<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 [FEE REQUIRED] For the Fiscal Year Ended December 31, 1998

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

     For the transaction period from _______________ to ______________.

     Commission File Number:  0-21992

                            FOURTH SHIFT CORPORATION
             (Exact name of registrant as specified in its charter)

             Minnesota                                 41-1437794
(State or other jurisdiction of         (I.R.S. Employer Identification Number)
incorporation or organization)

                                    Suite 800
                             Two Meridian Crossings
                          Minneapolis, Minnesota 55423
                     (Address of principal executive office)
                                 (612) 851-1500
              (Registrant's telephone number, including area code)

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

Securities registered pursuant to Section 12(g) of the Act:  Common Stock, 
$.01 par value

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 the Form 10-K. [ ]

As of February 28, 1999, the aggregate market value of the registrant's 
Common Stock, $.01 par value, held by nonaffiliates of the registrant was 
$50,123,498 (based on the closing sale price of common stock as of February 
28, 1999 as quoted on the Nasdaq National Market).

As of February 28, 1999, there were 10,293,777 shares of the registrant's  
Common Stock, $.01 par value, issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

The responses to items 10, 11, 12 and 13 herein are incorporated by reference 
to certain information in the Company's Definitive Proxy Statement for its 
Annual Meeting of Shareholders to be held May 4, 1999.

                                       1


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                                     PART I

ITEM 1.  BUSINESS.

GENERAL

Fourth Shift Corporation (the "Company") develops and markets 
client/server-based application software for industrial planning and 
management processes. The Company's principal product, the Fourth 
Shift-Registered Trademark- Manufacturing Software System for OBJECTS 
("MSS"), is a family of integrated manufacturing and financial management 
applications for intermediate-sized sites of manufacturing and distribution 
enterprises. The MSS system operates in a Windows NT and Novell open 
computing environment. Founded in 1982, the Company reincorporated in 
Minnesota in 1984. In 1985, the Company introduced the first modules of the 
MSS product line.

The period from 1994 through 1998 was a period of steady growth for the 
Company. The Company both expanded the range of services it offers with the 
MSS product line and the geography it covers. In 1994, the Company worked to 
expand sales both domestically and internationally, instituted new service 
programs, introduced CD-Rom based training aids, and introduced a release 
that combined the domestic and international versions of the MSS product into 
a single version with increased functionality. Total revenue continued to 
expand during 1995, as the breadth of the MSS product line continued to 
expand and the Company's sales continued to grow internationally in Asia and 
the Pacific Rim. The Company introduced a graphical user interface providing 
Windows operability and released a version of MSS for the Windows NT 
operating system in 1995, together with new modules designed to provide sales 
order processing and cash management functions.

During this period, the Company's operations were impacted by the December 
1992 acquisition of Just In Time Enterprise Resources ("JIT"). JIT is an ERP 
system for the aerospace industry that functioned in the UNIX/Oracle 
environment. The Company devoted substantial resources, including proceeds 
from its initial public offering, to improve the JIT code and instituting 
sales and development procedures designed to improve the profitability of the 
product line. Because of the drain on Company resources, the JIT product line 
was sold in 1995. The JIT operations are included in the Company's financial 
statements as discontinued operations.

In 1996, the Company experienced another year of growth, both internationally 
and domestically. This was accomplished through sales and marketing 
expansion, new product offerings and continued expansion of its international 
operations.

Total revenue expanded at a slower rate than the historical average during 
1997. The revenue growth in North America and Europe was offset by decreased 
revenue in Asia. The growth was achieved through sales and marketing 
expansion and increased product and service offerings. New MSS product 
offerings included the development of an enhanced graphical user interface, 
an engineering module, a screen customizer module, and an enlarged database. 
Revenues in Asia decreased primarily as a result of economic problems, 
particularly in the last half of the year.

The Company's 1997 operations were also impacted by the development of the 
Fourth Shift Objects technology ("OBJECTS"). Starting mid-1995, the Company 
devoted substantial resources to the development of OBJECTS. The Company 
completed a working model and introduced the first modules of this system in 
1997, however absent the broad functionality of the established MSS product, 
OBJECTS did not meet market expectations. As part of a restructuring plan 
announced in December 1997, the Company reevaluated its OBJECTS development 
activities and product strategy. As a result, the development operations of 
MSS and OBJECTS were combined in 1998 reducing product development costs 
absolutely and as a percentage of revenue.

In 1998, the Company returned to profitability by generating more than 
$3,250,000 in operating income with total revenue growth of 30%. North 
America and Europe revenue grew due to improved sales strategies, increased 
sales headcount and expanded product and service offerings. Asia revenue 
decreased slightly from 1997 to 1998. The decline is primarily attributable 
to economic problems in Asia that have softened the demand for enterprise 
software solutions.

The Company introduced eight new releases of MSS in 1998, as well as support 
for Microsoft SQL Server, which will open new markets for the Company. 
Additionally, customers trading with European Union countries were capable of 
accommodating the new currency rules due to the Company's products being 
Euro-ready.

                                       2

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PRODUCTS - MSS FOR OBJECTS

The Company's principal product, the Fourth Shift-Registered Trademark- 
Manufacturing Software System for OBJECTS ("MSS"), provides client/server 
computing in the Windows/Windows NT/NetWare open system environments and an 
integrated approach to the industrial planning and control processes known as 
MRP II. A customer can combine any number of software modules within this 
product line to provide on-line access to real-time information for MRP, 
bills of material, capacity requirements planning, master production 
scheduling and financial management. Information is communicated consistently 
among the various functional modules of MSS through a common database, 
facilitating the automatic updating of common information used by all 
applications. Using this system, a customer can manage inventory to 
significantly reduce carrying costs, manage material ordering to limit 
manufacturing shortages, manage manufacturing to reduce finished goods 
surpluses or shortages, immediately access information necessary to 
communicate customer order scheduling on-line, monitor overall manufacturing 
and problem areas to maximize efficiency and quickly produce financial 
reports that are consistent with manufacturing records.

MSS is a family of more than 40 integrated manufacturing, accounting, sales 
and information management applications and third party products designed to 
support decision-making in an industrial company. MSS is designed for and 
primarily licensed to intermediate-sized manufacturing and distribution 
companies and remote sites of larger companies, that are in need of a broadly 
functional but easily implemented, off-the-shelf application system for up to 
and beyond 100 concurrent users. MSS is distributed with a shrink-wrap 
license in standardized modules with extensive documentation and training 
aids. MSS is modular, so users can begin with fundamental applications and 
add more specialized functionality as their requirements evolve and grow.

The Company believes that the following features of MSS allow it to compete 
successfully with other LAN-based products: (i) MSS is an integrated and 
flexible system designed to allow fast, multi-user access to data; (ii) MSS 
includes over 40 integrated application modules and third party products that 
have been refined to provide broad, deep functionality in ERP applications, 
including international features such as multiple currency and language 
translation capabilities; (iii) MSS applications generally require fewer 
keystrokes and screens per task than comparable products; (iv) MSS can be 
rapidly and easily implemented through a standardized process using extensive 
training aids, both interactive CD-ROM and classroom; (v) MSS is easy to use 
and offers seamless integration with off-the-shelf word processing, 
electronic mail, spreadsheet and other applications, (vi) MSS is offered with 
a comprehensive support program with local, national and international 
support organizations, (vii) MSS supports multiple currencies and is 
available in most major languages, and (viii) MSS is designed to encourage 
business process reengineering and efficiency in its customers' manufacturing 
processes.

MSS also provides a means to interface MSS with third-party applications 
through the MSS connectivity modules. The Company licenses a number of 
third-party software products that have been designed to operate with MSS.

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The following is a list of current MSS product line offerings:

<TABLE>
<CAPTION>
MANUFACTURING MODULES                     FINANCIAL MODULES                        THIRD-PARTY PRODUCTS
---------------------                     -----------------                        --------------------
<S>                                       <C>                                      <C>
Inventory Management                      Financial Management                     Data Net, data collection system
    -Inventory Control                         -Accounts Payable                   VisiBar, collection system
    -Shipping                                  -Accounts Receivable &              Integrated EDI System
    -Lot Trace/Serialization                    Invoicing                          Advanced Planning (APS)
Manufacturing Operations                       -General Ledger                     Rules-Based Configurator
    -Manufacturing Order Management       Payroll Connection                       Cash Collection & Management
    -Repetitive Manufacturing             General Ledger Restructuring Package     Cycle Counting/Inventory
Product Definition                        Multi-Currency Management                   Management
    -Bill of Material                     Cash Management                          Manufacturing Variance Analysis
    -Product Costing                                                               Message Analysis & Reporting
Planning and Scheduling                   SYSTEM-WIDE MODULES                      Formula Management
    -Materials Requirements Planning      -------------------                      Remote Communications
Vendor Operations                         System Administration                    Customer Relationship Management
    -Purchasing                                -Configuration                        (CRM)
    -Approved Vendor Sourcing                  -System Control                     Paperless Document Management
Custom Products Manufacturing                  -CIM Data Import                    Electronic Business Forms
Co-Products Manufacturing                      -CIM Data Export                    Automated Timekeeping
Material Management/Analysis                   -Management Reports                 Quote Management
Operations Performance                         -Framework for Windows              Engineering Change Order
Shop Floor Tracking and Reporting         Executive Information System(EIS)           Management
Engineering Module                        CIM Customizer                           Forecast Management System
                                          Screen Customizer                        ISO9000 Implementation System
SALES ACTIVITY MODULES                                                             Bill of Material Analysis
----------------------                                                             Store Front Cash Collections System
Customer Operations                                                                
    -Order Entry
    -Advanced Price Book
Sales Analysis
Rules Based Pricing
Sales Order Processing

</TABLE>

The MANUFACTURING MODULES provide on-line information enabling users to solve 
material shortage, excess inventory and manufacturing efficiency problems. 
The Inventory Management Module, which maintains and provides inventory 
status information, is the basic building block for all other manufacturing 
applications. It works with the Planning and Scheduling Module, which 
calculates the optimum manufacturing plan based on continual updates from 
other modules; with the Product Definition Module, which maintains 
information relating to the materials, resources, costs, and tools necessary 
to manufacture each product; and with the Manufacturing Operations Module, 
which verifies component availability, picks materials and calculates 
material usage variances.

The function of these modules can be further enhanced for use in specific 
manufacturing environments with the Shop Floor Tracking and Reporting Module, 
the Co-Products Manufacturing Module and the Custom Products Module. In 
addition, the Vendor Operations Module helps buyers manage vendor 
relationships and the Material Management/Analysis Module allows for 
simulations and engineering-change control. The Engineering Module permits 
engineering information to be integrated with bill of material information.

The SALES ACTIVITY MODULES address customer service issues. The Sales Order 
Processing Module gives customer service representatives on-line support for 
entering and tracking orders. Representatives can act on credit problems and 
reschedule orders to meet changing delivery dates. The Rules Based Pricing 
Module further extends order entry functionality to allow the user to create 
pricing models for individual customers or buying groups. Sales Analysis 
tracks detailed and summarized sales information by item, customer, and 
order. Sales commissions are also captured and tracked with the Sales 
Analysis Module.

The FINANCIAL MODULES are tightly integrated with the manufacturing and sales 
activity modules so that financial transactions are automatically created as 
a result of business activity. The Financial Management Module provides 
comprehensive management of a company's financial position and generates 
financial reports through the module's general ledger function. This module 
also controls the processing of supplier invoices from invoice entry to check 

                                       4
<PAGE>

printing and reconciliation. Similarly, customer invoicing, cash application, 
and accounts receivable management is supported by the Financial Management 
Module. The Multi-Currency Management Module offers exchange rate tracking 
and allows transactions to be stated in the trading partners' currency. The 
Cash Management Module allows customers to track cash transactions and 
banking activity while providing period-end reconciliations of cash activity. 
The Payroll Connection permits outside payroll services to download payroll 
information into the general ledger portion of the Financial Management 
Module.

The SYSTEM-WIDE MODULES extend and enhance the manufacturing, sales activity 
and financial modules. The System Administration Module is used to tailor the 
MSS modules to each customer's needs, and contains key features such as audit 
trails, multi-language support, VAT tax, system-wide security and Novell or 
Windows NT support. The System Administration Module also provides CIM 
connectivity to either commercial or user-developed third-party applications. 
Open Database Connectivity (ODBC) is also provided under the System 
Administration Module: this provides access to the MSS database via ODBC 
enabled applications, i.e., MICROSOFT CORPORATION'S OFFICE SUITE OF PRODUCTS. 
Additional system-wide modules such as Executive Information Systems (EIS), 
CIM Customizer, and Screen Customizer complement the System Administration 
Module by providing broader functionality. The EIS Module provides 
decision-makers a key performance measurement tool that displays a quick 
overview of the state of the entire business. The CIM Customizer Module 
allows the user to extend the MSS applications by embedding other application 
software into the processing flow of the MSS system. The Screen Customizer 
permits the customers to configure certain screens to fit their business 
application.

The typical customer licenses between $50,000 and $90,000 of MSS software. 
MSS license revenue totaled $26,284,000 for the year ended December 31, 1998 
or approximately 39% of the overall revenue of the Company.

THIRD-PARTY PRODUCTS. The Company also licenses, implements and supports 
third-party software and hardware products, which are integrated to function 
with the MSS software. These products extend the functionality of Fourth 
Shift's software and provide a broader solution to Fourth Shift clients. At 
December 31, 1998, the Company had 14 agreements with various third-party 
software and hardware vendors to license third-party products. Third-party 
products revenue totaled $3,957,000 during the year ended December 31, 1998.

SERVICES

The Company offers a broad range of services for its MSS product line, 
including a comprehensive customer support program, implementation 
consulting, network-related technical consulting, custom software development 
and extensive training programs. Such services constituted 56%, 52% and 48% 
of the Company's revenue from continuing operations during 1998, 1997 and 
1996, respectively.

CUSTOMER SUPPORT PROGRAM. The Company offers a standardized customer support 
program ("CSP") for MSS. CSP is a comprehensive, fee-based program designed 
to help customers obtain the maximum benefit from their business management 
software. CSP subscribers pay an annual fee of 15-18% of the current list 
price of the modules licensed. Approximately 75% of the currently active 
users of MSS products subscribe to CSP. The Company believes CSP is a stable 
and reliable source of revenue, which the Company intends to continue to 
emphasize to its new and existing customer base.

Included among the materials and services furnished through CSP are new 
product releases, telephone technical and application support, a software 
tool kit, an electronic bulletin board, and newsletter and application notes. 
Updated and enhanced versions of the Company's software products are provided 
to CSP subscribers as part of the annual subscription fee. Telephone support 
calls are handled by manufacturing, financial and technical experts located 
in Fourth Shift offices in the United States, Mexico, United Kingdom, 
People's Republic of China, and Singapore. Additionally, certain distributors 
handle support calls in Eastern Europe and the Middle East.

PROFESSIONAL SERVICES. The Company offers implementation consulting and 
training for use of its MSS products, as well as custom software development 
services. Implementation consulting services, available on a fee basis, 
include implementation planning, project management and specialized custom 
training. The Company offers a special implementation workshop designed to 
ease the MSS implementation process, a readiness audit to identify problems 
prior to using the system, business reviews to maximize the utility of the 
system once installed and several benchmarking tests to measure performance 
against competitors.

                                       5

<PAGE>

The Company offers a series of classroom and individual on-site training 
options. Training includes classroom instruction at the Company's offices in 
the United States, United Kingdom and People's Republic of China and at 
authorized training centers or at customer sites. Customers may also purchase 
Mentor-TM-, the self-paced interactive CD-Rom training module, to supplement 
standard training classes while serving as an update class for the occasional 
user.

The Company also offers, on a limited basis, custom software development 
services to meet specific customer requirements, and to integrate MSS with a 
customer's existing computer systems and/or third-party software providers.

MARKETS

The Company targets the Tier 3 manufacturing market (Tier 3 is manufacturing 
companies with revenues less than $150 million). MSS is licensed primarily to 
mid-sized manufacturing companies, or business units of larger manufacturing 
companies, that generate more than $5 million of revenue annually and require 
up to approximately 100 concurrent users. In addition, MSS is licensed to 
manufacturing sites of Fortune 500 companies. MSS is used by discrete 
manufacturers (which assemble or machine parts into finished products) and by 
process manufacturers (which mix, separate and otherwise combine or control 
ingredients to create finished products). It has broad application and use in 
the computer and electronics, machinery, consumer goods, automotive and 
fabricated products industries.

SALES AND MARKETING

The Company distributes its products and services through a direct sales 
force and value-added resellers in major markets, and through sales agents in 
secondary markets. The Company maintains regional sales offices located in 
San Diego, Los Angeles, and San Ramon, California; Atlanta, Georgia; Boston, 
Massachusetts; Chicago, Illinois; Cleveland, Ohio; Dallas, Texas; 
Philadelphia, Pennsylvania; and Phoenix, Arizona; in addition to its 
headquarters located in Minneapolis, Minnesota. The Company sells directly 
through wholly owned subsidiaries in the United Kingdom, Mexico, the People's 
Republic of China, South Africa, Malaysia, and Singapore, and through 
distributors in the Americas, Europe, Africa, the Middle-East, and Asia. 
During 1998, approximately 93% of the Company's software license revenue was 
generated through direct sales personnel and 7% was generated through 
resellers and agents. Approximately 73% of software license revenue was 
generated in North America and 27% was generated abroad (see Note 11 to the 
Consolidated Financial Statements).

The Company's direct sales personnel are compensated on a salary plus 
commission basis with commissions paid monthly. This monthly commission plan 
assists the Company in managing the level of its sales activity throughout 
the quarter. The Company's reseller agreements generally provide that sales 
will be made by authorized resellers on a nonexclusive basis from offices 
within a designated territory. The agreements obligate the Company to license 
to the end-user through a value added reseller (VAR) at specified prices and 
to provide training to each reseller. The Company also maintains a staff of 
systems consultants who offer pre- and post-sales support to the sales force 
and to customers.

The Company markets its products through advertising campaigns in national 
trade periodicals, direct mail and telemarketing. These efforts are 
supplemented by listings in relevant directories and trade show and 
conference appearances. The Company also receives leads from its hardware and 
services vendors, customers and various accounting and consulting firms.

Sales cycles for the Company's products vary substantially based on the 
degree of integration, consulting and training required and also on the 
status of the customer's implementation of a hardware system. The product 
sales cycle is usually four to six months from the time an initial sales 
presentation is made to a customer until the software is delivered and 
licensed. The Company's products are typically shipped within 48 hours of 
receipt of order. Generally 40-50% of the price is paid when the order is 
made and the balance is due 30 days after delivery of the product.

                                       6

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STRATEGIC ARRANGEMENTS

Part of the Company's sales and marketing strategy is to build and develop 
relationships with companies that will play an important role in the 
successful marketing of the Company's products. These companies include 
system software suppliers (such as Microsoft Corporation) and database 
companies (such as Micro Data Base Systems, Inc. and Microsoft Corporation). 
The Company uses products from system software suppliers to develop the 
Company's application software products. The suppliers also serve as 
technical references for future prospects. Arrangements with database 
companies allow the Company to sublicense database management systems with 
its products and to provide fee-based support for licensees.

PRODUCT DEVELOPMENT

Historically, the Company has invested heavily in research and development. 
During the years ended December 31, 1998, 1997 and 1996, the Company recorded 
research and development expenses from continuing operations of $7,571,000, 
$9,271,000 and $8,674,000, respectively. In addition, the Company capitalized 
$1,023,000 and $3,819,000 in 1998 and 1997, respectively, of development 
costs related to the development of MSS for OBJECTS functionality and related 
modules that had reached technological feasibility. The Company begins 
amortization of previously capitalized costs upon general distribution of the 
product and uses a three-year economic life of the framework and modules. 
Amortization expense totaled $625,000 and $720,000 in 1998 and 1997, 
respectively.

In December 1997, the Company evaluated its cost structure and the future 
marketability of its products and wrote off $1,630,000 of previously 
capitalized development costs as a result in the change in product strategy. 
This write off is included in the 1997 restructuring charge totaling 
$2,566,000. In 1998, the Company wrote off $458,000 of previously capitalized 
technology that was no longer aligned with the Company's product strategy.

In 1997, in addition to investing significant resources in the development of 
OBJECTS, the Company continued to develop and enhance its MSS Product. New 
modules, an expanded database, and additional third party product offerings 
were added.

In 1998, the Company's product strategy was focused on providing solutions 
for the Company's primary customer base. Future releases will incorporate 
much of the OBJECTS technology including support for both Micro Data Base 
Systems Inc. (MDBS) and Microsoft SQL Server databases, and multi-company, 
multi-plant application functionality. Releases in 1998 provided an Internet 
ready application software release targeted for small to mid-size 
manufacturers.

The computer industry is characterized by rapid technological advances, 
changes in customer requirements and frequent new product introductions and 
enhancements. The Company's future success will depend upon its ability to 
enhance its current products and to develop and introduce new products that 
keep pace with technological developments, respond to evolving customer 
requirements and achieve market acceptance. In particular, the Company 
believes it must continue to respond quickly to users' needs for broad 
functionality and multiplatform support and to advances in hardware and 
operating systems. Failure to anticipate or respond adequately to 
technological developments and customer requirements, or any significant 
delays in product development or introduction, could result in a loss of 
competitiveness and revenues. In the past, the Company has experienced delays 
in the introduction of new products and product enhancements. These 
development efforts are dependent upon the availability of adequate cash to 
fund them. See "Item 7. Management's Discussion of Financial Condition and 
Results of Operations." There can be no assurance that the Company will be 
successful in developing and marketing new products or product enhancements 
on a timely basis or that the Company will not experience significant delays 
in the future, which could have a material adverse effect on the Company's 
results of operations. In addition, there can be no assurance that new 
products or product enhancements developed by the Company will achieve market 
acceptance.

COMPETITION

The computer industry is intensely competitive and rapidly changing. Due to 
the flexibility of the Company's products, the Company's competitors range 
from providers of high-end industrial application software for use on 
mainframes and minicomputers to providers of low-end application software for 
use on PCs and LANs. Because of the wide functionality of the Company's 
product line, competitors include providers of financial and business 
application software as well as industrial and manufacturing resource 
planning software. The Company competes generally on the basis of product 

                                       7

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features and functions, product architecture, the ability to run on a variety 
of industry standard platforms, technical support and other related services, 
ease of product integration with third-party application software and 
price/performance. The ability to address thoroughly the requirements for 
various forms of manufacturing (discrete, process, etc.), efficiency of the 
user interfaces and commands, computational speed and responsiveness, ease of 
implementation, support for application integration, extensive training 
materials, and established local support and training are key competitive 
factors with respect to MSS.

MSS currently competes primarily in the market for PC-based ERP software. The 
Company's primary competitors in this market include Lilly Software 
Associates, Made2Manage Systems, Inc., Micro MRP, Inc., Macola, Inc., Symix 
Systems, Inc., Platinum Software, and QAD, Inc. In addition, there are a 
number of smaller, regional companies that produce MRP II software for PCs. 
The Company believes that purchases in this market are based primarily on 
hardware platform and operating system (DOS/Windows/Windows NT/NetWare for 
LANs versus UNIX systems), functionality, ease of implementation, application 
integration and industry reviews. The Company believes that the MSS product 
line competes favorably in the portion of this market intended for 
DOS/Windows/Windows NT/NetWare operating systems and LANs.

The Company's products compete indirectly with providers of financial and 
accounting software for PCs and other specialized applications in the markets 
it serves. Competition from this market arises primarily when a customer is 
seeking only a very narrow solution and the Company believes its products 
compete favorably with such products on the basis of broad functionality and 
complete vertical integration.

Many of the Company's competitors have greater financial, marketing and 
technological resources than the Company. There can be no assurance that 
other companies have not developed or marketed or will not develop or market 
software products that are superior to those of the Company, that are offered 
at substantially lower prices than those of the Company or that have achieved 
or will achieve greater market acceptance than those of the Company.

INTELLECTUAL PROPERTY

The Company has registered its "FOURTH SHIFT", "FOURTH SHIFT OBJECTS 
ENTERPRISE SOFTWARE", and "MENTOR" trademark for software services and 
products with the United States Patent and Trademark Office and with the 
equivalent offices of most foreign countries in which it does business. The 
Company also registers the copyright on its MSS software products.

The Company regards its software as proprietary in that title to and 
ownership of the software reside exclusively with the Company. The Company 
attempts to protect its rights with a combination of trademark, copyright, 
employee and third-party nondisclosure agreements. Despite these precautions, 
it may be possible for unauthorized parties to copy or reverse-engineer 
portions of the Company's products. While the Company's competitive position 
could conceivably be threatened by its inability to protect its proprietary 
information, the Company believes that copyright and trademark protection are 
less important to the Company's success than other factors such as the 
knowledge, ability and experience of the Company's personnel, name 
recognition and ongoing product development and support.

The Company's software products are licensed to end users under a perpetual, 
nontransferable, nonexclusive license that stipulates which modules can be 
used and how many concurrent users may use them. The Company relies primarily 
on "shrink wrap" licenses for the protection of MSS. A "shrink wrap" license 
agreement is a printed license agreement included in the packaged MSS 
software that sets forth the terms and conditions under which the licensee 
can use the product, and binds the licensee by its acceptance and license of 
MSS to such terms and conditions. Shrink wrap licenses typically are not 
signed by the licensee and therefore may be unenforceable under the laws of 
certain jurisdictions.

As the number of software products in the industry increases and the 
functionality of these products further overlaps, the Company believes that 
software programs could become increasingly the subject of infringement 
claims. Although the Company's products have never been the subject of an 
infringement claim, there can be no assurance that third parties will not 
assert infringement claims against the Company in the future or that any such 
assertion will not require the Company to enter into royalty arrangements or 
result in costly litigation.

                                       8

<PAGE>

PRODUCTION

The principal materials and components used in the Company's software 
products include computer media, user manuals and training guides. The 
Company prepares master software disks, user manuals and packaging. In some 
cases, the Company uses third party vendors to duplicate disks containing its 
software and to print the Company's user manuals, packaging and related 
materials. To date, the Company has not experienced any material difficulties 
or delays in the manufacture and assembly of its products, or material 
returns due to product defects.

EMPLOYEES

As of December 31, 1998, the Company had 476 full-time employees, including 
154 in sales and marketing, 86 in software programming and documentation, 173 
in customer support services and 64 in finance 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 that its relations with its employees are good.

ITEM 2.  PROPERTIES

In 1998, the Company's corporate headquarters were located in Minneapolis, 
Minnesota, in a leased facility consisting of roughly 58,000 square feet, 
occupied under a lease which expired December 31, 1998. In conjunction with 
the expiration of the lease, the Company relocated its corporate headquarters 
in January 1999. A 10-year lease was signed for a new facility in Minneapolis 
that consists of approximately 57,000 square feet. The Company also leases 
15,400 square feet, approximately 8,700 square feet of which is subleased to 
a third-party, of space for a second principal office in San Ramon, 
California pursuant to leases expiring in August 1999. In conjunction with 
the December 1997 restructuring plan, the Company's San Jose office, which 
encompasses 4,561 square feet, has been vacated and the Company has subleased 
to a third-party. (See Note 4 of Notes to Consolidated Financial Statements 
for information on the Company's restructuring plan). The Company leases 
additional facilities for domestic operations in San Diego and Los Angeles, 
California; Atlanta, Georgia; Boston, Massachusetts; Chicago, Illinois; 
Cleveland, Ohio; Dallas, Texas; Philadelphia, Pennsylvania; Nashua, New 
Hampshire; and Phoenix, Arizona. The Company also leases facilities and 
offices for its international operations in London, Paris, Mexico City, 
Johannesburg, Port Elizabeth, Malaysia, Tokyo, Taiwan, Singapore and in 
Beijing, Tianjin, Guangzhou, Quing Dao, Nanjing, and Shanghai of the People's 
Republic of China. The Company believes that its existing facilities are 
adequate to meet its current needs and that suitable additional or 
alternative space will be available as needed to accommodate expansion of 
corporate operations and for additional sales offices. See Note 8 of Notes to 
Consolidated Financial Statements for information regarding the Company's 
lease obligations.

ITEM 3.  LEGAL PROCEEDINGS

From time to time the Company is involved in litigation relating to claims 
arising from its operations in the normal course of business. As of the date 
of this filing, neither the Company nor any of its subsidiaries is a party to 
any legal proceedings, the adverse outcome of which, in management's opinion, 
would have a material adverse effect on the Company's results of operations 
or financial position.

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

Not applicable

                                       9

<PAGE>

EXECUTIVE OFFICERS

Marion Melvin Stuckey, age 60, is the founder of the Company and has been the 
Chief Executive Officer and Chairman of the Company since 1982. Prior to 
forming the Company, Mr. Stuckey was an executive officer of Control Data 
Corporation ("CDC"), a multinational computer hardware, peripherals and 
services company, from 1975 to 1982. Prior to that Mr. Stuckey served in 
various sales, marketing and management positions at IBM from 1960 to 1975.

Jimmie H. Caldwell, age 59, has been President, Chief Operating Officer and a 
Director of the Company since 1984. Prior to that time, Mr. Caldwell served 
in various positions at CDC from 1964 to 1984 and held the position of Vice 
President of Operations for CDC's Peripheral Products Company when he left to 
join the Company.

David G. Latzke, age 39, has been Vice President and Chief Financial Officer 
since April 1994. Mr. Latzke joined the Company as director of special 
projects in April 1993. From 1982 until April 1993, Mr. Latzke was a manager 
with the Audit and Business Advisory Division of Arthur Andersen LLP.

                                       10

<PAGE>

                                    PART II

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

NASDAQ Symbol

    The Company's common stock trades on the NASDAQ National Market tier of The 
    NASDAQ Stock Market under the symbol FSFT.

Price Range of Common Stock

    The following table sets forth the high and low sales price of the Common
    Stock as quoted by the NASDAQ National Market System for the periods
    indicated. Such prices include inter-dealer prices, and may not include
    retail markup, markdown or commissions.

<TABLE>
<CAPTION>
                                        HIGH           LOW
                                        ----           ---
<S>                                     <C>           <C>
     FISCAL 1997:
               First Quarter            6 1/8         3 5/8
               Second Quarter           5             2 3/4
               Third Quarter            5 3/4         4
               Fourth Quarter           4 5/8         2 5/8
     FISCAL 1998:
               First Quarter            3 1/8         2 1/4
               Second Quarter           4 9/16        2 1/2
               Third Quarter            5 9/16        3 1/8
               Fourth Quarter           4 3/4         2 7/16

</TABLE>

As of December 31, 1998, there were 249 shareholders of record and, based on 
the best available information, approximately 2,194 beneficial holders of the 
Company's Common Stock. The Company has never paid cash dividends on its 
Common Stock and currently intends to retain earnings for use in operations.

                                       11

<PAGE>

ITEM 6.  SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
Selected Consolidated Financial Data
(In Thousands, Except Per Share Data)
STATEMENT OF OPERATIONS DATA-                                   1998         1997         1996         1995         1994
                                                             ----------   ---------   -----------  -----------   ----------
<S>                                                          <C>          <C>         <C>          <C>           <C>
REVENUE:
   Software license                                          $ 26,284     $ 21,883     $ 22,947     $ 17,128     $ 13,956
   Service                                                     37,963       27,137       23,822       18,097       13,937
   Third-party software and other                               3,957        3,298        2,541        1,999        2,183
                                                             ----------   ---------   -----------  -----------   ----------
               Total revenue                                   68,204       52,318       49,310       37,224       30,076
                                                             ----------   ---------   -----------  -----------   ----------
OPERATING EXPENSES:
   Cost of licenses                                             4,577        2,767        2,601        1,708        1,455
   Cost of services                                            18,274       13,209       11,747        8,868        6,356
   Cost of third-party software and other                       3,021        2,341        2,008        1,386        1,853
   Selling, general and administrative                         31,508       27,505       23,046       18,720       15,394
   Product development                                          7,571        9,271        8,674        5,732        2,817
   Restructuring charge                                             -        2,566            -          149            -
                                                             ----------   ---------   -----------  -----------   ----------
               Total operating expenses                        64,951       57,659       48,076       36,563       27,875
                                                             ----------   ---------   -----------  -----------   ----------
               Operating profit (loss)                          3,253       (5,341)       1,234          661        2,201

Other income (expense), net                                      (545)        (432)         (36)        (158)         213
                                                             ----------   ---------   -----------  -----------   ----------
     Income (loss) from continuing operations before            2,708       (5,773)       1,198          503        2,414
        provision for income taxes

Provision for income taxes                                        465          328          189          298          159
                                                             ----------   ---------   -----------  -----------   ----------
Income (loss) from continuing operations                        2,243       (6,101)       1,009          205        2,255
                                                             ----------   ---------   -----------  -----------   ----------
Discontinued operations:
   Loss from discontinued operations                                -            -            -       (7,642)      (4,977)
   Net gain on sale of discontinued operations                    281        2,311          761        2,037            -
                                                             ----------   ---------   -----------  -----------   ----------
               Total discontinued operations                      281        2,311          761       (5,605)      (4,977)
                                                             ----------   ---------   -----------  -----------   ----------
Net income (loss)                                            $  2,524     $ (3,790)    $  1,770     $ (5,400)    $ (2,722)
                                                             ----------   ---------   -----------  -----------   ----------
                                                             ----------   ---------   -----------  -----------   ----------
Basic income (loss) per common share (1):
   Continuing operations                                     $    .22     $   (.63)    $    .11     $    .02     $    .24
   Discontinued operations                                        .03          .24          .08         (.60)        (.54)
                                                             ----------   ---------   -----------  -----------   ----------
               Basic income (loss) per share                 $    .25     $   (.39)    $    .19     $  (0.58)    $  (0.30)
                                                             ----------   ---------   -----------  -----------   ----------
                                                             ----------   ---------   -----------  -----------   ----------
Diluted income (loss) per common share (1):
   Continuing operations                                     $    .22     $   (.63)    $    .10     $    .02     $    .24
   Discontinued operations                                        .03          .24          .08         (.59)        (.53)
                                                             ----------   ---------   -----------  -----------   ----------
               Diluted income (loss) per share               $    .25     $   (.39)    $    .18     $   (.57)    $   (.29)
                                                             ----------   ---------   -----------  -----------   ----------
                                                             ----------   ---------   -----------  -----------   ----------
BALANCE SHEET DATA -
   Working capital surplus (deficit)                         $   (364)    $ (4,161)    $    847     $  1,810     $  5,055
   Total assets                                                33,401       31,429       31,172       24,494       23,066
   Long-term obligations                                          835        1,299        2,304          275          269
   Shareholders' equity                                         7,079        4,047        7,087        4,700        9,632

</TABLE>

(1)  See Note 2 of notes to the Company's consolidated financial statements 
     for an explanation of the determination of shares used in the per common 
     share computation.

                                       12

<PAGE>

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

1998 Management's Discussion & Analysis of Financial Condition and Results of 
Operations

The following discussion and analysis provides information which management 
believes is relevant to an assessment and understanding of the Company's 
consolidated results of operations and financial condition and should be read 
in conjunction with the consolidated financial statements and notes thereto.

Cautionary statement for purposes of the "Safe Harbor" Provisions of the 
Private Securities Litigation Reform Act of 1995. The following Management's 
Discussion and Analysis contains various "forward looking statements" within 
the meaning of federal securities laws which represent management's 
expectations or beliefs concerning future events, including statements 
regarding anticipated sales, marketing and research and development 
expenditures, growth in revenue, capital requirements and the sufficiency of 
cash to meet operating expenses. These and other forward looking statements 
made by the Company, must be evaluated in the context of a number of factors 
that may affect the Company's financial condition and results of operations, 
including the following:

-  The ability of the Company to continually enhance the Manufacturing
   Software System for OBJECTS (MSS) product to meet ever changing market
   demands for both functionality and new technology;

-  Fluctuations in quarterly operating results caused by changes in the computer
   industry, buying patterns and general economic conditions;

-  The ability of the Company to successfully develop its MSS product to meet
   European Monetary Union requirements;

-  The dependence of the Company on revenue from licensing of its MSS product;

-  The effects of changes in technology and standards in the computer industry;

-  The significant competition among developers and marketers of industrial 
   software;

-  The ability of the Company to retain key employees;

-  The Company's international operations, particularly in Asia;

-  The ability of the Company to manage expansion of international 
   distribution channels;

-  The dependence of the MSS product line on a third-party database management 
   system; and

-  Evolving standards regarding intellectual property protection for software 
   products in general.


SALE OF JUST IN TIME ENTERPRISE SYSTEMS, INC.

In 1995, the Company sold all of the capital stock of Just In Time Enterprise 
Systems, Inc. (JIT), a wholly owned subsidiary of the Company, along with 
certain net assets related to the operations of JIT in the United Kingdom, to 
Interactive Group, Inc. (IGI). The Company deferred recognition of the gain 
associated with the note received in connection with the sale and recognized 
the gain associated with this note, as well as additional amounts receivable 
based on revenues generated from the JIT Enterprise System, as such amounts 
were collected or are deemed collectible.

In 1996 the Company recognized a gain totaling $761,000 related to cash 
received in 1996 and January 1997. In 1997 the Company recognized a gain of 
$2,311,000 relating to cash received in 1997 and January 1998. In 1998 the 
Company recognized a gain of $281,000 relating to cash received in 1998 and 
January 1999 (see Note 3). All income taxes related to these transactions 
have been offset through the utilization of net operating losses previously 
generated by JIT.

                                       13

<PAGE>

The gain on sales of JIT has been presented as discontinued operations in the 
Company's consolidated financial statements. Accordingly, the discussion 
contained herein relates to the continuing operations of the Company, unless 
otherwise noted.

RESULTS OF OPERATIONS

REVENUE:

Total revenue for the year ended December 31, 1998 increased 30% to 
$68,204,000 from $52,318,000 in 1997 and increased 6% to $52,318,000 from 
$49,310,000 in 1996. The overall growth in total revenue over the three-year 
period was achieved through increased market penetration in North America and 
geographic expansion internationally. North American total revenue increased 
34% from 1997 to 1998 and 10% from 1996 to 1997. Total revenue from the 
Company's subsidiary in Asia decreased 3% from 1997 to 1998 and 19% from 1996 
to 1997. The decrease in revenue was primarily a result of economic problems 
in Asia, particularly in the last half of 1997, continuing through 1998. 
Total revenue from the Company's European subsidiary grew 43% in 1998 and 18% 
in 1997. The growth was the result of continued market penetration in 
continental Europe. As a percentage of total revenue, sales outside of North 
America accounted for 27% in 1998, 29% in 1997 and 32% in 1996.

Software license revenue are fees paid by customers for the right to use the 
Company's software system. Software license revenue increased 20% to 
$26,284,000 in 1998 from $21,883,000 in 1997 and decreased 5% to $21,883,000 
in 1997 from $22,947,000 in 1996. In North America, license revenues 
increased 32% from 1997 to 1998, and license revenue in Europe grew by 24%. 
These increases resulted from increased penetration, an increase in the 
direct sales force, increased marketing and lead-generating activities and 
increased acceptance of client-server based manufacturing information 
systems. As stated above, economic problems in Asia resulted in reduced 
customer demand, particularly in new system licenses, as fewer new 
manufacturing enterprises opened, and those in place delayed capital 
expenditures. The overall decrease in license revenue in 1997 is primarily 
attributable to reduced license revenues in Asia.

Service revenue includes customer support fees, training, consulting, 
installation and project management. Service revenue increased 40% to 
$37,963,000 in 1998 from $27,137,000 in 1997 and increased 14% to $27,137,000 
in 1997 from $23,822,000 in 1996. The demand for services and support has 
increased proportionately with the increase in the installed software license 
base. In addition, the Company is strengthening its efforts to standardize 
and promote its consulting and training offerings, as well as developing 
additional value-added products and services for its customers. The Company 
believes that services are an important component to the overall product line 
offering and should grow in a manner consistent with the growth in the 
installed software license base.

Third-party software and other revenue are derived principally from the 
resale of third-party software licenses (complementary applications) along 
with limited hardware sales. These complementary applications have been 
integrated to function with the MSS software and extend the functionality of 
MSS for OBJECTS. Third-party software and other revenue increased 20% to 
$3,957,000 in 1998 from $3,298,000 in 1997 and increased 30% to $3,298,000 in 
1997 from $2,541,000 in 1996. The increase in 1998 and 1997 resulted from 
increased customer demand for broad ERP functionality, both among new 
customers and in the Company's previously installed base. These increases are 
also directly related to increases in MSS license revenue, since third-party 
software is often licensed in conjunction with the licensing of the MSS 
product.

                                       14

<PAGE>

OPERATING EXPENSES:

Cost of licenses increased to $4,577,000 in 1998 from $2,767,000 in 1997 and 
$2,601,000 in 1996 and increased as a percentage of total license revenue to 
17% in 1998 from 13% in 1997 and 11% in 1996. The increase in the cost of 
licenses as a percentage of license revenue in 1998 is primarily due to 
one-time royalty costs paid to third party software suppliers whose products 
are embedded in and distributed with the MSS product. In addition, a portion 
of the increased cost of licenses relates to $350,000 of database software 
inventory expensed in 1998 in connection with the execution of a long-term 
contract with the supplier. The increase in these costs as a percent of 
license revenue from 1996 to 1997 is due to increases in royalty costs paid 
to third-party software suppliers whose products are embedded in and 
distributed with the MSS product.

Cost of services increased to $18,274,000 in 1998 from $13,209,000 in 1997 
and $11,747,000 in 1996 and decreased as a percentage of service revenue to 
48% in 1998 from 49% in both 1997 and 1996. Margins were favorably impacted 
by improved customer support margins due to productivity improvements and 
high customer support renewal rates. This was partially offset by lower 
margins in consulting and training services due to pricing pressures.

Cost of third-party software and other expenses as a percentage of 
third-party software and other revenue was 76% in 1998, 71% in 1997 and 79% 
in 1996. The increase in 1998 of cost of third-party software and other 
expenses as a percentage of related revenues is due to headcount increases 
related to the sale of third party products and the mix of products sold. The 
decrease from 1996 to 1997 primarily resulted from the mix of products sold.

Selling, general and administrative expense increased to $31,508,000 in 1998 
from $27,505,000 in 1997 and $23,046,000 in 1996. As a percentage of total 
revenue, selling, general and administrative expense was 46% of total revenue 
in 1998, 53% in 1997 and 47% in 1996. The increase in spending in 1998, 1997 
and 1996 is due to the addition of sales and marketing personnel, and related 
commissions earned, in connection with the Company's expanded market 
penetration in North America and international markets. The rate of spending 
as a percent of revenue increased by six percentage points from 1996 to 1997 
and decreased seven percentage points from 1997 to 1998. The decrease of 
selling, general and administrative expenses as a percent of revenue in 1998 
reflects the Company's focused efforts to control expenses as revenues grow. 
The increase in the spending rate from 1996 to 1997 is due primarily to 
growth in selling and marketing expenses in the second half of 1997. During 
the second half of 1997, the Company incurred additional costs to reorganize 
and grow the sales organization, particularly in North America.

Product development expense decreased to $7,571,000 or 11% of total revenue 
in 1998, compared to $9,271,000 or 18% of total revenue during 1997 and 
compared to $8,674,000 or 18% of total revenue in 1996. The $1,700,000 
reduction in product development from 1997 to 1998 resulted from the 
execution of a product development restructuring plan to combine some of the 
OBJECTS technology with the functionality of the current MSS product and to 
redirect Company development activities. This plan was implemented in the 
fourth quarter of 1997. The restructuring plan merged two development 
operations into one, resulting in staff and contractor reductions and 
allowing the Company to close its development office in San Jose. The 
implementation of this plan has reduced the 1998 product development costs in 
absolute dollars and as a percentage of revenue.

In 1998 and 1997, the Company capitalized $1,023,000 and $3,819,000 of 
development costs respectively. Amortization expense for 1998 and 1997 
totaled $625,000 and $720,000, respectively, and is included as a component 
of product development expense. In 1998, the Company also wrote off $458,000 
of previously capitalized technology that was no longer aligned with the 
Company's current product strategy. In connection with its 1997 
restructuring, the Company wrote off $1,630,000 of previously capitalized 
costs relating to the OBJECTS products, net of accumulated amortization, to 
restructuring expense (see following discussion).

The increased expense in 1997 over 1996 is a direct result of increased 
headcount and support resources associated with the development of the 
Company's object-oriented, communications-centric technology (OBJECTS). The 
Company also completed several significant user enhancements associated with 
the MSS product Release 6.0, including enhanced graphical user interface 
features, an engineering module, a screen customizer module, and an enlarged 
database.

The Company's research and development activities are conducted internally 
and consist primarily of software development--the writing of code. The 
Company does not have any material fixed commitments for capital expenditures 

                                       15

<PAGE>

in research and development. The Company believes that product development 
spending is critical to the continuing success of the Company's products and 
intends to continue to invest heavily in research and development.

The Company accounts for capitalized development costs and related 
amortization under Statement of Financial Accounting Standards No. 86 ("SFAS 
No. 86"), "Accounting for the Costs of Computer Software to Be Sold, Leased, 
or Otherwise Marketed," capitalization of computer software development costs 
is to begin upon the establishment of technological feasibility, limited to 
the net realizable value of the software product, and cease when the software 
is available for general release to customers.

Restructuring Charge recorded in 1997 is the result of an evaluation of the 
Company's structure and organization, primarily in the product development 
area. In December 1997, the Company's development operations were 
restructured in conjunction with a change in product strategy. Specifically, 
all North American development activities were combined into a single 
operation - previously the Company maintained two development groups. The 
restructuring charge totaled $2,566,000 and included $394,000 of severance 
costs for employees and contractors, $392,000 to provide for the cost to exit 
office space that was no longer needed as a result of the staff reductions, 
and $150,000 of prepaid royalties relating to the OBJECTS product that had no 
future value. In addition, $1,630,000 of previously capitalized development 
costs was expensed as a result of the change in product strategy.

The reorganization of the development activities was completed during 1998 
and has reduced 1998 product development costs and streamlined product 
development. As of December 31, 1998, approximately $40,000 of the total 
restructuring charge remains to be paid in cash.

Other income (expense), net is comprised principally of interest expense on 
line-of-credit borrowings, equipment loans, and leases, net of interest 
income.

Provision for income taxes totaled $465,000 in 1998 versus $328,000 in 1997 
and $189,000 in 1996. The tax provision for 1998 is comprised of U.S. 
federal, state and foreign income taxes and is comprised of state and foreign 
taxes in 1997 and 1996. The Company's U.S. federal taxes are limited to 
alternative minimum taxes due to utilization of net operating loss 
carryforwards. The Company has not recognized any benefits related to 
deferred taxes or net operating loss carryforwards.

OPERATING INCOME:

The Company reported operating income of $3,253,000 for 1998 compared to an 
operating loss of $5,341,000 for 1997 and operating income of $1,234,000 for 
1996. The operating income in 1998 is a result of increased selling and 
marketing efforts, and the Company's focused efforts to control expenses as 
revenues grow. In addition, the restructuring in December 1997 has yielded 
reduced product development costs in 1998. The operating loss in 1997 is a 
result of the restructuring charge and other increases in operating expenses 
that were not entirely offset by increased revenue.

The Company has historically experienced higher revenue and gross margin in 
its fourth quarter compared to the other quarters. The Company attributes 
this primarily to customers' increased spending at the end of their calendar 
year budgetary periods. The Company believes this pattern will continue.

FOREIGN CURRENCY EXCHANGE

Approximately 13% of the Company's total revenue in 1998, 16% in 1997 and 14% 
in 1996, was derived from sales denominated in foreign currencies. These 
sales were made through certain foreign subsidiaries and were denominated in 
the subsidiaries' functional currencies. The effect of foreign currency 
exchange rate fluctuations versus the U.S. Dollar on these revenues is 
largely offset to the extent expenses of the foreign subsidiary are incurred 
and paid for in that same currency. None of these foreign operations have 
significant receivables, obligations or commitments denominated in currencies 
other than these operations' functional currencies.

LIQUIDITY AND CAPITAL RESOURCES

Cash provided by continuing operating activities was $8,509,000 in 1998 
compared to $1,775,000 in 1997 and $3,163,000 in 1996. In 1998, the net 
income adjusted for discontinued operations and noncash items resulted in a 
cash source of $5,887,000. Additional cash sources were decreases in accounts 
receivable and inventory of $188,000 and 

                                       16
<PAGE>

$391,000, respectively, and increases in accrued expenses and deferred 
revenue of $376,000 and $3,195,000, respectively. These sources were offset 
by an increase in prepaid expenses of $65,000 and a decrease in accounts 
payable of $1,463,000. The decrease in accounts receivable is a direct result 
of increased collection efforts. The decrease in inventory resulted from 
database software inventory expensed in connection with the execution of a 
long-term contract with the supplier in 1998. The increased accrued expenses 
results from increased accrued commissions and bonuses associated with the 
increase in revenues and profits, and costs of third-party software 
associated with fourth quarter growth. The increase in deferred revenue 
results from the continued growth of the business and increases in the number 
of annual customer support contracts.

Cash used for investing activities was $986,000 in 1998 compared to 
$3,377,000 in 1997 and $5,916,000 in 1996. The decrease from 1996 to 1997 
relates primarily to decreased capital spending offset by increased 
capitalized software development costs. Specifically, 1998 cash used for 
investing activities includes $1,023,000 of capitalized software development 
costs and $1,094,000 for purchases of furniture, fixtures and equipment. This 
is offset by the receipt of $881,000 related to the sale of JIT and a 
decrease in restricted cash of $250,000.

Cash used in financing activities was $3,178,000 in 1998. In 1997 and 1996, 
financing activities provided cash flow of $1,445,000 and $1,665,000. The 
Company's financing activities in 1998 related primarily to repayment of line-
of-credit borrowings, capital leases, and equipment financing arrangements. 
This was offset by the issuance of common stock under employee benefits plans.

As discussed in Note 5 of Notes to Consolidated Financial Statements, the 
Company had a $5,000,000 line-of-credit agreement with a bank, which expired 
March 2, 1999. In March 1999 the Company entered into a new line-of-credit 
agreement with a different bank. Borrowings under this agreement shall not 
exceed the lesser of $10,000,000 or a percentage of eligible accounts 
receivable. Borrowings are collateralized by accounts receivable and other 
assets of the Company and bear interest at the bank's base rate plus 1/2%. 
The agreement expires March 2002.

On July 1, 1998, the Company entered into a four year $12,000,000 commitment 
with a third-party database supplier whose product is embedded in and 
distributed with the MSS product. The agreement also includes three 
three-year renewal options. Payments will be made monthly. The Company does 
not anticipate this commitment to materially impact historical margin levels.

In January 1999 the Company moved its corporate headquarters to a new leased 
facility. The Company leased the majority of the capital assets associated 
with the move and does not anticipate a material impact on the company's 
financial condition or results of operations. The Company does not have any 
material scheduled commitments for capital expenditures during 1999.

The Company believes that the $10,073,000 of cash and cash equivalents on 
hand at December 31, 1998 together with anticipated cash flows from 
operations and the Company's available line-of-credit will be sufficient to 
fund operating cash needs for 1999. Beyond 1999, the Company plans to 
consistently generate positive cash flows from operations; however, if this 
does not occur, then the Company may need to seek additional funds through 
equity or debt financing.

The Company has available net operating loss carryforwards of approximately 
$14,201,000 and tax credit carryforwards of approximately $2,012,000 at 
December 31, 1998. The Company has not recognized any of these benefits in 
the related financial statements.

NEW ACCOUNTING PRONOUNCEMENTS

The Company adopted Statement of Position (SOP) 97-2, "Software Revenue 
Recognition," effective January 1998. This statement supersedes SOP 91-1 and 
provides guidance on applying generally accepted accounting principles in 
recognizing revenue on software transactions. The implementation of SOP 97-2 
did not have a material impact on the Company's financial condition or 
results of operations.

Effective January 1, 1998, the Company adopted Statement of Financial 
Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income," which 
established new rules for the reporting and presentation of comprehensive 
income and its components in a full set of financial statements. The 
Company's comprehensive income is comprised of net income and foreign 
currency translation adjustments. The adoption of SFAS No. 130 had no impact 
on the 

                                       17

<PAGE>

Company's net income or total shareholders' equity. Prior to the adoption of 
SFAS 130, translation adjustments were reported separately in the statement 
of shareholders' equity. The comprehensive income amounts in the prior fiscal 
years' financial statements have been reclassified to conform to SFAS 130.

The Financial Accounting Standards Board also has released SFAS No. 131, 
"Disclosures about Segments of an Enterprise and Related  Information," 
effective for fiscal years  beginning  after December 15, 1997.  SFAS No. 131 
requires  disclosure of business and geographic  segments in the consolidated 
 financial  statements of the Company.  The Company adopted SFAS No. 131 in 
1998 and has disclosed this  information in the attached Notes to 
Consolidated Financial Statements.

OTHER

The Company began addressing year 2000 issues in April of 1997. The Company 
utilizes both information technology ("IT") and non-IT systems and assets 
throughout its worldwide operations.

The Company has three main IT systems that are year 2000 ready. The main 
system is the Fourth Shift MSS for OBJECTS Software System. This product is 
owned and developed by Fourth Shift and is the product the Company sells and 
uses internally to run its business. The Company performed a complete review 
of the system for year 2000 readiness in early 1998. Nine areas of concern 
were discovered. These have been corrected and the process used to test for 
year 2000 readiness has been certified by the Information Technology 
Association of America to meet the information technology industry's best 
software development practices for addressing the year 2000 issue. There has 
been no material financial impact for the cost of corrections as these were 
addressed in the normal course of development of the product. The Company's 
Payroll and Human Resource systems were updated in the third quarter of 1998 
and are currently year 2000 ready. The cost associated with this effort has 
been immaterial and did not adversely impact the Company's operating results. 
In addition, the Company's Customer Support Center's system is a third-party 
product that is year 2000 ready. All other third-party IT systems sold by the 
Company and used in its internal operations are year 2000 ready or have 
committed to be year 2000 ready by January 1, 1999.

The Company has assessed the year 2000 impact on its non-IT systems and has 
purchased a software package to use in testing the Company's hardware and 
equipment. The Company will have tested all hardware by the end of the second 
quarter of 1999 and will correct any issues in the third quarter of 1999.

The Company is in the process of assessing the impact of non-compliant 
vendors. To date the Company has not identified any significant suppliers who 
will not be year 2000 ready.

While the Company has exercised its best efforts to identify and remedy any 
potential year 2000 issues, the primary remedy of the Company's contingency 
plan is to use alternative vendors. Although the Company does not anticipate 
a material impact on the Company's financial condition or results of 
operations, it is uncertain as to the extent the Company may be affected by 
such matters.

ITEM 7a.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company does not enter into financial instruments for trading or 
speculative purposes and does not currently utilize derivative financial 
instruments. Certain sales made through certain foreign subsidiaries are 
denominated in the subsidiaries' functional currencies. The effect of foreign 
currency exchange rate fluctuations versus the U.S. Dollar on these revenues 
is largely offset to the extent expenses of the foreign subsidiary are 
incurred and paid for in that same currency. None of these foreign operations 
have significant receivables, obligations or commitments denominated in 
currencies other than these operations' functional currencies. The Company 
does not have any foreign currency swaps or derivatives and is not subject to 
material foreign currency exchange risk.

                                       18

<PAGE>

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                    FOURTH SHIFT CORPORATION AND SUBSIDIARIES

                           Consolidated Balance Sheets

                                As of December 31

                 (In Thousands, Except Share and Per Share Data)

<TABLE>
<CAPTION>
                                                                 1998         1997
                        ASSETS                                 --------      -------
<S>                                                            <C>           <C>
CURRENT ASSETS:
   Cash and cash equivalents                                   $ 10,073      $ 5,758
   Accounts receivable, net                                      13,813       14,001
   Inventories                                                       91          482
   Prepaid expenses                                               1,096        1,031
   Royalty receivable                                                50          650
                                                               --------      -------
      Total current assets                                       25,123       21,922
                                                               --------      -------
FURNITURE, FIXTURES AND EQUIPMENT, at cost:
   Furniture and fixtures                                         2,529        2,644
   Computer equipment                                             8,430        7,553
   Leasehold improvements                                         1,481        1,150
   Assets held under capital lease                                3,312        2,784
   Less- Accumulated depreciation and amortization              (11,168)      (8,628)
                                                               --------      -------
      Net furniture, fixtures and equipment                       4,584        5,503

RESTRICTED CASH                                                     465          715

SOFTWARE DEVELOPMENT COSTS, net                                   3,229        3,289
                                                               --------      -------
      Total assets                                             $ 33,401      $31,429
                                                               --------      -------
                                                               --------      -------

</TABLE>

                                       19

<PAGE>

                    FOURTH SHIFT CORPORATION AND SUBSIDIARIES

                           Consolidated Balance Sheets

                                As of December 31

                 (In Thousands, Except Share and Per Share Data)

                                   (Continued)

<TABLE>
<CAPTION>
                                                                 1998         1997
         LIABILITIES AND SHAREHOLDERS' EQUITY                  --------      -------
<S>                                                            <C>           <C>
CURRENT LIABILITIES:
   Current portion of long-term obligations                    $  1,099      $  1,803
   Revolving credit facility                                          -         2,000
   Accounts payable                                               2,501         3,964
   Accrued expenses                                               8,377         8,001
   Deferred revenue                                              13,510        10,315
                                                               --------      --------
      Total current liabilities                                  25,487        26,083

LONG-TERM  OBLIGATIONS                                              835         1,299

COMMITMENTS AND CONTINGENCIES (Notes 7, 8 and 9)

SHAREHOLDERS' EQUITY:
   Common stock, $.01 par value, 20,000,000 shares 
      authorized; 10,201,783 and 9,828,447
      shares issued and outstanding                                 102            98
   Additional paid-in capital                                    31,591        30,640
   Deferred compensation                                           (417)            -
   Accumulated other comprehensive losses                          (266)         (236)
   Accumulated deficit                                          (23,931)      (26,455)
                                                               --------      --------
      Total shareholders' equity                                  7,079         4,047
                                                               --------      --------
      Total liabilities and shareholders' equity               $ 33,401      $ 31,429
                                                               --------      --------
                                                               --------      --------

</TABLE>

      The accompanying notes are an integral part of these consolidated
                                 balance sheets.

                                       20

<PAGE>

                    FOURTH SHIFT CORPORATION AND SUBSIDIARIES

                      Consolidated Statements of Operations

                         For the Years Ended December 31

                      (In Thousands, Except Per Share Data)

<TABLE>
<CAPTION>
                                                                  1998         1997         1996
                                                                --------     --------     --------
<S>                                                             <C>          <C>          <C>
REVENUE:
   Software license                                             $26,284      $21,883      $22,947
   Service                                                       37,963       27,137       23,822
   Third-party software and other                                 3,957        3,298        2,541
                                                                -------      -------      -------
               Total revenue                                     68,204       52,318       49,310
                                                                -------      -------      -------
OPERATING EXPENSES:
   Cost of licenses                                               4,577        2,767        2,601
   Cost of services                                              18,274       13,209       11,747
   Cost of third-party software and other                         3,021        2,341        2,008
   Selling, general and administrative                           31,508       27,505       23,046
   Product development                                            7,571        9,271        8,674
   Restructuring charge                                               -        2,566            -
                                                                -------      -------      -------
               Total operating expenses                          64,951       57,659       48,076
                                                                -------      -------      -------
               Operating profit (loss)                            3,253       (5,341)       1,234

OTHER EXPENSE, net                                                 (545)        (432)         (36)
                                                                -------      -------      -------
     Income (loss) from continuing operations before 
        provision for income taxes                                2,708       (5,773)       1,198

PROVISION FOR INCOME TAXES                                          465          328          189
                                                                -------      -------      -------
INCOME (LOSS) FROM CONTINUING OPERATIONS                          2,243       (6,101)       1,009
                                                                -------      -------      -------
DISCONTINUED OPERATIONS:
   Net gain on sale of discontinued operations                      281        2,311          761
                                                                -------      -------      -------
               Total discontinued operations                        281        2,311          761
                                                                -------      -------      -------
NET INCOME (LOSS)                                               $ 2,524      $(3,790)     $ 1,770
                                                                -------      -------      -------
                                                                -------      -------      -------
BASIC INCOME (LOSS) PER COMMON SHARE:
   Continuing operations                                        $   .22      $  (.63)     $   .11
   Discontinued operations                                          .03          .24          .08
                                                                -------      -------      -------
               Basic income (loss) per common share             $   .25      $  (.39)     $   .19
                                                                -------      -------      -------
                                                                -------      -------      -------
DILUTED INCOME (LOSS) PER COMMON SHARE:
   Continuing operations                                        $   .22      $  (.63)     $   .10
   Discontinued operations                                          .03          .24          .08
                                                                -------      -------      -------
               Diluted income (loss) per common share           $   .25      $  (.39)     $   .18
                                                                -------      -------      -------
                                                                -------      -------      -------

</TABLE>

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

                                       21

<PAGE>

                    FOURTH SHIFT CORPORATION AND SUBSIDIARIES

                 Consolidated Statements of Shareholders' Equity

              For the Years Ended December 31, 1998, 1997 and 1996

                                 (In Thousands)

<TABLE>
<CAPTION>
                                            Common Stock                                   Accumulated 
                                          ----------------                                     Other
                                          Number of   Par     Additional       Deferred    Comprehensive  Accumulated  Comprehensive
                                           Shares    Value  Paid-In Capital  Compensation      Losses        Deficit       Income
                                          ---------  -----  ---------------  ------------  -------------  -----------  ------------
<S>                                       <C>        <C>    <C>              <C>           <C>            <C>          <C>
BALANCE, December 31, 1995                  9,366    $ 94      $29,222        $   -           $(181)       $(24,435)
   Common stock issued                        234       2          591            -               -               -
   Issuance of restricted shares                5       -           59            -               -               -
   Net income                                   -       -            -            -               -           1,770       $ 1,770
   Foreign currency translation                 -       -            -            -             (35)              -           (35)
                                                                                                                          -------
   Comprehensive income                                                                                                   $ 1,735
                                           ------    ----      -------        -----           -----        --------       -------
BALANCE, December 31, 1996                  9,605      96       29,872            -            (216)        (22,665)      -------
   Common stock issued                        223       2          758            -               -               -
   Issuance of restricted shares                -       -           10            -               -               -
   Net loss                                     -       -            -            -               -          (3,790)      $(3,790)
   Foreign currency translation                 -       -            -            -             (20)              -           (20)
                                                                                                                          -------
   Comprehensive income                                                                                                   $(3,810)
                                           ------    ----      -------        -----           -----        --------       -------
BALANCE, December 31, 1997                  9,828      98       30,640            -            (236)        (26,455)      -------
   Common stock issued                        194       2          513            -               -               -
   Issuance of restricted shares              180       2          438         (438)              -               -
   Amortization of deferred compensation        -       -            -           21               -               -
   Net income                                   -       -            -            -               -           2,524       $ 2,524
   Foreign currency translation                 -       -            -            -             (30)              -           (30)
                                                                                                                          -------
   Comprehensive income                                                                                                   $ 2,494
                                           ------    ----      -------        -----           -----        --------       -------
BALANCE, December 31, 1998                 10,202    $102      $31,591        $(417)          $(266)       $(23,931)      -------
                                           ------    ----      -------        -----           -----        --------    
                                           ------    ----      -------        -----           -----        --------    

</TABLE>

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

                                       22

<PAGE>


                    FOURTH SHIFT CORPORATION AND SUBSIDIARIES

                      Consolidated Statements of Cash Flows

                         For the Years Ended December 31

                                 (In Thousands)

<TABLE>
<CAPTION>
                                                                                1998          1997         1996
                                                                              --------      --------     --------
<S>                                                                           <C>           <C>          <C>
OPERATING ACTIVITIES:
   Net income (loss)                                                          $ 2,524       $(3,790)     $ 1,770
   Adjustments to reconcile net income (loss) to net cash provided by
      continuing operating activities-
         Noncash items:
            Depreciation and amortization                                       3,165         3,339        2,065
            Net gain on sale of discontinued operations                          (281)       (2,311)        (761)
            Deferred Compensation                                                  21             -            -
            Restructuring charge                                                    -         2,566            -
            Capitalized development written off                                   458             -            -
            Other                                                                   -            10           60
         Change in current operating items:
            Accounts receivable, net                                              188          (994)      (2,878)
            Inventories                                                           391           114          182
            Prepaid expenses                                                      (65)          (25)        (292)
            Accounts payable                                                   (1,463)         (319)       2,158
            Accrued expenses                                                      376         1,730          272
            Deferred revenue                                                    3,195         1,455          587
                                                                              -------       -------      -------
               Net cash provided by continuing operating activities             8,509         1,775        3,163
                                                                              -------       -------      -------
INVESTING ACTIVITIES:
   Purchases of furniture, fixtures and equipment                              (1,094)       (1,200)      (4,162)
   (Increase) decrease in restricted cash                                         250          (215)        (500)
   Capitalized software development costs                                      (1,023)       (3,819)      (1,820)
   Proceeds from sale of discontinued operations                                  881         1,857          566
                                                                              -------       -------      -------
               Net cash used for investing activities                            (986)       (3,377)      (5,916)
                                                                              -------       -------      -------

</TABLE>

                                       23

<PAGE>

                    FOURTH SHIFT CORPORATION AND SUBSIDIARIES

                      Consolidated Statements of Cash Flows

                         For the Years Ended December 31

                                 (In Thousands)

                                   (Continued)


<TABLE>
<CAPTION>
                                                                                1998          1997         1996
                                                                              --------      --------     --------
<S>                                                                           <C>           <C>          <C>
FINANCING ACTIVITIES:
   Payments of long-term obligations                                          $(1,695)       $ (963)     $  (512)
   Proceeds from equipment loans and capital leases                                 -           195        2,004
   Borrowings on line-of-credit                                                   500         2,000        1,350
   Payments on line-of-credit borrowings                                       (2,500)            -       (1,350)
   Proceeds on issuance of common stock, net                                      517           213          173
                                                                              -------       -------      -------
               Net cash provided by (used in) financing activities             (3,178)        1,445        1,665

EFFECT OF EXCHANGE RATE ON FOREIGN CASH BALANCES                                  (30)          (20)         (35)
                                                                              -------       -------      -------
               Change in cash and cash equivalents                              4,315          (177)      (1,123)

CASH AND CASH EQUIVALENTS:
   Beginning of year                                                            5,758         5,935        7,058
                                                                              -------       -------      -------
   End of year                                                                $10,073        $5,758      $ 5,935
                                                                              -------       -------      -------
                                                                              -------       -------      -------
SUPPLEMENTAL CASH FLOW INFORMATION:
   Cash paid during each period for-
      Interest                                                                   $720        $  566      $   338
      Income taxes                                                                $27        $  149      $   140
    Noncash investing and financing activity
      Capital leases                                                             $527        $  698      $   961
                                                                              -------       -------      -------
                                                                              -------       -------      -------

</TABLE>

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

                                       24

<PAGE>

                    FOURTH SHIFT CORPORATION AND SUBSIDIARIES

                   Notes to Consolidated Financial Statements

                           December 31, 1998 and 1997

1.   NATURE OF BUSINESS AND COMPANY OPERATIONS:

Fourth Shift Corporation (a Minnesota corporation) and its subsidiaries 
(collectively referred to as the Company) engage principally in the 
development, marketing, licensing and support of integrated client/server 
application software used for industrial planning and management processes, 
primarily for use in the manufacturing industry. The Company's principal 
product, the Fourth Shift Manufacturing Software System for OBJECTS (MSS), is 
a family of integrated manufacturing and financial management applications 
for intermediate-sized sites of manufacturing and distribution enterprises. 
The MSS system operates in a Windows NT open computing environment.

The Fourth Shift JIT Enterprise System (JIT Enterprise System), which was 
offered through Just In Time Enterprise Systems, Inc. (JIT), a subsidiary of 
the Company, is an information management system for industrial companies 
involved in aerospace, defense and contract manufacturing which operates in 
the UNIX/Oracle environment. Effective December 31, 1995, the Company sold 
the common stock of JIT (see Note 3.). The gain on the sale of JIT has been 
presented as discontinued operations in the accompanying consolidated 
financial statements. Accordingly, the disclosures presented herein relate to 
the continuing operations of the Company, unless otherwise noted.

Although the Company had a working capital deficit at December 31, 1998, the 
Company believes that cash on hand, cash generated from operations and cash 
available under the Company's credit facility will be adequate to fund the 
Company's operations through 1999.

The consolidated financial statements include the accounts of Fourth Shift 
Corporation (Fourth Shift) and all of its subsidiaries. All significant 
intercompany balances and transactions have been eliminated in consolidation.

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

REVENUE RECOGNITION

Software license revenues derived from software license fees with standard 
acceptance periods are recognized upon shipment of software if there are no 
significant post delivery obligations and collectibility is reasonably 
assured. Insignificant contractual obligations are accrued at the time of 
revenue recognition. For fixed-fee software arrangements, the Company 
recognizes revenue on payments due within one year once all significant 
obligations have been met and defers the portion of the total fee which is 
attributable to insignificant undelivered services or products and recognizes 
this revenue as the associated services or products are delivered.

Service revenue includes customer support fees, training, consulting, 
installation and project management. Revenue from customer support agreements 
for maintaining, supporting and providing periodic upgrades is recognized 
ratably over the maintenance period, which in most cases is one year. Revenue 
is recognized for other services at the time the service is performed.

Third-party software and other revenue is derived from the resale of 
third-party licenses and hardware. Revenue is recognized upon delivery of the 
product.

SOFTWARE DEVELOPMENT COSTS

Capitalization of computer software development costs begins upon the 
establishment of technological feasibility, limited to the net realizable 
value of the software product, and ceases when the software product is 
available for general release to customers. Amortization is computed on each 
product based upon the greater of the amount 

                                       25

<PAGE>

computed on a units sold basis (ratio of gross product revenue to anticipated 
future gross revenue for that product) or straight-line basis over the 
remaining estimated economic life of the product. Costs of maintenance and 
customer support are to be charged to expense when related revenue is 
recognized or when those costs are incurred, whichever occurs first.

The Company capitalized $1,023,000 and $3,819,000 of development costs in 
1998 and 1997, respectively. These costs are amortized assuming a three-year 
economic life for the framework and modules. Amortization expense for 1998 
and 1997 totaled $625,000 and $720,000, respectively, and is included as a 
component of product development expense. In 1998, the Company also wrote off 
$458,000 of previously capitalized technology that was no longer aligned with 
the Company's current product strategy. This charge is included in product 
development expense. In connection with its 1997 restructuring (see Note 4), 
the Company wrote off $1,630,000 of previously capitalized costs relating to 
the OBJECTS products, net of accumulated amortization, to restructuring 
expense.

CASH EQUIVALENTS

The Company considers all highly liquid and short-term investments purchased 
with a maturity of three months or less to be cash equivalents. Short-term 
investments consist principally of government securities and mutual funds and 
are stated at cost, which approximates market.

ACCOUNTS RECEIVABLE

Accounts Receivable are stated net of allowances for uncollectible accounts. 
At December 31, 1998 and 1997, this allowance was $1,257,000 and $773,000 
respectively.

INVENTORIES

Inventories consist of third-party software held for resale, computer 
software media, instruction material and packaging, and are stated at the 
lower of first-in, first-out cost or market.

PREPAID EXPENSES

Prepaid expenses consist principally of prepaid rents and rental deposits, 
prepaid insurance premiums and deposits on capital leases.

FURNITURE, FIXTURES AND EQUIPMENT

Furniture, fixtures and equipment are recorded at cost and are depreciated 
principally under the straight-line method for financial and income tax 
reporting purposes over estimated useful lives that range from three to five 
years.

RESTRICTED CASH

Restricted cash consists of cash pledged to support certain facilities 
leases. These restrictions will decrease over time ending in 2006.

FOREIGN CURRENCY TRANSLATION

For the Company's foreign operations, assets and liabilities are translated 
at year-end exchange rates, and terms included in the consolidated statements 
of operations are translated at average exchange rates prevailing during the 
year. Translation adjustments are included in accumulated other comprehensive 
losses in the accompanying consolidated balance sheets.

OTHER COMPREHENSIVE INCOME

Effective January 1, 1998, the Company adopted Statement of Financial 
Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income," which 
established new rules for the reporting and presentation of comprehensive 
income and its components in a full set of financial statements. The 
Company's comprehensive income is comprised of net income and foreign 
currency translation adjustments. The adoption of SFAS No. 130 

                                       26

<PAGE>

had no impact on the Company's net income or total shareholders' equity. 
Prior to the adoption of SFAS 130, translation adjustments were reported 
separately in the statement of shareholders' equity. The comprehensive income 
amounts in the prior fiscal years' financial statements have been 
reclassified to conform to SFAS No. 130.

DEFERRED REVENUE

Deferred revenue primarily consists of customer support and other services 
for which cash has been received but services have not been provided. 
Services that must be provided relate to normal operations of the Company.

INCOME TAXES

The Company accounts for income taxes under the liability method of 
accounting. Deferred tax assets and liabilities are determined based on the 
difference between the financial statement and tax bases of assets and 
liabilities using currently enacted tax rates.

NET INCOME (LOSS) PER COMMON SHARE

Basic earnings per share was computed by dividing net income by the number of 
weighted average common shares outstanding during the year. Diluted earnings 
per share was computed similar to the computation of basic earnings per 
share, except that the denominator is increased for the assumed dilutive 
stock options and other dilutive securities (including nonvested restricted 
stock), using the treasury stock method.

Reconciliation of weighted average shares used in computing income (loss) per
share are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                                      1998       1997        1996
                                                                                      ----       ----        ----
<S>                                                                                  <C>         <C>        <C>
Weighted average common shares outstanding                                             9,956      9,738      9,567
Dilutive effect of stock options and other dilutive
    securities outstanding, using the treasury stock method                              183          -        298
                                                                                      ------      -----      -----
Shares used in computing diluted income (loss) per share                              10,139      9,738      9,865
                                                                                      ------      -----      -----
                                                                                      ------      -----      -----

</TABLE>

RECLASSIFICATIONS

Certain amounts previously reported in the 1997 financial statements have 
been reclassified to conform to the 1998 presentation. These 
reclassifications had no effect on previously reported net income or 
shareholders' equity.

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 period. 
The ultimate results could differ from those estimates.

3.   SALE OF JUST IN TIME ENTERPRISE SYSTEMS, INC.:

Effective December 31, 1995, the Company sold all of the capital stock of JIT 
to Interactive Group, Inc. (IGI). The Company deferred recognition of the 
gain associated with the note received from the sale and recognized the gain 
associated with this note, as well as the additional amounts receivable based 
on revenues generated from the JIT Enterprise System, as such amounts were 
collected or are deemed collectible.

Substantially all income taxes related to this transaction have been offset 
by operating losses previously generated by JIT. In addition, all previously 
generated net operating loss carryforwards related to JIT will continue to be 
available to offset future taxable income of the Company, subject to the 
limitations discussed in Note 7. The gain on the sale of JIT has been 
reported separately as discontinued operations in the accompanying 
consolidated financial statements.

                                       27

<PAGE>

4.   RESTRUCTURING CHARGES:

In the fourth quarter of 1997, the Company evaluated its structure and 
organization, primarily in the product development area. This resulted in a 
restructuring of the development operations and an associated change in 
product strategy. All North American development activities were combined 
into a single operation--previously the Company maintained two development 
groups. The restructuring charge totaled $2,566,000 and included $394,000 of 
severance costs for employees and contractors, $392,000 to provide for the 
cost to exit office space that was no longer needed as a result of the staff 
reductions and $150,000 of prepaid royalties relating to the OBJECTS product 
that had no future value. In addition, $1,630,000 of previously capitalized 
development costs were expensed as a result of the change in product strategy 
(See Note 2). As of December 31, 1998, approximately $40,000 of the total 
restructuring charge remains to be paid in cash.

5.   REVOLVING CREDIT FACILITY:

At December 31, 1998, the Company had a $5,000,000 line-of-credit agreement 
with the Company's principal bank. Actual borrowings were limited to a 
percentage of eligible accounts receivable, with a deduction for the amounts 
outstanding under the long-term equipment facility (See Note 6). Borrowings 
were collateralized by the Company's accounts receivable and all other assets 
of the Company and bear interest at prime plus 2%. The agreement expired on 
March 2, 1999. Maximum borrowings in 1998 under this facility were 
$2,500,000, with no outstanding borrowings at December 31, 1998.

In March 1999 the Company entered into a new line-of-credit agreement with a 
different bank. Borrowings under this agreement shall not exceed the lesser 
of $10,000,000 or a percentage of eligible accounts receivable. Borrowings 
are collateralized by accounts receivable and other assets of the Company and 
bear interest at the bank's base rate plus 1/2%. The agreement expires in 
March 2002.

6.   LONG-TERM OBLIGATIONS:

Long-term obligations consisted of the following at December 31 (in 
thousands):

<TABLE>
<CAPTION>
                                                             1998        1997
                                                           --------    --------
<S>                                                        <C>         <C>
Capital lease obligations, varying interest rates, 
  due in various monthly installments through 2001         $ 1,267     $ 1,335
Bank equipment financing                                       667       1,767
Less current portion                                        (1,099)     (1,803)
                                                           --------    --------
               Long-term obligations                       $   835     $ 1,299
                                                           --------    --------
                                                           --------    --------

</TABLE>

Future minimum payments under noncancelable capital leases, net of amounts 
representing interest are $599,000 in 1999, $435,000 in 2000, $204,000 in 
2001 and $29,000 in 2002.

In April 1996, the Company entered into a $1,500,000 long-term equipment 
facility with a bank to finance the purchase of capital equipment. The 
facility bears interest at 9.25% and is payable monthly. Principal payments 
are due in 36 equal monthly installments starting in May 1997 through April 
2000. This facility is governed by restrictive covenants that include 
maintenance of minimum net worth. Future minimum payments under this facility 
are $500,000 in 1999 and $167,000 in 2000. The carrying value of the 
Company's long-term obligations approximates fair value.

7.   INCOME TAXES:

At December 31, 1998, the Company had available net operating loss 
carryforwards of approximately $14,201,000 and tax credit carryforwards of 
approximately $2,012,000. These net operating losses and tax credit 
carryforwards will expire from 2001 to 2012.

                                       28

<PAGE>

The utilization of a portion of these net operating loss carryforwards may be 
subject to Internal Revenue Code section 382 if certain significant investors 
sell or purchase ownership interests. If an ownership change does occur, the 
Company's ability to utilize its tax net operating loss carryforwards to 
offset any future federal taxable income would be limited to a maximum amount 
in any one year.

The provision for income taxes is comprised of the following for the years 
ended December 31 (in thousands):

<TABLE>
<CAPTION>
                              1998      1997      1996
                             -----     -----     -----
<S>                          <C>       <C>       <C>
Current tax provision:
   Federal                   $ 121     $   -     $   -
   State                        83       105        43
   Foreign                     261       223       146
                             -----     -----     -----
                             $ 465     $ 328     $ 189
                             -----     -----     -----
                             -----     -----     -----

</TABLE>

The Company records deferred taxes for the difference between the financial 
reporting and income tax bases of certain assets and liabilities, computed in 
accordance with tax laws in effect currently. The principal differences which 
give rise to deferred taxes are as follows (in thousands):

<TABLE>
<CAPTION>
                                                            1998        1997
                                                          --------    --------
<S>                                                       <C>         <C>
Net operating loss and tax credit carryforwards           $ 7,409     $ 8,890
Accruals and reserves not currently deductible
    for tax purposes                                        1,571         887
Capitalized R&D costs                                      (1,227)     (1,304)
Other                                                         (97)       (159)
Less valuation allowance                                   (7,656)     (8,314)
                                                          --------    --------
Net deferred taxes                                        $     -     $     -
                                                          --------    --------
                                                          --------    --------

</TABLE>

The Company has provided a valuation allowance for the net deferred tax 
benefit resulting from net operating loss carryforwards and other differences 
between the reported book and tax bases of certain assets and liabilities, as 
the realizability of this net deferred tax benefit is not reasonably assured.

The Company's effective tax rate related to continuing operations differs 
from the statutory federal income tax rate of 34% as a result of state and 
foreign taxes.

                                       29

<PAGE>

8.   COMMITMENTS AND CONTINGENCIES:

OPERATING LEASES

The Company has operating leases for its corporate headquarters, additional 
office space and certain office equipment. The aggregate future minimum 
rental payments under these leases, net of amounts to be received related to 
the sublease of certain office space, are as follows (in thousands):

<TABLE>
<CAPTION>
Year                      Amount
----                    -----------
<S>                     <C>
1999                    $ 2,627
2000                      1,545
2001                      1,301
2002                      1,220
2003                      1,220
Thereafter                5,528
                        -------
                        $13,441
                        -------
                        -------

</TABLE>

Rent expense, including amounts paid under short-term arrangements, was 
approximately $2,423,000, $2,935,000 and $2,340,000, in 1998, 1997 and 1996, 
respectively.

SIGNIFICANT CONTRACTS

On July 1, 1998, the Company entered into a four-year $12,000,000 commitment 
with a third-party database supplier whose product is embedded in and 
distributed with the MSS product. The agreement also includes three 
three-year renewal options. Payments are made monthly. In 1998, the Company 
recognized $1,500,000 of expense under this agreement that is included in the 
cost of licenses.

LITIGATION

The Company is subject to litigation in the normal course of business. In the 
opinion of management, the resolution of these matters will not have a 
material adverse effect on the Company's consolidated results of operations 
or financial position.

9.   OPTIONS AND COMPENSATION PLANS:

STOCK OPTIONS

Under the terms of the Company's 1989 stock option plan (the 1989 Plan), 
options granted to employees expire no later than ten years after the date of 
grant, and the exercise price must be at least 100% of the fair market value 
of the shares at the date of grant. The 1989 Plan covers both incentive and 
nonqualified stock options and is limited to 200,000 total shares. Incentive 
stock options granted to employees, who immediately before such grant owned 
stock directly or indirectly representing more than 10% of the voting power 
of all classes of the stock of the Company, may not be exercisable more than 
five years after the date of grant and the exercise price per share must be 
at least 110% of the fair market value of the shares at the date of grant. 
Options vest over varying periods not to exceed five years. This plan is to 
remain in effect until October 17, 1999.

In June 1993, the Company's board of directors approved a new stock option 
plan (the 1993 Plan). The 1993 Plan covers both incentive and nonqualified 
stock options and is limited to 2,250,000 shares. The 1993 Plan terminates in 
June 2003.

                                       30

<PAGE>

Stock option plan activity is summarized as follows:

<TABLE>
<CAPTION>
                                                                                                   Option Price
                                                          1989 Plan    1993 Plan        Total        Per Share
                                                          ---------    ---------      ---------    ------------
<S>                                                       <C>          <C>            <C>          <C>
Option shares outstanding at December 31, 1995             165,138       916,057      1,081,195    $2.00-$8.25
      Options granted                                        4,000       210,000        214,000    $3.75-$7.625

      Options exercised                                    (77,375)       (3,250)       (80,625)   $2.00-$5.00

      Options forfeited                                       (400)      (77,000)       (77,400)   $2.00-$8.25
                                                          ---------    ---------      ---------    ------------
Option shares outstanding at December 31, 1996              91,363     1,045,807      1,137,170    $2.00-$8.25
      Options granted                                            -       383,000        383,000    $3.25-$5.50

      Options exercised                                    (84,063)      (14,375)       (98,438)   $2.00-$3.25

      Options forfeited                                     (3,300)     (211,691)      (214,991)   $2.00-$8.25
                                                          ---------    ---------      ---------    ------------
Option shares outstanding at December 31, 1997               4,000     1,202,741      1,206,741    $2.63-$8.25
      Options granted                                            -     1,132,900      1,132,900    $2.44-$4.06

      Options exercised                                          -       (46,125)       (46,125)   $2.63-$3.38

      Options forfeited                                          -      (492,866)      (492,866)   $2.56-$8.25
                                                          ---------    ---------      ---------    ------------
Option shares outstanding at December 31, 1998               4,000     1,796,650      1,800,650    $2.44-$8.25
                                                          ---------    ---------      ---------    ------------
                                                          ---------    ---------      ---------    ------------

</TABLE>

<TABLE>
<CAPTION>
                                                                 1998           1997             1996
                                                                -------        -------          -------
<S>                                                             <C>            <C>              <C>
Options exercisable at year-end                                 409,148        524,586          379,172
Weighted average price of options exercisable at year-end         $5.07          $5.31            $4.79
Weighted average fair market value of options granted             $2.67          $3.96            $4.03

</TABLE>

The Company accounts for these stock option plans under APB Opinion No. 25, 
under which no compensation cost has been recognized. Had compensation cost 
for these plans been determined consistent with FASB Statement No. 123, the 
Company's net income (loss) and earnings (loss) per share would have been as 
follows:

<TABLE>
<CAPTION>
                                                                      1998             1997             1996
                                                                      ----             ----             ----
<S>                                                                 <C>              <C>              <C>
Net income (loss):                               As reported        $ 2,524          $ (3,790)        $ 1,770

                                                 Pro forma          $ 1,408          $ (4,917)        $   984

Basic income (loss) per common share:            As reported        $   .25          $   (.39)        $   .19

                                                 Pro forma          $   .14          $   (.50)        $   .10

Diluted income (loss) per common share:          As reported        $   .25          $   (.39)        $   .18

                                                 Pro forma          $   .14          $   (.50)        $   .10

</TABLE>

The fair value of each option grant is estimated on the date of grant using 
the Black-Scholes option pricing model with the following assumptions: 
risk-free interest rate of 5.0% and expected life of 7.7 years for 1998, 
1997, and 1996; expected annualized volatility of .99, 1.03, and .85 for 
1998, 1997 and 1996, respectively.

                                       31
<PAGE>

OTHER EMPLOYEE COMPENSATION PLANS

The Company has a 401(k) plan that covers substantially all domestic 
employees over 21 years of age with at least six months of continuous 
service. The Company may make discretionary matching contributions to the 
plan based upon employee contributions. The Company made matching 
contributions to this plan of approximately $363,000 in 1998, none in 1997 
and $353,000 1996.

The Company has an employee stock purchase plan (the Stock Purchase Plan). 
Under the Stock Purchase Plan, participating full-time employees and 
directors of the Company are able to purchase shares of the Company's common 
stock at 85% of market value, as defined. A total of up to 900,000 shares of 
the Company's common stock has been reserved under the Stock Purchase Plan. 
In 1996, the Company issued 150,000, shares of which 100,000 were purchased 
in 1995 and 50,000 through June of 1996. In 1997, the Company issued 125,000 
shares, of which 50,000 were purchased in 1996 and 75,000 through June of 
1997. In 1998, the Company issued 147,000 shares, of which 72,000 were 
purchased in 1997 and 75,000 were purchased through June 1998. The fair value 
of shares purchased was $423,000 in 1998, $644,000 in 1997 and $706,000 in 
1996.

BOARD OF DIRECTORS' COMPENSATION PLAN

The board of directors has approved a compensation plan whereby certain 
directors may receive cash compensation for each directors' meeting attended 
or, in lieu of cash payment, shares of common stock through the Company's 
Stock Purchase Plan. The number of shares issued in lieu of cash fees is 
adjusted to reflect the fair market value of the common stock in accordance 
with the Company's Stock Purchase Plan. Total shares of approximately 18,000, 
26,000 and 14,000 were issued under this plan in 1998, 1997 and 1996, 
respectively. The expenses recognized in connection with shares issued to 
nonemployee directors was approximately $53,000, $78,000 and $55,000, in 
1998, 1997 and 1996, respectively. In addition, nonemployee directors are 
entitled to receive options to purchase shares of the Company's common stock 
under this plan.

10.  SHAREHOLDERS' EQUITY:

SHAREHOLDER RIGHTS PLAN

In December 1998, the Company adopted a new Shareholder Rights Plan (Rights 
Plan). Under the Rights Plan, a dividend of one preferred share purchase 
right (a Right) per share for each outstanding share of common stock was 
granted to shareholders of record. The Rights issued under the plan will 
become exercisable by shareholders other than a potential acquiror only 
following an acquisition by the acquiror without prior approval by the 
Company's board of directors, of 20% or more of the common stock, or the 
announcement of a tender offer for 20% or more of common stock. The rights 
will expire in December 2008.

RESTRICTED STOCK

In October 1998, the Company issued 180,000 shares of restricted stock and 
540,000 options under the terms of the 1993 Plan to certain employees. The 
restricted stock vests five years from the date of grant and is subject to 
forfeiture upon termination of employment. The options vest in lump sum eight 
years and expire ten years from the date of grant and have an exercise price 
equal to the fair market value on the date of grant. The vesting of both the 
restricted stock and the options are accelerated if certain Company 
performance criteria are met in any of the three calendar years in the period 
ended December 31, 2001. In 1998, the Company recognized compensation expense 
of $21,000 related to the restricted stock. The remaining deferred 
compensation of $417,000 will be recognized over the remainder of the 
five-year service period.

11.  SEGMENT REPORTING:

The Company adopted SFAS No. 131, "Disclosures about Segments of an 
Enterprise and Related Information," in the fourth quarter of 1998. SFAS No. 
131 established standards for disclosure of financial information related to 
operating segments of the Company as well as disclosure requirements for 
customer and geographic information. SFAS No. 131 defines an operating 
segment as a component of a company for which operating results are reviewed 
regularly by the chief operating decision-maker to determine resource 
allocation and assess performance. The 

                                       32
<PAGE>

Company has three operating segments under the guidelines of SFAS No. 131: 
North America, Asia and Europe. Each operating segment derives its revenues 
from licensing its proprietary software system, providing customer support, 
training, consulting and installation services related to its software, and 
through the resale of complementary third-party software licenses and 
hardware.

The accounting policies of the segments are the same as those described in 
the summary of significant accounting policies (see Note 1). Financial 
information by geographical segment is as follows (in thousands):

<TABLE>
<CAPTION>
                                        North 
                                       America       Europe        Asia       Eliminations     Consolidated
                                       -------      --------     --------     ------------     ------------
<S>                                    <C>          <C>          <C>          <C>              <C>
1998:
   Revenue                             $49,635      $11,657      $ 6,912        $     -          $ 68,204
   Depreciation and amortization         2,356          390          419              -             3,165
   Interest income (expense) (1)          (538)          50            -              -              (488)
   Income tax expense                      204          278          (17)             -               465
   Net income (loss)                     2,841          112         (429)             -             2,524
   Segment assets                       28,340        4,841        3,001         (2,781)           33,401
   Capital expenditures                    553          458           83              -             1,094
1997:
   Revenue                             $37,050      $ 8,175      $ 7,093        $     -          $ 52,318
   Depreciation and amortization         2,564          375          400              -             3,339
   Interest income (expense) (1)          (427)          30            -              -              (397)
   Income tax expense                      105           91          132              -               328
   Net income (loss)                    (1,857)        (542)      (1,391)             -            (3,790)
   Segment assets                       26,511        4,168        3,531         (2,781)           31,429
   Capital expenditures                    542          355          303              -             1,200
1996:
   Revenue                             $33,588      $ 6,936      $ 8,786        $     -          $ 49,310
   Depreciation and amortization         1,433          337          295              -             2,065
   Interest income (expense) (1)           (54)          18            -              -               (36)
   Income tax expense                       42          147            -              -               189
   Net income (loss)                     1,029           93          648              -             1,770
   Segment assets                       24,788        4,678        6,236         (4,530)           31,172
   Capital expenditures                  2,177        1,263          722              -             4,162

</TABLE>

(1)  In the consolidated statements of operations, interest income (expense)
     is reported net of other income (expense) of $(57,000), $(35,000), and
     $0 in 1998, 1997 and 1996, respectively.

                                       33

<PAGE>

The Company had no customers from whom it generated 10% or more of 
consolidated revenues. The only country that the Company generated revenues 
exceeding 10% of consolidated revenues was the United States. Following is 
information regarding operations in the United States (in thousands):

<TABLE>
<CAPTION>
                                           1998                         1997                         1996
                                           ----                         ----                         ----
                                               Long-lived                   Long-lived                    Long-lived
                                  Revenue        Assets        Revenue        Assets         Revenue        Assets
                                  -------      ----------      -------      -----------      -------      ----------
<S>                               <C>          <C>             <C>          <C>              <C>          <C>
   United States                  $47,638         $5,823       $35,688         $6,576        $32,458        $3,902
</TABLE>

                                       34

<PAGE>

12.  QUARTERLY FINANCIAL DATA (UNAUDITED):

The following is a condensed summary of actual quarterly results of operations 
for 1998 and 1997 (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                                                1998
                                                      --------------------------------------------------------
                                                       First     Second (1)     Third      Fourth       Total
                                                      -------    ---------     -------     -------     -------
<S>                                                   <C>        <C>           <C>         <C>         <C>
Revenue                                               $14,430     $17,328      $17,278     $19,168     $68,204
Operating profit (loss)                                   (96)        671        1,018       1,660       3,253
Income (loss) from continuing operations                 (311)        323          657       1,574       2,243
Results of discontinued operations                         68          88           50          75         281
                                                      -------     -------      -------     -------     -------
Net income (loss)                                     $  (243)    $   411      $   707     $ 1,649     $ 2,524
                                                      -------     -------      -------     -------     -------
                                                      -------     -------      -------     -------     -------
Basic income (loss) per common share:
  Continuing operations                               $  (.03)    $   .03      $   .06     $   .15     $   .22
  Discontinued operations                                 .01         .01          .01         .01         .03
                                                      -------     -------      -------     -------     -------
  Basic income (loss) per common share                $  (.02)    $   .04      $   .07     $   .16     $   .25
                                                      -------     -------      -------     -------     -------
                                                      -------     -------      -------     -------     -------
Diluted income (loss) per common share:
  Continuing operations                               $  (.03)    $   .03      $   .06     $   .15     $   .22
  Discontinued operations                                 .01         .01          .01         .01         .03
                                                      -------     -------      -------     -------     -------
  Diluted income (loss) per common share              $  (.02)    $   .04      $   .07     $   .16     $   .25
                                                      -------     -------      -------     -------     -------
                                                      -------     -------      -------     -------     -------

<CAPTION>
                                                                                 1997
                                                      --------------------------------------------------------
                                                       First      Second        Third      Fourth       Total
                                                      -------    --------     -------     -------     -------
<S>                                                   <C>        <C>           <C>         <C>         <C>
Revenue                                               $10,805     $12,876      $13,433     $15,204     $52,318
Operating profit (loss)                                (1,450)        (61)        (219)     (3,611)     (5,341)
Income (loss) from continuing operations               (1,496)       (145)        (394)     (4,066)     (6,101)
Results of discontinued operations                        201         205        1,255         650       2,311
                                                      -------     -------      -------     -------     -------
Net income (loss)                                     $(1,295)    $    60      $   861     $(3,416)    $(3,790)
                                                      -------     -------      -------     -------     -------
                                                      -------     -------      -------     -------     -------
Basic income (loss) per common share:                           
  Continuing operations                               $  (.15)    $  (.01)     $  (.04)    $  (.43)    $  (.63)
  Discontinued operations                                 .02         .02          .13         .07         .24
                                                      -------     -------      -------     -------     -------
  Basic income (loss) per common share                $  (.13)    $   .01      $   .09     $  (.36)    $  (.39)
                                                      -------     -------      -------     -------     -------
                                                      -------     -------      -------     -------     -------
Diluted income (loss) per common share:                         
  Continuing operations                               $  (.15)    $  (.01)     $  (.04)    $  (.43)    $  (.63)
  Discontinued operations                                 .02         .02          .13         .07         .24
                                                      -------     -------      -------     -------     -------
  Diluted income (loss) per common share              $  (.13)    $   .01      $   .09     $  (.36)    $  (.39)
                                                      -------     -------      -------     -------     -------
                                                      -------     -------      -------     -------     -------

</TABLE>

(1)  Reflects reclassifications from amounts reported in the Company's report 
on Form 10-Q. These reclassifications have no effect on previously reported net
income (loss).

                                       35

<PAGE>

                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To Fourth Shift Corporation:

We have audited the accompanying consolidated balance sheets of Fourth Shift 
Corporation (a Minnesota corporation) and Subsidiaries as of December 31, 
1998 and 1997, and the related consolidated statements of operations, 
shareholders' equity and cash flows for each of the three years in the period 
ended December 31, 1998. These financial statements are the responsibility of 
the Company's management. Our responsibility is to express an opinion on 
these financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in 
all material respects, the financial position of Fourth Shift Corporation and 
Subsidiaries as of December 31, 1998 and 1997, and the results of their 
operations and their cash flows for each of the three years in the period 
ended December 31, 1998, in conformity with generally accepted accounting 
principles.


                                       /s/  ARTHUR ANDERSEN LLP


Minneapolis, Minnesota,
   January 15, 1999

                                       36

<PAGE>


ITEM 9.  CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND 
FINANCIAL DISCLOSURE

Not applicable.

                                       37

<PAGE>

                                   PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by Item 10 with respect to executive officers is 
included under a separate caption entitled "Executive Officers" in Part I of 
the Form 10-K. The information with respect to directors is incorporated by 
reference to the information under the caption "Election of 
Directors-Nominees" of the Company's definitive proxy statement for its 
May 4, 1999 Annual Meeting of Shareholders.

ITEM 11.  EXECUTIVE COMPENSATION

The information required by Item 11 is incorporated by reference to the 
information under the captions "Election of Directors-Director Compensation," 
"Executive Compensation - Summary Compensation Table," "Executive 
Compensation -Stock Options," and "Executive Compensation - Long-Term 
Incentive Plan Awards" of the Company's definitive proxy statement for its 
May 4, 1999 Annual Meeting of Shareholders.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by Item 12 is incorporated by reference to the 
information under caption "Security Ownership of Certain Beneficial Owners 
and Management" of the Company's definitive proxy statement for its May 4, 
1999 Annual Meeting of Shareholders.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by Item 13 is incorporated by reference to the 
information under the caption "Election of Directors-Director Compensation" 
of the Company's definitive proxy statement for its May 4, 1999 Annual 
Meeting of Shareholders.

                                       38

<PAGE>

                                     PART IV

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

a.   Financial Statements

     1.  See the Financial Statement information contained in Item 8 of 
         this Form 10-K
     2.  Financial Statement Schedules

              No Financial Statement Schedules are required

b.   Reports on Form 8-K:

     The Company filed a current report on Form 8-K on December 17, 1998 
     reporting the adoption of a shareholder rights plan and a dividend of 
     one right for each share outstanding.

c.   Exhibits

<TABLE>
<CAPTION>

Exhibit No.     Description
-----------     -----------
<S>           <C>
     3.1      Restated Articles of Incorporation of the Company, as amended
              (incorporated by reference to Exhibit 4.1 of the Company's
              10-Q for the quarter ended March 31, 1994).

     3.2     Bylaws of the Company, as amended (incorporated by reference to
             Exhibit 3.2 to the Company's annual report on Form 10-Q for the
             quarter ended September 30, 1998).

     4.1     Form of Certificate for Common Stock (incorporated by reference
             to Exhibit 4.1 of Amendment No. 1 to the Company's Registration
             Statement on Form S-1 filed June 28, 1993 (File No. 33-63012)).

     4.2     Shareholder Rights Plan dated as of December 16, 1998
             (incorporated by reference to Exhibit 4 to the Company's
             Current Report on Form 8-K filed December 17, 1998).

    10.1     1989 Stock Option Plan (incorporated by reference to Exhibit
             10.4 of the Company's Registration Statement of Form S-1 filed
             May 19, 1993 (File No. 33-63012)).

    10.2     Fourth Shift Corporation 1994 Employee Stock Purchase Plan, as
             amended (incorporated by reference to Exhibit 10.5 to the
             Company's 10-K for the year ended December 31, 1994).

    10.3     Fourth Shift Corporation 1993 Stock Incentive Plan, as amended
             (incorporated by reference to Exhibit 10.6 to the Company's
             10-K for the year ended December 31, 1994).

   *10.4     Severance Pay Agreement dated October 21, 1997 between the
             Company and Marion Melvin Stuckey (incorporated by reference to
             Exhibit 10.8 to the Company's Form 10-K for the year ended
             December 31, 1997).

   *10.5     Severance Pay Agreement dated October 21, 1997 between the
             Company and Jimmie H. Caldwell (incorporated by reference to
             Exhibit 10.9 to the Company's Form 10-K for the year ended
             December 31, 1997).

</TABLE>

                                       39

<PAGE>

<TABLE>
<S>           <C>

   *10.6     Severance Pay Agreement dated October 21, 1997 between the
             Company and David Latzke (incorporated by reference to Exhibit
             10.10 to the Company's Form 10-K for the year ended 
             December 31, 1997).

    10.7     Loan and Security Agreement dated March 2, 1998 as amended
             between Fourth Shift Corporation and Silicon Valley Bank
             (incorporated by reference to Exhibit 10.15 to the Company's
             Form 10-K for the year ended December 31, 1997).

    10.8     Agreement dated July 1, 1998 between the Company and Micro Data
             Base Systems, Inc. (incorporated by reference to Exhibit 10.1
             to the Company's quarterly report on Form 10-Q for the quarter
             ended September 30, 1998).

    10.9     Restated and Amended Office Lease dated May 1, 1998 between Fourth
             Shift Corporation and Meridian Crossings LLC.

    23.1     Consent of Arthur Andersen LLP.

    27.0     Financial Data Schedule (For SEC use only).

</TABLE>

------------------
* Management contract or compensatory plan.


                                       40

<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 on March 30, 1999.


                                       Fourth Shift Corporation

                                       By: /s/ MARION MELVIN STUCKEY
                                          ---------------------------
                                       Marion Melvin Stuckey
                                       Chairman and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this 
report has been signed below by the following persons on behalf of the 
registrant and in the capacities indicated.

<TABLE>
<CAPTION>
            Name                           Position                                    Date
            ----                           --------                                    ----
<S>                               <C>                                                <C>

/s/ MARION MELVIN STUCKEY         Chairman, Chief Executive Officer,                 March 30, 1999
-----------------------------     (principal executive officer) and Director
Marion Melvin Stuckey    


/s/ JIMMIE H. CALDWELL            President, Chief Operating Officer and             March 30, 1999
-----------------------------     Director
Jimmie H. Caldwell                


/s/ DAVID G. LATZKE               Vice President and Chief Financial                 March 30, 1999
-----------------------------     Officer, Treasurer and Secretary
David G. Latzke                   (principal financial officer)


/s/ CRAIG A. THOMPSON             Controller                                         March 30, 1999
-----------------------------     (principal accounting officer)
Craig A. Thompson                 


/s/ MICHAEL J. ADAMS              Director                                           March 30, 1999
-----------------------------     
Michael J. Adams


/s/ TONY J. CHRISTIANSON          Director                                           March 30, 1999
-----------------------------     
Tony J. Christianson


/s/ STEVE J. LAIR                 Director                                           March 30, 1999
-----------------------------     
Steve J. Lair


/s/ ROBERT M. PRICE               Director                                           March 30, 1999
-----------------------------     
Robert M. Price


/s/ MARK W. SHEFFERT              Director                                           March 30, 1999
-----------------------------     
Mark W. Sheffert

</TABLE>

                                       41