company's operating
results from quarter to quarter.

A number of additional factors may cause the Company's revenues and operating
results to vary significantly from period to period. These factors include:
software "bugs" or other product quality problems, changes in operating
expenses, changes in Company strategy, personnel changes, foreign currency
exchange rates, and mix of products sold. Although the Company has seen
significant revenue growth for the last several years, there can be no assurance
that the Company will be able to continue its growth in revenue or profits on a
quarterly or annual basis. Due to all of the foregoing factors, the Company
believes that period-to-period comparisons of its results of operations are not
necessarily meaningful and should not be relied upon as an indication of future
performance. It is possible that, in some future quarters, the Company's
operating results could be below the expectations of stock market analysts and
investors. In such event, the price of the common stock could be materially and
adversely affected.

IMPORTANCE OF NEW PRODUCTS AND TECHNOLOGICAL CHANGE. The market for embedded
programming tools is fragmented and the market for desktop and embedded
programming tools is characterized by ongoing technological developments,
evolving industry standards and rapid changes in customer requirements. The
Company's success depends upon its ability to continue to develop and introduce
in a timely manner new products that take advantage of technical advantages, to
continue to enhance its existing product lines, to offer its products across a
spectrum of microprocessor families and operating systems used in the embedded
systems market and to respond promptly to customers' requirements. The Company
must continuously update its existing products to keep them current with
changing technology and must develop new products to take advantage of new
technologies that could render the Company's existing products obsolete. The
Company has historically experienced minor delays in the development of new
products. Such delays are common in the software industry and are likely to be
experienced by the Company in the future. The Company's future prospects depend
upon the Company's ability to increase the functionality of existing products in
a timely manner and to develop new products that address new technologies and
achieve market acceptance. New products and enhancements must keep pace with
competitive offerings, adapt to evolving industry standards and provide
additional functionality. There can be no assurance that the Company will be
successful in developing and marketing, on a timely basis or at all, competitive
products, product enhancements and new products that respond to technological
change, changes in customer requirements and emerging industry standards, or
that the Company's new or enhanced products will adequately address the changing
needs of the marketplace. The inability of the Company, due to resource
constraints or technological or other reasons, to develop and introduce new
products or product enhancements in a timely manner could have a material
adverse effect on the Company's business, financial condition and results of
operations. From time to time, the Company or its competitors may announce new
products, capabilities or technologies that have the potential to replace or
shorten the life cycles of the Company's existing products. There can be no
assurance that announcements of currently planned or other new products will not
cause customers to defer purchasing existing Company products. Any failure by
the Company to anticipate or respond adequately to changing market conditions,
or any significant delays in product development or introduction, would have a
material adverse effect on the Company's business, financial condition and
results of operations. If the results of product development efforts are
inadequate or delayed, the Company's business, financial condition and results
of operations would be materially adversely affected.

DEPENDENCE ON KEY PERSONNEL. The Company has experienced, and expects to
continue to experience, significant growth in the number of employees, the scope
and complexity of its operating and financial systems and the geographic
dispersion of its operations. The Company's continued success will depend
significantly on its ability to integrate new operations and new personnel.
There can be no assurance that the Company will be successful in achieving such
integration efficiently. The Company's future performance depends to a
significant 

                                       16
<PAGE>
 
degree upon the continued contributions of its key management, product
development, marketing, sales, customer support and operations personnel,
several of who have joined the Company only recently. In addition, the Company
believes its future success will depend in large part upon its ability to
attract and retain highly skilled managerial, product development, marketing,
sales, customer support and operations personnel, many of whom are in great
demand. Competition for such personnel is intense and there can be no assurance
that the Company will be successful in attracting and retaining such personnel.
The failure of the Company to attract, integrate and retain the necessary
personnel could have a material adverse effect on the Company's business,
financial condition and results of operations.

PROPRIETARY TECHNOLOGY. The Company's success is heavily dependent upon its
proprietary technology. To protect its proprietary rights, the Company relies on
a combination of copyright, trade secret, trademark laws, nondisclosure and
other contractual restrictions on copying, distribution and technical measures.
The Company seeks to protect its software, documentation and other written
materials through trade secret and copyright laws, which provide only limited
protection. As a part of its confidentiality procedures, the Company generally
enters into nondisclosure agreements with its employees, consultants,
distributors and corporate partners and limits access to and distribution of its
software, documentation and other proprietary information.

SOFTWARE DEFECTS. As a result of their complexity, software products may contain
undetected errors or compatibility issues, particularly when first introduced or
as new versions are released. There can be no assurance that, despite testing by
the Company and testing and use by current and potential customers, errors will
not be found in new products after commencement of commercial shipments. The
occurrence of such errors could result in loss of or delay in market acceptance
of the Company's products, which could have a material adverse effect on the
Company's business, financial condition and results of operations.

INTERNATIONAL SALES.  In the fiscal years ended July 31, 1996, 1997 and 1998,
the Company derived approximately 18%, 24%, and 18%, respectively, of its total
revenue from sales outside of North America. The Company expects that
international sales will continue to generate a significant percentage of its
total revenue in the foreseeable future. International operations are subject to
certain risks, including political and economic instability; foreign government
regulation; more prevalent software piracy; longer payment cycles; unexpected
changes in, or imposition of, regulatory requirements, tariffs, import and
export restrictions and other barriers and restrictions; greater difficulty in
accounts receivable collection; potentially adverse tax consequences; the
burdens of complying with a variety of foreign laws; staffing and managing
foreign operations; changes in diplomatic and trade relationships; possible
recessionary environments in economies outside the United States; and other
factors beyond the control of the Company. Sales by the Company's Japanese
subsidiary are denominated in the local currency, and an increase in the
relative value of the dollar against such currencies would reduce the Company's
revenues in dollar terms or make the Company's products more expensive and,
therefore, potentially less competitive in foreign markets. There can be no
assurance that the Company's future results of operations will not be adversely
affected by currency fluctuations. The Company relies on distributors for sales
of its products in certain foreign countries and, accordingly, is dependent on
their ability to promote and support the Company's products. The Company's
international distributors generally offer products of several different
companies, including in some cases products that are competitive with the
Company's products, and such distributors are not subject to any minimum
purchase or resale requirements. There can be no assurance that the Company's
international distributors will continue to purchase the Company's products or
provide them with adequate levels of support.

FLUCTUATION IN STOCK PRICE. The market price of the Company's common stock has
fluctuated in the past, and is likely to fluctuate in the future. The Company
believes that various factors, including quarterly fluctuations in results of
operations, announcements of new products by the Company or by its competitors,
and changes in the software industry in general cause, and may continue to
cause, the market price of the common stock to fluctuate, perhaps substantially.
In addition, in recent years the stock market in general, and the shares of
technology companies in particular, have experienced extreme price fluctuations.
This volatility has had a substantial effect on the market prices of securities
issued by the Company and other high technology companies, often for reasons

                                       17
<PAGE>
 
unrelated to the operating performance of the specific companies. There can be
no assurance that the market price of the common stock will remain at or near
its current level. In the past, following periods of volatility in the market
price of a company's securities, securities class action litigation has often
been instituted against that company. Such litigation, if instituted against the
Company, could result in substantial costs and a diversion of management
attention and resources, which could have a material adverse effect on the
Company's business, financial condition and results of operations, even if the
Company is successful in such suits. These market fluctuations, as well as
general economic, political and market conditions such as recessions, may
adversely affect the market price of the common stock.

ITEM 2.   PROPERTIES

The Company's headquarters are located in a leased facility in Austin, Texas,
consisting of approximately 97,200 square feet of office space. This lease
expires in March 2004. The Company has sub-leased 21,600 square feet of the
facility through May 2000.  The Company leases an additional 14,000 square feet
in Austin, Texas formerly used for fulfillment, distribution and administrative
operations which is now sub-leased for the remainder of the lease term. The
Company also leases offices in Cupertino, California; Boston, Massachusetts;
Saint-Laurent, Quebec, Canada; and Tokyo, Japan for sales, marketing and
engineering operations.

ITEM 3.   LEGAL PROCEEDINGS

There are no material pending legal proceedings to which the Company is a party
or to which any of the Company's properties are subject.

ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

                                       18
<PAGE>
 
ITEM 5.   MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Metrowerks' common stock is traded on the NASDAQ National Market under the
symbol MTWKF and The Toronto Stock Exchange and the Montreal Exchange under the
symbol MWK.

The closing price of the Company's common stock as reported by the NASDAQ
National Market as of July 31, 1998 was US$5.13 per share. The price per share
in the following table sets forth the low and high prices in the NASDAQ National
Market for the quarter indicated (all amounts in US $):

<TABLE>
<CAPTION>
                                                          LOW         HIGH
                                                       ---------   ----------
<S>                                                    <C>         <C>
Fiscal 1997
    First quarter ended October 31, 1996                 $9.25       $12.00
    Second quarter ended January 31, 1997                 7.00        11.25
    Third quarter ended April 30, 1997                    4.88         9.75
    Fourth quarter ended July 31, 1997                    4.00         7.75
 
Fiscal 1998
    First quarter ended October 31, 1997                 $6.50       $11.00
    Second quarter ended January 31, 1998                 7.79        10.00
    Third quarter ended April 30, 1998                    6.87         9.50
    Fourth quarter ended July 31, 1998                    5.12         7.87
</TABLE>

The closing price of the Company's common stock as reported by The Toronto Stock
Exchange as of July 31, 1998 was Canadian $7.73 per share. The price per share
in the following table sets forth the low and high prices in The Toronto Stock
Exchange for the quarter indicated (all amounts in Canadian $):

<TABLE> 
<CAPTION> 
                                                          LOW         HIGH
                                                       ---------   ----------
<S>                                                    <C>         <C>
Fiscal 1997
    First quarter ended October 31, 1996                 $12.75      $16.15
    Second quarter ended January 31, 1997                  9.50       14.30
    Third quarter ended April 30, 1997                     7.00       12.75
    Fourth quarter ended July 31, 1997                     5.50       10.50
 
Fiscal 1998
    First quarter ended October 31, 1997                 $ 9.87      $15.30
    Second quarter ended January 31, 1998                 10.87       14.30
    Third quarter ended April 30, 1998                     9.75       13.75
    Fourth quarter ended July 31, 1998                     7.72       11.85
</TABLE>

The Company has not paid dividends and does not plan to pay dividends on its
common stock in the foreseeable future. Additionally, the Company's letter of
credit restricts the Company from paying out any dividends. The Company
presently intends to reinvest earnings to fund future growth. At July 31, 1998,
there were approximately 75 stockholders of record of the Company. Certain
record holders are represented by brokers and other institutions on behalf of
stockholders. The Company believes the total number of beneficial owners of its
common stock to be in excess of 4,000 owners.

                                       19
<PAGE>
 
ITEM 6.   SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated financial data should be read in conjunction
with the Consolidated Financial Statements, including the Notes to Consolidated
Financial Statements included elsewhere in this report.

<TABLE>
<CAPTION>
                                                                                     YEAR ENDED JULY 31,                        
                                                              1994           1995           1996           1997           1998  
                                                          ------------------------------------------------------------------------
                                                              (IN THOUSANDS OF U.S. DOLLARS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S>                                                       <C>              <C>            <C>            <C>            <C>     
STATEMENT OF OPERATIONS DATA:                                                                                                   
Revenue                                                       2,040          5,143         10,619         18,293         19,055 
                                                                                                                                
Cost of sales                                                   207            910          2,664          4,563          3,046 
                                                                                                                                
Operating expenses:                                                                                                             
   Research and development                                   1,080          1,574          3,250          6,486          9,964   
   Selling, administrative and technical support              1,053          2,348          4,622          8,109         10,704   
   Depreciation                                                  66            155            355          1,154          1,684   
   Non-recurring charge                                           -              -              -          4,297              -   
                                                                                                                                  
Total operating expenses                                      2,199          4,077          8,227         20,046         22,352   
                                                                                                                                  
Operating income (loss) from operations                        (366)           156           (272)        (6,316)        (6,343)  
                                                                                                                                  
Other income:                                                                                                                     
   Interest income and other                                     34             98            377            341            446    
                                                                                                                                
Net earnings (loss)                                          $ (332)        $  254        $   105        $(5,975)       $(5,897)   
                                                                                                                                   
Net earnings (loss) per share basic and diluted(1)           $(0.05)        $ 0.03        $  0.01        $ (0.52)       $ (0.48)   
                                                                                                                                   
Shares used in per share calculation:                                                                                              
   Basic                                                      6,904          7,956         10,620         11,523         12,311    
   Diluted                                                    6,904          8,100         10,708         11,523         12,311  
</TABLE>

<TABLE>
<CAPTION>
                                                                                       AS OF JULY 31,
                                                              1994           1995           1996           1997           1998  
                                                          ------------------------------------------------------------------------
                                                              (IN THOUSANDS OF U.S. DOLLARS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S>                                                       <C>              <C>            <C>            <C>            <C>     
BALANCE SHEET DATA:                     
                                        
Cash and cash equivalents                                    $  767         $4,746         $11,498        $ 5,042        $ 6,708
Total assets                                                  1,677          6,634          18,305         14,168         20,511
Long-term debt, less current portion                            201              -               -              -              -
Total stockholders' equity                                      473          5,571          16,437         10,562         16,218
</TABLE>

(1) For an explanation of the determination of the number of shares used in
    computing per share amounts and the weighted average number of common stock
    outstanding, see Note 1 to the Financial Statements.

                                       20
<PAGE>
 
ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
                CONDITION AND RESULTS OF OPERATIONS

                                                     FORWARD-LOOKING INFORMATION

Statements in this report concerning expectations for the future constitute
forward-looking statements which are subject to a number of known and unknown
risks, uncertainties and other factors which may cause actual results,
performance or achievements of the Company or industry trends to differ
materially from those expressed or implied by such forward-looking statements.
Relevant risks and uncertainties include, among others, those discussed in Item
1 of Part I under the heading "Additional Risk Factors" and elsewhere in this
report and those described from time to time in the Company's other filings with
the Securities and Exchange Commission, press releases and other communications.

                                                                        OVERVIEW

Metrowerks designs, develops, markets and supports professional software
programming tools. The Company's products are used primarily by professional
software programmers, and by programmers in the academic community, to develop
software applications for a variety of platforms, including Windows 95/98/NT
operating systems used by PCs; the Mac OS operating system used by the Macintosh
and Power Macintosh computers; and for proprietary and multi-purpose real-time
operating systems used in the embedded systems market. The Company derives
substantially all of its revenue from a limited number of products. The
Company's future revenue is substantially dependent upon the continued
acceptance of its CodeWarrior products. The Company is also in the process of
developing a number of new products and new versions of existing products and
believes that its future operating results will depend upon the commercial
success of these new products. There can be no assurance that the Company's new
products will achieve market acceptance.

The Company also derives a significant portion of its revenue from product
development agreements pursuant to which the Company receives payments from a
third party for porting its programming tools to a particular platform,
operating system or programming language. The amount of revenue the Company
receives from this particular source will depend upon the number of such
agreements to which the Company is a party during such quarter and the timing of
deliverables under such agreements. Further, there can be no assurance that the
Company will be able to continue to enter into such development agreements in
the future. The Company's product development efforts have also entailed
significant research and development expenditures. In addition, to enhance its
competitive position in the future, it will be necessary for the Company to
broaden its product offerings. This objective may require expansion of the
Company's internal product development efforts or acquisitions of or investments
in complementary businesses, products or technologies. Furthermore, if the
Company were unable to enter into new software development agreements in the
future, the Company would, at a minimum, have to increase its internal research
and development expenditures. These higher expense levels combined with
fluctuations in revenue could affect the Company's quarterly and annual results
and result in fluctuations in its operating results. The Company intends to
continue to invest significant amounts in expanding its product line, and,
accordingly, may continue to experience losses and volatility of revenue and
operating results in future periods. The Company believes that the recent
revenue growth rates should not be relied upon as an indication of revenue
growth rates for future periods.

The Company has and will continue to make certain investments in its software
systems and applications to ensure the Company is year 2000 compliant. "Year
2000 Compliant" means that a program, when used in accordance with its
associated documentation, will (a) initiate and operate, (b) correctly store,
represent, and process dates, and (c) not cause or result in an abnormal
termination or ending, when processing data containing dates in the Year 2000
and in any preceding and following years, provided that all third-party products
that exchange date data with the program do so properly and accurately and in a
form and format compatible with the program.

                                       21
<PAGE>
 
The products provided by Metrowerks process dates only to the extent that these
products use date data provided by the host or target operating system for date
representations used in internal processes, such as file modifications.  Any
Year 2000 Compliance issues resulting from the operation of the products are
therefore necessarily subject to the Year 2000 Compliance of the relevant host
or target operating system.  The Company has directed its customers to the
relevant statements of Microsoft Corporation, Sun Microsystems, Inc., Apple
Computer, Inc., and other host or target operating systems relating to the Year
2000 Compliance of their operating systems.  Except as expressly described
above, the products, in themselves, do not process date data and therefore do
not implicate Year 2000 Compliance issues.

The Company has also assessed the readiness of its internal computer systems and
does not expect to incur significant costs in implementing Year 2000 changes if
necessary.  There can be no assurance that such changes will fully completed in
a timely manner.  Additionally, the Company could be adversely impacted by Year
2000 issues faced by major distributors, suppliers, customers and financial
service organizations with which the company interacts.

On August 1, 1995, the Company adopted the United States dollar as its reporting
currency, and the historical consolidated financial statements have been
restated to present amounts in United Sates dollars.

RESULTS OF OPERATIONS

The following table sets forth certain items from the Company's consolidated
statement of income as a percentage of revenue for the periods indicated.

<TABLE>
<CAPTION>
                                                                                 AS A PERCENTAGE OF REVENUE   
                                                                                      YEAR ENDED JULY 31,     
                                                               1994           1995           1996           1997           1998    
                                                            ---------------------------------------------------------------------- 
<S>                                                         <C>            <C>            <C>            <C>            <C>        
Revenue, net                                                  100.0%         100.0%         100.0%         100.0%         100.0%   
                                                                                                                                   
Cost of sales                                                  10.2           17.7           25.1           24.9           16.0    
                                                                                                                                   
Operating expenses:                                                                                                                
Research and development                                       52.9           30.6           30.6           35.5           52.3    
Selling, administrative and technical support                  51.6           45.7           43.5           44.3           56.2    
Depreciation                                                    3.2            3.0            3.3            6.3            8.8    
Non-recurring charge                                              -              -              -           23.5              -    
                                                                                                                                   
Total operating expenses                                      107.7           79.3           77.4          109.6          117.3    
                                                                                                                                   
Operating income (loss) from operations                       (17.9)           3.0           (2.5)         (34.5)         (33.3)   
                                                                                                                                   
Other income:                                                                                                                      
Interest income and other                                       1.7            1.9            3.5            1.8            2.4    
                                                                                                                                   
Net earnings (loss)                                           (16.2)%          4.9%           1.0%         (32.7)%        (30.9)%   

</TABLE>

                                                                         REVENUE

The Company sells its products through its direct sales force and indirectly
through distributors.  The Company recognizes revenue from the sale of its
products upon the later of shipment or the satisfaction of all significant
Company obligations. All revenue is derived from unaffiliated customers. Product
returns are estimated and provided for at the time of sale. Such return
allowances as a percentage of revenue have varied significantly over recent
years and periods, reflecting the Company's experience in product returns as it
has significantly expanded the proportion of its sales through third-party
distribution channels and increased its product portfolio. The Company expects
return allowances will continue to vary in the future. The Company's agreements
with its distributors generally provide the distributors with limited rights to
return unsold inventories under a stock 

                                       22
<PAGE>
 
balancing program. The Company monitors activities of its distributors in an
effort to minimize excessive returns and establishes its return allowances based
on its estimates of expected returns. While historically the Company's returns
have been within expectations, the establishment of return allowances requires
judgments regarding such factors as future competitive conditions and product
acceptance, which can be difficult to predict.

The Company also derives revenue from product development agreement fees.
Product development agreement fees related to software development are
recognized on a percentage of completion over the term of the contract, and are
included in revenue in the income statement.

Total revenue increased from $18.3 million in fiscal 1997 to $19.1 million in
fiscal 1998, a 4% increase. Product sales in fiscal 1998 increased $1.5 million,
or 11%, from $13.6 million in fiscal 1997 to $15.1 million in fiscal 1998. The
increase in product sales is due to the increase in embedded product sales from
$2.9 million in fiscal 1997 to $4.7 million in fiscal 1998, a 61% increase.
Embedded product revenues consist primarily of sales of CodeWarrior for PowerPC
and CodeWarrior for MIPS as well as the Company's OEM agreement with 3Com 
for their Palm Computing platform. Desktop product sales, consisting primarily
of the Company's flagship product CodeWarrior Professional and to a lesser
extent the licensing of the CodeWarrior IDE to Be, Inc., increased $405,000 from
$9.3 million in fiscal 1997 to $9.7 million in fiscal 1998. Product development
agreement revenues decreased 16%, or $800,000 from $4.7 million in fiscal 1997
to $3.9 million in fiscal 1998. The decrease in product development agreement
revenue occurred as many of the agreements entered into by the Company were
reaching final stages and the Company began to shift its focus towards the sales
of these newly developed products.

The Company's revenues in 1997 increased to $18.3 million from $10.6 million in
fiscal 1996, an increase of 72% or $7.7 million.  The increase in fiscal 1997
was due primarily to increased product sales of CodeWarrior for Mac OS as the
Company's subscriber base increased from approximately 50,000 registered users
at July 31, 1996 to approximately 100,000 users at July 31, 1997.  The Company's
product revenues increased $5.2 million or 62% from $8.4 million in fiscal 1996
to $13,578 in fiscal 1997.  In 1997, alliances with new partners such as NEC,
Motorola, Microsoft, and Microware resulted in an increase in product
development agreement revenues of $2.4 million from $2.3 million in fiscal 1996
to $4.7 million in fiscal 1997.

                                                                   COST OF SALES

Cost of sales consists primarily of the cost of product media and duplication,
the cost of packaging materials, amortization of capitalized software
development costs, royalties and shipping expenses. Costs associated with
product development agreement revenues are included in research and development
expenses and are not separately identified and approximate revenue. Costs
associated with technical support are included in selling, general and
administrative expenses and were $528,000, $566,000 and $690,000 in fiscal 1996,
1997 and 1998, respectively. Cost of sales decreased from $4.6 million in fiscal
1997 to $3.0 million in fiscal 1998, representing a 33% reduction.  Cost of
sales as a percentage of product revenue decreased from 34% in fiscal 1997 to
20% in fiscal 1998.  The Company restructured its production and fulfillment
operations by bringing in-house all packaging, fulfillment and shipping
activities.  In addition, the Company has increased the amount of sales
generated by its direct sales force, which typically result in higher margins
than those products sold through distributors.

Cost of sales increased from $2.7 million in fiscal 1996 to $4.6 million in
1997, an increase of 71%.  Cost of sales as a percentage of product revenue
increased from 32% in fiscal 1996 to 34% in fiscal 1997.  The increase in cost
of sales as a percentage of product revenue from fiscal 1996 to fiscal 1997
resulted from royalty payments paid by the Company in 1997 which did not exist
in 1996. Margins were also adversely affected by increased sales of hardware,
such as General Magic Inc.'s Magic Cap Communicator and the 3Com PalmPilot,
which have lower margins than software products.

                                       23
<PAGE>

                                                              OPERATING EXPENSES

Research and development costs increased 54% from $6.5 million in fiscal 1997 to
$10.0 million in fiscal 1998, representing 36% and 52% of total revenue,
respectively. Research and development expenditures consist primarily of
personnel-related costs. Increases in expenses were due primarily to the growth
of the Company's research and development team required to expand and enhance
the Company's product line. The Company's research and development headcount
increased from 90 at July 31, 1997 to 141 at July 31, 1998. Selling,
administrative and technical support costs increased 32% from $8.1 million in
fiscal 1997 to $10.7 million in fiscal 1998, representing 44% and 56% of total
revenue, respectively. The increase in 1998 resulted from the Company's focus on
developing the infrastructure necessary to provide support for the Company's
growth and expansion into new markets. These costs are primarily personnel
related, as the Company's selling, administrative and technical support
headcount has increased from 77 at July 31, 1997 to 109 at July 31, 1998.
Depreciation expense increased 46% from $1.2 million in fiscal 1997 to $1.7
million in fiscal 1998, representing 6% and 9% of total revenue, respectively.
The increase in 1998 resulted from significant investments in property and
equipment including leasehold improvements for the Company's new corporate
headquarters in Austin, Texas.

Research and development expenses increased from $3.3 million, or 31% of
revenues, in fiscal 1996 to $6.5 million, or 35% of revenues, in fiscal 1997.
The increase in research and development expenses was due to an increase in
headcount from 65 at July 31, 1996 to 90 at July 31, 1997. Selling,
administrative and technical support costs increased from $4.6 million in fiscal
1996 to $8.1 million in fiscal 1997, representing 44% of total revenue in each
year.  The increase selling, administrative and technical support costs was
primarily caused by an increase in headcount of 60 at July 31, 1996 to 77 at
July 31, 1997. The increases in the Company's total headcount in 1997 resulted
from the Company's commitment to develop the technology needed for the Company's
expansion into the Windows and embedded markets as well as building the
infrastructure necessary to provide support for the Company's anticipated growth
in these new markets. Depreciation expense increased from $355,000 in fiscal
1996 to $1.2 million in fiscal 1997. The increase in 1997 resulted from
significant investments in property and equipment necessary to provide support
for the Company's personnel growth during these periods.

                                                            NON-RECURRING CHARGE

The Company recorded a non-recurring charge of $4.3 million in fiscal 1997
related to the write-off of certain assets associated with the Mac OS. The
decision to record this charge was based on the significant decline in sales of
Mac OS-related products. In 1997, the Company accelerated its diversification
efforts to focus on the Windows and embedded systems markets and believed that
the Mac OS-related assets were significantly impaired.

                                                      PROVISION FOR INCOME TAXES

As a result of accumulated operating losses, the Company did not record any
provisions for income taxes in 1996, 1997 or 1998. As of July 31, 1998, the
Company had net operating loss carryforwards of approximately $4.4 million and
$6.9 million which begin to expire in 2000 and 2010 for state and federal
purposes, respectively. Due to the uncertainty regarding the recoverability of
these deferred tax assets, no benefit from the Company's operating losses has
been recorded. If the Company records profits in future periods, such losses may
reduce the amount of taxes payable.

                                       24
<PAGE>

                                                 LIQUIDITY AND CAPITAL RESOURCES

Since its inception, the Company has financed its cash requirements from cash
generated from operations, the sale of equity securities, bank lines of credit
and long-term and short-term debt. At July 31, 1998 the Company had cash and
cash equivalents of $6.7 million and no long-term debt. Metrowerks has working
capital of approximately $10.8 million at July 31, 1998 compared to $7.5 million
at July 31, 1997 and $13.5 million at July 31, 1996.

In fiscal 1996, 1997 and 1998, the Company's operating activities consumed cash
of  $1.4 million, $2.9 million and $6.8 million, respectively. In fiscal 1997,
the primary causes of the use in cash from operations was the increase in
receivables resulting from increased sales and increased use of third-party
distributors.  In fiscal 1998, the use in cash from operations was a result of
the net loss for the year and the increase in receivables.

The Company has made significant investments in technology fiscal 1996, 1997 and
1998 resulting in cash expenditures of $1.6 million,  $2.4 million and $2.7
million, respectively, for property and equipment. Total cash used for
investment activities was $2.6 million, $3.7 million and $3.1 million, in fiscal
1996, 1997 and 1998, respectively.

In February 1996, the Company issued 1,000,000 common shares for net proceeds of
$10.3 million. In December 1997, the Company completed an offering of 1,250,000
special warrants for net proceeds of $11.6 million to obtain the financial
resources needed for execution of its expansion into the embedded systems,
Windows and Java markets. All warrants were converted to common shares in
January 1998. Total cash provided by financing activities was $10.8 million,
$150,000 and $11.9 million in fiscal 1996, 1997 and 1998, respectively.

During April 1998, the Company entered into an $800,000 line of credit agreement
with a bank.  Borrowings under the agreement bear interest at the bank's prime
rate of interest plus one percent (9.5% as of July 31, 1998).  The agreement,
which expires in January 2000, is fully used to secure letters of credit issued
to the Company's landlord for leasehold improvements.  The assets of the
company, except the Company's intellectual property, collateralize borrowings
under the agreement.  The credit agreement contains certain minimum quarterly
profitability and various financial-ratio requirements.  If these financial-
ratio requirements are not met, the Company will need to collateralize the line
of credit with short-term securities until such time the Company is in
compliance.   Under the agreement, the Company may not pay dividends or make any
other distribution payment on account or in redemption, retirement or purchase
of any capital stock. The Company must also limit the amount of funds transfers
to any affiliate.

The Company currently anticipates that existing funds together with anticipated
cash flow from operations will be sufficient to meet its working capital and
capital expenditure requirements for at least the next twelve months. To the
extent that these sources of funds are insufficient to meet these requirements,
the Company will be required to raise additional funds. Possible sources of
financing include the sale of equity securities or borrowings from banks. The
sale of additional equity or convertible debt securities could be dilutive.
There can be no assurance that the Company will be able to obtain financing on
commercially reasonable terms, if at all, in the future.


                                       25
<PAGE>
 
                                                           RECENT PRONOUNCEMENTS

In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
Income," which establishes standards for reporting and display of comprehensive
income and its components in a full set of general-purpose financial statements.
SFAS No. 130 is effective for fiscal years beginning after December 15, 1997.

Also in June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Restated Information," and the Canadian Institute of Chartered
Accountants (CICA) issued Section 1701, which establishes standards for the way
that public business enterprises report information about operating segments in
annual financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports issued to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas, and major customers. SFAS No. 131 is
effective for financial statements for periods beginning after December 15,
1997.

Management does not believe the implementation of SFAS No. 130 and No. 131 will
have a material effect on its financial statements.

In October 1997, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition as
amended on March 31, 1998, which delineates the accounting for software product
and maintenance revenues.  SOP 97-2 supersedes the Accounting Standards
Executive Committee SOP 91-1, Software Revenue Recognition, and is effective for
transactions entered into in fiscal years beginning after December 15, 1997.
The Company is evaluating the requirements of SOP 97-2 and its amendments and
the effects, if any, on the Company's current revenue recognition policies.

                                       26
<PAGE>
 
ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See "Index to Consolidated Financial Statements" on F-1 for a listing of the
consolidated financial statements filed with this report.

ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
              FINANCIAL DISCLOSURES

None.


PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information regarding directors is incorporated herein by reference from the
section entitled "Particulars of Matters to be Acted Upon at the Meeting" of the
Company's definitive Proxy Statement to be filed pursuant to Regulation 14A of
the Securities Exchange Act of 1934, as amended, for the registrant's Annual
Meeting of Stockholders (the "Proxy Statement").  The Proxy Statement is
anticipated to be filed within 120 days after the end of the registrant's fiscal
year ended July 31, 1998.

ITEM 11.  EXECUTIVE COMPENSATION

Information regarding executive compensation is incorporated herein by reference
from the section entitled "Compensation of Executive Officers and Directors" of
the Proxy Statement.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Information regarding security ownership of certain beneficial owners and
management is incorporated herein by reference from the section entitled "Share
Capital - Principal Holders of Common Shares" of the Proxy Statement.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information regarding certain relationships and related transactions is
incorporated herein by reference from the section entitled   "Potential
Conflicts of Interest" of the Proxy Statement.

                                       27
<PAGE>
 
14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON 8-K

(a)  The following documents are filed as part of this report

     (1)  Consolidated Financial Statements - See "Index to Consolidated
          Financial Statements" on F-1

     (2)  Consolidated Financial Statement Schedule - See "Index to Consolidated
          Financial Statements" on F-1

     (3)  Exhibit Index

               Exhibit Number      Exhibit Title

                   3.10            Amended Articles of Incorporation of the
                                   Company (1)

                   3.20            By-Laws of Metrowerks (1)

                  10.10*           Incentive Stock Option Plan and related
                                   agreements (1)

                  10.20*           1995 Stock Option Plan and related agreements
                                   (1)

                  10.30            Lease agreement between the Company and
                                   Modular Power Facilities Limited Partnership
                                   (1)

                  10.31            Lease agreement between the Company and Met
                                   10W-97, Ltd., a Texas limited partnership (2)

                  10.32            First Amendment to Lease agreement between
                                   the Company and Met 10W-97, Ltd., a Texas
                                   limited partnership (2)

                  10.40            401(K) Plan of the Company (1)

                  11               Statement Regarding Computation of Per Share
                                   Earnings (2)

                  21               List of Subsidiaries (1)

                  27               Financial Data Schedule (2)


(b)  Reports on Form 8-K -

 None

________________________________________________________________________________
          *    Denotes a compensation plan or other agreement under which
               directors or executive officers may participate.

          (1)  Incorporated by reference to Exhibit of same number to the
               Registrant's Annual Report on Form 10-K for the fiscal year ended
               July 31, 1997.

          (2)  Filed herewith.

                                       28
<PAGE>
 
MANAGEMENT'S STATEMENT OF RESPONSIBILITY


The financial statements and other information contained in this Annual Report
are the responsibility of Management. They have been prepared in accordance with
generally accepted accounting principles and present fairly the consolidated
financial position, results of operations and changes in financial position of
the Company. Where necessary, Management has made informed judgments and
estimates of the outcome of events and transactions, with due consideration
given to materiality.

As a means of fulfilling its responsibility for the integrity of financial
information included in this Annual Report, Management relies on the Company's
system of internal control. This system has been established to ensure, within
reasonable limits, that the assets are safeguarded, that transactions are
properly recorded and executed in accordance with Management's authorization and
that the accounting records provide a solid foundation from which to prepare the
financial statements.

The Company's independent public accountants are responsible for auditing the
financial statements and giving an opinion on them. As part of that
responsibility, they review and assess the effectiveness of internal accounting
controls to establish a basis for reliance thereon in determining the nature,
timing and extent of audit tests to be applied. Management emphasizes the need
for constructive recommendations as part of the audit process.

The Board of Directors carries out its responsibility for the consolidated
financial statements principally through its Audit Committee, consisting solely
of outside directors, which reviews the financial statements and reports thereon
to the Board. The Committee meets periodically with the independent public
accountants and Management to review their respective activities and the
discharge of their responsibilities. The independent public accountants have
free access to the Committee, with or without Management, to discuss the scope
of their audit, the adequacy of the system of internal control and the adequacy
of financial reporting.

Management recognizes its responsibility for fostering a strong ethical climate
so that the Company's affairs are carried out according to the highest standards
of personal and corporate conduct. This responsibility is characterized in the
code of business conduct which is publicized throughout the Company.

                                       29
<PAGE>
 
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.

                                     Metrowerks Inc.

 
 
                                     By: /s/ Jean Belanger
                                         (Jean Belanger)
                                            Chairman & Chief Executive Officer
                                            Dated: October 16, 1998

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed by the following persons on behalf of the Registrant and in the
capacities and on October 16, 1998.

<TABLE> 
<CAPTION> 
Name                                         Title                                          Date
<S>                           <C>                                                    <C> 
/s/ Jean Belanger             Chairman & Chief Executive Officer                     October 16, 1998
-------------------------------------------------------------------------------------------------------------
     (Jean Belanger)          

/s/ Greg Galanos              President & Chief Technology Officer                   October 16, 1998
-------------------------------------------------------------------------------------------------------------
     (Greg Galanos)           

/s/ David Perkins             Senior VP, OEM Sales & Business Development            October 16, 1998
-------------------------------------------------------------------------------------------------------------
     (David Perkins)          

/s/ Geoff Beattie             Director                                               October 16, 1998
-------------------------------------------------------------------------------------------------------------
     (Geoff Beattie)          

/s/ Stephen Lockyer           Director                                               October 16, 1998
-------------------------------------------------------------------------------------------------------------
     (Stephen Lockyer)        

/s/ Peter Tolnai              Director                                               October 16, 1998
-------------------------------------------------------------------------------------------------------------
     (Peter Tolnai)           

/s/ Tom Woods                 Director                                               October 16, 1998
-------------------------------------------------------------------------------------------------------------
     (Tom Woods)         

/s/ Jim Welch                 Vice President Finance & Chief Financial Officer       October 16, 1998
------------------------------------------------------------------------------------------------------------- 
     (Jim Welch)              (principal financial and accounting officer)
</TABLE>

                                       30
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

  Consolidated Financial Statements:

 
  Report of Independent Accountants                                     F-2

  Consolidated Balance Sheets as of July 31, 1996, 1997 and 1998        F-3

  Consolidated Statements of Operations for the years
     ended July 31, 1996, 1997 and 1998                                 F-4

  Consolidated Statements of Changes in Stockholders' 
     Equity for the years ended July 31, 1996, 1997 and 1998            F-5

  Consolidated Statements of Cash Flows for the years
     ended July 31, 1996, 1997 and 1998                                 F-6

  Notes to Consolidated Financial Statements                            F-7
 
  Consolidated Financial Statement Schedule:

  Report of Independent Accountants                                     S-1

  Schedule II - Valuation and Qualifying Accounts                       S-2


All other schedules are omitted as the required information is not applicable or
the information is presented in the consolidated financial statements and
related notes.
<PAGE>
 
REPORT OF INDEPENDENT ACCOUNTANTS
--------------------------------------------------------------------------------
To the Board of Directors and Stockholders of
Metrowerks Inc. and Subsidiaries

  In our opinion, the accompanying consolidated balance sheets and the related
  consolidated statements of operations, stockholders' equity and cash flows
  present fairly, in all material respects, the financial position of Metrowerks
  Inc. and Subsidiaries (the "Company") as of July 31, 1996, 1997 and 1998, and
  the results of their operations and their cash flows for each of the three
  years in the period ended July 31, 1998, in conformity with generally accepted
  accounting principles in the United States and Canada.  These financial
  statements are the responsibility of the Company's management; our
  responsibility is to express an opinion on these financial statements based on
  our audits.  We conducted our audits of these statements in accordance with
  generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates
  made by management, and evaluating the overall financial statement
  presentation.  We believe that our audits provide a reasonable basis for the
  opinion expressed above.


  PricewaterhouseCoopers LLP



  Austin, Texas
  October 2, 1998

                                                                             F-2
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JULY 31, 1996, 1997 AND 1998
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
   ASSETS                                                                    1996               1997               1998
                                                                       --------------     --------------     --------------
<S>                                                                    <C>                <C>                <C>
   Current assets:
       Cash and cash equivalents                                              $11,498            $ 5,042           $  6,708
       Short-term investments                                                       -                  -                400
       Accounts receivable, net                                                 2,838              5,027              6,650
       Inventories                                                                254                302                293
       Income and other taxes recoverable                                         224                295                254
       Prepaid expenses and other current assets                                  573                456                804
                                                                       --------------     --------------     --------------
 
               Total current assets                                            15,387             11,122             15,109
 
   Long-term receivable                                                             -                  -              1,039
   Property and equipment, net                                                  1,716              3,046              4,363
   Software development costs, net                                              1,202                  -                  -
                                                                       --------------     --------------     --------------
 
               Total assets                                                   $18,305            $14,168           $ 20,511
 
   LIABILITIES AND STOCKHOLDERS' EQUITY
 
   Current liabilities:
       Accounts payable                                                       $ 1,129            $ 1,913           $  1,859
       Accrued liabilities                                                        550              1,498              1,712
       Deferred revenue                                                           189                195                722
                                                                       --------------     --------------     --------------
 
               Total current liabilities                                        1,868              3,606              4,293
 
   Commitments (Note 11)                                                            -                  -                  -
 
   Stockholders' equity:
       Capital stock:
           Preferred stock, Class A and B, no par value,
               Authorized unlimited number;
               None outstanding in 1996, 1997 or 1998                               -                  -                  -
           Common stock, no par value, authorized unlimited number
               Issued and outstanding: 11,494,543 shares in 1996,
               11,535,094 in 1997 and 12,919,030 in 1998                       17,446             17,596             29,465
 
       Accumulated deficit                                                     (1,009)            (6,984)           (12,881)
       Cumulative translation adjustment                                            -                (50)              (366)
                                                                       --------------     --------------     --------------
 
               Total stockholders' equity                                      16,437             10,562             16,218
                                                                       --------------     --------------     --------------
 
               Total liabilities and stockholders' equity                     $18,305            $14,168           $ 20,511
</TABLE>

Signed on behalf of the Board of Directors.

/s/ JEAN BELANGER              /s/ JIM WELCH
 
JEAN BELANGER                  JIM WELCH
Director                       Vice President, Finance & Chief Financial Officer

The accompanying notes are an integral part of these consolidated financial
statements.

                                                                             F-3
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED JULY 31, 1996, 1997 AND 1998
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                         1996               1997               1998
                                                   --------------     --------------     --------------
 
<S>                                                <C>                <C>                <C>
    Revenue, net                                   $       10,619     $       18,293     $       19,055
 
    Cost of product sales                                   2,664              4,563              3,046
 
    Operating expenses:
         Research and development                           3,250              6,486              9,964
         Selling, administrative and technical              4,622              8,109             10,704
         support
         Depreciation                                         355              1,154              1,684
         Non-recurring charge (Note 3)                          -              4,297                  -
                                                   --------------     --------------     --------------
 
         Total operating expenses                           8,227             20,046             22,352
 
    Loss from operations                                     (272)            (6,316)            (6,343)
 
    Other income:
         Interest income and other, net                       377                341                446
                                                   --------------     --------------     --------------
 
    Net income (loss)                              $          105     $       (5,975)    $       (5,897)
 
    Net income (loss) per share, basic and diluted $         0.01     $        (0.52)    $        (0.48)
 
    Shares used in per share calculation:
         Basic                                             10,620             11,523             12,311
         Diluted                                           10,708             11,523             12,311
</TABLE>


The accompanying notes are an integral part of these consolidated financial
statements.

                                                                             F-4
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED JULY 31, 1996, 1997 AND 1998
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                                                                     Cumulative      Total
                                         Common Stock            Special Warrants       Accumulated  Translation  Stockholders'
                                      Shares      Amount       Shares        Amount       Deficit     Adjustment      Equity
                                  ---------------------------------------------------------------------------------------------
<S>                               <C>            <C>          <C>            <C>         <C>            <C>         <C>
Balance at August 1, 1995            8,177,293    $ 2,221       2,000,000    $  4,464    $ (1,114)      $      -    $  5,571
 Conversion of special                                                                             
  warrants                           2,000,000      4,464      (2,000,000)     (4,464)          -              -           -
 Issuance of common stock,
 from  private 
 offerings (Note 6)                  1,000,000     10,341               -           -           -              -      10,341 
 Issuance of common stock                                                                          
  upon exercise of stock                                                                           
  options                              317,250        420               -           -           -              -         420 
 Net income                                  -          -               -           -         105              -         105
-------------------------------------------------------------------------------------------------------------------------------
Balance at July 31, 1996            11,494,543     17,446               -           -      (1,009)             -      16,437
 Issuance of common stock                                                                          
  upon exercise of stock                                                                           
  options                               40,551        150               -           -           -              -         150   
 Foreign currency translation                                                                      
  Adjustment                                 -          -               -           -           -            (50)        (50)
 Net loss                                    -          -               -           -      (5,975)             -      (5,975)
-------------------------------------------------------------------------------------------------------------------------------
Balance at July 31, 1997            11,535,094     17,596               -           -      (6,984)           (50)     10,562
 Issuance of special warrants                -          -       1,500,000      11,718           -              -      11,718
 Conversion of special                                                                             
  warrants (Note 6)                  1,475,000     13,759      (1,500,000)    (11,718)          -              -       2,041 
 Purchase and retirement of                                                                        
  officers' shares (Note 6)           (225,000)    (2,166)              -           -           -              -      (2,166) 
 Issuance of common stock                                                                          
  upon exercise of stock                                                                           
  options                              133,936        276               -           -           -              -         276 
 Foreign currency translation                                                                      
  adjustment                                 -          -               -           -           -           (316)       (316) 
 Net loss                                    -          -               -           -      (5,897)             -      (5,897)
-------------------------------------------------------------------------------------------------------------------------------
Balance at July 31, 1998            12,919,030   $ 29,465               -     $     -    $(12,881)       $  (366)    $16,218
</TABLE>


The accompanying notes are an integral part of these consolidated financial
statements.


                                                                             F-5
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED JULY 31, 1996, 1997 AND 1998
(IN THOUSANDS)
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                           1996               1997                1998
                                                        ---------           ---------           ---------
<S>                                                     <C>                 <C>                 <C>
    Cash flows from operating activities:
       Net income (loss)                                  $   105             $(5,975)            $(5,897)
       Adjustments to reconcile net income (loss) to
        net cash used in operating activities:
       Depreciation of property and equipment                 355               1,154               1,684
       Amortization of software development costs             275                 289                   -
       Non-recurring charge (Note 3)                            -               4,297                   -
 
       Changes in operating assets and liabilities:
          Accounts receivable                              (2,278)             (3,911)             (1,623) 
          Inventories                                        (190)               (406)                  9
          Income and other taxes receivable                    13                 (71)                 41
          Prepaid expenses and other assets                  (375)                117                (348)
          Long-term receivable                                  -                   -              (1,039)
          Accounts payable                                    521                 685                (357)
          Accrued liabilities                                  63                 948                 214
          Deferred revenue                                    106                   6                 527
                                                        ---------           ---------           ---------
 
          Net cash used in operating activities            (1,405)             (2,867)             (6,789)
 
    Cash flows from investing activities:
       Purchase of available-for-sale securities                -                   -                (400)
       Acquisition of property and equipment               (1,599)             (2,385)             (2,698)
       Software development costs capitalized              (1,005)               (833)                  -
       Acquisition of software company's net assets             -                (471)                  -
                                                        ---------           ---------           ---------
 
          Net cash used in investing activities            (2,604)             (3,689)             (3,098)
 
    Cash flows from financing activities:
       Proceeds from issuance of common stock, net         10,341                   -                   -
       Proceeds from issuance of special
        warrants, net                                           -                   -              11,593
       Proceeds from exercise of stock options                420                 150                 276
                                                        ---------           ---------           ---------
 
          Net cash provided by financing activities        10,761                 150              11,869
 
    Increase (decrease) in cash and cash equivalents        6,752              (6,406)              1,982
 
    Effect of exchange rate changes on cash                     -                 (50)               (316)
 
    Cash and cash equivalents at beginning of year          4,746              11,498               5,042
                                                        ---------           ---------           ---------
 
    Cash and cash equivalents at end of year              $11,498             $ 5,042             $ 6,708
 
    Non-cash investing and financing activities:
       Property and equipment financed by
        accounts payable                                  $   115             $    99             $   303
</TABLE>


The accompanying notes are an integral part of these consolidated financial
statements.


                                                                             F-6
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

1.  NATURE OF OPERATIONS:

    The Company's principal line of business is the research, design,
    development, marketing and support of computer software development tools.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

    BASIS OF PRESENTATION

    These financial statements have been prepared by the Company in accordance
    with accounting principles generally accepted in the United States ("US
    GAAP") and in Canada ("Canadian GAAP"). All dollar amounts presented are
    denominated in United States dollars.

    BASIS OF CONSOLIDATION

    The consolidated financial statements include the accounts of the Company
    and its wholly owned subsidiary, Metrowerks Corporation, a Texas
    corporation, which was formed in June 1994, and Metrowerks Corporation's
    wholly owned subsidiary, Metrowerks Co. Ltd., a Japanese corporation, which
    was formed in August 1996. All significant intercompany transactions and
    balances have been eliminated.

    USE OF ESTIMATES

    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 periods. Actual results could differ from those estimates.

    REVENUE RECOGNITION

    Product revenue, which consists of sales to distributors and from corporate
    license programs, is recognized when the related products are shipped, when
    no significant vendor obligations remain, and collection of the receivable,
    net of provisions for estimated future returns, is probable. Accounts
    receivable that were not billed as of July 31, 1996, 1997 and 1998 totaled
    $186, $1,268 and $2,670, respectively. The allowance for estimated future
    returns was $275, $1,192 and $1,825 at July 31, 1996, 1997 and 1998,
    respectively. Long-term receivables are discounted using applicable interest
    rates for obligations with similar terms on the interest rate method.

    Product development agreement revenue is recognized on a percentage of
    completion basis calculated by the ratio of cost incurred to total estimated
    costs.

    COST OF SALES

    Cost of sales consists primarily of the cost of product media and
    duplication, the cost of packaging materials, fulfillment, amortization of
    capitalized software development costs, royalties and shipping expenses.
    Cost associated with product development agreement revenue is included in
    research and development expense and not separately identified and
    approximates the related contract revenue.

    TECHNICAL SUPPORT

    Technical support expense consists primarily of personnel, telephone and on-
    line product assistance costs. These costs totaled $528, $566 and $690 for
    the years ended July 31, 1996, 1997 and 1998, respectively.

    ADVERTISING COSTS

    Advertising expense consists of costs from catalog advertising, trade
    journal advertising, mass mailings and various other promotional items.
    Advertising costs are expensed as incurred. For the years ended July 31,
    1996, 1997 and 1998, advertising expense amounted to $1,179, $1,865 and
    $1,841, respectively.


                                                                             F-7
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:


    CASH AND CASH EQUIVALENTS

    The Company considers investments in highly liquid instruments purchased
    with original maturities of 90 days or less to be cash equivalents. The
    Company's cash equivalents consist principally of government guaranteed
    instruments and are reported at cost which approximates fair market value.

    The Company maintains its cash and cash equivalents in major, creditworthy
    financial institutions in the United States, Canada and Japan and has not
    experienced any losses on its deposits.

    During fiscal 1998, the Company adopted the Canadian Institute of Chartered
    Accountants ("CICA") Section 5040 "Cash Flow Statements". This adoption did
    not have a material effect on the financial statements of the Company.

    SHORT-TERM INVESTMENTS

    As of July 31, 1998, short-term investments are comprised of a certificate
    of deposit. The Company classifies its investments in debt and equity
    securities as available for sale. These investments are recorded at fair
    value based on quoted market prices and unrealizable gains and losses
    thereon are included as a separate component of stockholders' equity. As of
    July 31, 1998 unrealizable gains and losses were not significant. The cost
    of securities is based on the specific identification method.

    CREDIT RISK

    The Company performs ongoing credit reviews of its customers and records an
    allowance for doubtful accounts receivable when accounts are determined to
    be uncollectible. The allowance for doubtful accounts at July 31, 1996, 1997
    and 1998 was $9, $75 and $90, respectively.

    INVENTORIES

    Inventories, consisting of product documentation, magnetic media and
    hardware are stated at the lower of cost or net realizable value. Cost is
    determined using the average cost method.

    SOFTWARE DEVELOPMENT COSTS

    Research and development expenditures are charged to operations as incurred.
    The Company capitalizes certain software development costs subsequent to the
    establishment of technological feasibility, if material. In addition, the
    Company periodically reviews its software development costs to assess net
    realizable value. Any impairments are recognized in operating results when a
    permanent diminution in value occurs. Based on the Company's product
    development process, technological feasibility is established upon
    completion of a working model. In both fiscal 1997 and fiscal 1998, costs
    incurred by the Company between completion of the working model and the
    point at which the product is ready for general release were insignificant.

    For the years ended July 31, 1996 and 1997, amortization expense amounted to
    $275 and $289, respectively, and as of July 31, 1996 accumulated
    amortization totaled $358.

    Research and software development costs are reduced by investment tax
    credits.

    PROPERTY AND EQUIPMENT

    Purchased property and equipment are recorded at cost. Depreciation is
    provided using the straight-line method over the estimated useful lives of
    the respective assets as follows:

    Office equipment                3-5 years

    Computer equipment              2-5 years

    Software                        3 years


                                                                             F-8
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:

    PROPERTY AND EQUIPMENT, CONTINUED

    The Company provides for depreciation of leasehold improvements over the
    shorter of the estimated useful lives of the improvements or the terms of
    the related leases. Expenditures for maintenance and repairs are expensed as
    incurred. Upon retirement or other disposition of assets, the cost and
    related accumulated depreciation are eliminated from the accounts and the
    resulting gain or loss is reflected in operations.

    DEFERRED REVENUE

    Deferred revenue consists of amounts received in advance for product,
    maintenance, documentation, magnetic media and development services to be
    delivered in future periods.

    Allowances for estimated future software updates are provided for in the
    same period as the related revenue.

    FOREIGN CURRENCY TRANSLATION

    The financial statements of the parent company and the Japanese subsidiary
    have been translated into U.S. dollars. The functional currency of the
    parent company and the Japanese subsidiary is the applicable currency.
    Monetary asset and liability amounts have been translated using the exchange
    rates in effect at the applicable year end. Inventories, property and
    equipment, and non-monetary asset and liability amounts have been translated
    at historical exchange rates. Income statement amounts have been translated
    using the weighted average exchange rate for the applicable year. The
    adjustment resulting from the changes in exchange rates from year to year
    have been reported as a separate component of stockholders' equity. Currency
    transaction gains or losses are included in the results of operations and
    are immaterial for all periods presented.

    FEDERAL INCOME TAXES

    The Company accounts for income taxes in accordance with the liability
    method. This method requires that deferred taxes be computed utilizing the
    liability method and adjusted when new tax laws or rates are enacted.
    Valuation allowances are established when necessary to reduce deferred tax
    assets to the amounts expected to be realized. The Company recorded no
    income tax expense in 1996, 1997 or 1998, and has provided a full valuation
    allowance to reduce the net deferred tax asset to zero because the
    realization of tax benefits associated with net operating loss carryforwards
    is not assured.

    During fiscal 1998, the Company adopted the CICA Section 3465 "Income
    Taxes". This adoption did not have a material effect on the financial
    statements of the Company.

    COMPUTATION OF NET INCOME (LOSS) PER SHARE

    The Company has adopted the provisions of Statement of Financial Accounting
    Standards ("SFAS") No. 128 effective December 31, 1997. SFAS No. 128
    requires the presentation of basic and diluted earnings per share. Basic EPS
    is computed by dividing income available to common shareholders by the
    weighted average number of common shares outstanding for the period. Diluted
    EPS is computed by giving effect to all dilutive potential common shares
    that were outstanding during the period. For the Company, dilutive potential
    common shares consist of the incremental common shares issuable upon
    exercise of stock options for all periods. In accordance with SFAS No. 128,
    all prior period earnings per share amounts have been restated to reflect
    this method of calculation.

    FAIR VALUE OF FINANCIAL INSTRUMENTS

    The Company's financial instruments include cash equivalents, accounts
    receivable, accounts payable and accrued liabilities. The carrying value of
    these financial instruments approximate fair value at July 31, 1996, 1997
    and 1998 due to their short-term nature.



                                                                             F-9
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:

    RECLASSIFICATIONS

    Certain prior year financial statement items have been reclassified to
    conform to the current year presentation.

3.  NON-RECURRING CHARGE:

    The Company recorded a non-recurring charge of $4,297 in fiscal 1997 related
    to the write-off of certain assets associated with Apple Computer's
    Macintosh Operating System ("Mac OS"). The decision to record this charge
    was based on the significant decline in sales of Mac OS related products.
    The Company had accelerated its diversification efforts to focus on the
    Windows and embedded systems markets and believed that the Mac OS related
    assets were significantly impaired.

    The components of the write-off were as follows:

     Software development costs                                      $1,746
     Provision for promotional and inventory related costs            1,722
     Write-off of inventories                                           358
     Acquired in-process research and development                       471
                                                           ----------------
 
        Total                                                        $4,297

    The $1,746 write-off of software development costs relates to previously
    capitalized Mac OS IDE development costs. The provision for accounts
    receivable primarily relates to promotional costs in assisting distributors
    and retail outlets in selling Mac OS related products already existing in
    the distribution channel. The write-off of inventories relates to Mac OS
    inventory on-hand as of quarter ended April 30, 1997. The write-off of
    acquired in-process research and development relates to the purchase of
    substantially all of the assets of a software company. The assets of the
    software company acquired will be developed to assist in porting Mac OS
    applications to Apple's next generation operating system, Rhapsody. At the
    time of acquisition, technological feasibility had not been reached.

4.  PROPERTY AND EQUIPMENT:

    Property and equipment consist of the following:

 
                                                July 31, 1996

                                                 Accumulated
                                       Cost     Depreciation      Net
                                  ----------------------------------------
    Office equipment                   $  464      $    62        $  402
    Computer equipment                  1,288          403           885
    Software                              505           91           414
    Leasehold improvements                 17            2            15
                                  -----------   ----------   -----------
                                             
                                       $2,274      $   558        $1,716

 
                                              July 31, 1997

                                               Accumulated
                                      Cost     Depreciation       Net
                                  ---------------------------------------
    Office equipment                   $1,336      $  265         $1,071
    Computer equipment                  2,372       1,077          1,295
    Software                              798         306            492
    Leasehold improvements                275          87            188
                                  -----------   ----------   -----------
                                                                  
                                       $4,781      $1,735         $3,046


                                                                            F-10
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

4.  PROPERTY AND EQUIPMENT, CONTINUED:

<TABLE>
<CAPTION>
 
                                                                            July 31, 1998

                                                                             Accumulated
                                                             Cost            Depreciation            Net
                                                      --------------------------------------------------------
<S>                                                   <C>                 <C>                 <C>
    Office equipment                                        $1,939              $  701              $1,238
    Computer equipment                                       3,335               1,889               1,446
    Software                                                   960                 591                 369
    Leasehold improvements                                   1,515                 205               1,310
                                                      ----------------    ----------------    ----------------
 
                                                            $7,749              $3,386              $4,363
</TABLE>

5.  ACCRUED LIABILITIES:

<TABLE>
<CAPTION>
                                                                               July 31,
                                                             1996                1997                1998
                                                      --------------------------------------------------------
<S>                                                   <C>                 <C>                 <C>
    Accrued payroll and related costs                       $ 241              $  550              $  844
    Professional fees                                         115                 250                 248
    Provision for costs of software update                     59                 169                  50
    Royalties                                                  47                 113                 140
    Other                                                      88                 416                 430
                                                      ----------------    ----------------    ----------------
 
                                                            $ 550              $1,498              $1,712
</TABLE>


6.  CAPITAL STOCK:

    PREFERRED STOCK

    The Class A preferred shares are non-voting, non-cumulative preferred
    shares, redeemable at the option of the Company or the holder at their
    stated amount. Dividends on Class A shares, having priority over all other
    classes of shares may be paid at the discretion of the Board of Directors up
    to a maximum of 10% of the stated capital.

    The terms of the Class B preferred shares will be determined by the Board of
    Directors at the time of issuance of the shares.

    As of July 31, 1998, there were no issued Class A or Class B preferred
    shares.


    STOCK OPTION PLAN

    The Company maintains an incentive stock option plan ("Plan") for the
    benefit of directors, officers and employees under which 2,600,000 shares of
    common stock were reserved for issuance. The exercise price of the incentive
    stock option is the fair market value of the shares as at the date of the
    grant. Stock options generally become vested ratably over a three-year
    period and have an exercise period of no later than five years after the
    date of grant.



                                                                            F-11
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

6.  CAPITAL STOCK, CONTINUED:

    STOCK OPTION PLAN, CONTINUED:

    Option activity under the Plan follows:


<TABLE>
<CAPTION>
                                                                        OUTSTANDING OPTIONS
                                  OPTIONS     --------------------------------------------------------------------------
                                 AVAILABLE                                                    WEIGHTED          TOTAL
                                   FOR                                                         AVERAGE         EXERCISE
                                  GRANTS        SHARES                EXERCISE PRICE            PRICE           AMOUNT
                                ----------    ----------         ----------------------       ---------       ----------
<S>                              <C>           <C>                <C>                         <C>              <C>
    Balance at August 1, 1995      833,750       612,950          $0.99       -  $ 4.14        $1.48          $   907
         Granted                  (443,050)      443,050           3.69       -   12.82         5.80            2,569
         Exercised                    -         (317,250)          1.05       -    3.69         1.33             (420)
         Canceled                  124,600      (124,600)          1.05       -   12.82         4.11             (513)
 
    Balance at July 31, 1996       515,300       614,150           1.10       -   12.82         4.14            2,543
         Reserved                1,000,000          -                         -                 -                 -
         Granted                  (758,500)      758,500           5.06       -   11.77         7.25            5,497
         Exercised                    -          (40,551)          0.99       -    4.14         3.69             (150)
         Canceled                  165,332      (165,332)          1.13       -   12.82         8.78           (1,453)
 
    Balance at July 31, 1997       922,132     1,166,267           0.99       -   11.77         5.50            6,427
         Granted                  (551,200)      551,200           6.38       -    9.48         8.28            4,564
         Exercised                    -         (133,936)          0.99       -    7.00         2.06             (276)
         Canceled                  128,930      (128,930)          3.48       -    9.37         7.12             (934)
 
    Balance at July 31, 1998       499,862     1,454,601          $1.03       -  $11.77        $6.72          $ 9,781
</TABLE>

    The Company has applied Accounting Principles Board Opinion No. 25,
    "Accounting for Stock Issued to Employees," and related interpretations, in
    accounting for the Plan. Accordingly, no compensation expense has been
    recognized under the Plan as all grants were made at fair value. Had
    compensation expense for the Plan been determined based upon the fair value
    at the grant date for awards under the Plan consistent with the methodology
    prescribed under Statement of Financial Accounting Standards No. 123,
    "Accounting for Stock-Based Compensation," the Company's net income (loss)
    would have changed to the pro forma amounts, indicated below:

 

<TABLE>
<CAPTION>
                                                                                 Year Ended July 31,
                                                                   1996                 1997                 1998
                                                            ----------------     ----------------     ----------------
<S>                                                         <C>                  <C>                  <C>
    Net income (loss) - as reported                             $     105             $ (5,975)            $ (5,897)
    Net loss - pro forma                                        $     (69)            $ (6,422)            $ (7,319)
    Net income (loss) - per share as reported                   $    0.01             $  (0.52)            $  (0.48)
    Net loss - per share pro forma                              $   (0.01)            $  (0.56)            $  (0.59)
</TABLE>

    The aggregate fair value and weighted average fair value per share of
    options granted in fiscal 1996, 1997 and 1998 were $1,411,384, $3,434,170
    and $3,025,266 and $3.19, $4.53 and $5.49 per share, respectively. The fair
    value of each option grant is estimated on the date of grant using the 
    Black-Scholes option pricing model with the following weighted assumptions:



                                                                            F-12
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

6.  CAPITAL STOCK, CONTINUED:

    STOCK OPTION PLAN, CONTINUED

<TABLE>
<CAPTION>
                                                         Year Ended July 31,
                                          1996                 1997                 1998
                                    ----------------     ----------------     ----------------
<S>                                      <C>                  <C>                  <C>
    Expected volatility                    53%                  53%                  79%
    Risk-free interest rate               5.80%                6.25%                5.74%
    Expected life                        4 years              4 years              4 years
    Expected dividend yield               0.00%                0.00%                0.00%
</TABLE>

    The following table summarizes information about fixed stock options
    outstanding at July 31, 1998:


<TABLE>
<CAPTION>
                               WEIGHTED                 OPTIONS OUTSTANDING                    OPTIONS EXERCISABLE
                                AVERAGE        ------------------------------------    ------------------------------------
                               REMAINING             NUMBER             AVERAGE           NUMBER               AVERAGE
      RANGE OF                CONTRACTUAL         OUTSTANDING          EXERCISE         EXERCISABLE           EXERCISE 
   EXERCISE PRICES            LIFE (YEARS)       JULY 31, 1998           PRICE         JULY 31, 1998            PRICE
  ---------------------    ----------------    ----------------    ----------------    ----------------    ----------------
    <S>                       <C>                 <C>                 <C>                 <C>                 <C>
    $ .03 - $ 4.14                1.90             254,700               $2.90             203,207              $ 2.75
    $ .06 - $ 8.62                3.72           1,136,151               $7.40             255,424              $ 6.86
    $9.35 - $11.77                3.86              63,750               $9.97              10,000              $10.56
                                               ----------------                        ----------------                    
 
    TOTAL                         3.41           1,454,601               $6.72             468,631              $ 5.16
</TABLE>

    At July 31, 1996 and 1997 options to purchase 128,473 and 250,684 shares of
    common stock at a weighted exercise price of $1.55 and $2.67 per share,
    respectively, were exercisable.

    On July 17, 1997, the Company repriced 618,500 options to a price equal to
    110% of the then market value. These options were repriced from a range of
    between $8.50 and $13.14 to $7.00.


    ISSUANCE OF COMMON SHARES

    On February 27, 1996, the Company entered into an Underwriting Agreement for
    the purpose of issuing to certain underwriters 1,000,000 common shares at a
    price of $11.84 ($11.19 net of underwriters' fee). The company received net
    proceeds of $10,341 from the offering. The proceeds are net of offering
    costs of $1,504.

    ISSUANCE AND CONVERSION OF SPECIAL WARRANTS

    On October 21, 1997, the Company entered into an Underwriting Agreement for
    the purpose of issuing to certain underwriters by way of private placement,
    1,500,000 special warrants ("Special Warrants") at a price of $10.08 each
    ($9.62 net of underwriters' fee). Upon the exercise of the 1,500,000 Special
    Warrants thereby sold, 1,250,000 shares were to have been issued from
    treasury by the Company and 250,000 were to have been transferred by three
    officers of the Company. These arrangements were modified in that the
    Company agreed to assume two of the officers' obligations to deliver an
    aggregate of 225,000 Common Shares upon the exercise of the Special Warrants
    in consideration of the payment by those officers of the proceeds received
    by them in connection with the offering of the Special Warrants. The special
    warrants were exercised in January 1998. Accordingly, 1,475,000 shares were
    issued from treasury by the Company and 25,000 shares were transferred by an
    officer of the Company. The 225,000 Common Shares owned by the other two
    officers of the Company were purchased by the Company for cancellation in
    December 1997. The Company received net proceeds of $11,593 from the
    offering. The proceeds are net of offering costs of $1,007.



                                                                            F-13
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

7.  EARNINGS PER SHARE:

    In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share" which
    establishes standards for computing and presenting earnings per share. SFAS
    No. 128 is effective for fiscal years ending after December 15, 1997.

    Earnings per share calculated under SFAS No. 128 are as follows:

<TABLE>
<CAPTION>
    BASIC:                                                                   Year Ended July 31,
                                                           1996                     1997                     1998
                                                    -----------------        ----------------         ----------------
 
<S>                                                 <C>                      <C>                      <C>
    Net income (loss) for the year                            $   105                 $(5,975)                 $(5,897)
                                                    -----------------        ----------------         ----------------
 
    Weighted average number of common shares
    issued and outstanding                                     10,620                  11,523                   12,311
 
    Earnings (loss) per share                                 $  0.01                 $ (0.52)                 $ (0.48)

<CAPTION>
    DILUTED:                                                                 Year Ended July 31,
                                                           1996                     1997                     1998
                                                    -----------------        ----------------         ----------------
 
<S>                                                 <C>                      <C>                      <C>
    Net income (loss) for the year                            $   105                 $(5,975)                 $(5,897)
                                                    -----------------        ----------------         ----------------
 
    Weighted average number of common shares
    issued and outstanding                                     10,620                  11,523                   12,311
 
    Common stock equivalents:
    Employee stock options                                        108                      --                       --
                                                    -----------------        ----------------         ----------------
 
    Average common and common stock equivalents                10,728                  11,523                   12,311
                                                    -----------------        ----------------         ----------------
 
    Earnings (loss) per share                                 $  0.01                 $ (0.52)                 $ (0.48)
</TABLE>

    For the years ended July 31, 1997 and 1998, stock options are excluded as
    their inclusion would be anti-dilutive given the Company's loss. The
    earnings per share calculation does not include outstanding options with
    exercise prices ranging from $0.99 to $11.77 and $1.03 to $11.77 for the
    years ended July 31, 1997 and 1998, respectively.


8.  LINE OF CREDIT:

    During April 1998, the Company entered into a $800 line of credit agreement
    with a bank. Borrowings under the agreement bear interest at the bank's
    prime rate of interest plus one percent (9.5% as of July 31, 1998). The
    agreement, which expires in January 2000, is fully utilized to collateralize
    letters of credit issued to the Company's landlord for leasehold
    improvements. Borrowings under the agreement are collateralized by the
    assets of the Company except the Company's intellectual property. The credit
    agreement contains certain minimum quarterly profitability and various
    financial-ratio requirements. Under the agreement, the Company may not pay
    dividends or make any other distribution payment on account or in
    redemption, retirement or purchase of any capital stock, and the Company
    must also limit the amount of funds transferred to any affiliate.


9.  RELATED PARTY TRANSACTIONS:

    In fiscal 1998, the Company paid a fee of approximately $150 in connection
    to a special warrant offering to an underwriter in which a director of the
    Company is an officer.

    In fiscal 1997, and 1998, the Company paid fees of approximately $50, and
    $150, respectively, to a law firm in which a director of the Company was a
    senior partner.



                                                                            F-14
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

10. EMPLOYEE BENEFITS:

    In January 1996, the Company established a 401(k) retirement savings plan
    (the "Plan") for all employees. All employees meeting minimum age
    requirements are eligible to enroll in the Plan after 250 hours of
    employment. The Company did not provide matching contributions to employee
    accounts for the years ended July 31, 1996, 1997 or 1998.

11. COMMITMENTS:

    The Company leases various facilities under noncancelable operating leases.
    Future minimum lease payments required under operating leases that have
    initial or remaining noncancelable lease terms in excess of one year as of
    July 31, 1998 are as follows:

    1999                                                       $    1,056
    2000                                                            1,027
    2001                                                            1,142
    2002                                                            1,139
    2003                                                            1,142
    2004                                                              761
                                                               ----------
                                                      
                                                               $    6,267

    Total rent expense for noncancelable operating leases was $139, $422 and
    $783 for the years ended July 31, 1996, 1997 and 1998, respectively.

    The Company has an option to renew the lease for its headquarters for an
    additional period of five years beginning in April 2004 at the market price
    at the time of renewal.

    The Company engages the services of individual contractors to assist in
    research and development related to the Company's software products.

12. RISKS AND UNCERTAINTIES:

    CUSTOMER CONCENTRATIONS:

    As of July 31, 1998, the Company has accounts receivable in excess of 10% of
    its total accounts receivable with two unrelated parties, aggregating
    approximately $1,094 (16% of total accounts receivable) and $1,150 (17% of
    total accounts receivable). As of July 31, 1997, the Company has accounts
    receivable in excess of 10% of its total accounts receivable with one
    unrelated party, aggregating approximately $2,146 (34% of total accounts
    receivable). Historically, the Company has not incurred any bad debt expense
    in connection with any transactions with any of these unrelated parties.
    Additionally, the Company had sales in excess of 10% of its net sales to one
    unrelated party for the year ended July 31, 1997, aggregating approximately
    $3,050 (15.6% of total sales). They were no customer concentrations of
    revenue greater than 10% of sales for the years ended July 31, 1996 or 1998.



                                                                            F-15
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

12. RISKS AND UNCERTAINTIES, CONTINUED:

    YEAR 2000 COMPLIANCE:

    "Year 2000 Compliant" means that a program, when used in accordance with its
    associated documentation, will (a) initiate and operate, (b) correctly
    store, represent, and process dates, and (c) not cause or result in an
    abnormal termination or ending, when processing data containing dates in the
    Year 2000 and in any preceding and following years, provided that all third
    party products that exchange date data with the program do so properly and
    accurately and in a form and format compatible with the program.

    The products provided by Metrowerks process dates only to the extent that
    these products use date data provided by the host or target operating system
    for date representations used in internal processes, such as file
    modifications. Any Year 2000 Compliance issues resulting from the operation
    of the products are therefore necessarily subject to the Year 2000
    Compliance of the relevant host or target operating system. The Company has
    directed its customers to the relevant statements of Microsoft Corporation,
    Sun Microsystems, Inc., Apple Computer, Inc., and other host or target
    operating systems relating to the Year 2000 Compliance of their operating
    systems. Except as expressly described above, the products, in themselves,
    do not process date data and therefore do not implicate Year 2000 Compliance
    issues.

    The Company has also assessed the readiness of its internal computer systems
    and does not expect to incur significant costs in implementing Year 2000
    changes if necessary. There can be no assurance that such changes will fully
    completed in a timely manner. Additionally, the Company could be adversely
    impacted by Year 2000 issues faced by major distributors, suppliers,
    customers and financial service organizations with which the company
    interacts.

13. INCOME TAXES:

    The components of the net deferred tax asset are as follows at July 31:

<TABLE>
<CAPTION>
                                                              1996                 1997                 1998
                                                       ----------------     ----------------     ----------------
         <S>                                                  <C>                <C>                  <C>
         Net operating loss carryforward                      $ 272              $ 2,043              $ 3,813
         Property and equipment                                  30                  178                  101
         Reserves                                               120                  546                  668
         Research and development tax credit                     98                  270                  477
         Other                                                 (119)                  46                  247
                                                       ----------------     ----------------     ----------------
         Net deferred tax asset before valuation 
           allowance                                            401                3,083                5,307
         Valuation allowance                                   (401)              (3,083)              (5,307)
                                                       ----------------     ----------------     ----------------
 
         Net deferred tax asset                               $   -              $     -              $     -
</TABLE>

    During the years ended July 31, 1996, 1997 and 1998 the valuation allowance
    decreased by $21 and increased by $2,682 and $2,224, respectively.

    Net operating loss carryforwards of $4,447 and $6,900 begin to expire in
    2000 and 2010 for state and federal purposes, respectively.

    The difference between the actual income tax provision computed by applying
    the statutory income tax rate to income (loss) before taxes is attributed to
    the following:

<TABLE>
<CAPTION>
                                                                           YEAR ENDED JULY 31,
                                                              1996                 1997                 1998
                                                                %                    %                    %
                                                       ----------------     ----------------     ----------------
         <S>                                             <C>                  <C>                  <C>
         Statutory tax rate (benefit)                         38.00               (38.00)              (38.00)
         Foreign taxes                                                                                  (1.80)
         Future benefit of timing differences not            
            recognized                                       (43.11)               39.40                40.90
         Permanent differences                                 5.11                (1.40)               (1.10)
                                                       ----------------     ----------------     ----------------
         Effective rate                                        -                    -                    -
</TABLE>


                                                                            F-16
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

14. REVENUE:

    Revenue is comprised of the following:

<TABLE>
<CAPTION>
                                                                          YEAR ENDED JULY 31,
                                                             1996                1997                1998
                                                       ----------------    ----------------    ----------------
<S>                                                    <C>                 <C>                 <C>
         Product                                               $  7,246            $ 12,254            $ 14,450
         Product development agreements                           2,263               4,715               3,944
         Hardware and other                                       1,110               1,324                 661
                                                       ----------------    ----------------    ----------------

                                                               $ 10,619            $ 18,293            $ 19,055
</TABLE> 

15.    GEOGRAPHIC DATA:
       The Company's revenue by geographic location are as
       follows:
<TABLE>
<CAPTION>
                                                                          YEAR ENDED JULY 31,
                                                              1996                1997                1998
                                                       ----------------    ----------------    ----------------
<S>                                                      <C>                 <C>                 <C>
         United States                                         $  8,320            $ 11,316            $ 12,593
         Canada                                                   2,299               4,980               4,342
         Japan                                                      -                 1,997               2,120
                                                       ----------------    ----------------    ----------------

                                                               $ 10,619            $ 18,293            $ 19,055
</TABLE>

  The Company's net income (loss) by geographic location are as follows:


<TABLE>
<CAPTION>
                                                                           YEAR ENDED JULY 31,
                                                              1996                 1997                 1998
                                                       ----------------     ----------------     ----------------
<S>                                                    <C>                  <C>                  <C>
         United States                                         $   (726)           $  (4,346)          $   (3,135)
         Canada                                                     831               (1,317)              (1,943)
         Japan                                                      -                   (312)                (819)
                                                       ----------------     ----------------     ----------------

                                                               $    105            $  (5,975)          $   (5,897)
</TABLE>

  The Company's assets by geographic location are as follows:


<TABLE>
<CAPTION>
                                                                                JULY 31,
                                                              1996                1997                1998
                                                       ----------------    ----------------    ----------------
<S>                                                    <C>                 <C>                 <C>
         United States                                         $  4,466            $  6,947            $ 12,928
         Canada                                                  13,839               6,197               6,355
         Japan                                                      -                 1,024               1,228
                                                       ----------------    ----------------    ----------------
 
                                                               $ 18,305            $ 14,168            $ 20,511
</TABLE>



                                                                            F-17
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
--------------------------------------------------------------------------------

16. RECENT PRONOUNCEMENTS:

    In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
    Income," which establishes standards for reporting and display of
    comprehensive income and its components in a full set of general-purpose
    financial statements. SFAS No. 130 is effective for fiscal years beginning
    after December 15, 1997.

    Also in June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments
    of an Enterprise and Restated Information," and the Canadian Institute of
    Chartered Accountants (CICA) issued Section 1701, which establishes
    standards for the way that public business enterprises report information
    about operating segments in annual financial statements and requires that
    those enterprises report selected information about operating segments in
    interim financial reports issued to shareholders. It also establishes
    standards for related disclosures about products and services, geographic
    areas, and major customers. SFAS No. 131 is effective for financial
    statements for periods beginning after December 15, 1997.

    Management does not believe the implementation of SFAS No. 130 and No. 131
    will have a material effect on its financial statements.

    In October 1997, the Accounting Standards Executive Committee of the AICPA
    issued Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition
    as amended on March 31, 1998, which delineates the accounting for software
    product and maintenance revenues. SOP 97-2 supersedes the Accounting
    Standards Executive Committee SOP 91-1, Software Revenue Recognition, and is
    effective for transactions entered into in fiscal years beginning after
    December 15, 1997. The Company is evaluating the requirements of SOP 97-2
    and its amendments and the effects, if any on the Company's current revenue
    recognition policies.



                                                                            F-18
<PAGE>
 
REPORT OF INDEPENDENT ACCOUNTANTS
--------------------------------------------------------------------------------
To the Board of Directors and Stockholders of
Metrowerks Inc. and Subsidiaries

  Our report on the consolidated financial statements of Metrowerks Inc. and
  Subsidiaries is included on page F-2 of this Form 10-K.  In connection with
  our audits of such financial statements, we have also audited the consolidated
  financial statement schedule listed in the index on page F-1 of this Form 10-K
  herein.

  In our opinion, the consolidated financial statement schedule referred to
  above, when considered in relation to the basic consolidated financial
  statements taken as a whole, presents fairly, in all material respects, the
  information required to be included therein.


  PricewaterhouseCoopers LLP



  Austin, Texas
  October 2, 1998



                                                                             S-1
<PAGE>
 
METROWERKS INC. AND SUBSIDIARIES
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------------
                                                      Balance at      Charged to Costs               Balance at End of
Description                                        Beginning of Year    and Expenses     Deductions         Year
----------------------------------------------------------------------------------------------------------------------
<S>                                                <C>                <C>                <C>         <C>
Allowance for doubtful accounts and returns
1996                                                       257               901               874            284
1997                                                       284             2,623             1,640          1,267
1998                                                     1,267             6,164             5,516          1,915
</TABLE>



                                                                             S-2