<PAGE>

                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549

                                   FORM 10-KSB

               /X/ ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE
                 SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED]

                     FOR THE FISCAL YEAR ENDED JUNE 30, 1999

                                       OR

             / / TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE
                SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

             For the transition period from __________ to __________

                         COMMISSION FILE NUMBER: 0-27106

                                RSI SYSTEMS, INC.
                                -----------------
                 (Name of small business issuer in its charter)

                 MINNESOTA                                  41-1767211
                 ---------                                  ----------
     (State or other jurisdiction of                      (IRS Employer
      incorporation or organization)                    Identification No.)

                         5555 WEST 78TH STREET, SUITE F
                              MINNEAPOLIS, MN 55439
                              ---------------------
              (Address of principal executive offices and zip code)

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (612) 896-3020

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

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:       COMMON STOCK,
                                                                  $.01 PAR VALUE

Check 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 / /

Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB for any
amendment to this Form 10-KSB. /X/

The Company's revenues for its most recent fiscal year were $9,199,135.

On September 23, 1999, the Company had 6,971,281 shares of common stock, $.01
par value, outstanding, and the aggregate market value of the common stock as of
that date (based on the average of the closing bid and asked prices as of that
date as reported by the NASDAQ SmallCap Market), excluding outstanding shares
beneficially owned by directors and officers, was approximately $9,219,000

                    DOCUMENTS INCORPORATED BY REFERENCE: None

Transitional Small Business Disclosure Format (check one):  Yes ___; No _X_


<PAGE>

                                     PART I

CAUTIONARY STATEMENT IDENTIFYING IMPORTANT FACTORS THAT COULD CAUSE THE
COMPANY'S ACTUAL RESULTS TO DIFFER FROM THOSE PROJECTED IN FORWARD LOOKING
STATEMENTS

         In connection with the "safe harbor" provisions of the Private
Securities Litigation Reform Act of 1995, readers of this document and any
document incorporated by reference herein, are advised that this document and
documents incorporated by reference into this document contain both statements
of historical facts and forward looking statements. Forward looking statements
are subject to certain risks and uncertainties, which could cause actual results
to differ materially from those indicated by the forward looking statements.
Examples of forward looking statements include, but are not limited to (i)
projections of revenues, income or loss, earnings or loss per share, capital
expenditures, dividends, capital structure and other financial items, (ii)
statements of the plans and objectives of the Company or its management or Board
of Directors, including the introduction of new products, or estimates or
predictions of actions by customers, suppliers, competitors or regulatory
authorities, (iii) statements of future economic performance, and (iv)
statements of assumptions underlying other statements and statements about the
Company or its business.

         This document and any documents incorporated by reference herein also
identify important factors which could cause actual results to differ materially
from those indicated by the forward looking statements. These risks and
uncertainties include price competition, the decisions of customers, the actions
of competitors, the effects of government regulation, possible delays in the
introduction of new products, customer acceptance of products and services, and
other factors which are described herein and/or in documents incorporated by
reference herein.

         The cautionary statements made pursuant to the Private Litigation
Securities Reform Act of 1995 above and elsewhere by the Company should not be
construed as exhaustive or as any admission regarding the adequacy of
disclosures made by the Company prior to the effective date of such Act. Forward
looking statements are beyond the ability of the Company to control and in many
cases the Company cannot predict what factors would cause results to differ
materially from those indicated by the forward looking statements.

ITEM 1.       DESCRIPTION OF BUSINESS.

(a)      BUSINESS DEVELOPMENT

              RSI Systems, Inc., (the "Company" or "RSI"), designs, manufactures
and sells high performance, business quality videoconferencing systems
throughout a worldwide network of resellers and OEM or private label partners.
The Company's fourth-generation product family, the MediaPro-TM- system, is now
being manufactured and is available for sale. This system provides television
quality video and audio via a miniaturized, self-contained free-standing device
which is fully industry standards based and is sold in three different
configurations: laptop, computer-free and dual platform.

              The Company was incorporated under the laws of Minnesota on
December 21, 1993. Its founders developed a self-contained desktop
videoconferencing device for connection to personal computers and Apple
Macintosh systems. On July 25, 1995, the Company conducted a public offering of
its common stock, par value $0.01 per share (the "Common Stock"). With the net
proceeds from the public offering, including proceeds from the exercise of the
underwriter's overall allotment option (approximately $7,400,000), the Company
funded further research and development related to the enhancement of the
original product. By June 1996, the target market for this product had not
developed and the product had not achieved its price performance objectives.

              In July 1996, a new management team redirected Company efforts
away from the computer-based desktop videoconferencing systems marketplace and
towards the emerging workgroup and settop television-based market. Subsequently,
the Company designed a second-generation system, the Video Flyer, that created a
new level of video, audio and price performance without need for interfacing to
any type of computer system. Deemed a COMPUTER-FREE SYSTEM, the original Video
Flyer evolved into the Video Flyer Plus computer product line of
videoconferencing engines with enhanced features and functionality.


                                       1
<PAGE>

              In September 1996, to fund the development and marketing of its
videoconferencing products, the Company completed a private placement of
1,500,000 shares of its Common Stock resulting in net proceeds to the Company of
approximately $3,943,000. In January 1998, to provide additional funds for
expanded marketing, distribution, product development and general corporate
purposes, the Company completed the private placement of 1,671,255 shares of its
Common Stock resulting in net proceeds of approximately $2,523,000.

              In the fall of 1998, the Company began development of a new
videoconferencing engine. The Company's MediaPro system, introduced in June
1999, is a cross-platform, multimedia videoconferencing engine, capable of
operating either with or without a host computer and displaying through a
variety of output devices.

OVERVIEW OF THE MARKETPLACE

              Various forms of videoconferencing equipment have been introduced
to the global marketplace during the past 20 years. Initial system offerings
were very expensive and sold primarily as a method to reduce travel expense or
conduct distance meetings between large groups of individuals.

              With the establishment of industry standards by the International
Telecommunications Union (ITU) in the early 1990s and the availability of lower
cost electronic componentry, marketplace sales began to rapidly accelerate.
Since then, better products and lower prices throughout the marketplace have
increased the applications for videoconferencing systems, creating distinct
product segments.

              The videoconferencing equipment marketplace continued to evolve in
fiscal year 1999, with a clear continued shift toward high quality, reasonably
priced systems, which incorporate expanded capabilities and functionality. This
shift has continued to create expanding opportunities and challenges for the
Company, in what is believed to be an overall market of approximately $1.3
billion currently.

              The market is generally recognized as having the following
segmentation:

              (1)  Consumer Systems. These systems are generally very
                   inexpensive, operate on standard telephone lines and provide
                   minimal levels of quality picture and audio performance.
                   List pricing for these systems currently ranges from $500 to
                   $1,000.

              (2)  Desktop Systems. These systems consist of electronic
                   components or internal devices being added to existing
                   desktop personal computers. Available from a variety of
                   different manufacturers, product performance varies widely.
                   Pricing of these systems based upon system requirements,
                   functionality, and upgradability also varies widely and
                   ranges from $1,000 to $5,000.

              (3)  Set-top/Workgroup Videoconferencing Systems. This segment
                   has been labeled by H. C. Wainwright & Co., Inc. as "not
                   only the sweet spot in the videoconferencing market right
                   now--it IS the market."(1) RSI's Video Flyer product was the
                   first system to enter this marketplace as a fully
                   self-contained, high performance television quality
                   non-computer based product. Deemed COMPUTER-FREE, the Video
                   Flyer contained no disk drive or internalized moving parts
                   nor did it require a keyboard for operation. The Company's
                   new MediaPro product is also targeted toward this market
                   segment which is estimated to be in the area of $300
                   million.(2)

                   The systems in this market segment generally attach to high
                   quality brand name televisions or other non-computerized
                   displays to provide medium to exceptional video and audio
                   performance at price points ranging from $25,000 to under
                   $10,000. Systems provided by manufacturers in this market
                   segment are interoperable between each other, thus allowing
                   for rapid expansion of use and cross-platform compatibility.
                   This is similar to facsimile machines standardization in the
                   late 1980s to allow for rapid expansion of the marketplace
                   regardless of the product brand.

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

              (1) H. C. Wainwright & Co., Inc.; Videoconferencing Industry THE
RISE OF THE SMALL-GROUP SYSTEM, December 2, 1998.

              (2) Ibid.


                                       2
<PAGE>

              (4)  Permanent Room Systems. With the improvement in quality of
                   settop/workgroup systems, this market segment is not growing
                   as rapidly as it once was, but many permanent rooms are
                   undergoing refurbishment, creating opportunities for
                   manufacturers of products that are easily integrated into
                   permanent room systems. Permanent room systems are intended
                   to provide a high level of consistent operation for both
                   audio and video signals. Prices for full room systems are in
                   the $50,000 and up category, excluding installation. The
                   Company's videoconferencing engines, because of their
                   adaptability and quality, can be integrated into these room
                   systems.

              H.C. Wainwright believes that the settop/workgroup systems segment
will continue to grow at a rate of over 45% annually.(3) The Company believes
that the market will generally remain stratified over the next few years within
the segments identified above. New capabilities and features will be introduced
that will encourage more demand in the marketplace. User applications will
become the primary driver of product development and market expansion.

(b)      BUSINESS OF THE COMPANY

PRODUCTS

MEDIAPRO 384.

              In June 1999, the Company introduced its fourth-generation
product, the MediaPro 384 product family, which is aimed primarily at the
settop/workgroup market segment. The MediaPro 384 product family is a 384 Kbps
product that builds upon the strengths of the Company's Video Flyer Plus product
and added several additional enhancements.

              Price points for the MediaPro products are targeted to compete
directly with the Company's major competitors in the workgroup segment. The Dual
Platform model, described below, incorporates greater functionality than the
competitions' at similar or lower price points.

              The primary capabilities designed into the MediaPro are:

              (1)  ETHERNET. All members of the MediaPro 384 product family
                   have a 10/100 Mbps Ethernet (LAN) interface. By
                   incorporating an Ethernet interface the product has the
                   hardware support required to implement H.323 packet based
                   video conferencing, which will be added in fiscal year 2000.
                   The MediaPro 384 product also includes an embedded Web
                   Server that can be accessed via the LAN. The Web Server
                   provides a remote diagnostics/maintenance interface that
                   makes installing and supporting the MediaPro 384 product
                   much easier than other competitive products that exist in
                   the market.

              (2)  EASE OF USE. All members of the MediaPro 384 product family
                   have a Setup Genie (similar to a Windows Wizard) that
                   assists the person installing the system. The Setup Genie
                   will prompt the installer to configure all the important
                   parameters of the system thereby simplifying the
                   installation process. The new Graphical User Interface (GUI)
                   that is part of the MediaPro 384 product family further
                   simplifies the operation of the product. The Company
                   believes the MediaPro 384 GUI is state of the art in terms
                   of ease of use.

              (3)  ARCHITECTURE. All MediaPro 384 systems use a single high
                   performance motherboard developed by the Company. This
                   architecture dramatically reduces the chances for system
                   failure, cost of manufacture and opportunity for increasing
                   overall operational performance. The network interface is
                   contained on a daughter card. This allows the Company to
                   rapidly develop new connectivity options as new network
                   technologies come to market.

              (4)  INTERNALIZATION OF MULTIPLE DEVICES. The MediaPro 384 has
                   all of the components required to perform video conferencing
                   internalized into the system. The MediaPro 384 system
                   contains all of

-------------------
              (3)  Ibid.


                                       3
<PAGE>

                   the electronics for video, audio, memory for retention of
                   code, inverse multiplexer and network interfaces which lower
                   overall cost and eliminate the need for many cumbersome
                   peripheral devices connected to the videoconferencing
                   engine.

              (5)  EXPANSIVE CONNECTIVITY. The MediaPro 384 has the greatest
                   range of external component connectivity of any system in
                   its market segment. All MediaPro 384 systems can connect to
                   any size or brand television set, LCD projector, flat screen
                   display or other video display device. This flexible
                   connectivity allows the MediaPro 384 to fit into a variety
                   of applications ranging from classrooms to boardrooms,
                   factory floors, lunchrooms, conference centers, hotel
                   meeting halls, outdoor facilities, living rooms or offices.

                   The MediaPro 384's unique self-contained component design
                   also gives it the flexibility to connect to an unlimited
                   variety of audio devices such as mixers, microphones,
                   speaker systems, etc. This means that the system can be
                   installed in virtually any type of environment regardless of
                   the customer's existing electronic design.

                   MediaPro's connectivity also permits the use of VCRs and
                   digital video disk systems (DVDs) for input and playback or
                   recording of video conferences. This has proved to be very
                   useful in both educational, legal and various business
                   applications where training or negotiation sessions need to
                   be captured or played back for group review.

              (6)  APPLICATION PROGRAMMING INTERFACE (API). Another important
                   feature that the MediaPro 384 provides is a well documented,
                   easy to use, Software Development Kit. This allows System
                   Integrators to develop custom applications that incorporate
                   the MediaPro 384.

              (7)  SOFTWARE ARCHITECTURE. To deliver high performance
                   television-like video and audio conferencing signals,
                   customized software must be developed by a manufacturer that
                   operates within the ITU's published standards (H.320). RSI's
                   team of engineers created software code that could reside on
                   flash memory and provide high quality video and audio signal
                   performance with a high level of operational simplicity.

                   RSI delivers its software to product users over telephone
                   lines, which eliminates the need for diskettes or hard
                   drives. When a new version of software is made available to
                   the marketplace, existing product users merely place a phone
                   call to a MediaPro 384 software server and request an
                   unattended download of the new software. In a matter of
                   minutes, the new software is loaded onto the user's system
                   and they are now able to take advantage of all of the new
                   features or enhancements.

              (8)  STANDARDS-BASED COMPATIBILITY. The Company has continued to
                   develop 100-percent standards-based systems. By doing so, it
                   guaranteed that the MediaPro 384 would interoperate with any
                   other standards-based videoconferencing system regardless of
                   manufacturer. The MediaPro 384 system contains no
                   proprietary standards that will not interoperate with other
                   standards-based systems. Standards are established and
                   published by the International Telecommunications Union
                   (ITU) and are available to all manufacturers for voluntary
                   compliance.

              (9)  TWO HIGH SPEED RS232 DATA COMMUNICATION PORTS. The high
                   speed data ports can be used for a number of applications.
                   One application is to allow Microsoft NetMeeting to be used
                   for T.120 data collaboration allowing users to share files
                   and other information during videoconferences. Another
                   application is for connection of an external control system
                   (such as an AMX or Crestron control system). A modem can
                   be attached to a data port to allow for remote dial up
                   diagnostics and control. System Integrators can take
                   advantage of the high speed data ports to integrate
                   additional applications with the MediaPro 384.

              (10) INTERNALIZATION OF THE NETWORK TERMINAL ADAPTERS (NT1S). In
                   North America most telecommunication services require an
                   external device known as an NT1 to be attached to each ISDN
                   line connected to a videoconferencing system. In the case of
                   a 384 Kbps (three ISDN lines) based system,


                                       4
<PAGE>

                   this means that up to three NT1s may have to be purchased by
                   the customer. Assuming normal wear and tear, compatibility
                   issues, available power outlets, etc., this can be a source
                   of frustration and repair. The MediaPro 384 internalizes
                   these devices and thus eliminates any requirements for
                   external componentry. At this time, the Company believes it
                   may be the only video conferencing product in its market
                   segment that does not require external NT1s.

              (11) SYSTEM ENCLOSURE. All members of the MediaPro 384 product
                   family are packaged in a very attractive and compact
                   enclosure that is easily transported. The enclosure also
                   makes it easy to integrate the product into custom
                   installations. The MediaPro 384 product family supports an
                   optional remote Infrared Detector that allows the system to
                   be installed in a wiring closet or in the bottom of a cart.

              (12) WARRANTY PROGRAM. The MediaPro 384 was engineered to
                   eliminate the need for field maintenance and repair. Often
                   costly and inconsistent, field support can degrade the
                   functionality and reputation of the manufacturer's installed
                   base of systems. In 1998, the Company developed and
                   introduced its full system exchange warranty program named
                   ServiceAngel. In conjunction with overnight shippers, RSI
                   will ship an exchange system within one business day of
                   notification to anywhere in North America or Europe.
                   Customers have readily endorsed this alternative program to
                   time consuming and often frustrating in-office system repair
                   provided by many of the Company's competitors. The
                   ServiceAngel program also allows the Company to dramatically
                   reduce its requirement for parts, spares, bench test beds,
                   and field technicians.

              The MediaPro 384 product family is available in three
configurations and each configuration is available with a variety of different
network interfaces such as ISDN BRI and V.35.

              (1)  MEDIAPRO 384 CF (COMPUTER-FREE). The MediaPro 384 CF is
                   controlled by an infrared (IR) remote controller and
                   operates as a standalone device. The new GUI is the easiest
                   to use and most intuitive User Interface in the market at
                   this time. The MediaPro 384 CF can be attached to
                   televisions, LCD display devices, flat panel display devices
                   and other video display systems. The systems operation is
                   controlled by a custom designed IR remote controller. The
                   MediaPro 384 GUI simplifies system setup and operation.

              (2)  MEDIAPRO 384 LT (LAPTOP). This model works in conjunction
                   with a Personal Computer or laptop running Windows 95/98 or
                   Windows NT 4.0. The unit comes with a user interface that is
                   an application that runs on the computer. The MediaPro 384
                   LT can display the received video on either the computer's
                   display device (CRT) or a television. The MediaPro 384 LT
                   is attached to the computer by an industry standard
                   peripheral bus known as SCSI. Using the SCSI port as the
                   interconnect between the MediaPro 384 LT and the computer
                   allows the MediaPro 384 LT to be used with any properly
                   equipped desktop or laptop computer. The Company is not
                   aware of any other system on the market that can bring high
                   performance, ISDN based, video conferencing to a laptop
                   computer.

              (3)  MEDIAPRO 384 DP (DUAL PLATFORM). The MediaPro 384 DP
                   combines the functionality of the MediaPro 384 CF and
                   MediaPro 384 LT into one dual purpose product that can
                   operate as either a MediaPro 384 CF or as a MediaPro 384 LT.

              All MediaPro 384 systems can accept additional software features
and upgrades to allow the products to continue to meet the demands of a
continuously changing market. The Company may charge a fee for new, substantial,
software features that it develops. The software updates are received by making
a telephone call to the Company's software server and downloading the software
into the unit to be updated.

VIDEO FLYER.

              In addition to the MediaPro 384, the Company manufactures a line
of computer-free videoconferencing engines sold worldwide under the name Video
Flyer. These units were first introduced in the spring of 1997 and are available
in both a 384 Kbps version (three ISDN lines) known as Video Flyer Plus and a
128 Kbps version


                                       5
<PAGE>

(single ISDN line) called Video Flyer PVS (personal video system).

              The Video Flyer Plus system offers high quality 384 audio and
video and carries many of the features and functionality of the Company's
MediaPro systems, including the latest GUI software. Price points are very
competitive with other comparable systems on the market.

              The Video Flyer PVS system is aimed toward applications which do
not require all the features or full television-like quality of the 384 system,
at very affordable price points ranging from $2,495, with a small personal
camera, to $3,295, incorporating a pan tilt zoom camera.

ON-GOING PRODUCT DEVELOPMENT.

              The Company expects to continue refining its videoconferencing
products to provide greater performance, capability and enhancements to the
marketplace and its existing users. Through increased sales volume, the Company
believes that the overall manufacturing cost of the system may decline, thus
allowing the Company and the marketplace to share in the potential cost
reductions. Additionally, as new forms of communication connectivity are brought
to the marketplace, such as ATM, DSL, etc., the Company will continue to review
their viability and, if deemed appropriate, the Company will create the
connectivity electronics to interoperate within these networks. It is
management's belief that the MediaPro 384 will have an extended life cycle
because of its unique architecture, software design and cross-platform
flexibility.

SALES AND DISTRIBUTION

              In 1999, the Company continued with its multilevel approach to
distribution. This approach includes Resellers and Distributors, OEM
partnerships and Preferred Accounts.

RESELLERS AND DISTRIBUTORS.

              In fiscal year 1999, the Company introduced its Millennium
Partners Program and used it to strengthen distribution throughout North
America, Europe, Asia, Australia and portions of the Middle East and South
Africa. Through the Millennium program, authorized product resellers and
distributors can purchase videoconferencing equipment and related peripheral
devices from the Company and resell them in their local geographic markets. The
Company provides classroom training, literature, sales, marketing and technical
support to these customers. The Company believes its Millennium program offers
very competitive margins to its resellers and distributors.

              The Company plans to continue strengthening its reseller network
on an on-going basis to improve sales coverage by developing successful
long-term relationships with successful resellers, including systems integrators
who provide turnkey solutions to end users.

ORIGINAL EQUIPMENT MANUFACTURER (OEM) PARTNERSHIPS.

              In fiscal year 1999, the Company sold equipment under three OEM or
private label distribution agreements.

              (1)  Gentner Communications Corporation. In October 1998, the
                   Company entered into a private label agreement with Gentner.
                   Gentner asked the Company to provide a version of the Video
                   Flyer Plus for the purpose of integration into Gentner's
                   product line. The agreement calls for Gentner to purchase a
                   specific quantity of products through December 1999. There
                   is no limit to the quantity of product Gentner is allowed to
                   purchase from the Company. The Company expects a successful
                   relationship with Gentner.

              (2)  Philips Business Electronics N.V. of Eindhoven, The
                   Netherlands. The Company has designed, manufactured and
                   delivered a version of the Video Flyer product to Philips
                   Business Electronics. The contract called for specific
                   minimum quantities to be purchased by Philips and Philips
                   fulfilled that commitment by June 30, 1999. The Company does
                   not expect Philips to order significant quantities of the
                   product in the future.


                                       6
<PAGE>

              (3)  VTEL Corporation. In the summer of 1998, the Company entered
                   into an OEM agreement with VTEL Corporation. The Company
                   developed a version of the Video Flyer Plus system for the
                   purpose of resale by VTEL. The contract called for VTEL to
                   purchase a specific quantity of product and as of June 30,
                   1999, VTEL had purchased this minimum quantity. The Company
                   does not expect VTEL to purchase significant quantities of
                   product in the future.

PREFERRED ACCOUNT SALES.

              In selected instances, RSI will continue to sell directly to
and/or support accounts in North America that are of either significant size or
their requirements dictate direct interaction with the manufacturer (the
Company). Though it is not RSI's intention to compete with its other
distribution channels, many of the organizations which make larger purchases of
videoconferencing equipment have dictated that the manufacturer provide
specialized services (be they domestic or global) or modify products for their
specific application. Where practical, RSI will create an environment for these
accounts that will allow them to be transitioned to its authorized resellers or
OEM business partners for long-term future sales and support.

MARKETPLACE COMPETITION

              The videoconferencing marketplace has continued to evolve into
relatively well-defined product segments. RSI's videoconferencing product line
is targeted at the settop/workgroup and permanent room marketplaces. The
competition within this marketplace is intense and constant. Many of the
Company's competitors are large companies with resources substantially greater
than those available to RSI.

              Polycom, Inc., with its broad distribution channel, is the
industry leader in the settop/workgroup marketplace. Their system is
computer-free, and it integrates a camera and videoconferencing engine into a
single device that has the capability of performing four-location
videoconferences without the use of an independent bridging service. The Polycom
unit also can be used in H.323 (LAN) applications. The price point for the
system is comparable with the Company's price points for its products. The
Company believes that Polycom will continue to create market opportunities for
theirs and the Company's products by aggressively emphasizing the value of
settop videoconferencing architecture. The Company feels that its product can be
differentiated from the Polycom system in architecture, software capability and
selected performance levels in both video, audio and connectivity.

              PictureTel Corporation offers products for sale within all market
segments. They offer products which directly compete against RSI's product line.
Currently, their Concorde, Venue and SwiftSite systems are based on personal
computer engines and list at price points higher than RSI's products. RSI is
fully compatible with these systems when operated under published industry
standards. Long-term, the Company believes that PictureTel will continue to
produce competitive products into the market segments and remain a significant
marketplace participant.

              VTEL Corporation offers computer-based products that are targeted
at the education and medical vertical markets. Their distribution is through
large interexchange communications carriers such as MCI, Sprint and the Bell
Operating Companies. In order to meet the needs of the workgroup market segment,
they have entered into an OEM agreement with the Company to resell a version of
the RSI product under the VTEL label.

              Tandberg offers a full range of videoconferencing systems for sale
within most of the existing marketplace segments. They have strong distribution,
and within the settop rollabout workgroup market segment they offer a
non-computer-based system which delivers consistent video and audio quality.
Their systems are generally higher in price than the Company's products.

              Sony Corporation offers a settop and a rollabout system that
compete with the RSI product line. They have worldwide distribution and solid
name recognition.

              VCON competes in the Company's identified market segment. They
also provide a computer-based settop and rollabout videoconferencing system.
With a focus on H.323 (LAN) applications, VCON has established distribution in
North America, Europe and portions of Asia. The Company believes that VCON will
continue to expand its distribution presence.


                                       7
<PAGE>

              Intel competes in the workgroup market segment with its rollabout
system. Intel has solid name recognition and strong distribution.

              Aethra, C-Phone and several other companies also compete in the
settop market.

              Though the Company has unique products with identifiable features
and levels of performance, there is no guarantee that another manufacturer or
organization could not enter the marketplace with similar or improved levels of
capability. The Company expects to continue refining its products, remain at the
lower end of the price curve for high performance systems, offer aggressive
margins to its customers and keep the product at the high end of the performance
curve for comparable systems.

MANUFACTURING

         The Company's videoconferencing engines are manufactured by a third
party manufacturer, Altron, Inc. (Altron) under a manufacturing agreement signed
on September 10, 1996. In addition to manufacturing, Altron provides all
purchasing, material control, testing services and product warranty coverage for
the Company's videoconferencing engines. Altron warrants that all products will
be free from defects in material and workmanship for fifteen (15) months from
the date Altron ships to the Company, or for twelve (12) months from the date
the Company ships to the customer, whichever comes first.

         A major component in the Video Flyer product family for which the
Company depends on a single source is the compression chip. The Company
currently maintains an inventory of the compression chips sufficient to allow
for time to redesign its videoconferencing engines to accommodate similar
components from other vendors in the event the compression chip currently used
was to become unavailable to the Company. Although materials purchasing services
are provided by Altron, alternate suppliers have been identified by the Company
for most other components in its videoconferencing engines. The Company has no
information which would indicate that the compression chip or other components
currently used may become unavailable during the product life cycle of its
products.

         The Company believes Altron has the capacity and capability to satisfy
manufacturing requirements for its videoconferencing engines in the foreseeable
future. The Company has identified an alternate manufacturer with capabilities
acceptable to the Company. If a disruption in manufacturing were to occur, the
Company believes it could utilize the alternative manufacturer to satisfy
production requirements.

APPROVALS AND CERTIFICATIONS

         Government and telecommunications carrier approvals, safety
certifications and Electromagnetic Compliance (EMC) certifications are a key
requirement for electronic systems that use the telephone network. The MediaPro
384 product family has received the Safety, EMI and Telephone certifications
required to sell the product into the United States, Canada, the European Union
and Australia. The Company is currently pursuing certification for the MediaPro
product family in other countries.

         In the United States the Video Flyer Plus system and similar products
have been certified by the FCC as a class A (business) device. The Company has
received certification from Underwriters Laboratories Inc. ("UL") that the Video
Flyer and similar systems comply with the applicable requirements for U.S. and
Canada Listing. The Company has also received telephone, safety and EMC
certifications for its Video Flyer system in Australia, the European Union,
Singapore, Malaysia, Korea, Indonesia and South Africa.

         Although the Company has obtained telephone, safety and EMC
certifications for its videoconferencing systems in the countries noted above,
the Company cannot predict whether it will obtain necessary approvals and
certifications for the systems and similar products or for future products in
additional countries. Also, the Company cannot predict whether applicable law or
regulations might change in a way adverse to the Company's ability to sell its
products in a particular country.


                                       8
<PAGE>

INTELLECTUAL PROPERTY AND ROYALTY AGREEMENTS

         The Company's success is dependent in part on its proprietary
information, technology and expertise. The Company relies on a combination of
patents, trade secrets, copyrights and confidentiality agreements to establish
and protect its proprietary rights. In fiscal year 1998, the Company amended its
U.S. utility patent application for its peripheral videoconferencing system,
originally filed in September 1994, to narrow and refocus the Company's claims.
The Company received a patent on its system on September 1, 1998. The Company
has also applied for various foreign patents relating to its videoconferencing
engines, none of which have been granted to date.

         With respect to its technical employees and consultants, the Company
requires these employees to sign an agreement which obligates them to keep
confidential certain trade secrets and information of the Company and to assign
to the Company any inventions arising from their work for the Company, as
permitted by law. Depending on the responsibilities of a particular employee,
the Company may also consider having such an employee sign a non-compete
agreement.

         The software embedded in the Company's videoconferencing systems
carries a standard license agreement for the end-user. The software license
agreement is included in the System manuals and grants the purchaser a
non-exclusive and non-transferable license to use the software program.

         The Company entered into a software licensing agreement in November
1998 with a software development company. Pursuant to the agreement, the Company
is to pay a royalty fee of $5.00 per unit of videoconferencing systems sold.
Sales of the related videoconferencing systems are expected to begin shipping in
the first quarter of fiscal year 2000.

         The Company entered into a software license agreement with a software
development company on April 8, 1998. Pursuant to the agreement, the Company
pays a royalty fee of up to $5.00 per unit of videoconferencing systems sold.
Sales of the related videoconferencing systems began in fiscal year 1998.

         The Company entered into a license agreement with a software
development company on February 2, 1996. Pursuant to the agreement, the Company
was granted a non-exclusive, non-transferable license to use and modify specific
software components in the creation of the Company's videoconferencing systems,
subject to certain limitations. License fees payable by the Company included an
initial licensing fee of $60,000 for the right to develop a stand alone
videoconferencing system and an additional $30,000 upon production. In addition
to these licensing and production fees, the Company is required to pay a royalty
of $40.00 on each of the first 1,000 videoconferencing systems sold, $4.75 for
the following 9,000 videoconferencing systems sold, $6.25 for the following
90,000 videoconferencing systems sold and $5.10 for each videoconferencing
systems sold in excess of 100,000. Sales of the related videoconferencing
systems began in fiscal year 1997.

         Pursuant to a license agreement with a software development company,
which provides certain ISDN software used in the Company's videoconferencing
systems, the Company pays a royalty of $25 on each of the first 10,000 systems
sold, $15 on each system over 10,000 up to 50,000 and $8 on each system sold in
excess of 50,000.

RESEARCH AND DEVELOPMENT

         The Company incurred research and development expenses in fiscal year
1999 and 1998 of $1,281,718 and $993,525 respectively.

EMPLOYEES

         On September 27, 1999, the Company had thirty-nine full-time employees;
ten in sales; five in marketing and customer support; five in technical support;
nine in product development and engineering; three in operations and seven in
administration and finance. None of the Company's employees is represented by a
labor union. The Company believes its employee relations are good.


                                       9
<PAGE>

CERTAIN IMPORTANT FACTORS

         There are several important factors that could cause the Company's
actual results to materially differ from those anticipated by the Company or
which are reflected in any forward-looking statements of the Company. These
factors, and their impact on the success of the Company's operations and its
ability to achieve its goals, as well as those listed in the "Risk Factors"
section of the Company's Registration Statement on Form S-3 (File No.
333-46721), include the following:

          (1)  The history of operating losses experienced by the Company since
               its inception and the ability of the Company to avoid additional
               operating losses and net losses over the next year.

          (2)  The ability of the Company to identify and develop new products
               and gain their acceptance by the marketplace and the impact of
               new technology on the Company's products.

          (3)  The impact of competition within the mobile workgroup, private
               office and other segments of the overall market for
               videoconferencing equipment.

          (4)  The impact of Year 2000 issues on the Company.

ITEM 2.    DESCRIPTION OF PROPERTY

         The Company leases 7,651 square feet of space at its headquarters in
Edina, Minnesota under a lease agreement which expires on September 30, 1999.
The Company also leases 3,479 square feet of warehouse space near its
headquarters. The Company believes its current space is sufficient for its
current and anticipated needs. Currently, the Company is in negotiations with
its landlord to extend the lease for its headquarters until July 2000. If the
lease were not extended, the Company believes it could locate alternative space
suitable for operations with minimal disruption to operations. The following
schedule summarizes payments made in fiscal year 1999 for space leased by the
Company:

<TABLE>
<CAPTION>
             Location                                         Amount
             --------                                         ------
<S>                                                           <C>
             Edina, MN Headquarters                           $95,840
             Edina, MN Warehouse                               15,531
             Amsterdam Sales Office                            40,141
             Florida Sales Office                               1,220
             Chicago Sales Office                               4,691
             Australia Sales Office                             5,869
                                                                -----
             TOTAL                                           $163,292
                                                             --------
                                                             --------
</TABLE>

ITEM 3.    LEGAL PROCEEDINGS

         The Company is not a party to any material legal or administrative
proceedings.

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

         None


                                       10
<PAGE>

                                     PART II

ITEM 5.    MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

         Since July 25, 1995 (the date of the Company's initial public offering
of Common Stock), the Company's Common Stock has been traded in the
over-the-counter market and is quoted on the NASDAQ SmallCap Market System. The
following table sets forth the high and low close prices for the Company's
Common Stock as reported by NASDAQ. Such quotations represent interdealer
prices, without retail markup, markdown or commission, and do not necessarily
represent actual transactions for the fiscal quarters indicated.

<TABLE>
<CAPTION>
                                                       HIGH               LOW
                                                       ----               ---
<S>                                                    <C>               <C>
                1998

                First Quarter                          $3.875            $1.250
                Second Quarter                          4.000             2.375
                Third Quarter                           3.000             1.750
                Fourth Quarter                          3.000             1.500

                1999

                First Quarter                          $4.000            $1.500
                Second Quarter                          3.750             1.875
                Third Quarter                           3.563             2.375
                Fourth Quarter                          2.375             1.625
</TABLE>

         As of September 23, 1999, there were (a) 6,971,281 shares of Common
Stock outstanding, held of record by approximately 125 persons, (although the
Company has been informed that there are approximately 1,100 beneficial owners)
(b) outstanding options to purchase an aggregate of 1,418,166 shares of Common
Stock, and (c) outstanding warrants to purchase an aggregate of 595,626 shares
of Common Stock. The Company has not declared or paid any cash dividends on its
Common Stock since its inception and does not intend to pay any dividends for
the foreseeable future.

ITEM 6.       MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
              RESULTS OF OPERATIONS.

RESULTS OF OPERATIONS

FISCAL YEAR 1999 COMPARED TO FISCAL YEAR 1998.

         NET SALES. In fiscal year 1999, net sales increased to $9,199,135, up
97.3% from $4,662,558 in fiscal year 1998. The increase in sales in fiscal year
1999 compared to fiscal year 1998 was the result of higher unit volume
associated with increased marketing and broader distribution channels, which was
partially offset by lower average pricing.

         The Company experienced increased unit sales volume to OEM partners in
both Europe and the United States in fiscal year 1999. In fiscal year 1999, OEM
sales accounted for approximately 50% of total net sales dollars, while OEM
sales amounted to roughly 15% of net sales in fiscal year 1998.

         In fiscal year 1999, the Company sold units under a private label
relationship with Philips Business Electronics N.V. (Philips) of Eindhoven, The
Netherlands. Under the agreement, the Company and Philips co-developed a
videoconferencing system for sale to Philips and ultimate distribution through
Philips' worldwide network of resellers. Sales to Philips accounted for
approximately $159,000 of the $4,536,577 increase in net sales in fiscal year
1999 over fiscal year 1998.


                                       11
<PAGE>

         In July, 1998, the Company entered into another co-development
agreement with VTEL Corporation of Austin, Texas (VTEL). Under the terms of this
agreement the Company co-developed videoconferencing systems for distribution
through VTEL's worldwide network of resellers. Sales to VTEL accounted for
approximately $2,885,000 of the $4,536,577 increase in net sales in fiscal year
1999 over fiscal year 1998.

         In October 1998, the Company entered into a private label agreement
with Gentner Corporation, in which the Company provided a modified version of
the Video Flyer Plus system for the purpose of integration into Gentner's
product line, which is aimed at providing turnkey communications solutions to
its customers. Sales to Gentner accounted for approximately $700,000 of the
$4,536,577 increase in net sales in fiscal year 1999 compared to fiscal year
1998.

         Net sales in the fourth quarter of fiscal year 1999 were approximately
$1,453,000, which dropped significantly from average quarterly sales of
approximately $2,582,000 for the nine-month period ending March 31, 1999. The
decrease in net sales during the fourth quarter of fiscal year 1999 was caused
primarily by a reduction in net sales to OEM and private label customers along
with lower net sales to the Company's resellers in the fourth quarter compared
to average quarterly net sales to these customers during the first three
quarters. Net sales to OEM and private label customers decreased during the
fourth quarter of fiscal year 1999 because these customers ordered the minimum
quantities required under their OEM and private label agreements with the
Company. In the fourth quarter of fiscal year 1999, these minimum quantities
were lower than average quarterly minimum quantities during the nine months
ended March 31, 1999.

         Sales to the Company's resellers declined during the fourth quarter of
fiscal year 1999 as a result of the Company's introduction of its new MediaPro
product in June 1999. The Company believes many of its current or new resellers
who ordinarily would have ordered units in the fourth quarter of fiscal year
1999 did not do so because they wanted to sell the MediaPro product and
production units were not available until after the end of the Company's fiscal
year. The Company believes that most of the reduction in sales from resellers in
the fourth quarter of fiscal year 1999 may not be recovered in fiscal year 2000
because end users may have purchased alternative equipment from competitors in
the fourth quarter due to the unavailability of MediaPro.

         Although the Company plans to continue pursuing and supporting OEM and
private label customers and their needs, it also expects to aggressively pursue
a strategy of building a stronger channel of resellers to sell its products
under the RSI label in fiscal year 2000. The Company believes that the addition
of the MediaPro product line, combined with an ability to offer programs that
provide attractive margins to resellers allows the Company to pursue such a
strategy. With this plan, the Company expects increased unit volume in fiscal
year 2000 compared to fiscal year 1999. The increase resulting from a higher mix
of sales through resellers is expected to more than offset the impact of a lower
mix of sales through private label relationships in fiscal year 2000 compared to
fiscal year 1999.

         Average pricing decreased during fiscal year 1999 as a result of an
increased proportion of sales through private label relationships compared to
fiscal year 1998 and competitive pressure on the Company's Video Flyer Plus
product. The Company's new MediaPro product carries higher average pricing than
Video Flyer Plus. The Company's plan to increase the mix of sales to resellers
under its own name in fiscal year 2000 and to emphasize the MediaPro product
line are expected to mitigate downward pressure on price points. Since the
Company may experience increased competition in the future, the Company plans to
continue its strategy of providing additional value added enhancements to its
products in fiscal year 2000 to further counteract any downward pressure on
price points.

         As a result of higher expected unit volume and Company plans to
mitigate downward pressure on price, the Company expects fiscal year 2000
revenues to increase compared to fiscal year 1999.

         GROSS PROFIT (LOSS). The Company generated a gross profit of $4,751,192
or 51.6% of net sales for fiscal year 1999 compared to a gross profit of
$2,539,005 or 54.5% of net sales for fiscal year 1998. Cost of goods sold in
fiscal year 1999 amounted to $4,447,943, or 48.4% of net sales compared to
$2,123,553 or 45.5% of net sales in fiscal year 1998. The higher cost of goods
sold relative to net sales in fiscal year 1999 resulted from a higher proportion
of sales in fiscal year 1999 to OEM and private label customers which were
priced lower than sales to resellers under the RSI label.


                                       12
<PAGE>

         The Company's new MediaPro product was designed with a lower
manufacturing cost than Video Flyer Plus in order to minimize gross profit
erosion. As a result of this factor and an expected shift toward a higher
proportion of sales to resellers under the RSI label, even with increased
competition overall gross margins are expected to remain relatively stable in
fiscal year 2000 compared to fiscal year 1999.

         RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses
were $1,281,718 or 13.9% of net sales for fiscal year 1999 compared to $993,525
of 21.3% of net sales for fiscal year 1998. The decrease as a percentage of net
sales was due to higher sales volume in fiscal year 1999 as discussed above. The
higher amount of dollar spending on research and development in fiscal year 1999
compared to fiscal year 1998 was caused by the Company's full scale development
of its new MediaPro product in fiscal year 1999. In fiscal year 1998, the
Company's research and development activities were concentrated on enhancements
to the Video Flyer product line which required lower overall expenditures.

         SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling general and
administrative expenses were $4,268,296 or 46.4% of net sales for fiscal year
1999 compared to $3,478,665 or 74.6% of net sales for fiscal year 1998. The
percentage decrease was due to the higher sales volume in fiscal year 1999. In
fiscal year 1999, the Company increased its marketing, sales and technical
support expenses in North America and Europe to help generate and support higher
sales volume, resulting in a higher level of dollar expenditures.

         OTHER INCOME AND EXPENSE. In fiscal year 1999, interest expense was
$151,569 compared to $86,649 for fiscal year 1998. The increase in fiscal year
1999 was due to increased outstanding borrowings on the Company's line of credit
throughout fiscal year 1999, compared to fiscal year 1998. The higher borrowing
was a result of growth of the business and related working capital needs in
fiscal year 1999. Interest income was $68,946 in fiscal year 1999 compared to
$53,249 in fiscal year 1998. The higher interest income in fiscal year 1999 was
due to increased cash and cash equivalents available to the Company in fiscal
year 1999 from the Company's private placement in January 1998.

         NET OPERATING LOSS CARRYFORWARDS. The Company has net operating loss
carryforwards for financial and federal income tax reporting purposes of
approximately $14,848,000 which can be used to offset taxable income in future
years. Sales of the Company's equity during fiscal year 1998, 1997 and 1996 have
caused changes in ownership under section 382 of the Internal Revenue Code of
1996, which limits the use of the Company's net operating loss carryforwards
existing as of the date of the ownership change. It is not anticipated that any
limitation would have a material adverse effect on the Company.

         As a result of the above, the net loss for fiscal year 1999 was
$(878,675) or $(0.13) per share, compared to a net loss of $(1,959,956), or
$(0.34) per share for fiscal year 1998. The net loss was primarily a result of
lower net sales in the fourth quarter of fiscal year 1999 compared to the first
three quarters as discussed above. Although there can be no assurances of
profitability, the Company believes it has entered fiscal year 2000 with a solid
plan for increasing net sales and profitability. This plan is centered around
Company efforts to increase the mix of sales through resellers and maintain
gross margins comparable to fiscal year 1999 with a focus on the MediaPro
product line.

FISCAL YEAR 1998 COMPARED TO FISCAL YEAR 1997.

         NET SALES. In fiscal year 1998, net sales increased to $4,662,558, up
81.4% from $2,570,851 in fiscal year 1997. The increase in sales in fiscal year
1998 compared to fiscal year 1997 was the result of higher unit volume
associated with increased marketing and broader distribution channels as well as
higher average pricing.

         Although sales to resellers in the Pacific Rim declined in fiscal year
1998 due to the economic uncertainty in that region, the Company experienced
increased unit sales volume to resellers in both Europe and the United States in
fiscal year 1998. Also in fiscal year 1998, units sold directly to end users
increased over end user sales volume in fiscal year 1997, due to the Company's
increased focus on large national accounts.

         In fiscal year 1998, the Company began selling units under a private
label relationship with Philips Business Electronics N.V. (Philips) of
Eindhoven, The Netherlands. Under the agreement, the Company and Philips
co-


                                       13
<PAGE>

developed a videoconferencing system for sale to Philips and ultimate
distribution through Philips' worldwide network of resellers. Sales to Philips
accounted for approximately 37% of the $2,091,707 increase in sales in fiscal
year 1998 over fiscal year 1997.

         The average pricing levels increased in fiscal year 1998 because the
Company's product mix shifted to its new Video Flyer and Video Flyer Plus
products in fiscal year 1998. Video Flyer was first shipped in March, 1997.
Therefore, product mix in fiscal year 1997 included a significant portion of the
Company's previous generation product, which carried a lower overall sales
price.

         GROSS PROFIT (LOSS). The Company generated a gross profit of $2,539,005
or 54.5% of net sales for fiscal year 1998 compared to a gross loss of
$(763,793) or (29.7%) of net sales for fiscal year 1997. The 1997 gross loss
resulted from an inventory writedown to lower of cost or market of $1,430,428
related to the Company's previous generation product. Cost of goods sold in
fiscal year 1998 amounted to $2,123,553, or 45.5% of net sales compared to
$1,904,216 or 74.1% of net sales in fiscal year 1997. The lower cost of goods
sold relative to net sales in fiscal year 1998 resulted from a full year of
production of the Company's Video Flyer and Video Flyer Plus products in fiscal
year 1998, compared to only four months in fiscal year 1997. A significant
portion of the Company's sales in fiscal year 1997 were generated from its
previous generation product, which was lower priced and more costly to
manufacture than the Video Flyer.

         RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses
were $993,525 or 21.3% of net sales for fiscal year 1998 compared to $1,528,493
of 59.5% of net sales for fiscal year 1997. The decrease as a percentage of net
sales was due to higher sales volume in fiscal year 1998 as discussed above. The
higher amount of dollar spending on research and development in fiscal year 1997
compared to fiscal year 1998 was caused by the Company's full scale development
of its new Video Flyer product in fiscal year 1997. In fiscal year 1998, the
Company's research and development activities were concentrated on enhancements
to the Video Flyer, requiring lower overall expenditures.

         SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling general and
administrative expenses were $3,478,665 or 74.6% of net sales for fiscal year
1998 compared to $3,445,301 or 134.0% of net sales for fiscal year 1997. The
percentage decrease was due to the higher sales volume in fiscal year 1998. In
fiscal year 1998, the Company increased its marketing and sales expenses in
North America and Europe to help generate higher sales. Offsetting these expense
increases were reductions in the Company's Pacific Rim sales office and in
intangible assets amortization expenses. As a result, the actual dollar amount
of expenses in fiscal year 1998 were comparable with the expenses in fiscal year
1997.

         OTHER INCOME AND EXPENSE. Interest income was $53,249 for fiscal year
1998 compared to $90,324 for fiscal year 1997. The higher interest income in
fiscal year 1997 was due to higher cash and cash equivalents available to the
Company during fiscal year 1997 due to the Company's private offering in
September, 1996 which raised approximately $3,943,000. In fiscal year 1998,
interest expense was $86,649 compared to $40,340 for fiscal year 1997. The
increase in fiscal year 1998 was due to outstanding borrowings on the Company's
line of credit throughout fiscal year 1998. There was no line of credit during
fiscal year 1997.

         As a result of the above, the net loss for fiscal year 1998 was
$(1,959,956) or $(0.34) per share, compared to a net loss of $(5,684,690),
or $(1.30) per share for fiscal year 1997.

LIQUIDITY AND CAPITAL RESOURCES

FISCAL YEAR 1999 COMPARED TO FISCAL YEAR 1998.

         CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES. Cash and cash
equivalents, combined with marketable securities, totaled $1,411,808 on June 30,
1999 compared to $1,361,648 on June 30, 1998. The primary reason for the
relatively stable level of cash and marketable securities during fiscal year
1999 was that cash used in operating activities was largely offset by increased
borrowing from the Company's line of credit, as discussed below.

         NET CASH USED IN OPERATING ACTIVITIES. The amount of cash used in
operating activities was $(598,245) during fiscal year 1999 compared to
$(2,582,643) during fiscal year 1998. The cash used in operating activities


                                       14
<PAGE>

resulted mainly from a net loss of $(878,675) which was partially offset by
non-cash depreciation expenses of $291,613.

         At June 30, 1999, an increase in the Company's supply of compression
chips and other components resulted in increased levels of inventory compared to
June 30, 1998. In addition, the Company had a higher inventory of Video Flyer
Plus products at June 30, 1999, compared to June 30, 1998. The Company expects
to continue selling both its Video Flyer Plus products and MediaPro products in
fiscal year 2000. In addition, inventory levels are expected to increase in
fiscal year 2000 to support the multiple lines of products and expected overall
growth in sales volume.

         In connection with its business growth and new products, accounts
payable increased $294,823 from June 30, 1998 to June 30, 1999, partially
offsetting the cash used in operations resulting from increased inventory
levels.

         NET CASH USED IN INVESTING ACTIVITIES. In fiscal year 1998, the Company
invested a portion of the proceeds of a January 1998, private placement of its
common stock in marketable securities. As of June 30, 1999, $1,952,015 of these
securities had matured and a total of $1,964,770 had been invested.

         During fiscal year 1999, the Company also invested in new equipment
totaling $122,806 to support the overall growth in the Company.

         NET CASH PROVIDED BY FINANCING ACTIVITIES. Cash provided by financing
activities was $770,576, which was comprised primarily of $750,042 borrowed on
the Company's line of credit and $101,719 from the issuance of common stock
associated with the exercise of employee stock options and stock warrants held
by individuals and a director. Offsetting these sources of cash were payments
made for equipment leased under capital leases of $81,185.

         On September 3, 1999, the Company amended its commercial loan agreement
with a bank. The new agreement provided the Company with an increase in its
committed line of credit, from $2,000,000 to $2,500,000. The line is secured by
all corporate assets and provides working capital based on a borrowing base
comprised of accounts receivable, inventory and marketable securities.

         Management plans to continue to increase sales and improve operating
results through increased marketing and broader distribution of its products
through a stronger dealer network. The Company believes that funds generated
from operations and funds available under the line of credit will be sufficient
to cover cash needs. In the event these sources of cash are not sufficient,
management would seek additional financing or would conserve cash by reducing
administrative, product development, and sales and marketing expenses.

NASDAQ LISTING REQUIREMENTS

         The Nasdaq SmallCap Stock Market requires several minimum valuations
for member companies such as the Company to remain listed. One such requirement
is that the Company maintain a net tangible asset balance of at least $2
million. On June 30, 1999, the Company had a net tangible asset balance of
$1,486,383, which was below the Nasdaq requirement. The Company expects to raise
additional capital and improve operating results in order to meet the Nasdaq
requirement. However, there can be no assurance that the Company will be able to
raise such capital, or of the timing of such activity, or that the Company will
continue to remain listed even if such capital is raised. If the Company is
delisted from the Nasdaq SmallCap Market for failure to meet the listing
requirements, the common stock would be subject to the rules relating to "penny
stocks". These rules require brokers who sell penny stocks to persons other than
established customers and "institutional accredited investors" to complete
documentation, make suitability inquiries of investors and provide investors
with information concerning the risks of trading in the security. These rules
may restrict the ability of brokers to sell the Company's common stock and may
affect the ability of owners of the common stock to sell it in the secondary
market.

YEAR 2000 ISSUES

         The Company has completed what it believes to be the critical aspects
of preparing for Year 2000 issues relative to its business. The following
information outlines the current status of the Company's activities and plans


                                       15
<PAGE>

regarding the Year 2000 issue.

COMPANY STATE OF READINESS.

         DESCRIPTION OF THE COMPANY'S INFORMATION TECHNOLOGY AND NON-INFORMATION
TECHNOLOGY SYSTEMS. The Company uses a widely used PC based information system
to process financial transactions and generate financial information. The
Company also uses various other PC based software packages to support its
business. These systems are linked by a network at the Company's headquarters in
Edina, Minnesota. No significant information systems are located outside the
Company's headquarters, other than individual stand alone PC software packages
used by sales personnel. The Company's videoconferencing products utilize
imbedded technology supported by microcontrollers which do not utilize time or
dates to operate.

         STATUS OF COMPANY TIMETABLE FOR YEAR 2000 READINESS. The Company has
completed the following phases and timetable for becoming ready for the Year
2000:

         Awareness Phase - The Company has researched the Year 2000 issue and
has had communication both internally and with outside parties including its
bank, key suppliers and certain customers. The Company is aware of the potential
issues surrounding the Year 2000 problem and this phase is complete.

         Assessment Phase - This phase included establishing a Year 2000 team
and investigating how Year 2000 issues may impact the Company, both in terms of
the specific aspects of the business which could be affected, and the
consequences to the Company if it is not prepared. The Company has completed
this phase.

         Renovation Phase - The renovation phase covered all Company actions to
correct systems which were not Year 2000 compliant, or develop alternate systems
in all areas which were determined to have a significant impact on the Company
if not corrected. The Company completed this phase.

         Validation Phase - This phase included all Company activities performed
to test any new or alternate systems for conducting its business, and taking
corrective actions in situations where new systems do not properly handle year
2000 problems. This phase is completed.

         Implementation Phase - In this phase, the Company began utilizing all
newly developed systems which were installed to correct Year 2000 problems as
they relate to the Company. This phase is completed.

         DESCRIPTION OF COMPANY RELATIONSHIPS WITH THIRD PARTIES RELATIVE TO
YEAR 2000 ISSUES. The Company has relationships with key suppliers to support
its business. These suppliers include its third party manufacturer, (Altron,
Inc.), suppliers for critical components including 8x8, Inc., suppliers for
third party software utilized in the Company's product and other key vendors.
While the Company believes alternate vendors could be utilized to provide
comparable products and services currently provided by its key vendors, the
Company currently relies on its relationships with its key vendors to conduct
its business, and changes in sources of key products and services could have a
material impact on the Company. The Company has completed the process of
assessing the impact of these third party risks and has determined the risks to
be minimal.

COSTS TO ADDRESS COMPANY'S YEAR 2000 ISSUES.

         The costs of assessing the year 2000 problem have been insignificant
and remediation costs have not been material to the Company's financial
condition or operating results.

RISKS OF THE COMPANY'S YEAR 2000 ISSUES.

         A worst case scenario relative to the Year 2000 issue would be that the
Company needs to replace both its information technology and non-information
technology systems, and utilize alternate sources of supply for its critical
components and third party manufacturing. Because of its current size, the
Company believes replacement of its current information systems would not result
in costs material to the Company's financial condition or results of operations.
In the event key sources of supply were disrupted due to Y2K issues with
vendors, the Company


                                       16
<PAGE>

believes it could implement suitable alternative sources of supply but the
situation could have a material impact on the Company's business. The Company
has analyzed these uncertainties as part of its Year 2000 assessment phase and
has a plan of action to minimize the uncertainties and mitigate the potential
costs involved, should the worst case scenario occur.

CONTINGENCY PLANS.

         The Company currently has a contingency plan to handle the worst case
scenario above. The Company believes it is not practical to implement
remediation efforts to remove the risks of the worst case scenario above, due to
the costs involved and the Company's belief that the likelihood of the worst
case scenario occurring is remote. The Company continues to monitor the Y2K
situation carefully as is relates to its business and expects to take
appropriate measures to mitigate the impact of a worst case scenario should
signs of it become apparent.


                                       17
<PAGE>

ITEM 7.       FINANCIAL STATEMENTS.

              The following Financial Statement and Independent Auditors' Report
thereon are included herein.

<TABLE>
<CAPTION>
                                                                                             Page
                                                                                             ----
<S>                                                                                          <C>
              Independent Auditors' Report............................................        25

              Balance Sheets as of June 30, 1999 and 1998.............................        26

              Statements of Operations for the years ended
                June 30, 1999, 1998 and 1997..........................................        27

              Statements of Stockholders' Equity for
                the years ended June 30, 1999, 1998 and 1997..........................        28

              Statements of Cash Flows for the years ended
              June 30, 1999, 1998 and 1997............................................        29

              Notes to Financial Statements...........................................        30
</TABLE>

ITEM 8.      CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
             FINANCIAL DISCLOSURE

               None.


                                       18
<PAGE>

                                    PART III

ITEM 9.      DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
             COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

(a)           DIRECTORS AND EXECUTIVE OFFICERS

<TABLE>
<CAPTION>
Name                           Age         Position with Company
----                           ---         ---------------------
<S>                             <C>        <C>
Donald C. Lies                  51         Chairman of the Board, Chief Executive
                                           Officer and President

Richard F. Craven               56         Chairman of the Board, and Acting Chief Executive
                                           Officer and President

David W. Stassen                47         Director

Manfred D. Haiderer             59         Director

James D. Hanzlik                43         Chief Financial Officer

Marti D. Miller                 42         Vice President of Engineering
</TABLE>

         DONALD C. LIES became President, Chief Executive Officer and a director
of the Company on July 1, 1996. Before joining the Company, Mr. Lies founded
CHORUS Marketing Group in May of 1989 and served as its President until June of
1996. CHORUS specialized in both reengineering of management, marketing and
sales processes for a variety of office and factory automation systems
manufacturers and service providers. From 1987 to 1989, Mr. Lies served as the
Vice President of Marketing and Sales for Com Squared Systems, a computer
software design, manufacturing and reselling company. From 1985 to 1987, Mr.
Lies was director of Scanning Products Marketing for commercial products at
National Computer Systems. Prior to that, Mr. Lies served as General Manager and
Vice President for Norstan, Inc. in its information systems division for five
years. Before joining Norstan, Mr. Lies was in sales for the office systems
group of IBM. Mr. Lies is the brother-in-law of David W. Stassen who is also a
director of the Company. Mr. Lies resigned his position as Chairman, Chief
Executive Officer and President on September 7, 1999.

         RICHARD F. CRAVEN became acting President, Chief Executive Officer and
Chairman of the Board on September 7, 1999. He is a founder of the Company and
has served as a director since its inception in December 1993. Mr. Craven is a
private investor and has been involved as a manager, owner and developer in
several real estate ventures. He has been a licensed real estate broker and a
licensed insurance agent since 1965. Mr. Craven is also a director of VideoLabs,
Inc.

     DAVID W. STASSEN was elected as a director of the Company in June 1995. He
has served as President and Chief Executive Officer of Spine-Tech, Inc., a
manufacturer of spinal implants, since June 1992 and as a director since June
1991. From January 1990 until June 1992, Mr. Stassen served as Executive Vice
President of St. Paul Venture Capital, Inc. He is also a director of Avecor
Cardiovascular, Inc., a medical products company. Mr. Stassen is the
brother-in-law of Donald C. Lies. Mr. Stassen resigned his position as a
director on August 30, 1999.

     MANFRED D. HAIDERER was elected as a director of the Company in February
1998. Mr. Haiderer has served as President and V.P., U.S.A. Operations for
Richards-Wilcox Inc., a manufacturer of office and material handling products
since 1990. Prior to that, Mr. Haiderer was President and CEO of Baker Material
Handling Corporation. Mr. Haiderer resigned his position as a director on
September 7, 1999.

     JAMES D. HANZLIK became Chief Financial Officer on January 9, 1997. Before
joining the Company, Mr. Hanzlik was Vice President, Controller for Sterner
Lighting Group, a manufacturer of commercial lighting. Prior to that, Mr.
Hanzlik served as Controller and Product Group Manager for Despatch Industries
Ltd. a manufacturer of industrial heat processing equipment.


                                       19
<PAGE>

     MARTI D. MILLER became Vice President of Engineering in August 1995. Before
joining the Company, Mr. Miller was Director of Engineering for Transition
Networks, Inc.

         The members of the Board of Directors are elected annually at the
Annual Meeting of Shareholders. Executive officers are elected by the Board of
Directors and serve until their successors are elected and appointed.

BOARD OF DIRECTORS' COMMITTEES

         The Board of Directors has established an Audit Committee and a
Compensation Committee. The Audit Committee supervises the financial affairs of
the Company and generally reviews the results and scope of the audit and other
services provided by the Company's independent accountants and reports the
results of their review to the full Board and to the Company's management. The
Compensation Committee has general responsibility for management of compensation
matters, including recommendations to the Board of Directors on compensation
arrangements for officers and incentive compensation for employees of the
Company. Currently, both committees consist of Mr. Craven only until
replacements to the Board of Directors are installed.

(B)      SECTION 16 (a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

         Section 16(a) of the Securities Exchange Act of 1934, as amended,
requires the Company's directors and executive officers and all persons who
beneficially own more than 10% of the outstanding shares of the Company's Common
Stock to file with the Securities and Exchange Commission initial reports of
ownership and reports of changes in ownership of the Company's Common Stock.
Executive officers, directors and greater than 10% beneficial owners are also
required to furnish the Company with copies of all Section 16(a) forms they
file. To the Company's knowledge, based upon a review of the copies of such
reports furnished to the Company and written representations that no other
reports were required, during the year ended June 30, 1999, none of the
Company's directors or officers or beneficial owners of greater than 10% of the
Company's Common Stock failed to file on a timely basis the forms required by
Section 16 of the Exchange Act.

ITEM 10.     EXECUTIVE COMPENSATION

EXECUTIVE COMPENSATION

         The following table sets forth the compensation paid or accrued by the
Company for services rendered for the years ended June 30, 1997, 1998 and 1999
to (i) all persons who served as the Chief Executive Officer of the Company
during fiscal year 1999 and (ii) the other most highly compensated executive
officers of the Company whose salary and bonus exceeded $100,000 in fiscal year
1999 (the "Named Executive Officers"). Other than those individuals listed
below, no executive officer of the Company received cash compensation of more
than $100,000 in fiscal year 1999.

                           SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                                                    RESTRICTED                         ALL OTHER
   NAME AND PRINCIPAL       FISCAL       ANNUAL COMPENSATION          STOCK         UNDERLYING       COMPENSATION
        POSITION             YEAR      SALARY ($)      BONUS ($)      AWARDS        OPTIONS (#)            $
   ------------------       ------     ----------      ---------    ----------      ----------       ------------
<S>                         <C>        <C>             <C>          <C>             <C>               <C>
Donald C. Lies               1997       150,000         0           200,000(1)        215,000            7,800
CHIEF EXECUTIVE OFFICER      1998       171,693         0               0             200,000            7,800
AND PRESIDENT                1999       194,769         0               0             150,000

Mr. James D. Hanzlik         1997        39,885         0               0              40,000            1,800
CHIEF FINANCIAL OFFICER      1998        89,885         0               0              20,000            4,200
                             1999       102,625         0               0              40,000            4,800

Marti D. Miller              1997        96,000         0               0              40,000                0
VICE PRESIDENT,              1998       107,723         0               0              20,000                0
ENGINEERING                  1999       129,969         0               0              40,000                0
</TABLE>


                                       20
<PAGE>

(1)      On July 1, 1996, the Company granted Donald C. Lies 25,000 shares of
         restricted common stock vesting in equal increments of 25% of such
         shares at each interval of six months from July 1, 1996, so long as Mr.
         Lies remains employed by the Company. On June 30, 1999, Mr. Lies owned
         25,000 shares of the restricted stock pursuant to the agreement, with
         an aggregate value of $42,200 based on the June 30, 1999, closing bid
         price of the Company's Common Stock of $1.688 per share.

OPTION GRANTS AND EXERCISES

         The tables below set forth information about the stock options held by
the Named Executive Officers and the potential realizable value of the options
held by such person on June 30, 1999. No stock options were exercised by the
Named Executive Officers of the Company during fiscal year 1999.

                        OPTION GRANTS IN LAST FISCAL YEAR
                                INDIVIDUAL GRANTS

<TABLE>
<CAPTION>
                        NUMBER OF SECURITIES    % OF TOTAL OPTIONS GRANTED
                            UNDERLYING                 TO EMPLOYEES          EXERCISE PRICE
        NAME           OPTIONS GRANTED (#)(1)       IN FISCAL YEAR 1999          ($/SH)          EXPIRATION DATE
        ----           ----------------------   --------------------------   --------------      ---------------
<S>                    <C>                      <C>                          <C>                 <C>
Donald C. Lies                150,000(2)                23.0%                     2.00          September 7, 1999
CHIEF EXECUTIVE
OFFICER AND
PRESIDENT

Marti D. Miller                40,000(3)                 6.1%                     2.00           October 6, 2003
VICE PRESIDENT,
ENGINEERING

James D. Hanzlik               40,000(4)                 6.1%                     2.00           October 6, 2003
CHIEF FINANCIAL
OFFICER
</TABLE>

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

(1)  During fiscal year 1999, options to acquire an aggregate of 653,000 shares
     of Common Stock were granted to all employees and options to acquire 50,000
     shares of Common Stock were granted to non-employee directors and other
     non-employees.

(2)  150,000 options were granted to Mr. Lies on October 7, 1998. As a result of
     his resignation from the Company on September 7, 1999, (See Employment
     Agreements), the options were cancelled, and none are vested or
     exercisable.

(3)  40,000 options were granted to Mr. Miller on October 7, 1998. The options
     become vested and exercisable in three equal installments commencing one
     year after the date of the grant.

(4)  40,000 options were granted to Mr. Hanzlik on October 7, 1998. The options
     become exercisable in three equal installments commencing one year after
     the date of the grant.


                                       21
<PAGE>

                AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
                       AND FISCAL YEAR-END OPTION VALUES

<TABLE>
<CAPTION>
                                                                                          VALUE OF UNEXERCISED
                                                         NUMBER OF UNEXERCISED            IN-THE-MONEY OPTIONS
                      SHARES ACQUIRED     VALUE       OPTIONS AT JUNE 30, 1999 (#)      AT JUNE 30, 1999 ($)(1)
        NAME          ON EXERCISE (#)   REALIZED ($)   EXERCISABLE UNEXERCISABLE       EXERCISABLE UNEXERCISABLE
        ----          ---------------   ------------  ------------ ---------------     ----------- -------------
<S>                   <C>               <C>           <C>                              <C>
Donald C. Lies               0              0            406,666       158,334             55,988       4,692
CHIEF EXECUTIVE
OFFICER AND
PRESIDENT

Marti D. Miller
VICE PRESIDENT,              0              0             51,667        68,333             16,890       5,630
ENGINEERING

James D. Hanzlik             0              0             36,667        63,333             16,890       5,630
CHIEF FINANCIAL
OFFICER
</TABLE>

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

(1)  Based on the June 30, 1999, closing bid price of the Company's Common Stock
     of $1.688 per share.

EMPLOYEE AGREEMENTS

         The Company and Donald C. Lies entered into an employment agreement,
dated as of July 1, 1996, which provides that Mr. Lies will receive the
following: (i) an annual salary of $150,000; (ii) a grant of 25,000 shares of
restricted Common Stock vesting in equal increments of 25% of such shares at
each interval of six months from the effective date of Mr. Lies employment, so
long as Mr. Lies remains employed by the Company; (iii) a grant of options to
purchase 110,000 shares of Common Stock at $8.00 per share, vesting in equal
increments of 25% of such options at each interval of six months from July 1,
1996, so long as Mr. Lies remains employed by the Company; and (iv) an
automobile allowance of $650 per month. In October, 1997, Mr. Lies's annual
salary was increased to $180,000 and in 1998, Mr. Lies's salary was increased to
$200,000. In addition to the foregoing, the agreement entitled Mr. Lies to all
other benefits available generally to employees of the Company, including
vacation and health benefits. On September 7, 1999, Mr. Lies resigned from the
Company. Under the terms of a severance agreement, Mr. Lies is to be paid his
annual salary of $200,000 in 12 equal monthly installments beginning September
8, 1999. The severance agreement precludes Mr. Lies from competing with the
Company until August 31, 2000.

COMPENSATION OF DIRECTORS

         The Board of Directors of the Company has established the following
compensation policies for non-employee directors of the Company. Non-employee
directors receive $100 for each meeting attended. Also, under the Company's 1994
Stock Plan, each non-employee director is granted, upon election to the Board,
an option to purchase 10,000 shares of Common Stock, exercisable at market value
on the date of grant, vesting in equal increments of 25% every three months and
expiring ten years from the date of grant. After the year of election, each
non-employee director will also receive annually an option to purchase 5,000
shares of Common Stock exercisable at market value on the date of grant, vesting
in equal increments of 25% every three months and expiring ten years from the
date of grant. On November 19, 1998, options to acquire 10,000 shares of the
Company's Common Stock were granted to non-employee directors, exercisable at
market value on the date of grant, vesting in equal increments of 25% every
three months and expiring ten years from the date of grant. Directors who are
employees of the Company receive no additional compensation for serving as
directors.


                                       22
<PAGE>

ITEM 11.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The following table sets forth as of September 23, 1999, the number of
shares of the Company's Common Stock beneficially owned by (i) each director of
the Company; (ii) each of the Named Executive Officers; (iii) each person known
by the Company to beneficially own more than 5% of the outstanding shares of
Common Stock; and (iv) all executive officers and directors as a group. Unless
otherwise indicated, each person has sole voting and dispositive power over such
shares. Shares not outstanding but deemed beneficially owned by virtue of the
right of a person or member of a group to acquire them within 60 days are
treated as outstanding only when determining the amount and percent owned by
such group or person. The address for all directors and officers of the Company
is 5555 West 78th Street, Suite F, Minneapolis, MN, 55439.

<TABLE>
<CAPTION>
                                                     NUMBER OF SHARES
NAME                                                BENEFICIALLY OWNED                  OWNED PERCENTAGE
----                                                ------------------                  ----------------
<S>                                                 <C>                                 <C>
Donald C. Lies................................             454,991  (1)                        6.2%
Richard F. Craven.............................             998,000  (2)                       14.2%
David W. Stassen..............................              80,000  (3)                        1.1%
Manfred D. Haiderer...........................              20,000  (4)                           *
Marti D. Miller...............................              61,668  (5)                           *
James D. Hanzlik..............................              56,668  (6)                           *
All Current Executive Officers and
Directors as a Group (6 persons)..............           1,671,327  (7)                       22.0%

Perkins Capital Management....................             554,200                             8.0%
</TABLE>

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

*    Indicates ownership of less than 1%.

(1)  Includes 406,666 shares which may be acquired within 60 days upon the
     exercise of stock options.

(2)  Includes (i) 47,500 shares which may be acquired within 60 days upon the
     exercise of stock options and warrants and (ii) 45,000 shares owned by Mr.
     Craven's three children.

(3)  Includes 40,000 shares which may be acquired within 60 days upon the
     exercise of stock options.

(4)  Includes 20,000 shares which may be acquired within 60 days upon the
     exercise of stock options.

(5)  Includes 61,668 shares which may be acquired within 60 days upon the
     exercise of stock options.

(6)  Includes 56,668 shares which may be acquired within 60 days upon the
     exercise of stock options.

(7)  Includes 632,502 shares which may be acquired within 60 days upon the
     exercise of stock options and warrants.


                                       23
<PAGE>

ITEM 12.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         Mr. Richard F. Craven, a director of the Company, is the father-in-law
of the owner/partner of Pointe Design, which is a Minneapolis, Minnesota based
company that designs and prints advertising and other marketing tools. The
Company has used Pointe Design's services to print marketing brochures and other
advertising media. Net purchases by the Company from Pointe Design totaled
$148,371, $108,405 and $97,500 during fiscal year 1999, 1998 and 1997
respectively. The Company believes its transactions with Pointe Design have been
on terms no less favorable than could have been obtained from unaffiliated third
parties on an arm's length basis.

         In connection with the private offering of the Company's Common Stock
in January 1998, certain members of the Board of Directors of the Company
purchased a total of 176,725 shares of the Company's Common Stock.

ITEM 13.   EXHIBITS AND REPORTS ON FORM 8-K

(a)      EXHIBITS.

                  See Exhibit Index on page 41 which is incorporated herein by
         reference. Exhibits that cover management contract or compensatory
         plans or arrangements are marked with an asterisk (*) in the Exhibit
         Index.

(b)      REPORTS ON FORM 8-K

                  None.


                                       24
<PAGE>

                          INDEPENDENT AUDITORS' REPORT


The Stockholders and Board of Directors
RSI Systems, Inc.:

We have audited the accompanying balance sheets of RSI Systems, Inc. (the
Company) as of June 30, 1999 and 1998, and the related statements of operations,
stockholders' equity and cash flows for each of the years in the three-year
period ended June 30, 1999. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of RSI Systems, Inc. as of June
30, 1999 and 1998, and the results of its operations and its cash flows for each
of the years in the three-year period ended June 30, 1999, in conformity with
generally accepted accounting principles.






Minneapolis, Minnesota
August 12, 1999, except as to notes 3 and 5
  which are as of September 3, 1999, and
  note 7(b) which is as of September 7, 1999



<PAGE>

                               RSI SYSTEMS, INC.

                                 Balance Sheets

                             June 30, 1999 and 1998


<TABLE>
<CAPTION>
                                             ASSETS                                  1999           1998
                                                                                  ------------  -------------
<S>                                                                             <C>             <C>
Current assets:
   Cash and cash equivalents                                                    $     418,863        382,093
   Marketable securities                                                              992,945        979,555
   Accounts receivable, net of allowance for doubtful
     accounts of $228,000 in 1999 and $254,000 in 1998                              1,517,650      1,541,626
   Inventories (note 4)                                                             1,034,238        637,422
   Prepaid expenses                                                                    86,566         56,949
                                                                                  ------------  -------------

             Total current assets                                                   4,050,262      3,597,645
                                                                                  ------------  -------------

Property and equipment:
   Furniture and equipment                                                          1,318,843      1,038,463
   Leasehold improvements                                                              56,279         50,625
     Less accumulated depreciation and amortization                                  (852,016)      (560,403)
                                                                                  ------------  -------------

             Net property and equipment                                               523,106        528,685
                                                                                  ------------  -------------

                                                                                $   4,573,368      4,126,330
                                                                                  ------------  -------------
                                                                                  ------------  -------------

                              LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
   Revolving credit facility (note 5)                                           $   1,247,757        497,715
   Current portion of capital lease obligations (note 6)                              106,140         55,388
   Accounts payable                                                                 1,332,154      1,037,331
   Accrued expenses                                                                   183,569        124,254
   Deferred revenue                                                                    77,800         40,664
                                                                                  ------------  -------------

             Total current liabilities                                              2,947,420      1,755,352
                                                                                  ------------  -------------

Long-term liabilities:
   Capital lease obligations, net of current portion (note 6)                         139,565        107,639
                                                                                  ------------  -------------

             Total long-term liabilities                                              139,565        107,639
                                                                                  ------------  -------------

Stockholders' equity (note 9):
   Common stock, par value $.01 per share, authorized 10,000,000
     shares;6,837,281 and 6,657,281 issued and outstanding at
     June 30, 1999 and 1998, respectively                                              68,373         66,573
   Additional paid-in capital                                                      17,338,241     17,238,322
   Accumulated deficit                                                            (15,920,231)   (15,041,556)
                                                                                  ------------  -------------

             Total stockholders' equity                                             1,486,383      2,263,339

Commitments and contingencies (notes 6 and 7)
                                                                                  ------------  -------------

                                                                                $   4,573,368      4,126,330
                                                                                  ------------  -------------
                                                                                  ------------  -------------
</TABLE>

See accompanying notes to financial statements.

                                       2
<PAGE>

                                RSI SYSTEMS, INC.

                            Statements of Operations

                    Years ended June 30, 1999, 1998, and 1997


<TABLE>
<CAPTION>
                                                                1999         1998         1997
                                                             -----------  ------------ ------------
<S>                                                        <C>            <C>          <C>
Net sales                                                  $  9,199,135     4,662,558    2,570,851
Cost of goods sold                                            4,447,943     2,123,553    1,904,216
Inventory writedown to lower of cost or market (note 4)              --            --    1,430,428
                                                             -----------  ------------ ------------

           Gross profit (loss)                                4,751,192     2,539,005     (763,793)

Research and development                                      1,281,718       993,525    1,528,493
Selling, general, and administrative                          4,268,296     3,478,665    3,445,301
                                                             -----------  ------------ ------------

           Operating loss                                      (798,822)   (1,933,185)  (5,737,587)

Other income (expense):
   Other income                                                   2,770         6,629        2,913
   Interest income                                               68,946        53,249       90,324
   Interest expense                                            (151,569)      (86,649)     (40,340)
                                                             -----------  ------------ ------------

Other income (expense), net                                     (79,853)      (26,771)      52,897
                                                             -----------  ------------ ------------

           Net loss                                        $   (878,675)   (1,959,956)  (5,684,690)
                                                             -----------  ------------ ------------
                                                             -----------  ------------ ------------

Basic loss per share                                       $      (0.13)        (0.34)       (1.30)

Diluted loss per share                                     $      (0.13)        (0.34)       (1.30)
                                                             -----------  ------------ ------------
                                                             -----------  ------------ ------------

Weighted average common shares outstanding:
   Basic                                                      6,695,859     5,706,145    4,378,326
   Diluted                                                    6,695,859     5,706,145    4,378,326
                                                             -----------  ------------ ------------
                                                             -----------  ------------ ------------
</TABLE>


See accompanying notes to financial statements.


                                       3
<PAGE>

                                RSI SYSTEMS, INC.

                       Statements of Stockholders' Equity

                    Years ended June 30, 1999, 1998, and 1997


<TABLE>
<CAPTION>
                                                                                 FOREIGN                    UNEARNED
                                                 COMMON STOCK      ADDITIONAL   CURRENCY                 COMPENSATION--
                                             --------------------   PAID-IN     TRANSLATION ACCUMULATED     RESTRICTED
                                              SHARES       AMOUNT   CAPITAL     ADJUSTMENT   DEFICIT         STOCK         TOTAL
                                             ---------  ---------  ----------  -----------  ------------     -----------  ---------
<S>                                          <C>        <C>        <C>         <C>         <C>           <C>              <C>
Balances at June 30, 1996                    3,251,015  $  32,510  10,214,252    28,400      (7,396,910)          --      2,878,252

   Common stock sold in private
     placement [note 9(a)]                   1,500,000     15,000   3,927,892        --              --           --      3,942,892

   Exercise of stock options                     1,250         13       4,362        --              --           --          4,375

   Common stock warrant issued to
     underwriter                                    --         --          50        --              --           --             50

   Shutdown of foreign subsidiary                   --         --          --   (28,400)             --           --        (28,400)

   Restricted stock award [note 7(b)]               --         --     200,000        --              --     (100,000)       100,000

   Common stock issued in settlement
     of claim                                    5,000         50      11,825        --              --           --         11,875

   Net loss for the year ended June 30, 1997        --         --          --        --      (5,684,690)          --     (5,684,690)
                                             ---------  ---------  ----------  -----------  ------------     -----------  ---------

Balances at June 30, 1997                    4,757,265     47,573  14,358,381        --     (13,081,600)    (100,000)     1,224,354

   Common stock sold in private
     placement [note 9(a)]                   1,671,255     16,712   2,506,233        --              --           --      2,522,945

   Common stock warrant issued
     to underwriter                                 --         --         100        --              --           --            100

   Restricted stock award [note 7(b)]           18,750        188        (188)       --              --      100,000        100,000

   Common stock issued in settlement of
     trade payables [note 9(a)]                210,011      2,100     373,796        --              --           --        375,896

   Net loss for the year ended June 30, 1998        --         --          --        --      (1,959,956)          --     (1,959,956)
                                             ---------  ---------  ----------  -----------  ------------     -----------  ---------

Balances at June 30, 1998                    6,657,281     66,573  17,238,322        --     (15,041,556)          --      2,263,339

   Exercise of stock options                    23,750        237      26,482        --              --           --         26,719

   Common stock warrant exercised
     by individuals                            150,000      1,500      73,500        --              --           --         75,000

   Restricted stock award [note 7(b)]            6,250         63         (63)       --              --           --             --

   Net loss for the year ended June 30, 1999        --         --          --        --        (878,675)          --       (878,675)
                                             ---------  ---------  ----------  -----------  ------------     -----------  ---------

Balances at June 30, 1999                    6,837,281  $  68,373  17,338,241        --     (15,920,231)          --      1,486,383
                                             ---------  ---------  ----------  -----------  ------------     -----------  ---------
                                             ---------  ---------  ----------  -----------  ------------     -----------  ---------
</TABLE>

See accompanying notes to financial statements.


                                       4
<PAGE>

                                RSI SYSTEMS, INC.

                            Statements of Cash Flows

                    Years ended June 30, 1999, 1998, and 1997


<TABLE>
<CAPTION>
                                                                                            1999          1998         1997
                                                                                         ------------  -----------  -----------
<S>                                                                                    <C>             <C>          <C>
Cash flows from operating activities:
   Net                                                                                 $   (878,675)   (1,959,956)  (5,684,690)
   loss
   Adjustments to reconcile net loss to net cash used in operating activities:
       Depreciation and amortization                                                         291,613      255,230      239,867
       Inventory writedown to lower of cost or market (note 4)                                    --           --    1,430,428
       Compensation from restricted stock                                                         --      100,000      100,000
       Common stock issued in settlement of claim                                                 --           --       11,875
       Foreign currency translation adjustment                                                    --           --     (28,400)
       Changes in operating assets and liabilities:
         Accounts receivable                                                                  23,976    (794,199)    (222,994)
         Inventories                                                                       (396,816)     (92,809)    (365,173)
         Prepaid expenses                                                                   (29,617)     (15,393)      143,102
         Accounts payable                                                                    294,823      246,720      887,687
         Accrued expenses                                                                     59,315    (238,911)    (364,067)
         Deferred revenue                                                                     37,136     (83,325)      123,989
                                                                                         ------------  -----------  -----------

                 Net cash used in operating activities                                     (598,245)   (2,582,643)  (3,728,376)
                                                                                         ------------  -----------  -----------

Cash flows from investing activities:
   Proceeds from sale of marketable securities                                             1,952,015      197,995           --
   Purchase of marketable securities                                                     (1,964,770)   (1,169,603)          --
   Additions to property and equipment                                                     (122,806)     (227,218)    (99,191)
                                                                                         ------------  -----------  -----------

                 Net cash used in investing activities                                     (135,561)   (1,198,826)    (99,191)
                                                                                         ------------  -----------  -----------

Cash flows from financing activities:
   Proceeds from issuance of common stock                                                    101,719    2,522,945    3,947,267
   Proceeds from issuance of warrants                                                             --          100           50
   Repayments of obligations under capital leases                                           (81,185)      (9,869)           --
   Net proceeds from revolving line of credit                                                750,042      497,715           --
                                                                                         ------------  -----------  -----------

                 Net cash provided by financing activities                                   770,576    3,010,891    3,947,317
                                                                                         ------------  -----------  -----------

                 Increase (decrease) in cash and cash equivalents                             36,770    (770,578)      119,750

Cash and cash equivalents at beginning of year                                               382,093    1,152,671    1,032,921
                                                                                         ------------  -----------  -----------

Cash and cash equivalents at end of year                                               $     418,863      382,093    1,152,671
                                                                                         ------------  -----------  -----------
                                                                                         ------------  -----------  -----------

Supplemental disclosure of cash flow information:
   Cash paid during the year for interest                                              $     126,068       83,600       39,970
                                                                                         ------------  -----------  -----------
                                                                                         ------------  -----------  -----------
</TABLE>

Supplemental schedule of noncash investing and financing activities:

   During fiscal year 1999 and 1998, the Company entered into capital lease
   obligations for the purchase of equipment in the amount
     of $146,307 and $173,204, respectively.

   During fiscal year 1998, the Company issued 210,011 shares of its common
   stock in exchange for the settlement of $375,896 of
     trade payables.


See accompanying notes to financial statements.


                                       5
<PAGE>

                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997


(1)  DESCRIPTION OF BUSINESS

     Founded in 1993, RSI Systems, Inc. (the Company) designs, manufactures, and
     resells business level videoconferencing systems for domestic and
     international markets. These systems are available in a variety of
     configurations and price points.

(2)  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     (A)  NEW ACCOUNTING PRONOUNCEMENTS

          Statement of Financial Accounting Standards (SFAS) No. 130, REPORTING
          COMPREHENSIVE INCOME, became effective for the Company in fiscal 1999.
          This standard prescribes a new way of reporting and displaying the
          balances of changes in certain equity accounts. SFAS No. 130 does not
          affect the measurement or accounting for these accounts. SFAS No. 131,
          DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION,
          also became effective for the Company in fiscal 1999. This standard
          replaces existing disclosure requirements for industry and geographic
          segments with requirements for annual and quarterly disclosure
          information about reportable operating segments and certain geographic
          data. By their nature, SFAS Nos. 130 and 131 had no effect on the
          Company's reported operations or financial position.

          SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING
          ACTIVITIES, effective in 2001, establishes new standards for
          recognizing all derivatives as either assets or liabilities, and
          measuring those instruments at fair value. The Company does not
          anticipate that SFAS No. 133 will have a material impact on its
          financial position or results of operations.

     (B)  CASH AND CASH EQUIVALENTS

          The Company considers investments in highly-liquid debt securities
          having an initial maturity of three months or less to be cash
          equivalents. Cash equivalents amounted to $413,743 and $359,891 at
          June 30, 1999 and 1998, respectively.

     (C)  MARKETABLE SECURITIES

          The Company has adopted the provisions of SFAS No. 115, ACCOUNTING FOR
          CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES. Marketable
          securities have an original maturity of more than three months and a
          remaining maturity of less than 1 year. These investments are
          classified as held-to-maturity and are carried at cost in accordance
          with SFAS No. 115. The cost of debt securities is adjusted for
          amortization of premiums and accretion of discounts to maturity. This
          amortization and accretion, as well as interest income and realized
          gains and losses, are included in interest income. Marketable
          securities at June 30, 1999 and 1998, represent investments in
          government bonds.

     (D)  INVENTORIES

          Inventories are stated at the lower of cost or market using the
          first-in first-out (FIFO) method.

                                                                    (Continued)

                                       6
<PAGE>

                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997


     (E)  PROPERTY AND EQUIPMENT

          Property and equipment are recorded at cost. Depreciation is provided
          using the straight-line method over their estimated useful lives which
          range from two to seven years.

     (F)  CAPITALIZED SOFTWARE COSTS

          Software development costs are accounted for in accordance with SFAS
          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 research and 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, when material. During 1999, 1998,
          and 1997, no software development costs were capitalized.

     (G)  STOCK-BASED COMPENSATION

          The Company accounts for stock-based compensation under Accounting
          Principles Board (APB) Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO
          EMPLOYEES. Accordingly, no compensation expense has been recognized
          for its stock-based compensation plans. The Company has adopted the
          disclosure requirements under SFAS No. 123, ACCOUNTING AND DISCLOSURE
          OF STOCK-BASED COMPENSATION.

     (H)  WARRANTY ACCRUAL

          The Company's product carries a warranty from a third party custom
          manufacturer of twelve (12) months from the date the Company ships to
          the customer, or fifteen (15) months from the date the third party
          manufacturer ships to the Company, whichever comes first [note 7(c)].
          The cost to the Company for this warranty is included in the total
          manufacturing costs charged by the third party custom manufacturer to
          the Company for each unit produced. As a result, the third party
          manufacturer covers warranty costs for defective units.

     (I)  REVENUE RECOGNITION

          The Company recognizes revenue from system sales upon shipment. Post
          sale customer support costs are insignificant and are expensed as
          incurred.

     (J)  RESEARCH AND DEVELOPMENT COSTS

          Research and development costs are charged to operations when
          incurred.

                                                                    (Continued)

                                       7
<PAGE>

                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997


     (K)  INCOME TAXES

          Deferred tax assets and liabilities are recognized for the future tax
          consequences attributable to differences between the financial
          statement carrying amount of existing assets and liabilities and their
          respective tax bases. Deferred tax assets and liabilities are measured
          using enacted tax rates expected to apply to taxable income in the
          years in which those temporary differences are expected to be
          recovered or settled. The effect on deferred tax assets and
          liabilities of a change in tax rates is recognized in income in the
          period that includes the enactment date. Deferred tax assets are
          subject to a valuation allowance based on the estimated realization of
          these assets.

     (L)  ADVERTISING COSTS

          All costs related to advertising the Company's products are expensed
          in the period incurred. Advertising expense for the fiscal years ended
          June 30, 1999, 1998, and 1997 was $324,127, $167,408, and $85,162,
          respectively.

     (M)  NET LOSS PER SHARE

          Basic earnings (loss) per common share is computed using the weighted
          average number of common shares outstanding during each period.
          Diluted earnings (loss) per common share is computed using the
          weighted average number of common shares plus potential dilutive
          shares of common stock.

     (N)  USE OF ESTIMATES

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

(3)  LIQUIDITY

     On September 3, 1999, the Company amended a previous commercial loan
     agreement with a Bank for a $2,500,000 revolving credit facility (note 5).

     Management plans to continue to increase sales and improve operating
     results through increased marketing and broader distribution of products
     through a stronger dealer network. The Company believes that funds
     generated from operations and funds available under the revolving credit
     facility will be sufficient to cover cash needs. In the event sales do not
     materialize at the expected rates, management would seek additional
     financing or would conserve cash by reducing administrative, product
     development, and sales and marketing expenses.

                                                                    (Continued)

                                       8
<PAGE>

                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997


(4)  INVENTORIES

     Inventories consisted of the following at June 30:

<TABLE>
<CAPTION>
                                                  1999           1998
                                               ------------   -----------
<S>                                          <C>              <C>
         Components                          $     683,279       476,261
         Finished goods                            350,959       161,161
                                               ------------   -----------

                                             $   1,034,238       637,422
                                               ------------   -----------
                                               ------------   -----------
</TABLE>

     The fiscal 1997 statement of operations reflects a $1,430,428 charge to
     reduce inventory to lower of cost or market. The write-down was associated
     with excess inventory resulting from the Company's decision to transition
     to a new product line.

(5)  REVOLVING CREDIT FACILITY

     In September 1998, the Company completed a commercial loan agreement with a
     bank for a $2,000,000 committed line of credit facility. This agreement
     amended and restated the previous commercial loan agreement dated April
     1998. The facility is secured by all corporate assets and provides working
     capital based on a borrowing base comprised of accounts receivable,
     inventory, and marketable securities. The facility contains certain
     covenants and conditions, including minimum net worth and tangible net
     worth levels. Interest on outstanding borrowings accrue at the bank's base
     rate, which was 8.75 % at June 30, 1999. On June 30, 1999, borrowings on
     the facility were $1,247,757 leaving $752,243 unused and $744,243
     available. The facility had a maturity date of June 26, 2000. On June 30,
     1999, the Company was in default of the net worth and tangible net worth
     covenant. An amended agreement was completed on September 3, 1999 which
     waived the defaults, increased the line of credit facility to $2,500,000,
     modified the minimum net worth covenant and extended the maturity date to
     June 26, 2001.

(6)  LEASES

     (A)  OPERATING LEASES

          The Company leases office space and various equipment under
          noncancelable operating leases. Future minimum rental payments due
          under noncancelable operating leases are as follows:

<TABLE>
<CAPTION>
                  Fiscal year ending June 30:
<S>                                                       <C>
                     2000                                 $   49,333
                     2001                                     11,519
                     2002                                      4,182
</TABLE>

          Total rental expense was $177,677, $204,223, and $135,901 for the
          years ended June 30, 1999, 1998, and 1997, respectively.

                                                                    (Continued)

                                       9
<PAGE>

                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997


     (B)  CAPITAL LEASES

          The following is a summary of the leased equipment as of June 30,
          1999:

<TABLE>
<S>                                                                       <C>
             Equipment                                                    $   321,232
             Less accumulated amortization                                    (84,718)
                                                                          -----------

                                                                          $   236,514
                                                                          -----------
                                                                          -----------
</TABLE>

          The following is a schedule of future minimum lease payments under
          capital leases with the present value of the minimum lease payments as
          of June 30, 1999:

<TABLE>
<CAPTION>
             Years ending June 30:
<S>                                                                       <C>
             2000                                                         $    130,011
             2001                                                              119,723
             2002                                                               27,733
                                                                          ------------

                        Total minimum lease payments                           277,467

             Less amount representing interest from 9 % to 15 %                (31,762)
                                                                          ------------

                        Present value of minimum lease payments                245,705

             Less current portion                                             (106,140)
                                                                          ------------

                                                                          $    139,565
                                                                          ------------
                                                                          ------------
</TABLE>

(7)  COMMITMENTS AND CONTINGENCIES

     (A)  SOFTWARE LICENSE AGREEMENT

          During 1999, the Company entered into a software license agreement
          with a software development company. Pursuant to the agreement, in
          addition to upfront licensing and production fees of $25,000, the
          Company is to pay a royalty fee of $5 per unit of videoconferencing
          systems containing the software. Sales of the related systems are to
          begin shipping in the first quarter of 2000.

          During 1998, the Company entered into a software license agreement
          with a software development company. Pursuant to the agreement, the
          Company is to pay a royalty fee of up to $5.00 per unit of
          videoconferencing systems containing the software. Sales of the
          related systems began in fiscal year 1998. Royalty expenses related to
          this agreement for fiscal years 1999, 1998, and 1997 were $11,315,
          $1,580, and $0, respectively.

                                                                    (Continued)
                                       10
<PAGE>

                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997

          During 1996, the Company entered into a software license agreement
          with a separate software development company. Pursuant to the
          agreement, in addition to upfront licensing and production fees of
          $90,000, the Company is to pay a royalty fee of $40 on each of the
          first 1,000 videoconferencing systems sold, $4.75 for the following
          9,000 systems, $6.25 for the following 90,000 systems and $5.10 for
          each system sold in excess of 100,000. Sales of the related systems
          began in fiscal year 1997. Amounts expensed related to this agreement
          for fiscal years 1999, 1998, and 1997 were $12,749, $32,560, and
          $6,920, respectively.

          During 1994, the Company entered into a software license agreement
          with a separate software development company. Pursuant to the
          agreement, the Company is to pay a royalty fee of $25 on each of the
          first 10,000 systems sold, $15 on each system over 10,000 up to
          50,000, and $8 on each system sold in excess of 50,000. Amounts
          expensed related to this agreement for fiscal years 1999,1998, and
          1997 were $56,825, $23,050, and $17,450, respectively.

     (B)  EMPLOYMENT AGREEMENTS

          In July 1996, the Company entered into a two-year employment agreement
          with its President and Chief Executive Officer. Pursuant to the
          original agreement and subsequent amendments, the officer receives an
          annual salary of $200,000. On September 7, 1999, the Company's
          President and Chief Executive Officer terminated his employment with
          the Company. Under the terms of the employment agreement, the Company
          is obligated to pay twelve months' salary to the officer in connection
          with the termination.

          Also in connection with the employment agreement, on July 1, 1996, the
          Company granted 25,000 shares of the Company's common stock to its
          President and Chief Executive Officer. The stock is subject to certain
          restrictions which lapse at a rate of 6,250 shares every six months
          from the date of grant. As of June 30, 1999, all shares of the stock
          had been issued. Total compensation expense recognized in fiscal years
          1998 and 1997 related to this stock grant was $100,000 per year.

     (C)  MANUFACTURING AGREEMENT

          On August 28, 1996, the Company entered into manufacturing agreement
          with a third party custom manufacturer (Manufacturer). Pursuant to
          this agreement, the Manufacturer agrees to produce the Company's
          videoconferencing products, and warrant that all products will be free
          from defects in material and workmanship for twelve (12) months from
          the date the Company ships to the customer, or fifteen (15) months
          from the date the Manufacturer ships to the Company, whichever comes
          first.

          The agreement may be terminated by either party upon failure of the
          other party to comply with any material term of the agreement after a
          30 day written notice and cure period. In the event of such
          termination, the Company would be obligated to pay for any goods
          accepted under the terms of the agreement. The Company may also
          terminate the agreement upon 30 days written notice. In such case, the
          Company would be obligated to pay for material and work in progress
          for products ordered. As of June 30, 1999, the Company's obligation
          for material and work in progress for products ordered was $900,000.

                                                                    (Continued)

                                       11
<PAGE>

                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997

     (D)  DISTRIBUTOR, DEALER, AND MANUFACTURER REPRESENTATIVE AGREEMENTS

          The Company is a party to distributor or dealer agreements with
          several companies. Each distributor or dealer has minimum purchase
          obligations. The term of each agreement is one year, renewable for
          additional one-year periods. Distributors and dealers receive
          discounts depending upon the number of systems ordered from the
          Company.

(8)  INCOME TAXES

     At June 30, 1999, the Company has approximately $14,848,000 of net
     operating loss carryforwards and $150,000 of tax credit carryforwards for
     federal income tax purposes, which begin to expire in 2010. Section 382 of
     the Internal Revenue Code of 1986 limits the use of the Company's net
     operating loss carryforwards as of the date of a more than 50% change in
     ownership. As a result of the public offering discussed at note 9(A), a
     Section 382 ownership change occurred. As a result of prior ownership
     changes, a portion of the net operating losses are limited in use in any
     one year. Subsequent ownership changes may further limit the use of the net
     operating losses in any one year.

     The provisions for income taxes differs from the expected tax benefit
     computed by applying the federal corporate tax rate for the three years
     ended June 30, 1999, 1998, and 1997, are as follows:

<TABLE>
<CAPTION>
                                                               1999       1998        1997
                                                             ---------  ---------   --------
<S>                                                          <C>        <C>         <C>
        Expected federal benefit                                34%        34%         34%
        State taxes, net                                         3          6           6
        Research credits                                         5          6           --
        Change in valuation allowance                          (42)       (46)        (40)
                                                             ---------  ---------   --------

                  Actual tax benefit                            --%         --%           --%
                                                             ---------  ---------   --------
                                                             ---------  ---------   --------
</TABLE>

     The tax effects of items which comprise a significant portion of deferred
     tax assets as of June 30, 1999 and 1998, are as follows:

<TABLE>
<CAPTION>
                                                               1999             1998
                                                             --------------   ---------------
<S>                                                          <C>              <C>
        Deferred tax assets:
          Net operating loss carryforwards                   $    5,649,000        5,847,000
          Other                                                     471,000          279,000
          Valuation allowance                                    (6,120,000)      (6,126,000)
                                                              --------------   ---------------

                 Net deferred tax asset                      $           --               --
                                                              --------------   ---------------
                                                              --------------   ---------------
</TABLE>

     A valuation allowance is provided when there is some likelihood that all or
     a portion of a deferred tax asset may not be recognized. The net deferred
     assets at June 30, 1999 and 1998 are fully offset by a valuation allowance.
     The valuation allowance is reviewed periodically.

                                                                    (Continued)

                                       12
<PAGE>

                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997

(9)  CAPITAL STOCK

     (A)  COMMON STOCK

          In January 1998, the Company completed a private offering of its
          common stock. The Company received $2,522,945, net of offering costs,
          in exchange for 1,671,255 shares of common stock ($1.65 per share). A
          registration statement for these shares was declared effective by the
          Securities and Exchange Commission and the shares are registered and
          freely tradable.

          On October 14, 1997, the Company issued 210,011 shares of its common
          stock as payment on $375,896 in trade debt to two of the Company's key
          vendors. A registration statement for these shares was declared
          effective by the Securities and Exchange Commission and the shares are
          registered and freely tradable.

          On September 30, 1996, the Company completed a private offering of its
          common stock. The Company received $3,942,892, net of offering costs,
          in exchange for 1,500,000 shares of common stock ($3.00 per share). A
          registration statement for these shares was declared effective by the
          Securities and Exchange Commission and the shares are registered and
          freely tradable.

     (B)  STOCK WARRANTS

          As of June 30, 1999, there were outstanding warrants held by a
          director of the Company for the purchase of 141,500 shares of common
          stock at exercise prices ranging from $1.00 to $3.00 per share. There
          were also outstanding warrants held by other third parties for the
          purchase of 148,500 shares of common stock at exercise prices ranging
          from $0.50 to $1.00 per share.

          In January 1998, in connection with the Company's private offering of
          1,671,255 shares of its common stock, the Company issued warrants to
          the placement agent for the purchase of 167,126 shares of its common
          stock. Such warrants have a ten year term and are exercisable at $1.65
          per share.

          On September 30, 1996, in connection with the Company's private
          offering of 1,500,000 shares of its common stock, the Company issued
          warrants to the placement agent for the purchase of 150,000 shares of
          common stock. Such warrants have a ten year term and are exercisable
          at $3.00 per share.

     (C)  STOCK OPTIONS

          The Company has a stock plan which permits the granting of stock
          options, including incentive stock options as defined under Section
          422 of the Internal Revenue Code of 1986, nonqualified stock options
          and restricted stock. The exercise price for options granted under the
          stock plan shall be at a price determined at the sole discretion of
          the compensation committee of the Company's board of directors
          provided, however, that incentive stock options granted under the plan
          shall be granted at exercise prices equal to the fair market value on
          the date of grant (110% for a stockholder holding 10% or more of the
          outstanding shares of common stock).

                                                                    (Continued)

                                       13
<PAGE>

                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997

          The Company has reserved 1,500,000 shares of common stock for issuance
          under the plan. At June 30, 1999, 267,250 shares remained available
          for grant. Options issued become exercisable over varying periods as
          provided in the individual plan agreements and certain options are
          subject to accelerated vesting based upon individual employment
          agreements or changes in control of the Company.

          A summary of changes in common stock options during the years ended
          June 30, 1999 and 1998, is as follows:

<TABLE>
<CAPTION>
                                                                                           WEIGHTED
                                                                                            AVERAGE
                                                                                           EXERCISE
                                                                                           PRICE PER
                                                                       SHARES                SHARE
                                                                  ------------------   ------------------
<S>                                                               <C>                  <C>
              Outstanding at June 30, 1997                              560,750             $ 2.16

                  Granted                                               292,500               2.24
                  Exercised                                                   --                  --
                  Canceled                                             (137,000)              2.28
                                                                  ------------------   ------------------

              Outstanding at June 30, 1998                              716,250               2.17

                  Granted                                               703,000               2.11
                  Exercised                                             (23,750)              1.13
                  Canceled                                             (162,750)              1.93
                                                                  ------------------   ------------------

              Outstanding at June 30, 1999                            1,232,750           $   2.19
                                                                  ------------------   ------------------
                                                                  ------------------   ------------------

              Exercisable at June 30, 1999                              482,670           $   2.27
                                                                  ------------------   ------------------
                                                                  ------------------   ------------------
</TABLE>

          Options outstanding at June 30, 1999 have an exercisable price per
          share ranging between $1.125 and $9.25 and have a weighted average
          exercisable price of $2.27 and a weighted average remaining
          contractual life of 5.5 years.

          The Company also has issued stock options outside the stock option
          plan. In July 1996, the Company issued stock options for the purchase
          of 110,000 shares of the Company's common stock to an employee of the
          Company. The stock options have an exercise price of $8.00 per share
          and were fully vested as of June 30, 1999.

          In September 1997, the Company also granted stock options for the
          purchase of 71,000 shares of the Company's common stock to three
          employees of the Company. The stock options have an exercise price of
          $2.81 per share and were fully vested as of June 30, 1999.

          In September 1997, the Company also granted stock options for the
          purchase of 200,000 shares of the Company's common stock to an
          employee of the Company. The stock options have an exercise price of
          $2.81 per share and vest at a rate of 100,000 in September 1997,
          50,000 in June 1998, and 50,000 in June 1999.

                                                                    (Continued)

                                       14
<PAGE>

                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997

          The Company applies APB No. 25 and related interpretations in
          accounting for its stock option plans. Accordingly, no compensation
          cost has been recognized in the accompanying statements of operations.
          Had compensation cost been recognized based on the fair values of
          options at the grant dates consistent with the provisions of SFAS No.
          123, the Company's net loss and net loss per common share would have
          been increased to the following pro forma amounts:

<TABLE>
<CAPTION>
                                                                       FISCAL YEAR ENDED JUNE 30,
                                                                  --------------------------------------
                                                                        1999                 1998
                                                                  ------------------   -----------------
<S>                                                               <C>                  <C>
              Net loss:
                  As reported                                   $        (878,675)         (1,959,956)
                  Pro forma                                            (1,346,890)         (2,452,932)

              Net loss per common share:
                  As reported                                              (0.13)               (0.34)
                  Pro forma                                                (0.20)               (0.43)
</TABLE>

          The fair value of each option grant is estimated on the date of the
          grant using the Black-Scholes option pricing model with the following
          weighted average assumptions used for grants in 1999 and 1998,
          respectively; risk-free interest rates of 4.49% and 6.16%, expected
          option lives of 4.02 years and 6.77 years, expected volatility of
          83.8% and 55.5%, and expected dividend yield of $0.

          Because the SFAS No. 123 method of accounting has not been applied to
          options granted prior to July 1, 1995, the resulting pro forma
          compensation cost may not be representative of that to be expected in
          future years.

          The weighted average fair values of options granted in 1999 and 1998
          were as follows:

<TABLE>
<S>                                                                        <C>
              Fiscal 1999 grants                                           $   2.16
              Fiscal 1998 grants                                               1.49
</TABLE>

(10) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

     The carrying amount of cash equivalents, marketable securities, and
     revolving credit facility approximates fair value because of the short
     maturity of those instruments.

                                                                    (Continued)

                                       15
<PAGE>
                                RSI SYSTEMS, INC.

                          Notes to Financial Statements

                          June 30, 1999, 1998, and 1997

(11) NET LOSS PER SHARE

     The following table sets forth the computation of basic and diluted net
     loss per share:

<TABLE>
<CAPTION>
                                                                               YEARS ENDED JUNE 30,
                                                             ----------------------------------------------------------
                                                                   1999                1998                1997
                                                             ------------------  ------------------  ------------------
<S>                                                          <C>                 <C>                 <C>
         Numerator:
             Net loss                                        $    (878,675)          (1,959,956)        (5,684,690)
                                                             ------------------  ------------------  ------------------

                       Net loss available to
                         common stockholders                 $    (878,675)          (1,959,956)        (5,684,690)
                                                             ------------------  ------------------  ------------------
                                                             ------------------  ------------------  ------------------

         Denominator:
             Weighted average shares outstanding             $     6,695,859          5,706,145          4,378,326
                                                             ------------------  ------------------  ------------------
                                                             ------------------  ------------------  ------------------

         Basic loss per share                                $       (.13)               (0.34)              (1.30)
                                                             ------------------  ------------------  ------------------
                                                             ------------------  ------------------  ------------------

         Diluted loss per share                              $       (.13)               (0.34)              (1.30)
                                                             ------------------  ------------------  ------------------
                                                             ------------------  ------------------  ------------------
</TABLE>

(12) MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISK

     Sales to three customers represented approximately 48% of net sales in
     fiscal 1999, with accounts receivable for these three customers
     representing approximately 32% of total accounts receivable as of June 30,
     1999. In fiscal 1998, sales to one customer represented approximately 17%
     of net sales, with accounts receivable from this customer representing
     approximately 33% of total accounts receivable as of June 30, 1998.

(13) RELATED PARTY

     During the year ended June 30, 1999, the Company purchased approximately
     $148,000 of advertising and marketing services from a related party. The
     Company believes that the fees paid related to these services were
     equivalent to those that would be paid under an arm's-length transaction.


                                       16
<PAGE>

                                   SIGNATURES

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

Dated: September 27, 1999                RSI SYSTEMS, INC.

                                         By: /s/ Richard F. Craven
                                            ------------------------------------
                                         Chairman of the Board, and Acting Chief
                                         Executive Officer and President

         Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on September 27, 1999.

                                POWER OF ATTORNEY

         Each person whose signature appears below constitutes and appoints
Richard F. Craven as his true and lawful attorney-in-fact and agent, with full
power of substitution and resubstitution, for him and in his name, place and
stead, in any and all capacities, to sign any or all amendments to this Annual
Report on Form 10-KSB and to file the same, with all exhibits thereto, and other
documents in connection therewith, with the Securities and Exchange Commission,
granting unto said attorney-in-fact and agent, full power and authority to do
and perform each and every act and thing requisite and necessary to be done in
and about the premises, as fully to all intents and purposes as he might or
could do in person, hereby ratifying and confirming all said attorney in-fact
and agent, or his substitute or substitutes, may lawfully do or cause to be done
by virtue thereof.

        SIGNATURE                                      TITLE

/s/ Richard F. Craven                    Chairman of the Board, and Acting Chief
---------------------------------        Executive Officer and President
Richard F. Craven

/s/ James D. Hanzlik                     Chief Financial Officer
---------------------------------
James D. Hanzlik


                                       41
<PAGE>

                                RSI SYSTEMS, INC.
                                EXHIBIT INDEX TO
                  FORM 10-KSB FOR THE YEAR ENDED JUNE 30, 1999
<TABLE>
<CAPTION>
Exhibit No.                Title of Document                                        Method of Filing
-----------                -----------------                                        ----------------
<S>               <C>                                                <C>
3.1               Articles of Incorporation, as amended              Filed as Exhibit 3.1 to the Form SB-2 Registration Statement
                                                                     of the Company, File No. 33-93240C, (the "SB-2 Registration
                                                                     Statement") and incorporated herein by reference.

3.2               Bylaws, as amended                                 Filed as Exhibit 3.2 to the SB-2 Registration Statement and
                                                                     incorporated herein by reference.

10.1              1994 Stock Plan*                                   Filed as Exhibit 10.5 to the SB-2 Registration
                                                                     Statement and incorporated herein by reference.

10.2              Form of Inventions, Confidential                   Filed as Exhibit 10.2 to the SB-2 Registration
                  Information and Non-Competition                    Statement and incorporated herein by reference.
                  Agreement

10.3              Letter of Credit Agreement, dated                  Filed as Exhibit 10.13 to the SB-2 Registration
                  September 19, 1994                                 Statement and incorporated herein by reference.

10.4              Letter of Credit Agreement, dated                  Filed as Exhibit 10.14 to the SB-2 Registration
                  December 13, 1994, as amended                      Statement and incorporated herein by reference.

10.5              Link Technology Inc. Source Code Software          Filed as Exhibit 10.15 to the SB-2 Registration
                  License Agreement                                  Statement and incorporated herein by reference.

10.6              Design Royalty Agreement between the               Filed as Exhibit 10.16 to the SB-2 Registration
                  Company and Worrell Design Inc.                    Statement and incorporated herein by reference.

10.7              License Agreement with DSP Software                Filed as Exhibit 10.15 to the Company's 1996 10-KSB
                  Engineering, Inc. dated February 1, 1996           and incorporated herein by reference.

10.8              Addendum to License Agreement with Link            Filed as Exhibit 10.17 to the Company's 1996 10-KSB
                  Technology, Inc. dated April 29, 1996              and incorporated herein by reference.

10.9              Employment Agreement between the                   Filed as Exhibit 10.20 to the Company's 1996 10-KSB
                  Company and Donald Lies*                           and incorporated herein by reference.

10.10             Manufacturing Agreement with Altron, Inc.          Filed as Exhibit 10.21 to the Company's 1996 10-KSB
                  dated August 28, 1996                              and incorporated herein by reference.

10.11             Selling Agency Agreement with Miller               Filed as Exhibit 10.23 to the Company's 1996 10-KSB
                  Johnson & Kuehn Incorporated dated                 and incorporated herein by reference.
                  August 22, 1996

10.12             Shareholder Agreement dated April 30,              Filed as Exhibit 10.24 to the Company's 1996 10-KSB
                  1996                                               and incorporated herein by reference.

10.13             New Employee Inventions, Confidentiality           Filed as exhibit 10.13 to the Company's
                  and noncompete Agreement                           1997 10-KSB and incorporated herein by reference

10.14             Non-Qualified Stock Option Agreement               Filed as exhibit 10.14 to the Company's
                  with Donald C. Lies*                               1997 10-KSB and incorporated herein by reference
</TABLE>
-------------------
*    Denotes an exhibit that covers management contracts or compensatory plans
     or arrangements


                                       42
<PAGE>

<TABLE>
<CAPTION>
Exhibit No.                Title of Document                                        Method of Filing
-----------                -----------------                                        ----------------
<S>               <C>                                                <C>
10.15             Restricted Stock Agreement with                    Filed as exhibit 10.15 to the Company's
                  Donald C. Lies*                                    1997 10-KSB and incorporated herein by reference

10.16             Qualified Stock Option Agreement with              Filed as exhibit 10.16 to the Company's
                  Donald C. Lies*                                    1997 10-KSB and incorporated herein by reference

10.17             Termination of Stock Purchase and                  Filed as exhibit 10.17 to the Company's
                  Subscription Agreement*                            1997 10-KSB and incorporated herein by reference

10.18             Norwest Loan Agreement                             Filed as exhibit 10.18 to the Company's
                                                                     1997 10-KSB and incorporated herein by reference

10.19             Selling Agency Agreement with Miller               Filed as exhibit 10.19 to the Company's
                  Johnson & Kuehn Incorporated dated                 1998 10-KSB and incorporated herein by reference
                  December 29, 1997.

10.20             Amended and Restated Credit and Security           Filed as exhibit 10.20 to the Company's
                  Agreement (Norwest Bank Minnesota, N. A.)          1998 10-KSB and incorporated herein by reference

10.21             Amended and Restated Credit and Security           Filed as exhibit 10.21 to the Company's
                  Agreement (Norwest Business Credit, Inc.)          1998 10-KSB and incorporated herein by reference

10.22             First Amendment to the Eximbank guar-              Filed as exhibit 10.22 to the Company's
                  anteed Amended and Restated Credit and             1998 10-KSB and incorporated herein by reference
                  Security Agreement

10.23             Second Amendment to Amended & Restated             Filed herewith electronically
                  Credit & Security Agreement

10.24             Third Amendment to Amended & Restated              Filed herewith electronically
                  Credit & Security Agreement

10.25             First Amendment to Patent & Trademark              Filed herewith electronically
                  Security Agreement

10.26             First Amendment to Patent & Trademark              Filed herewith electronically
                  Security Agreement

10.27             Severance Agreement Between the                    Filed herewith electronically
                  Company and Donald C. Lies

21.1              Subsidiary of the Registrant                       Filed as Exhibit 21.1 to the Company's 1996 10-KSB
                                                                     and incorporated herein by reference.

23.1              Consent of KPMG LLP                                Filed herewith electronically.

24.1              Power of Attorney                                  Included in signature page of this report
                                                                     and incorporated herein by reference

27.1              Financial Data Schedule                            Filed herewith electronically.
</TABLE>

The exhibits referred to in this Exhibit Index will be supplied to a shareholder
at a charge of $.25 per page upon written request directed to Secretary, RSl
Systems, Inc. at the executive offices of the Company.

-------------------
*    Denotes an exhibit that covers management contracts or compensatory plans
     or arrangements


                                       43