<PAGE>

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

                                   FORM 10-K

  X   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
 ---  EXCHANGE ACT OF 1934

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996

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

                  FOR THE TRANSITION PERIOD FROM ____ TO ____

                        Commission file number:  0-25578

                            SOFTWARE ARTISTRY, INC.
             (Exact name of registrant as specified in its charter)

                   INDIANA                              35-1731589
(State or other jurisdiction of organization)        (I.R.S. Employer
                                                   Identification Number)

9449 PRIORITY WAY WEST DRIVE, INDIANAPOLIS, IN              46240
  (Address of principal executive offices)                (Zip Code)

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (317) 843-1663

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

          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: 
                           COMMON STOCK, NO PAR VALUE
                                (Title of class)


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

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

The aggregate market value of the voting stock held by non-affiliates of the
Registrant, based on the closing sale price of the Common Stock on March 11,
1997, as reported on the NASDAQ National Market System was $27,146,304.  Shares
of Common Stock held by each executive officer and director and by each person
who is known to own 5% or more of the outstanding Common Stock have been
excluded from this computation in that such persons may be deemed to be
affiliates. This determination of affiliate status is not a conclusive
determination for other purposes.  As of March 11, 1997, the Registrant had
7,041,451 shares of Common Stock outstanding.

                      DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's Proxy Statement for its 1997 Annual Meeting of
Shareholders are incorporated by reference in Part III hereof.

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                                     PART I

ITEM 1.  BUSINESS

GENERAL

    Software Artistry, Inc. (the "Company" or "Software Artistry") was formed 
and incorporated in Indiana in 1988. Software Artistry develops, markets, and 
supports two suites of internal and external customer support software 
applications. In 1996, the Company expanded the number of applications it 
markets and introduced the SA-EXPERTISE-TM- suite designation for its 
Customer Relationship Management products for external customer support, 
which is expected to be released in late first quarter/early second quarter 
of 1997.  In addition, the SA-EXPERTISE-TM- suite for Enterprise Support 
Management provides organizations with an integrated solution for internal 
support for employees and end users. Both EXPERTISE suites are designed to 
increase operational efficiency and enhance customer satisfaction through 
improved problem management and problem resolution capabilities.

BACKGROUND

    Over the past year the internal and external customer support markets have
continued to mature as more organizations realize the importance of providing
assistance to employees having problems with technology and/or providing
automation tools to their external customer support organizations.

    The shift from mainframe-based applications to client/server computing 
continues to drive the demand for support of internal customers (i.e., 
employees and others working within the enterprise).  While this shift has 
delivered better performance and functionality as promised, the immaturity of 
systems management tools has yielded an even greater support burden than 
anticipated, leading to increasing demands on support centers. At the same 
time, increased market competition is causing companies to focus on 
differentiating themselves from their competitors by providing faster and 
more effective responses to customer needs. Providing high-quality external 
customer support is seen as a key competitive advantage.

   The Company believes that the internal and external support markets are 
being further defined as separate and distinct markets. The core applications 
for call and problem management and resolution in both markets are very 
similar; however, unique related applications have emerged to define vastly 
different product "suites" for each market. For example, the typical external 
customer support suite is characterized by additional products for service 
dispatch, contract management, and sales and marketing management.  The 
internal support (often referred to as help desk) suite continues to develop, 
with products for asset and change management along with integration with 
popular network and systems management tools.  One trend that is common to 
both markets is end-user empowerment tools, which allow users (customers or 
employees) to directly submit problems, inquire on their status, and even 
resolve problems without a customer support analyst interaction.

THE SOFTWARE ARTISTRY SOLUTION

    Software Artistry applications help companies increase customer 
satisfaction, reduce time to problem resolution, allow end users to solve 
problems without interfacing directly with the help desk, allow for strategic 
management of corporate assets, and facilitate changes that occur in an 
organization's environment.

    Software Artistry is maintaining a leader position in the market for the 
strategic internal help desk. The Company's flagship product SA-EXPERT 
ADVISOR-TM-, for call and problem management and resolution, provides the 
foundation for this leadership position. SA-EXPERT ADVISOR-TM- provides its 
users both internal information technology help desk analysts and external 
customer support analysts -- with a number of  techniques to diagnose customer 
problems and quickly provide solutions.  In 1996, Software Artistry released 
several revisions of related internal support products that, together, form an 
integrated suite of software applications that go beyond basic call and problem 
management and focus on the expanded issue of ENTERPRISE SUPPORT MANAGEMENT.

                                       1 
<PAGE>

    Enterprise Support Management is a natural evolution of an organization's 
desire to move from reactive support management to proactive support 
management. Initially, help desk systems were used to capture, transfer, and 
escalate problems and, in the case of Software Artistry customers, to provide 
problem resolution technology. As help desk call volumes have continued to 
increase, organizations are now looking for ways to effectively handle and/or 
reduce their call volume.  Software Artistry has responded to this challenge 
by developing END-USER EMPOWERMENT tools which allow help desks to offer 
their end users direct access to corporate knowledge.

    Software Artistry has been a leader in this area by enabling an 
organization to use its installed electronic mail system (for example, Lotus 
cc:Mail or Microsoft Mail) as a vehicle for the forward deployment of 
information. SA-EXPERT MAIL AGENT-TM- enables end users to submit problems to 
the help desk, check the status of an existing problem, or even resolve 
problems themselves. 

    In addition, the Company markets a gateway product -- SA-EXPERTVIEW-TM- --
which allows the help desk to tie into market-leading network management 
platforms such as HP OpenView-TM- and IBM NetView-TM-. This tool keeps all 
support analysts informed of network failures and automatically notifies 
these analysts that certain corporate locations may be affected by specific 
network events.

    Software Artistry is also building on its successful introduction in 1995 
of asset management (SA-EXPERT FOUNDATION MANAGER-TM-) and change management 
(SA-EXPERT EVOLUTION-TM-) applications to its portfolio of products for 
Enterprise Support Management. Expert Foundation Manager provides a vital 
link in helping the enterprise track assets from initial purchase to eventual 
disposition. Assets are tracked based on the location, owner, and 
characteristics. This informs support analysts of the exact hardware and 
software being used by any end user reporting a problem. Expert Evolution 
allows an enterprise to more easily put an efficient process in place with 
approval and review cycles to manage changes to the information technology 
infrastructure. In addition, Expert Evolution provides the ability to assess 
the impact of a change before it is implemented.

    Software Artistry has an installed base of over 425 corporate customers 
worldwide in a wide range of industries. Customers include over 33% of the 
1996 Fortune 100 companies. No single customer or distributor accounted for 
more than 10% of the Company's revenues in 1996.  International revenues were 
17% of total revenues in 1996 (see Geographic Operations information in Notes 
to Consolidated Financial Statements section of  Item 8).

STRATEGY

    Software Artistry is committed to maintaining its leadership position in the
Enterprise Support Management market by enhancing current products, continuing
to add new products and services, integrating with related products, and
building additional product and services partnerships.

    The Company has been able to meet the needs of certain external customer 
support customers due to the strong problem resolution capabilities of Expert 
Advisor. At the same time, the Company is developing product and service 
offerings specifically designed for the external customer support market -- the 
SA-EXPERTISE suite for Customer Relationship Management. 

    The underlying strategies the Company is using to meet these objectives 
include:

PARTNERSHIPS WITH KEY VENDORS

    The Company is actively pursuing relationships with product providers to 
proactively create interfaces with the Company's products, as well as with 
service providers, to provide business process reengineering, product 
implementation, and customization.


                                       3

<PAGE>


OPEN PRODUCT ARCHITECTURE

    The Company is evolving the product suite to an open architecture with 
well defined application programming interfaces (APIs) to allow:

    -  Addition of functionality without code modification.
    -  Ease of integration with other proprietary or packaged software.
    -  Rapid adoption of new technology as justified by market and/or customer
       needs.

EXPAND WORLDWIDE PRESENCE

    The Company has a strong direct sales channel in North America augmented 
by a growing list of key partners that provide the comprehensive set of 
products and services demanded by this market. The Company is moving into its 
third full year of sales in Europe through a combination of a direct sales 
force in the U.K. and France and distributors in the other key countries. The 
Company's expansion into the Asia/Pacific region continued during 1996 after 
the opening in late 1995 of a regional headquarters in Singapore and the 
establishment of a direct sales organization in Australia. The Company is 
expanding in this region in 1997 by adding additional distributor 
relationships, the first one in Hong Kong. The Company also currently has 
plans to begin sales operations in Latin America during 1997.

PROVIDE SUPERIOR SERVICES AND SUPPORT EXCELLENCE

    The Company believes that providing superior support and services 
(implementation, consulting, and educational)  enhances its market leadership 
position. The Company also believes that there is demand for additional 
services surrounding the planning for, implementation of, and utilization of 
its products. Consequently, the Company plans to more aggressively grow its 
capabilities to address select opportunities to support in these areas.

    Just as the Company's products are designed to enable its customers to 
provide SUPPORT EXCELLENCE, the Company uses its own products to provide the 
same level of quality service to its customers. For example, the Company is 
using SA-EXPERT ADVISOR-TM- in its Customer Support Center.  The Company is 
also using its defect and enhancement tracking software, SA-EXPERT 
QUALITY-TM-, for improved response to issues where resolution falls outside 
of the support center. In 1996, the Company also made e-mail support 
available over the Internet for problem submittal, status checking, and 
problem resolution.

PRODUCTS

    Software Artistry seeks to offer extensive, integrated product suites 
that provide complete support resolution appropriate for managing an 
organization's internal information technology resources as well as an 
organization's external customer relationships. The Company's integrated 
application suite for Enterprise Support Management (ESM) is marketed under 
the umbrella name SA-EXPERTISE for ESM and the suite for Customer 
Relationship Management (CRM) will be marketed under the name SA-EXPERTISE 
for CRM.

CURRENTLY AVAILABLE PRODUCTS

INTERACTION AND REQUEST MANAGEMENT FOR ESM

    SA-EXPERT ADVISOR (client/server version 3.5 released in 1996), the 
Company's flagship product, provides the core functions of interaction and 
request management. Embedded in this product is the ability to provide call 
tracking, transfer, and escalation along with extensive problem resolution 
through multiple diagnostic techniques. The unique aspects of Expert Advisor 
include separate consideration of calls and problems, a single solutions 
database, and a variety of diagnostic paradigms to address the matrix of 
varying analyst experience, varying complexities of problems, and the varying 
level of experience of the end users.


                                       4

<PAGE>

NETWORK AND SYSTEMS MANAGEMENT INTERFACE

    SA-EXPERTVIEW (version 1.0 released in 1996) provides an interface 
between the support center and network and systems management platforms. It 
gives the support analyst immediate visibility to failures on the network and 
relates them to the affected department or group. When the network failure is 
corrected, any "problem tickets" opened as a result of the failure will be 
automatically closed, and the affected group notified.

ASSET MANAGEMENT

    SA-EXPERT FOUNDATION MANAGER (version 2.0 released in 1996) provides 
"cradle to grave" management of corporate assets. It allows assets to be 
tracked by owner, location and type.   Assets can be categorized in any 
number ("n-level" hierarchies) of nested levels (e.g., Country, State, Site, 
Building, Department, Office). The asset database can be populated and 
updated through an interface to LAN discovery products such as Tally 
NetCensus-TM-.

    SA-EXPERT EVOLUTION (version 1.0 released in 1996) allows an enterprise 
to manage changes to the business environment and their effects on users. 
Changes can be defined along with the review and approval process required. 
Models for changes can be built to facilitate changes that occur often in an 
environment, and the affects of changes can be tested through impact analysis 
evaluations before actual implementation.

END-USER EMPOWERMENT

    SA-EXPERT MAIL AGENT (version 1.1 released in 1996) uses existing e-mail 
systems to provide end users with access to the solutions database for 
problem submission, status checking, and problem resolution.

    SA-EXPERT WEB (version 1.0 released in 1996) is designed to allow use of 
the Internet and the World Wide Web to provide end users with direct access 
to the support center for problem submission, status checking, and problem 
resolution using the entire set of diagnostics capabilities of Expert Advisor.

QUALITY AND PRODUCT CHANGE MANAGEMENT

    SA-EXPERT QUALITY (version 1.0 released in 1995) enables a customer 
support center to make better use of the suggestions it receives from 
customers for enhancements to its products and/or services. Expert Quality 
provides the framework for coordinating the product improvement and change 
process through the departments responsible for customer support, product 
development, and quality assurance. As such, it is part of the EXPERTISE 
suite for CRM, along with the soon-to-be-released SA-EXPERT SUPPORT-TM-.

PLANNED 1997 PRODUCT INTRODUCTION

INTERACTION AND REQUEST MANAGEMENT FOR CRM

    SA-EXPERT SUPPORT (expected release by late First Quarter/early Second 
Quarter, 1997) is designed to specifically address the needs of external 
customer service and support centers. It combines the industry-leading 
problem resolution capabilities of Expert Advisor with expanded interaction 
and request management capabilities to provide the adaptability required to 
handle the vast array of combinations involved with managing customers, 
products, and service level agreements.

SERVICES

    As a provider of customer support software, the Company recognizes the 
importance of offering quality service and support to its customers. The 
Company provides service and support through its Client Services department, 
which has three groups responsible for customer satisfaction:  Professional 
Services, Educational Services, and Support Services.


                                       5

<PAGE>

PROFESSIONAL SERVICES

    The Company's Professional Services group offers a wide range of custom 
services including: project management, data conversion, custom coding, 
systems integration, and host connectivity.  To further expedite their 
implementation projects, customers can also select from several pre-packaged 
plans providing such service options as computer/telephony integration, 
knowledge engineering, and specific product deployment packages.

EDUCATIONAL SERVICES

    The Company offers a comprehensive education and training program to 
customers on a fee basis.  The Company provides on-site training on the 
administration and use of its products. Additionally, customers can obtain a 
comprehensive training program on the customization of the applications. The 
Company also provides courses on advanced customization techniques, systems 
administration, knowledge engineering, and other topics (including customized 
courses).

SUPPORT SERVICES

    The Company relies on the use of its own products to provide superior 
service and support through its Customer Support Center. The Company provides 
a 24-hour hotline telephone support, staffed with a group of experienced 
professionals and supported by SA-EXPERT ADVISOR-TM- software. License fees 
include inbound telephone support, BBS support, e-mail support, and the 
monthly SUPPORT REPORT publication, all managed or produced within Support 
Services.

SALES AND MARKETING

    The Company markets and sells its software and services in North America 
primarily through a direct sales organization. To support its sales force, 
the Company conducts comprehensive marketing programs which include public 
relations, direct mail, advertising, telemarketing, seminars, trade shows, 
and ongoing customer communication programs. The sales cycle begins with the 
generation of a sales lead, or the receipt of a request for proposal ("RFP") 
from a prospect, which is followed by the qualification of the lead, an 
analysis of the customer's needs, response to an RFP (if solicited by the 
customer), one or more presentations/demonstrations to the prospective 
customer, contract negotiation, and commitment. While the sales cycle varies 
substantially from customer to customer, it typically requires six to nine 
months. The North American sales staff is based at the Company's corporate 
headquarters in Indianapolis and approximately 15 field sales offices.

    The Company markets its products outside North America through a 
combination of direct sales and distributors. The Company operates a European 
headquarters located in Windsor in the United Kingdom and an Asia/Pacific 
headquarters located in Singapore. The Company has established direct sales 
organizations in the United Kingdom, France, and Australia. As of December 
31, 1996, the Company had distributors or a direct sales organization in the 
following locations: Australia, Denmark, Germany, France, Italy, the 
Netherlands, Norway, Spain, Sweden, Singapore and United Kingdom. In addition 
to marketing and selling the Company's products, the distributors are 
required to provide local language translations for the software as well as 
educational and consulting services to customers.

    Software Artistry has established multiple partnerships, with hardware 
platform providers, software platform providers, technology partners, and 
service providers. Hardware platform providers consist primarily of the 
vendors of the computer hardware that run the Company's applications. These 
relationships are integral to managing the performance and compatibility of 
the Company's products with the platforms demanded by the Company's 
customers. 

    Software platform providers include database vendors and other software 
tool vendors that provide the systems software environment required to 
support the Company's applications. These relationships are critical to 
managing the installation, performance, and compatibility of the Company's 
applications.


                                       6

<PAGE>

     Technology partnerships allow the Company to provide integration between 
the Company's applications and related products such as systems and network 
management tools, telephony systems and pre-packaged knowledge. Relationships 
with service providers augment the Company's service capability to provide 
business reengineering, implementation planning and assistance, custom 
programming, and full systems integration. The overall purpose of these 
relationships is to help the Company provide a more comprehensive solution to 
its customers.

PRODUCT DEVELOPMENT

     The Company, through its development and support personnel, works 
closely with its customers and prospective customers to determine their 
requirements and to design enhancements and new products to meet their needs. 
The Company intends to continue to expand the functionality of Expert Advisor 
and all other EXPERTISE products. However, there can be no assurance that the 
development of these projects will be completed successfully or on time or 
that they will include the features required to achieve market acceptance. 
The Company has in the past experienced delays in software development and 
there can be no assurance that the Company will not experience delays in 
connection with its current development or future development activities.  
Delays or difficulties associated with introductions of new features, 
modules, and products, could have a material adverse effect on the Company's 
business or results of operations.

    During 1996, 1995, and 1994, the Company's product development expense, 
which is net of capitalized development costs, was $4,926,000, $2,890,000, 
and $1,675,000, or 15%, 11%, and 11% of total revenues, respectively.  In 
accordance with Statement of Financial Accounting Standards No. 86, the 
Company capitalizes certain development costs.  During fiscal, 1996, 1995, 
and 1994, the Company capitalized $845,000, $616,000, and $261,000, 
respectively, or 7%, 13%, and 6%, respectively, of total product development 
costs, net of amortization. 

     The market for the Company's applications is characterized by rapid 
technological advances, changes in customer requirements and frequent new 
product introductions and enhancements.  The Company's growth and future 
financial performance will depend in part upon its ability to enhance 
existing applications and to develop and introduce new applications that meet 
technological advances, respond to evolving customer requirements, respond to 
competitive products or announcements, and achieve market acceptance. There 
can be no assurance that the Company will be successful in developing and 
marketing new applications or enhancements to existing applications on a 
timely basis, or that its enhancements and new applications will adequately 
address the changing needs of the marketplace and achieve market acceptance. 
Any such failure could have a material adverse effect on the Company's 
business or results of operations. Furthermore, programs as complex as those 
offered by the Company may contain a number of undetected errors or bugs when 
they are first introduced or as new versions are released. There can be no 
assurance that, despite testing by the Company and by third-party test sites, 
errors will not be found in future applications or enhancements, with the 
possible result of delay in or loss of market acceptance and a material 
adverse effect on the Company's business or results of operations.

COMPETITION

     The market for customer support software and services is highly 
competitive. The Company has a large number of competitors which range from: 
(i) large information technology providers such as Computer Associates and 
IBM, which have substantially greater sales and marketing, product 
development, and financial resources than the Company; (ii) public and 
private companies generally with $100 million or less in 1996 annual sales 
(including Astea International, Inc., Clarify, Inc., Inference Corporation, 
McAfee Associates, Inc., Peregrine Systems, Inc., Remedy Corporation, Scopus 
Technology, Inc., and The Vantive Corporation) which, like the Company, are 
attempting to provide a strategic enterprise-wide customer support software 
and services solution; and (iii) a large number of small privately-held 
vendors of tactical products that may address one or more aspects of customer 
support.


                                      7

<PAGE>

     Both internal and external customer support markets appear to be 
stratifying into a cost-driven segment and a strategic business-driven 
segment. Both markets have also expanded from companies offering single 
products to companies offering a product suite to meet the enterprise 
requirements. This offering expansion is particularly visible in the 
strategic business-driven market. In the Company's view, these product suites 
can be thought of as a wheel with problem management serving as the hub and 
the spokes serving as integration to various additional products on the rim.

     In the Enterprise Support Management market, the key spokes lead to 
asset management, change management, network and systems management, and 
end-user empowerment. The Company believes it is in the unique position of 
currently being only one of a few vendors that can provide the entire 
Enterprise Support Management solution to customers through its own 
applications and integration with other applications. Most competitors in 
this market come from a position of strength in network and systems 
management. Astea and McAfee Associates, Inc. have recently acquired 
competing privately-held help desk vendors. McAfee has extensive experience 
and a number of products for the systems management arena. The major 
competitors in the external support market have also developed internal 
support versions of their problem resolution applications and have introduced 
interfaces to network management applications. In addition, Clarify has 
introduced a change tracking module to address the service request aspect of 
change management. 

     Competitors in the external support market also address the market from
different positions of strength. Vantive, Scopus, and Clarify, claim
comprehensive sets of applications to fill external support requirements.
Depending on the company, these sets of applications offer problem management
along with service management, service dispatch, depot repair, and data
replication products. In addition, there is a group of companies that has
focused principally on the sales force automation and service management
applications area and include customer support as part of their suite.

     The competitive factors affecting the market for the Company's software 
and services include: vendor and product reputation, availability of products 
on "popular" computer and communications platforms, scalability, integration 
with other enterprise applications, functionality and features, ease-of-use, 
product quality, performance, price, quality of support, documentation, and 
training. The relative importance of each of these factors depends upon the 
market segment. The Company believes that it competes effectively with 
respect to these factors but there can be no assurance that it will continue 
to do so.

PROPRIETARY RIGHTS AND LICENSES

     The Company relies on a combination of contract, copyright, trademark, 
trade secret laws, and other measures to protect its proprietary information. 
The Company does not have any patents, and existing copyright laws afford 
only limited protection. The Company believes that, because of the rapid pace 
of technological change in the computer software industry, trade secret and 
copyright protection are less significant in affecting the Company's business 
and results of operations than factors such as the knowledge, ability, and 
experience of the Company's employees, frequent product enhancements, and the 
timeliness and quality of support services.

     The Company typically provides its products to its customers under 
non-exclusive, perpetual licenses which generally are nontransferable. The 
Company generally licenses its products solely for the customer's internal 
operations. In certain circumstances, the Company makes available site and 
enterprise licenses. The Company makes source code available for certain of 
the Company's products, and often enters into source code escrow agreements 
for the balance of the source code. The provision of source code may increase 
the likelihood of misappropriation or other misuse of the Company's 
intellectual property.

     The Company is not aware that its products, trademarks, or other 
proprietary rights infringe the property rights of third parties. However, 
there can be no assurance that third parties will not assert infringement 
claims against the Company in the future with respect to current or future 
products or that any such assertion may not require the Company to enter into 
royalty arrangements or result in costly litigation. As the number of 
software products in the industry increases and the functionality of these 
products further overlap, the Company believes that software developers may 
become increasingly subject to infringement claims. Any such claims, with or 
without merit, can be time consuming and expensive to defend.


                                      8

<PAGE>

OTHER CONSIDERATIONS

     In addition to the other information set forth in this report, the 
following are certain risks that should be considered with regard to the 
Company and its Common Stock.

     Although the Company has experienced strong growth in recent periods, 
such growth rates may not be sustainable and may not be indicative of future 
operating results. The Company's continued growth will depend in part upon 
its ability to enhance existing applications and develop and introduce new 
applications that are technologically advanced, respond to evolving customer 
requirements, respond to competitive products or announcements, and achieve 
market acceptance of its products; none of which can be assured.

     The Company's quarterly operating results reflect distinct seasonality, 
with the fourth quarter historically having the highest total revenues and 
operating income. The Company believes that this pattern may repeat in the 
future. 

     The Company may experience significant fluctuations in operating results 
depending upon many factors, including, among others, the timing of new 
application announcements and releases by the Company and its competitors, 
budgeting cycles of its customers, demand for the Company's products, the 
size and timing of customer orders, changes in the proportion of revenues 
attributable to license fees versus renewal fees and services, changes in the 
level of operating expenses, and general economic conditions. As a result, 
the Company believes that period-to-period comparisons are not necessarily 
meaningful and should not be relied upon as an indication of future 
performance.

     The Company currently derives substantially all of its revenue from the 
SA-EXPERTISE-TM- suites of products and related services and expects this 
concentration to continue for the foreseeable future. As a result, any factor 
adversely affecting the demand for, or pricing of, the SA-EXPERTISE-TM- suites
of products and related services would have a material adverse effect on the 
Company's business and results of operations. The Company's future financial 
performance will depend significantly on the successful development and customer
acceptance of new and enhanced versions of the SA-EXPERTISE-TM- suites of 
products.

     In conjunction with the license of SA-EXPERTISE-TM- applications, the 
Company markets a proprietary application development environment, including 
its own fourth generation language, SA-SCRIPT.  In the event that the 
Company's proprietary application development environment does not keep pace 
with the technological changes required by its customers, there can be no 
assurance that the Company would be able to modify its proprietary 
application development environment or rewrite its applications, and the 
inability or delays in doing so could have a material adverse effect on the 
Company's business or results of operations.

     Because the Company provides its licensees with the source code to certain
Company-licensed applications, licensees have the ability to customize such
applications. However, there can be no assurance that all licensees will
appropriately isolate their customizations. As a result, the Company, while not
contractually obligated, may incur additional costs for services in excess of
those that would ordinarily be required, and customer satisfaction could
diminish substantially, resulting in a material adverse effect on the Company's
business or results of operations.

     The trading price of the Company's Common Stock could be subject to wide
fluctuations in response to quarterly differences in the Company's operating
results, announcements of new products or technological innovations by the
Company or its competitors, as well as other events or factors. Changes in
earnings estimates made by brokerage firms and industry analysts relating to the
market in which Software Artistry does business, or relating to Software
Artistry specifically, have in the past resulted and could in the future result
in an immediate and adverse effect on the market price of the Company's Common
Stock. In addition, the stock market has from time to time experienced extreme
price and volume fluctuations, which have particularly affected the market
prices of securities of many high-technology companies and which have often been
unrelated to the operating performance of these companies. The broad market
fluctuations may adversely affect the market price of the Company's Common
Stock. 


                                      9

<PAGE>

     The Company has significant investments and despite the high credit 
ratings on the Company's marketable securities, there is no assurance such 
agencies will not default on their obligations which could result in losses 
of principal and accrued interest to the Company.

EMPLOYEES

     As of December 31, 1996, the Company employed 240 people, including 67 
in sales and marketing, 67 in product development, 73 in services, 31 in 
general management, finance, internal information technology, and 
administration, and 2 in distribution.  None of the Company's employees is 
represented by a labor union or is subject to a collective bargaining 
agreement.  The Company believes that its relations with its employees are 
good.

     The Company believes that its future success will depend upon its 
ability to attract, motivate, and retain qualified personnel, including key 
members of senior management. Competition for such personnel is intense. The 
inability to hire and retain qualified personnel could have a material 
adverse effect on the Company's business or results of operations.

     The growth in the Company's customer base and expansion of its 
applications have placed, and are expected to continue to place, a strain on 
the Company's management and other resources. The Company's future 
performance will depend in part on its ability to implement and improve its 
operational, financial, and management information systems and to hire, 
train, and manage its employees.

EXECUTIVE OFFICERS OF THE REGISTRANT

The Executive Officers of the Company are as follows:

      NAME               AGE             POSITION WITH COMPANY    
      ----               ---             ---------------------
W. Scott Webber. . . . .  43  President, Chief Executive Officer, and Director
Michael J. Robbins . . .  38  Sr. Vice President, Worldwide Operations
Steven M. Ehrlich. . . .  35  Vice President, ESM Business Unit
Scott McCorkle . . . . .  30  Vice President, CRM Business Unit
Thomas E. Vanneman . . .  41  Vice President, Finance, Chief Financial Officer,
                               Secretary, and Treasurer

     W. Scott Webber has served as President and a Director of the Company 
since January 1991 and as Chief Executive Officer since December 1994.  From 
1981 to 1990, Mr. Webber was employed by Pansophic Systems, Inc., a computer 
software company, most recently as Director, North American Sales Operations. 
 Mr. Webber serves on the board of directors of the Indiana Software 
Association.  He holds a MM degree from Northwestern University and a BA 
degree from Carleton University, Ottawa, Canada.

     Michael J. Robbins has served as Senior Vice President, Worldwide 
Operations of the Company since July 1996.  From 1991 to 1994, he served as 
Vice President, Domestic Sales, and from 1995 to 1996, he served as Vice 
President and General Manager, European Operations. From 1986 to 1991, he was 
employed by Pansophic Systems, Inc., most recently as Director, Midwest Area 
Sales. From 1980 to 1986, Mr. Robbins held various positions at Xerox 
Corporation and Honeywell Corporation. He holds a BA degree from the 
University of Detroit.

     Steven M. Ehrlich has served as Vice President, ESM Business Unit of the 
Company since November 1996.  Prior to that, he served as Vice President, 
Client Services since May 1991. From 1986 to 1991, he was employed by 
Pansophic Systems, Inc., most recently as Product Manager, Systems Software 
Division. Mr. Ehrlich holds an MBA degree from Northern Illinois University 
and a BA in Computer Science from Southern Illinois University at Carbondale.

     Scott McCorkle has served as Vice President, CRM Business Unit of the 
Company since November, 1996.  He has been with the Company since 1995.  From 
May, 1996 to October, 1996 he was Director of Development.  Prior to that he 
was Manager of Information Technology from November, 1995 to April, 1996.   


                                      10

<PAGE>

Mr. McCorkle began his role at Software Artistry as an Information Systems 
Analyst in August, 1995.   From 1989 to 1995, he was Senior Scientific 
Analyst for Lilly Research Laboratories.  He has an MBA from Indiana 
University and a BS from Ball State University.

     Thomas E. Vanneman has served as Vice President, Finance, Chief 
Financial Officer, Secretary, and Treasurer of the Company since December, 
1996.  From 1992 to 1996, he was Vice President and Treasurer for Acordia, 
Inc.  Prior to joining Acordia, Mr. Vanneman served as Assistant Treasurer 
and various other management positions with Alexander and Alexander Services, 
Inc. in Baltimore, Maryland, and Chicago, Illinois.  He holds an MA and a BBA 
degree from the University of Iowa.

ITEM 2.  PROPERTIES

     The Company is headquartered in Indianapolis, Indiana, where it leases 
approximately 42,000 square feet of space housing product development, sales 
and marketing, customer service, and administrative activities.  This lease, 
with the Precedent, expires in October, 2004.  However, the Company has 
entered into a lease with a new Landlord, Duke Realty Limited Partnership, 
for a new facility to accommodate the Corporate office's growing space 
requirements.  In the new lease, Duke agreed to indemnify the Company from 
its rental obligations under the Precedent Lease from and after the 
commencement date of the new lease with Duke which was signed October 2, 1996 
and commences January 1, 1998 (dependent upon the completion of construction).
The new lease term is sixteen years (with certain options to extend) and 
covers 80,000 square feet (with certain expansion options available).  The 
aggregate annual base rental payments on the leases (not including operating 
expenses, insurance, property taxes, and assessments) is $715,000 (Precedent, 
1997) and $1,421,600 (Duke, thereafter).  In addition, the Company leases 
office space for one year or less in 25 locations in North America as well as 
offices in the United Kingdom, France, Australia and Singapore.  The Company 
also intends to add additional remote and international offices as necessary.

ITEM 3.  LEGAL PROCEEDINGS

     The Company is not party to any material legal proceedings.
   
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
   
     No matters were submitted to a vote of security holders during the quarter
ended December 31, 1996.


                                      11

<PAGE>

                                       PART II

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

     The Company's common stock began trading on the NASDAQ National Market
effective on March 3, 1995, under the symbol SWRT.  Prior to that date, there
was no public market of the common stock.  As of  March 11, 1997, the Company
had 173 shareholders of record and approximately 2,200 beneficial holders of its
common stock.

     The Company has never declared or paid any cash dividends on its common
stock.  The Company currently intends to retain all earnings to finance future
growth and therefore does not anticipate paying any cash dividends in the
foreseeable future.

     The following table sets forth, for the quarter indicated, the high and 
low sales prices for the common stock as reported on the NASDAQ National Market.

    Quarter Ended   March 31   June 30   Sept. 30    Dec. 31 
    -------------------------------------------------------- 
       1996
          High      $ 15.00    $ 12.00    $  9.13    $ 10.25
          Low       $ 11.00    $  6.38    $  6.25    $  6.13
       1995
          High      $ 26.00    $ 28.00    $ 27.50    $ 19.25
          Low       $ 17.50    $ 20.00    $ 17.00    $ 12.50

     The Company believes factors such as quarterly fluctuations in results 
of operations and announcement of new products by the Company or by its 
competitors may cause the market price of the common stock to fluctuate, 
perhaps substantially.  In addition, in recent years the stock market in 
general and the share prices of technology companies in particular, have 
experienced extreme price fluctuations.  These broad market and industry 
fluctuations may adversely affect the market price of the Company's common 
stock.


                                     12

<PAGE>

ITEM 6.  SELECTED FINANCIAL DATA

<TABLE>
(In thousands, except per share data)
                                                   1996      1995      1994      1993      1992
------------------------------------------------------------------------------------------------
<S>                                              <C>       <C>       <C>       <C>        <C>
YEAR ENDED DECEMBER 31
Statement of operations data:
Total revenues                                   $34,395   $25,628   $14,652   $ 7,494   $ 2,035
Operating income (loss)                            2,479     4,940     2,471     1,504    (1,235)
Net income (loss)                                  1,937     3,748     1,666     1,450    (1,271)
Per share:
  Primary:
    Net income (loss) per share                     0.26      0.52      0.33      0.30     (0.52)
    Shares used in computing net income (loss)
       per share                                   7,478     7,150     4,532     4,232     2,730
  Fully diluted:
    Net income (loss) per share                     0.26      0.51      0.27      0.24     (0.52)
    Shares used in computing net income (loss)
       per share                                   7,478     7,393     6,050     5,752     2,730
Cash dividends declared per common share               -         -         -         -         -

AS OF DECEMBER 31
Balance sheet data:
Cash, cash equivalents, and short-term
  marketable securities                          $17,822   $18,079   $   398   $ 1,411   $    24
Total assets                                      40,077    35,494    10,357     4,790     1,047
Long-term obligations, less current portion            -         -        21        59        60
Accrued interest payable to stockholders               -         -       362       362       362
Deferred income taxes                                737       462       113         -         -
Redeemable convertible preferred stock                 -         -     2,900     2,900     2,900
Redeemable preferred stock                             -         -       563       563       563
Accumulated dividends payable on preferred
  stock                                                -         -       488       322       156
Total stockholders' equity (deficit)              26,452    25,638    (1,175)   (2,681)   (3,964)
</TABLE>

On March 3, 1995, the Company completed its initial public offering of common
stock.  The Company received net proceeds of $19.7 million, paid accrued
interest payable to stockholders, redeemable preferred stock, and accumulated
dividends, and converted redeemable convertible preferred stock to common
stock.

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

OVERVIEW

     The Company was formed in 1988 to develop, market, and support a variety
of software tools, some of which were predecessors to the Company's multiple
diagnostics for the software applications it currently markets.  In 1991, the
Company introduced its first application, SA-EXPERT ADVISOR-TM- 1.0, which
incorporated call and problem management with multiple problem resolution
technologies.  In 1995, the Company began marketing the SA-EXPERTISE-TM- name
as an umbrella for its evolving product suite for Enterprise Support
Management (ESM).  The EXPERTISE suite for Enterprise Support Management
provides organizations with an integrated solution for internal support for
employees and end users.

     In 1996, the Company expanded the number of applications it markets and
began using the SA-EXPERTISE-TM- suite designation for its Customer
Relationship Management products for external customer support.  The first of
these products is SA-EXPERT SUPPORT-TM-, which is expected to be released in
late first

                                     13
<PAGE>

quarter/early second quarter of 1997.  Both EXPERTISE suites are designed to
increase operational efficiency and enhance customer satisfaction through
improved problem management and problem resolution capabilities.

RESULTS OF OPERATIONS

     In 1996, the Company made a strategic decision to increase investing in
sales and marketing activities, product development activities, and general
and administrative expenses.  As a result of the increased investments, sales
and marketing, product development, and general and administrative expenses
were a greater percentage of total revenues in 1996 compared to 1995.
Overall, operating income as a percentage of revenues declined to 7% in 1996
from 19% in 1995 and 17% in 1994.

     The Company's quarterly operating results reflect distinct seasonality.
This seasonality, combined with uneven changes in sales and marketing
expenses, created marked fluctuations in quarterly results of operations.
Similar fluctuations may be expected in the future, although they will be
somewhat mitigated as service revenues increase as a percentage of total
revenues.

     The following table sets forth certain income and expense items as a
percentage of total revenues, and the percentage change in dollar amounts of
such items, for the years ended December 31, 1996, 1995 and 1994.

                                                               Percent Increase
                                                                   (Decrease)
                                                               ----------------
                                      Year Ended December 31,    1996     1995
                                      -----------------------    over     over
                                      1996     1995     1994     1995     1994
                                      ----     ----     ----     ----     ----
Revenues:
  Initial license fees                  68%      73%      79%      24%      62%
  Renewal license fees and services     32       27       21       61      123
                                       ---      ---      ---
    Total revenues                     100      100      100       34       75
                                       ---      ---      ---
Operating expenses:
  Costs of license fees                  5        6        6        26      83
  Cost of renewal license fees
   and services                         19       17       14        52     107
  Sales and marketing                   44       39       40        52      67
  Product development                   14       11       11        70      72
  General and administrative            10        8       10        57      53
  Nonrecurring charge                    1        -        2         *       *
                                       ---      ---      ---
    Total operating expenses            93       81       83        54      70
                                       ---      ---      ---
Operating income                         7       19       17       (50)    100
Interest income, net                     2        3        -         *       *
                                       ---      ---      ---
Income before taxes                      9       22       17       (44)    127
Provision for income taxes               3        7        6       (44)    131
                                       ---      ---      ---
Net income                               6%      15%      11%      (48)    125
                                       ---      ---      ---
                                       ---      ---      ---

* Not a meaningful number

     REVENUES

     The Company's revenue is derived from initial license fees, renewals of
license fees, and services. The Company recognizes initial license fee revenue
upon shipment. The Company unbundles the product support and services revenues
included in the license agreement and recognizes that as revenue in renewal
license fees and services in future periods. The Company's license agreements
do not provide a right of return. The continued use of the Company's software
typically requires the payment of a license renewal which is offered for
annual periods at approximately 18% of the then current initial license fee.
Renewal license fees include customer technical support and product
enhancements and are recognized ratably over the term of the license period.
The Company provides a comprehensive range of services, including consulting
and education; services revenue is recognized at the time the service is
provided. Allowances are maintained for potential credit losses, which have
not been significant to date.

     INITIAL LICENSE FEES. Initial license fees revenue increased by $4.5
million (24%) from 1995 to 1996 and by $7.2 million (62%) from 1994 to 1995.
The increase in license revenues for the three years ended December 31, 1996,
is due to a number of factors. First, the number of initial licensees in each
year has increased to 133 in 1996, 131 in 1995 and from 114 in 1994. Second,
an increase in the number of licensees

                                     14
<PAGE>

expanding the number of users on a previously purchased product or buying
additional products increased in 1996 to 40% of total contracted initial
license fees, up from 34% and 9% in 1995 and 1994, respectively. The number of
these license expansions has increased to 230 in 1996 from 161 in 1995 and 44
in 1994. During 1996 the Company recorded $3.6 million of revenue for the two
newly released SA-EXPERTISE-TM- applications (Expert Evolution and Expert
Web). Providing the foundation for this growth in revenues is the expansion of
marketing operations, opening of new offices in each of the three years, and
successful marketing efforts. In 1997, the Company expects the percent of
total revenue attributable to initial license fees to continue to decrease as
a percentage of total revenues.

     North American initial license fees increased by $667,000 (4%) to $18.3
million in 1996 compared to an increase of $6.4 million (72%) to $17.6 million
in 1995. The decrease in the growth rate in North American license fees
reflect the effects of increased domestic competitive pressures and the impact
of the change in warranty period (discussed below in the second paragraph of
RENEWAL LICENSE FEES AND SERVICES).

     Initial license fees from outside North America increased by $3.9 million
(354%) to $5.0 million, or 22% of total initial license fees revenue for 1996,
and $1.1 million, or 5%, of total initial license fees revenue for 1995. As
both the European and Asia-Pacific operations continue to mature, the Company
believes that initial license fees from outside North America will continue to
increase both in actual dollars and as a percent of total initial license
fees.  The initial license fees for products are based on the number of seats
a licensee contracts to use.

     RENEWAL LICENSE FEES AND SERVICES. Renewal license fees include a portion 
of initial license fee amounts representing support (unbundled based on the 
license renewal rates) and annual license renewals. Renewal license fees 
revenue increased by $2.6 million (61%) to $6.8 million from 1995 to 1996 and 
by $2.2 million (123%) to $4.2 million from 1994 to 1995. These increases are 
due to an expanded user base as a result of product installations during 1996, 
1995, and 1994.  Of the Company's end-of-year 1995 customer base,  88% 
renewed their licenses in 1996.

     Beginning on April 1, 1996, the Company extended its standard warranty
period, which includes initial  product support, from three months to 12
months on all contracts.  As a result of extending the standard warranty
period, a larger percentage of  revenues in each contract is now deferred,
which may have negatively impacted the amount of initial license fee revenues
recognized for the last nine months of 1996 and in the first quarter of 1997.
However, the impact of this change in standard warranty period cannot be
conclusively determined due to various factors involved in the contract
negotiation process.

     Services revenues increased by $1.6 million (59%) to $4.3 million from
1995 to 1996 and by $1.6 million (141%) to $2.7 million from 1994 to 1995.
These increases were attributable to the initial licensing of the
SA-EXPERTISE-TM- products and an additional emphasis on providing complete
services solutions to existing customers.  The Company expects services
revenue to increase in 1997.

     COSTS OF LICENSE FEES

     Costs of license fees consist primarily of costs of third party royalty
and commission payments, product media, documentation, duplication, shipment,
and amortization of capitalized software costs. As a percent of total
revenues, these expenses were 5% in 1996, and 6% in 1995 and 1994. The
decrease in percent of total revenues in 1996 compared to 1995 and 1994 is
principally because of lower third-party commission costs in 1996.

     COST OF RENEWAL LICENSE FEES AND SERVICES

     Cost of renewal license fees and services consist primarily of the costs
of providing customer technical support, consulting, and education. Cost of
renewal license fees and services constituted 19%, 17%, and 14% of total
revenues and 59%, 62% and 67% of renewal license fees and services in 1996,
1995, and 1994, respectively.  The dollar increase was due primarily to the
growth in the Company's installed customer base and the growth of customer
technical support, consulting, and training staff.

     SALES AND MARKETING

     Sales and marketing expenses were 44%, 39%, and 40% of total revenues in
1996, 1995, and 1994, respectively. The increase in sales and marketing
expenses was primarily due to the increased number of sales representatives
reaching the higher commission brackets, expansion of the marketing staff, and
an increase in the number of trade shows and other marketing activities.

                                     15
<PAGE>

     PRODUCT DEVELOPMENT

     The following table sets forth information regarding product development
costs (dollar amounts in thousands):

                                                     1996     1995     1994
                                                    ------   ------   ------
Total product development costs                     $5,771   $3,506   $1,936
Costs capitalized                                      845      616      261
                                                    ------   ------   ------
  Product development expense                       $4,926   $2,890   $1,675
                                                    ------   ------   ------
                                                    ------   ------   ------
Amortization of capitalized software development
  costs (included in costs of license fees)         $  420   $  174   $  137
                                                    ------   ------   ------
                                                    ------   ------   ------
Percentage of costs capitalized                         15%      18%      13%
Percentage of costs capitalized, net of amortization     7%      13%       6%

     Product development expenses were 14%, 11%, and 11% of total revenues in
1996, 1995, and 1994, respectively. The increase in amounts was due primarily
to the acceleration in the pace of product development.

     The Company capitalized software development costs in accordance with
Statement of Financial Accounting Standards No. 86, "Accounting for the Costs
of Computer Software to be Sold, Leased or Otherwise Marketed." The amounts
capitalized are dependent on the specific activities that the development
staff is engaged in during each year. Capitalized software development costs
are amortized over the estimated life of the related products (up to three
years) and amounts amortized are included in the costs of license fees.

     GENERAL AND ADMINISTRATIVE

     General and administrative expenses include the costs of finance, human
resources, internal information systems, and administrative departments of the
Company. These expenses increased as a percentage of total revenues to10% in
1996 from 8% in 1995 and 10% in 1994. The dollar increase resulted primarily
from additional personnel and other costs incurred to support the growth of
the Company's operations.

     NONRECURRING CHARGE

     In 1996, the Company incurred severance charge amounts resulting from
certain management separations.  The Company included all compensation and
benefits resulting from this separation as a nonrecurring charge in 1996. 

     In 1994, the Company and its former Chief Executive Officer mutually 
agreed to a consulting and severance arrangement effective October 1, 1994. 
The Company included all payments under this agreement as a nonrecurring 
charge in 1994.

     INTEREST INCOME, NET

     In March 1995, the Company completed an initial public offering of common
stock. The proceeds were invested in short-term U.S. government securities,
high quality municipal issues, and interest-bearing deposits; these
investments account for substantially all of the interest income generated in
1995 and 1996. In 1994 and prior, interest income and expense was not
significant to operating results.  The decrease in interest income in 1996 is
partially a result of the Company repurchasing  242,500 shares of its common
stock for $2.0 million.  In January 1997, the Company announced the
discontinuation of its stock repurchase program.

     PROVISION FOR INCOME TAXES

     The Company's effective income tax rate was 38.9% and 33.9% in 1996 and
1995, respectively, The increase in effective income tax rate was due to the
Company not being able to utilize the benefit from foreign losses resulting
from international start up and expansion efforts 1996.  The Company
anticipates the effective income tax rate in 1997 to decrease.

                                     16

<PAGE>


LIQUIDITY AND CAPITAL RESOURCES

     In 1996 and 1995, the Company financed its operations through cash 
generated from operations. In 1994 and prior, the Company funded its 
operations primarily through Company founders' investments, private 
investments in preferred stock, and cash generated from operations. 

     Cash provided by operations was $5.6 million, $1.6 million, and $1.2 
million for the years ended December 31, 1996, 1995, and 1994, respectively.  
The increase in cash provided by operating activities in 1996 compared to 
1995 was due to an increase in deferred revenue and accounts payable and a 
less significant increase in accounts receivable in 1996 compared to 1995. 
The increase in cash provided by operating activities in 1995 compared to 
1994 was due primarily to net income and an increase in deferred revenue 
offset by an increase in accounts receivable. 

     Accounts receivable increased to $13.8 million from $12.4 million and 
deferred revenues increased to $7.6 million from $5.9 million on December 31, 
1996 and 1995, respectively. The increase in accounts receivable and deferred 
revenue is primarily attributable to the increase in licensing activity and 
the concentration of such activity in the final month of each period. The 
Company calculates days sales outstanding as (i) the amount of accounts 
receivable at quarter end (ii) divided by the sum of quarterly revenues and 
the change in deferred revenues (iii) multiplied by 90. The Company believes 
this calculation to be relevant because deferred revenues (in addition to 
recognized revenues) are typically billable, and therefore contribute to the 
increase in accounts receivable each period. Days sales outstanding were 88 
days as of December 31, 1996 and 104 days as of December 31, 1995. The 
decrease in such days is partially attributable to increased collection 
efforts, shorter payment terms on contracts, and use of outside financing 
sources.  Because of the concentration of licensing activity at the end of 
each year, the Company expects that accounts receivable and days sales 
outstanding may continue to be substantial in the foreseeable future.

     The Company used $4.6 million, $4.9 million, and $2.2 million for 
investment activities in 1996, 1995, and 1994, respectively. In 1996, 1995, 
and 1994 the Company expended $3.8 million, $2.0 million and  $1.9 million, 
respectively, for purchases of property and equipment. Due to planned 
business expansion, additions to property and equipment are expected to 
continue, including the purchase of equipment for new employees, upgrading 
equipment for existing employees, and expansion of Company facilities. As of 
December 31, 1996, the Company had no material commitments for capital 
expenditures.  In 1996, the Company used $2.0 million to repurchase 242,500 
shares of its own stock.  The stock repurchase plan was discontinued in 
January 1997.  The Company intends to utilize the repurchased shares to 
satisfy future exercises of stock options.

     As of December 31, 1996, the Company had $15.6 million of cash and cash 
equivalents, $2.2 million of marketable securities, and working capital of 
$20.2 million. In addition, at December 31, 1996, the Company had a working 
capital line of credit of $2.0 million. 

     Management believes that existing cash balances and marketable 
securities, cash flow from operations, and the line of credit commitment will 
be sufficient to meet the Company's currently anticipated working capital, 
and capital expenditure requirements.

BUSINESS ENVIRONMENT AND RISK FACTORS

     Although the Company has experienced strong growth in recent periods, 
such growth rates may not be sustainable and may not be indicative of future 
operating results. The Company's continued growth will depend in part upon 
its ability to enhance existing applications and develop and introduce new 
applications that are technologically advanced, respond to evolving customer 
requirements, respond to competitive products or announcements, and achieve 
market acceptance of its products, including its new external customer 
support product.  There is no assurance this will occur.

     The Company's quarterly operating results fluctuate from quarter to 
quarter with the fourth quarter historically having the highest total 
revenues and operating income. The Company believes that this pattern will 
repeat in the future. 

     The Company may experience significant fluctuations in operating results 
depending upon many factors, including, among others, the timing of new 
application announcements and releases by the Company and its competitors, 
budgeting cycles of  its customers, demand for the Company's products, the 
size and timing of customer orders, changes in the proportion of revenues 
attributable to license fees versus renewal fees and services, changes in the 
level of operating expenses, and general economic conditions. As a result, 
the Company


                                      17

<PAGE>

believes that period-to-period comparisons are not necessarily meaningful and 
should not be relied upon as an indication of future performance.

     The Company has significant investments and despite the high credit 
ratings on the marketable securities held by the Company, there is no 
assurance such agencies will not default on their obligations which could 
result in losses of principal and accrued interest to the Company.

     This report includes a number of forward-looking statements which 
reflect the Company's current views with respect to future events and 
financial performance.  These forward-looking statements are subject to 
certain risks and uncertainties that could cause actual results to differ 
materially from historical results or those anticipated.  In this report, the 
words "believes, "plans," "expects," or similar expressions identify 
forward-looking statements. Readers are cautioned not to place undue reliance 
on these forward-looking statements, which reflect management's analysis only 
as of the date hereof.  The Company undertakes no obligation to update this 
discussion except as may be legally required in its reporting statements.





















                                      18

<PAGE>

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)

<TABLE>
                                                                               December 31,
                                                                           ------------------
                                                                             1996       1995
                                                                           -------    -------
<S>                                                                          <C>        <C>
ASSETS
Current assets:
  Cash and cash equivalents                                                $15,606    $15,816
  Marketable securities                                                      2,216      2,263
  Trade account receivables, net of allowance for doubtful accounts of
   $480 in 1996 and $394 in 1995                                            13,785     12,442
  Other receivables                                                            366          -
  Prepaid expenses                                                             870        672
  Deferred income taxes                                                        262        103
                                                                           -------    -------
    Total current assets                                                    33,105     31,296

Property and equipment, net                                                  5,676      3,318
Capitalized software development costs, net                                  1,245        820
Other assets                                                                    51         60
                                                                           -------    -------
    Total assets                                                           $40,077    $35,494
                                                                           -------    -------
                                                                           -------    -------

LIABILITIES AND STOCKHOLDERS' EQUITY 
Current liabilities:
  Current portion of long-term debt                                        $     -    $    22
  Accounts payable and accrued liabilities                                   2,556      1,095
  Accrued compensation and related expenses                                  1,898      1,527
  Income taxes payable                                                         874        877
  Deferred revenue                                                           7,560      5,873
                                                                           -------    -------
    Total current liabilities                                               12,888      9,394

Deferred income taxes                                                          737        462
                                                                           -------    -------
    Total liabilities                                                       13,625      9,856
                                                                           -------    -------

Stockholders' equity:
  Common stock, no par value; 10,000,000 shares authorized,
   6,985,708 shares issued and outstanding at December 31, 1996;
   6,777,148 shares issued and outstanding at December 31, 1995             24,091     23,103
  Treasury stock; 242,500 shares at December 31, 1996                       (2,028)         -
  Accumulated translation adjustments                                          (83)         -
  Retained earnings                                                          4,472      2,535
                                                                           -------    -------
  Total stockholders' equity                                                26,452     25,638
                                                                           -------    -------
    Total liabilities and stockholders' equity                             $40,077    $35,494
                                                                           -------    -------
                                                                           -------    -------
</TABLE>


SEE ACCOMPANYING NOTES.



                                          19

<PAGE>

CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)

<TABLE>
                                                           Year Ended December 31,
                                                       -----------------------------
                                                         1996       1995       1994
                                                       -------    -------    -------
<S>                                                      <C>        <C>        <C>
Revenues:
  Initial license fees                                 $23,246    $18,722    $11,548
  Renewal license fees and services                     11,149      6,906      3,104
                                                       -------    -------    -------
    Total revenues                                      34,395     25,628     14,652
                                                       -------    -------    -------

Operating expenses:
  Costs of license fees                                  1,873      1,490        815
  Costs of renewal license fees and services             6,547      4,303      2,083
  Sales and marketing                                   14,973      9,850      5,892
  Product development                                    4,926      2,890      1,675
  General and administrative                             3,390      2,155      1,412
  Nonrecurring charge                                      207          -        304
                                                       -------    -------    -------
    Total operating expenses                            31,916     20,688     12,181
                                                       -------    -------    -------

Operating income                                         2,479      4,940      2,471

Interest income, net                                       693        728         25
                                                       -------    -------    -------

Income before income taxes                               3,172      5,668      2,496

Provision for income taxes                               1,235      1,920        830
                                                       -------    -------    -------

Net income                                             $ 1,937    $ 3,748    $ 1,666
                                                       -------    -------    -------
                                                       -------    -------    -------

Per share amounts:
  Primary:
    Net income per share                               $  0.26    $  0.52    $  0.33
                                                       -------    -------    -------
                                                       -------    -------    -------

    Shares used in computing net income per share        7,478      7,150      4,532
                                                       -------    -------    -------
                                                       -------    -------    -------

  Fully diluted:
    Net income per share                               $  0.26    $  0.51    $  0.27
                                                       -------    -------    -------
                                                       -------    -------    -------

    Shares used in computing net income per share        7,478      7,394      6,050
                                                       -------    -------    -------
                                                       -------    -------    -------
</TABLE>

SEE ACCOMPANYING NOTES.



                                          20


<PAGE>

CONSOLIDATED STATEMENTS OF 
STOCKHOLDERS' EQUITY (DEFICIT)
(Dollars in thousands)

<TABLE>
                                           Common Stock            Treasury Stock
                                       --------------------     --------------------
                                                                                                        Retained
                                                                                       Accumulated      Earnings
                                       Number of                Number of              Translation    (Accumulated  
                                         Shares     Amount        Shares     Amount    Adjustments      Deficit)   
                                       ---------   --------     ---------   --------   ------------   ------------
<S>                                    <C>         <C>           <C>         <C>        <C>            <C>
Balances, December 31, 1993            2,500,000   $      1            -    $      -     $      -       $ (2,682)
  Dividends on preferred stock                 -          -            -           -            -           (166)
  Exercise of common stock options         9,375          6            -           -            -              -
  Net income                                   -          -            -           -            -          1,666
                                       ---------   --------      -------    --------     --------       --------

Balances, December 31, 1994            2,509,375          7            -           -            -         (1,182)
  Dividends on preferred stock                 -          -            -           -            -            (31)
  Conversion of preferred stock        2,470,321      2,900            -           -            -              -
  Issuance of common stock, net        1,563,750     19,741            -           -            -              -
  Exercise of common stock options       233,702        220            -           -            -              -
  Income tax benefit of stock option
    exercises                                  -        235            -           -            -              -
  Net income                                   -          -            -           -            -          3,748
                                       ---------   --------      -------    --------     --------       --------

Balances, December 31, 1995            6,777,148     23,103            -           -            -          2,535
  Issuance of common stock, net            7,859         56            -           -            -              -
  Exercise of common stock options       200,701        387            -           -            -              -
  Income tax benefit of stock option
    exercises                                  -        545            -           -            -              -
  Treasury stock                               -          -      242,500      (2,028)           -              -
  Accumulated translation
    adjustments                                -          -            -           -          (83)             -
  Net income                                   -          -            -           -            -          1,937
                                       ---------   --------      -------    --------     --------       --------
Balances, December  31, 1996           6,985,708   $ 24,091      242,500    $ (2,028)    $    (83)      $  4,472
                                       ---------   --------      -------    --------     --------       --------
                                       ---------   --------      -------    --------     --------       --------
</TABLE>

SEE ACCOMPANYING NOTES.


                                       21

<PAGE>

<TABLE>
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
                                                            Year Ended December 31,
--------------------------------------------------------------------------------------
                                                           1996      1995       1994
--------------------------------------------------------------------------------------
<S>                                                     <C>        <C>        <C>
Operating activities:
  Net income                                            $  1,937   $  3,748   $  1,666
  Adjustments to reconcile net income to net cash
   provided by operating activities:
    Depreciation and amortization of property and
     equipment                                             1,432        676        267
    Amortization of software development costs               420        174        137
    Change in allowance for doubtful accounts                 86        219        100
    Disposition of furniture and equipment                    50         13         30
    Amortization of financing costs                            -          1          5
    Changes in assets and liabilities:
      Trade accounts receivable                           (1,429)    (5,526)    (4,668)
      Prepaid expenses                                      (564)      (493)       (80)
      Accounts payable and accrued liabilities             1,461       (148)       817
      Accrued compensation and related expenses              371        272        607
      Income taxes payable                                    (3)       162        652
      Deferred revenue                                     1,687      2,038      1,767
      Deferred income taxes                                  116        444        (55)
                                                        --------   --------   --------
    Net cash provided by operating activities              5,564      1,580      1,245

Investing activities:
  Purchase of marketable securities                       (9,456)   (12,575)         -
  Sale of marketable securities                            1,375      1,603          -
  Maturities of marketable securities                      8,128      8,709          -
  Purchase of property and equipment                      (3,840)    (1,971)    (1,931)
  Capitalization of software development costs              (845)      (616)      (261)
  (Increase) decrease in other assets                          9        (28)       (11)
                                                        --------   --------   --------
    Net cash used in investing activities                 (4,629)    (4,878)    (2,203)

Financing activities:
  Proceeds from issuance of common stock, net
   of issuance costs                                          56     19,741          -
  Proceeds from exercise of stock options                    387        220          6
  Income tax benefit of stock option exercises               545        235          -
  Purchase of treasury stock                              (2,028)         -          -
  Redemption of Series D preferred stock                       -       (563)         -
  Payment of accumulated dividends on preferred stock          -       (519)         -
  Payment of interest payable to stockholders                  -       (362)         -
  Principal payments on equipment obligations                (22)       (36)       (61)
                                                        --------   --------   --------
    Net cash provided (used) by financing activities      (1,062)    18,716        (55)
Accumulated translation adjustments                          (83)         -          -
                                                        --------   --------   --------
Change in cash and cash equivalents                         (210)    15,418     (1,013)
Cash and cash equivalents, beginning of year              15,816        398      1,411
                                                        --------   --------   --------
Cash and cash equivalents, end of year                  $ 15,606   $ 15,816   $    398
                                                        --------   --------   --------
                                                        --------   --------   --------

Supplemental disclosures:
  Cash paid for:
    Interest expense                                    $     10   $     19   $     10

    Income taxes                                             570      1,079        120
  Noncash investing and financing activities:
    Conversion of redeemable convertible preferred
     stock to common stock                                     -      2,900          -

    Accrued dividends on preferred stock                       -         31        166
</TABLE>


SEE ACCOMPANYING NOTES.  


                                       22

<PAGE>


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

     Software Artistry, Inc. (the Company) develops, internationally markets, 
and supports a family of internal and external customer support software 
applications.  The Company does not have a concentration of credit risk in 
any one industry, geographic region, or customer.

     A significant portion of the Company's revenues in 1996 were derived 
from licenses of Expert Advisor, a complete problem management system to 
resolve customer problems.

     The market for the Company's applications is characterized by rapid 
technological advances, changes in customer requirements, and frequent new 
product introductions and enhancements.

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     CONSOLIDATION
     The consolidated financial statements include the accounts of the 
Company and its wholly-owned subsidiaries:  Software Artistry, Inc., Software 
Artistry Europe, Inc., Software Artistry International, Inc., Software 
Artistry UK LTD, Software Artistry SARL, Software Artistry Asia Pacific Pte 
Ltd, and Software Artistry Asia Pacific Pty Ltd. All significant intercompany 
balances and transactions have been eliminated.

     CASH, CASH EQUIVALENTS, AND 
     MARKETABLE SECURITIES
     The Company considers all highly liquid investments with a maturity of 
three months or less to be cash equivalents.  Cash equivalents and marketable 
securities consist primarily of U.S. government securities, municipal issues 
and interest-bearing deposits with major banks.
     In accordance with Statement of Financial Accounting Standards No. 115, 
"Accounting for Certain Investments in Debt and Equity Securities", the 
Company classifies all of its marketable debt securities as available-for-sale 
securities.  These securities are valued at their fair value.  There was no 
significant difference between cost and fair value at December 31, 1996 and 
1995.

     PROPERTY AND EQUIPMENT
     Property and equipment are recorded at cost.  Depreciation is computed 
principally using the straight-line method over the estimated useful lives of 
the related assets.  Equipment under capital leases is amortized using the 
straight-line method over the life of the lease.

     SOFTWARE DEVELOPMENT COSTS
     Software development costs are accounted for in accordance with 
Statement of Financial Accounting Standards No. 86, "Accounting for the Costs 
of Computer Software to be Sold, Leased, or Otherwise Marketed."  Costs 
associated with the planning and designing phase of software development, 
including coding and testing activities necessary to establish technological 
feasibility, are classified as product development and expensed as incurred.  
Once technological feasibility has been determined, additional costs incurred 
in development, including coding, testing, and product quality assurance, are 
capitalized.

     Amortization is provided on a product-by-product basis over the 
estimated economic life of the software, not to exceed three years, using the 
straight-line method.  This method results in greater amortization than the 
ratio of current year gross product revenues to current and anticipated 
future gross product revenue method.  Amortization commences when a product 
is available for general release to customers.  Unamortized capitalized costs 
determined to be in excess of the net realizable value of a product are 
expensed at the date of such determination.

     REVENUE RECOGNITION
     Initial license fee revenues are derived from initial licenses of Expert 
Advisor and related software applications developed by the Company.  Renewal 
license fees and services revenues are derived from renewal licenses of 
Expert Advisor and related software applications, consulting, and education.


                                     23

<PAGE>

     Initial contracts include the use of the software as well as the first 
year support.  Software license revenues are recognized when a noncancellable 
license agreement is signed, the product is shipped and all significant 
contracted obligations are satisfied.  Since April 1, 1996, the Company's 
standard licensing agreement provides for one year of customer support and 
product updates.  The portion of the initial contract



















                                      24

<PAGE>

associated with support is deferred for revenue recognition purposes and 
recognized in renewal license fees and services.

     Renewal license fees from agreements for maintaining, supporting and 
providing periodic upgrades are recognized monthly on a straight-line basis 
over the renewal period, which in most instances is one year.  Revenues for 
consulting and education services are recognized as services are performed.

     NET INCOME PER SHARE
     Primary net income per share is computed based upon the weighted average 
number of common and common equivalent shares outstanding and gives effect to 
certain adjustments.  Common equivalent shares include outstanding stock 
options and, in 1995 and 1994, Series A redeemable convertible preferred 
stock.  Common equivalent shares are included in the per share calculation 
using the modified treasury stock method.  In accordance with Securities and 
Exchange Commission requirements, common and common equivalent shares issued 
during the twelve-month period immediately preceding the filing of the 
initial public offering have been included in the calculation of earnings per 
share as if they were outstanding for all periods, using the treasury stock 
method and an assumed initial public offering price.

     Fully diluted net income per share is computed in the same manner as 
primary net income per share, except that, in 1995 and 1994, all outstanding 
shares of Series B and C redeemable convertible preferred stock are assumed 
to have been converted to common stock at the time of issuance.

     USE OF MANAGEMENT ESTIMATES
     The preparation of financial statements in conformity with generally 
accepted accounting principles requires management to make estimates and 
assumptions that affect the amounts reported in the financial statements and 
accompanying notes.  Actual results could differ from those estimates.

     ACCOUNTING FOR STOCK OPTIONS
     In 1996, the Company adopted the Statement of Financial Accounting 
Standards No. 123, "Accounting for Stock-Based Compensation".  In accordance 
with SFAS No. 123, the Company uses the intrinsic value method to account for 
stock options, consistent with the existing rules established by Accounting 
Principles Board No. 25, "Accounting for Stock Issued to Employees". 
Accordingly, no compensation expense has been recognized for stock options 
granted to employees.

     RECLASSIFICATIONS
     Certain amounts in the 1995 and 1994 consolidated financial statements 
have been reclassified to conform to the 1996 presentation.

2.  PROPERTY AND EQUIPMENT

    Property and equipment consists of the following amounts (in thousands):

                                                 1996       1995
                                                ------     ------
           Leasehold improvements               $  260     $  236
           Computer equipment                    4,105      2,193
           Furniture and equipment               1,928      1,529
           Software                              1,950        506
                                                ------     ------
                                                 8,242      4,464
           Less accumulated depreciation
            and amortization                     2,567      1,146
                                                ------     ------
                                                $5,676     $3,318
                                                ------     ------
                                                ------     ------




                                      25

<PAGE>

3.  CAPITALIZED SOFTWARE DEVELOPMENT COSTS

    Capitalized software development costs consists of the following amounts 
(in thousands):

                                               1996       1995
                                              ------     ------
          Capitalized costs                   $1,838     $1,004

          Less accumulated amortization          593        184
                                              ------     ------
                                              $1,245     $  820
                                              ------     ------
                                              ------     ------

     During 1996 and 1995, the Company eliminated $11,000, and $256,000 of 
cost and related accumulated amortization for fully amortized capitalized 
software development costs, respectively.

4.  CREDIT AGREEMENT

    The Company has a revolving line of credit arrangement with a bank that 
provides for borrowings of up to $2,000,000.  Borrowings under this line of 
credit bear interest at the bank's prime rate and are collateralized by trade 
accounts receivable and property and equipment.  The facility will expire on 
April 30, 1997.  No amounts were outstanding at December 31, 1996 and 1995.

    The line of credit agreement contains restrictive covenants, the most 
significant of which relate to minimum defined stockholders' equity and cash 
flow coverage ratio.  At December 31, 1996 and 1995, the Company was in 
compliance with such covenants.

5.  INCOME TAXES

    The components of income (loss) from operations before income taxes are 
as follows (in thousands):

                                  1996      1995      1994
                                 ------    ------    ------
          United States          $3,837    $6,224    $2,638
          Foreign                  (665)     (555)     (142)
                                 ------    ------    ------
                                 $3,172    $5,668    $2,496
                                 ------    ------    ------
                                 ------    ------    ------

    The provision for income taxes is as follows (in thousands):

                                     1996      1995      1994
                                    ------    ------     ----
          Current:
            Federal                 $  830    $1,176     $725
            State                      145       300      160
            Foreign                    144         -        -
                                    ------    ------     ----
                                    $1,119     1,476      885
                                    ------    ------     ----
          Deferred:
            Federal                     91       404      (45)
            State                       25        40      (10)
                                    ------    ------     ----
                                       116       444      (55)
                                    ------    ------     ----
                                    $1,235    $1,920     $830
                                    ------    ------     ----
                                    ------    ------     ----



                                      26

<PAGE>

     The provision for income taxes differs from the federal statutory tax
rate as follows (in thousands):

                                                       1996     1995      1994
                                                      ------   ------    -----
     Federal tax at statutory rate                    $1,079   $1,927   $ 848
     State income tax, net of federal tax benefit        143      224      99
     Tax credits generated                              (159)    (132)   (118)
     Non-taxable interest income                        (166)    (170)      -
     Foreign subsidiary losses                           289        -       -
     Tax credits carried forward                           -        -      (25)
     Other                                                49       71       26
                                                      ------   ------    -----
                                                      $1,235   $1,920    $ 830
                                                      ------   ------    -----
                                                      ------   ------    -----

     The Company provides deferred income taxes for temporary differences
between assets and liabilities recognized for financial reporting and income
tax purposes.  The income tax effects of these temporary differences are as 
follows (in thousands):

                                             1996     1995
                                            -----    -----
      Deferred tax assets:
        Accounts receivable allowance       $ 182    $ 150
        Deferred revenue                       80       76 
                                            -----    -----
                                              262      226
                                            -----    -----
      Deferred tax liabilities:
        Development costs capitalized        (473)    (287)
        Depreciation                         (264)    (175)
                                            -----    -----
                                             (737)    (462)
                                            -----    -----
      Valuation allowance                       -     (123)
                                            -----    -----
                                            $(475)   $(359)
                                            -----    -----
                                            -----    -----

     Undistributed earnings of the Company's foreign subsidiaries amounted to
less than $1 million at December 31, 1996.  Those earnings are considered to be
indefinitely reinvested and, accordingly, no provision for U.S. federal and
state income taxes has been provided thereon.  Upon distribution of those
earnings in the form of dividends or otherwise, the Company would be subject to
both U.S. income taxes (subject to an adjustment for foreign tax credits) and
withholding taxes payable to the various foreign countries.  Determination of
the amount of unrecognized deferred U.S. income tax liability is not practicable
because of the complexities associated with its hypothetical calculation;
however, unrecognized foreign tax credit carry-forwards would be available to
reduce some portion of the U.S. liability.

     In 1995, due to the uncertainty surrounding the timing of realizing the
benefits of its favorable tax attributes in future tax returns, the Company had
a valuation allowance against a portion of its deferred tax assets.

     6.  COMMITMENTS

     The Company rents its corporate office space under a ten-year
noncancellable operating lease which expires in October 2004.  The Company has
entered into a lease for a new facility to accommodate the Corporate office's
growing space requirements.  The Landlord, Duke Realty Limited Partnership, has
agreed to indemnify the Company from its rental obligations under the current
lease from and after the commencement date of the new lease, January 1, 1998
(dependent upon the completion of construction).  The new lease term is sixteen
years.

                                     27
<PAGE>

     Future minimum required rent payments for the corporate office and other
operating leases outstanding with initial terms of more than one year as of
December 31, 1996, are summarized as follows (in thousands):

               Payable in:
                    1997                $   715
                    1998                  1,330
                    1999                  1,449
                    2000                  1,422
                    2001                  1,422
                    Thereafter           15,756
                                        -------
                                        $22,094
                                        -------
                                        -------

     The Company also rents office space for sales offices under month-to-month
leases and leases with terms generally less than three years.

     Total rent expense for office leases was $1,421,000, $908,000, and $441,000
in 1996, 1995, and 1994, respectively.

     7.  STOCKHOLDERS' EQUITY

     In March 1995, the Company completed an initial public offering of
1,563,750 shares of common stock at $14.00 per share, resulting in total
proceeds of $19,741,000 after deducting underwriting discounts and commissions
and other expenses.  All issued and outstanding Series A, B, and C convertible
preferred stock was automatically converted to common stock in accordance with
the underlying agreements.  All issued and outstanding Series D redeemable
preferred stock was redeemed in accordance with the underlying agreements.

     STOCK OPTION PLANS

     As of December 31, 1996 and 1995, the Company had two stock option plans
under which options to purchase common stock may be granted to its employees,
officers, directors and others.  One of these plans is qualified under the
Internal Revenue Code while the other is a nonqualified plan.

     Generally, options granted before December 31, 1996 under the qualified
plan become vested over a five-year period, 20% each year, and are subject to
the employee's continued employment. Options granted on or after December 31,
1996 under the qualified plan generally become vested over a two-year period,
25% each six months, and are also subject to the employee's continued
employment.  Stock options are issued at the full fair market value at the date
of grant.  The vesting of the options will be accelerated in the event of
certain occurrences including the sale of the Company or a significant merger.
The plans terminate in 2001 but may be terminated earlier by the Board of
Directors at any time.

     Under the amended Nonstatutory Stock Option Plan approved by the
stockholders in 1996, options are granted to independent directors for 6,000
shares each year, at the fair market value on the date of grant; with 2,000
shares vested every 12 months for three years, while continuing as a director of
the Company.  At December 31, 1996, 1,875,000 and 312,500 shares of common stock
were reserved for purchase under the incentive and nonstatutory stock option
plans, respectively.

     In January 1996 and April 1996, the Board of Directors approved the
cancellation and repricing of 558,238 options with the condition that all
repriced options would begin vesting on the date of repricing.  The average
price before repricing was $15.38 per share.  These options were repriced at
$6.88 per share, the fair market value on the date of repricing.

                                     28
<PAGE>

     A summary of the Company's stock option activity, and related information
for the years ended December 31 follows:

<TABLE>
                                                    1996           1995        1994
                                         ---------------------------------------------
                                                      Weighted-
                                                       Average
                                                       Exercise
                                             Options     Price    Options     Options
                                         ---------------------------------------------
<S>                                        <C>          <C>      <C>          <C>
Outstanding at beginning of year            1,357,858   $ 4.99   1,309,748     928,801
  Granted (1)                               1,196,788     8.71     306,373     390,322
  Exercised                                  (200,701)    1.92    (233,077)     (9,375)
  Canceled (1)                               (737,338)   13.39     (25,186)          0
                                         ---------------------------------------------
Outstanding at end of year                  1,616,607   $ 4.29   1,357,858   1,309,748
                                         ---------------------------------------------
                                         ---------------------------------------------
Price range of grants                    $6.88-$15.00         $7.39-$24.25  $.53-$7.35
Price range of exercised options           $.48-$7.39           $.48-$7.39  $.48-$2.65
Weighted-average fair value of options
 granted                                        $2.81
Available for grant at December, 31 1996      127,740
</TABLE>

     (1)  The 1996 amounts include the cancellation and repricing of 558,238
          options.
 
     The following table summarizes information about the fixed price stock
options outstanding at December 31, 1996.

                                   Options Outstanding     Options Exercisable
                                  ---------------------  -----------------------
                                   Weighted
                      Number        Average    Weighted      Number     Weighted
                   Outstanding at  Remaining   Average   Exercisable at Average
    Range of        December 31,  Contractual  Exercise   December 31,  Exercise
 Exercise Prices       1996          Life       Price        1996        Price
--------------------------------------------------------------------------------
$0.0480 - $ 1.2400   474,294        5 years    $0.49545    474,294      $0.495
$2.4100 - $ 6.0300   310,337        6 years    $2.51658    302,948      $2.501
$6.0600 - $ 6.8800   434,613        9 years    $6.87985        350      $6.163
$7.1300 - $17.7500   397,363       10 years    $7.39547     30,699      $8.767
                   -----------------------------------------------------------
$0.4800 - $17.750  1,616,607        8 years    $4.29549    808,291      $1.563
                   ---------                               -------
                   ---------                               -------

     Pro forma information regarding net income and earnings per share is
required by Financial Accounting Statement No. 123, which also requires that
the information be determined as if the Company has accounted for its employee
stock options granted subsequent to December 31, 1994 under the fair value
method of that Statement.  The fair value for these options was estimated at the
date of grant using a Black-Scholes option pricing model with the following
weighted-average assumptions for 1995 and 1996, respectively:  risk-free
interest rates of 5.5%; a dividend yield of 0%; volatility factors of the
expected market price of the Company's common stock of .75; and an expected life
of the option of 5 years.

     The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable.  In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility.  Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.

                                     29

<PAGE>

     For purposes of pro forma disclosures, the estimated fair value of the 
options is amortized to expense over the options' vesting period.  The 
Company's pro forma information follows (in thousands except for earnings per 
share information):

                                           1996      1995  
                                          ------    ------ 
          Pro forma net income            $1,147    $3,327 
          Pro forma earnings per share  
             Primary                       $0.16     $0.45 
             Fully diluted                 $0.16     $0.44 

     Because Statement 123 is applicable only to options granted subsequent 
to December 31, 1994, its pro forma effect will not be fully reflected until 
1997.

     EMPLOYEE STOCK PURCHASE PLAN

     Also, in January 1996, the Board of Directors proposed and in April 
1996, the stockholders adopted the Employee Stock Purchase Plan and reserved 
100,000 shares of the Company's common stock for issuance.  Under the 
Purchase Plan, employees are granted the right to purchase shares of common 
stock at a price per share that is 85% of the lesser of: (i) the mean market 
price on the Offering Commencement Date, or (ii) the mean market price on the 
Offering Termination Date. During 1996, shares totaling 7,859 were issued 
under the Purchase Plan at an average price of $6.00 per share.               

     The Company intends to utilize the repurchased treasury shares to 
satisfy future exercises of stock options.

     8.  NONRECURRING CHARGE
         
     The Company incurred severance charges resulting from certain management
separations in 1996; all payments under this arrangement were included as a
nonrecurring charge in the second quarter 1996.

     The Company and its former Chief Executive Officer mutually agreed to a
consulting and severance agreement effective October 1, 1994.  Under the terms
of this agreement, the former Chief Executive Officer received certain
previously established incentive and other consulting payments through the end
of 1995.  The Company included all payments under this agreement as a
nonrecurring charge in the fourth quarter of 1994.

     9.  RETIREMENT PLAN

     The Company has a retirement plan which is qualified under Section 401(k)
of the Internal Revenue Code.  This plan covers substantially all employees who
meet minimum age requirements and allows participants to defer a portion of
their annual compensation on a pre-tax basis.  Company contributions to the plan
may be made at the discretion of the Board of Directors.  No Company
contributions have been made through December 31, 1996.  The Board of Directors
has approved a matching contribution of 25% of the first 6% of employee
contributions, limited to $750 per employee, beginning January 1996.

     The Company does not offer post-retirement or post-employment benefits.


                                      30 
<PAGE>

     10.  GEOGRAPHIC OPERATIONS

     The following table presents information about the Company's operations by
geographical areas for each of the three years in the period ended December 31,
1996:

               GEOGRAPHICAL AREAS:
-------------------------------------------------------------------------------
                                            Operating   Operating  Identifiable
                                            Revenues     Income      Assets    
-------------------------------------------------------------------------------
               1996
                 North America               $28,567     $2,656     $38,007 
                 Europe/Asia Pacific           5,828       (177)      2,070 
                                             -------     ------     ------- 
                                             $34,395     $2,479     $40,077 
                                             -------     ------     ------- 
                                             -------     ------     ------- 
               1995
                 North America               $24,547     $5,638     $35,285 
                 Europe/Asia Pacific           1,081       (698)        209 
                                             -------     ------     ------- 
                                             $25,628     $4,940     $35,494 
                                             -------     ------     ------- 
                                             -------     ------     ------- 
               1994
                 North America               $14,312     $2,613     $10,324 
                 Europe/Asia Pacific             340       (142)         33 
                                             -------     ------     ------- 
                                             $14,652     $2,471     $10,357 
                                             -------     ------     ------- 
                                             -------     ------     ------- 















                                      31 
<PAGE>

                       REPORT OF INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Software Artistry, Inc.

     We have audited the accompanying consolidated balance sheets of Software
Artistry, Inc. as of December 31, 1996 and 1995, and the related consolidated
statements of operations, stockholders' equity (deficit), and cash flows for
each of the three years in the period ended December 31, 1996.  Our audits also
included the financial statement schedule listed in Item 14(a).  These financial
statements and schedule are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.

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

     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Software Artistry, Inc. at December 31, 1996 and 1995, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1996, in conformity with generally accepted accounting
principles.  Also, in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.


                                                  /s/  Ernst & Young LLP
                                                  
                                                  
Indianapolis, Indiana
January 27, 1997







                                      32 
<PAGE>

QUARTERLY FINANCIAL INFORMATION

     The Company believes that fourth quarter revenues and expenses are affected
by a number of seasonal factors, including the Company's sales compensation
plans.  The Company believes that these seasonal factors are common in the
computer software industry.  Such factors historically have resulted in first
quarter revenues in any year being lower than revenues in the immediately
preceding fourth quarter.  The Company expects this trend to repeat in the first
quarter of fiscal 1997.

<TABLE>
         Quarter Ended           March 31   June 30   September 30   December 31   Year
----------------------------------------------------------------------------------------- 
                  (unaudited -- in thousands, except per share data)
<S>                               <C>        <C>         <C>           <C>        <C>     
1996 
---- 
Total revenues                    $6,072    $7,526       $8,261        $12,536    $34,395 
Income (loss) from operations       (399)      (58)         266          2,670      2,479 
Net income (loss)                   (148)       86          310          1,689      1,937 
Net income (loss) per share:
  Primary                         $(0.02)   $ 0.01       $ 0.04        $  0.23    $  0.26 
  Fully diluted                   $(0.02)   $ 0.01       $ 0.04        $  0.23    $  0.26 

1995 
---- 
Total revenues                    $4,234    $5,707       $6,433        $ 9,254    $25,628 
Income from operations               391     1,120        1,178          2,251      4,940 
Net income                           294       861          912          1,681      3,748 
Net income per share:
  Primary                         $ 0.05    $ 0.11       $ 0.12        $  0.22    $  0.52 
  Fully diluted                   $ 0.04    $ 0.11       $ 0.12        $  0.22    $  0.51 

1994 
---- 
Total revenues                    $1,981    $3,013       $3,809        $ 5,849    $14,652 
Income from operations               108       576          638          1,149      2,471 
Net income                            75       389          433            769      1,666 
Net income per share:
  Primary                         $ 0.01    $ 0.08       $ 0.09        $  0.16    $  0.33 
  Fully diluted                   $ 0.01    $ 0.07       $ 0.07        $  0.13    $  0.27 
</TABLE>




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

         None.







                                      34 
<PAGE>

                                    PART III
                                        
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The information required by this item is contained in the sections 
captioned "Board of Directors - Nominees for Director" and "Voting Securities 
and Principal Holders - Exchange Act Compliance" in the Company's Proxy 
Statement for the Annual Meeting of Shareholders to be held on April 25, 1997 
(the "Proxy Statement"), and is incorporated herein by reference.  
Information with respect to Executive Officers of the Company is set forth 
under the caption "Executive Officers of the Registrant" in Part I of this 
report.

ITEM 11. EXECUTIVE COMPENSATION

     The information required by this item is contained in the section captioned
"Executive Compensation" of the Company's Proxy Statement and is incorporated 
herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The information required by this item is contained in the section captioned
"Executive Compensation" of the Company's Proxy Statement and is incorporated
herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The Company did not engage in any transaction or business relationship 
requiring disclosure under the Securities Exchange Act of 1934, as amended.




















                                      35 
<PAGE>
                                  PART IV

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

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

         1.  Financial Statements
               
             The following information appears in Item 8 of this Form 10-K:

<TABLE>
                                                                                      PAGE(S) 
                                                                                      ------- 
<S>                                                                                   <C>     
               -    Consolidated Balance Sheets as of December 31, 1996 and 1995......     18 
               -    Consolidated Statements of Operations for the Years Ended 
                      December 31, 1996, 1995, and 1994...............................     19 
               -    Consolidated Statements of Stockholders' Equity (Deficit) for 
                      the Years Ended December 31, 1996, 1995 and 1994................     20 
               -    Consolidated Statements of Cash Flows for the Years Ended 
                      December 31, 1996, 1995, and 1994...............................     21 
               -    Notes to Consolidated Financial Statements........................  22-29 
               -    Report of Independent Auditors....................................     30 
</TABLE>

         2.  Financial Statement Schedules

             The following financial statement schedule is included in this 
             report on Form 10-K:

             Schedule II - Valuation and Qualifying Accounts 

             All other schedules are omitted because they are not required, not
             applicable, or the required information is otherwise shown in the 
             consolidated financial statements or the notes thereto.   

         3.  Exhibits

             Exhibit                                
               No.                         Document 
             --------                      -------- 
              3.1*     Articles of Amendment to the Third Amended and Restated
                       Articles of Incorporation of Software Artistry, Inc. and
                       Amendments.
              3.2*     Amended and Restated Code of By-Laws of Software 
                       Artistry, Inc.
              4.1*     Form of Certificate for Common Stock. 
             10.1**    Form of Software License Agreement.
             10.2*     Form of Nondisclosure Agreement.
             10.3*     Lease Agreement with the Precedent, dated January 10, 
                       1994, and addendum I and II. 
             10.4**    Amended and Restated Line of Credit Loan Agreement with
                       Society National Bank, Indiana dated April 28, 1995.
             10.5*     Employment Agreement with Michael J. Robbins dated 
                       December 27, 1991.
             10.6*     Employment Agreement with Steven M. Ehrlich dated July 8,
                       1991.
             10.7*     Employment Agreement with W. Scott Webber dated February
                       28, 1991.
             10.8**    October 18, 1995 Amendment to the Amended and Restated
                       Nonstatutory Stock Option Incentive Plan, dated December
                       9, 1994.
             10.9**    Form of Nonstatutory Stock Option Incentive Agreement.
             10.10*    Amended and Restated Incentive Stock Option Plan, dated
                       December 9, 1994. 
             10.10a    Amendment to the Incentive Stock Option Plan, adopted by 
                       the board January 15, 1997. 
             10.11*    Form of Incentive Stock Option Agreement.
             10.12*    Salary Deferral [401(k)] and Savings Prototype Profit
                       Sharing Plan and Trust. 


                                      36 
<PAGE>

             10.13*    Registration Rights Agreement, dated March 16, 1990, as
                       amended January 22, 1992.
             10.14*    Form of Employee Agreement Regarding Competitive 
                       Activities.
             10.15     Lease Agreement with Duke, dated October 2, 1996. 
             11.1      Statements re Computation of Per Share Earnings.
             21.1      Subsidiaries of the Registrant.
             23.1      Consent of Ernst & Young LLP.
             24.1      Power of Attorney of Jerry Baker.
             24.3      Power of Attorney of Lawrence W. Olson.
             24.4      Power of Attorney of Joseph A. Piscopo.
             27.1      Financial Data Schedule

             *  Incorporated herein by reference to the Registration Statement 
                on Form S-1 of Software Artistry, Inc. with Registration No. 
                33-88622 declared effective March 2, 1995.
               
             ** Incorporated herein by reference to the 1995 Annual Report on 
                Form 10-K filed on March 30, 1996.

           (b)  Reports on Form 8-K
                No reports on Form 8-K were filed during the quarter ended 
                December 31, 1996.




















                                      37 
<PAGE>

                                   SIGNATURES

     Pursuant to the requirements of the 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. 

                                       SOFTWARE ARTISTRY, INC.


DATE: MARCH 21, 1997                   By: /s/  W. Scott Webber
                                          ----------------------------------
                                           W. Scott Webber 
                                       President 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 and on the date indicated.

<TABLE>

          Signature                          Title (Capacity)                          Date
          ---------                          ----------------                          ----
<S>                                          <C>                                       <C>
   /s/  W. Scott Webber            President, Chief Executive Officer,           March 21, 1997
-------------------------------    and Director
      W. Scott Webber              (Principal Executive Officer)

  /s/  Thomas E. Vanneman          Vice President, Finance, Chief Financial      March 21, 1997
-------------------------------    Officer, Treasurer, and Secretary
        Thomas E. Vanneman         (Principal Financial and
                                   Accounting Officer)

             *
-------------------------------    Director                                      March 21, 1997
        Jerry Baker


             *
-------------------------------    Director                                      March 21, 1997
     Lawrence W. Olson


             *
-------------------------------    Chairman of the Board of Directors            March 21, 1997
    Joseph A. Piscopo

</TABLE>

* By  /s/  W. Scott Webber
    ---------------------------
           W. Scott Webber
          ATTORNEY-IN-FACT



                                                38

<PAGE>

<TABLE>
                            SOFTWARE ARTISTRY, INC.
                Schedule II - Valuation and Qualifying Accounts

                Col. A                    Col. B                     Col. C                           Col D.            Col E.
--------------------------------------  ----------   -------------------------------------   ---------------------  --------------
                                                                   Additions
                                        Balance at   -------------------------------------
                                        Beginning    Charged to Costs    Charged to Other                           Balance at End
            Description                 of Period      and Expenses    Accounts - Describe   Deductions - Describe    of Period
--------------------------------------  ----------   ----------------  -------------------   ---------------------  --------------
<S>                                        <C>             <C>                    <C>                   <C>                <C>
Year ended December 31, 1996:
  Deducted from asset accounts:                                                                  $(477,976)(2)
    Allowance for doubtful accounts. .   $394,296        $300,464           $368,230(1)           (105,014)(3)         $480,000
                                         --------        --------           --------             ---------             --------
      Total. . . . . . . . . . . . . .   $394,296        $300,464           $368,230             $(582,990)            $480,000
                                         --------        --------           --------             ---------             --------
                                         --------        --------           --------             ---------             --------
Year ended December 31, 1995:
  Deducted from asset accounts:                                                                  $(123,215)(2)
    Allowance for doubtful accounts. .   $175,000        $258,700           $271,120(1)           (187,309)(3)         $394,296
                                         --------        --------           --------             ---------             --------
      Total. . . . . . . . . . . . . .   $175,000        $258,700           $271,120             $(310,524)            $394,296
                                         --------        --------           --------             ---------             --------
                                         --------        --------           --------             ---------             --------
Year ended December 31, 1994:
  Deducted from asset accounts:
    Allowance for doubtful accounts. .   $ 75,000        $138,000           $    -               $ (38,000)(2)         $175,000
                                         --------        --------           --------             ---------             --------
      Total. . . . . . . . . . . . . .   $ 75,000        $138,000           $    -               $ (38,000)            $175,000
                                         --------        --------           --------             ---------             --------
                                         --------        --------           --------             ---------             --------

----------------------
(1)  Represents allowance established for non-renewals of license renewal fees; amounts charged to license renewal fees revenue.
(2)  Uncollectible accounts written off.
(3)  Non-renewals written off.
</TABLE>

<PAGE>


                                EXHIBITS TO FORM 1996 10-K

<TABLE>
Exhibit                                                                           Page
  No.                                   Document                                   No.
-------                                 --------                                  ----
<S>                                       <C>                                      <C>

10.10a     Amendment to the Incentive Stock Option Plan, adopted by the board
           January 15, 1997.                                                      02-03
10.15      Lease Agreement with Duke, dated October 2, 1996.                      04-38
11.1       Statements re Computation of Per Share Earnings.                          39
21.1       Subsidiaries of the Registrant.                                           40
23.1       Consent of Ernst & Young LLP.                                             41
24.1       Power of Attorney of Jerry Baker.                                         42
24.3       Power of Attorney of Lawrence W. Olson.                                   43
24.4       Power of Attorney of Joseph A. Piscopo.                                   44
27.1       Financial Data Schedule.                                                  45
</TABLE>