<PAGE>   1

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

                                    FORM 10-K

                                   (Mark One)
      [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
                              EXCHANGE ACT OF 1934
                   For the Fiscal Year Ended December 31, 1997
                                       or
     [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
                              EXCHANGE ACT OF 1934

                         Commission File Number: 0-25580

                        DIAMOND MULTIMEDIA SYSTEMS, INC.
             (Exact name of registrant as specified in its charter)

          DELAWARE                                      77-0390654
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
incorporation or organization)

                2880 JUNCTION AVENUE, SAN JOSE, CALIFORNIA 95134
               (Address of principal executive offices) (Zip Code)

       Registrant's telephone number, including area code: (408) 325-7000

           Securities registered pursuant to Section 12(b) of the Act:
                            Title of each class: None
                 Name of each exchange on which registered: None

           SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
                          COMMON STOCK, $.001 PAR VALUE
                                (TITLE OF CLASS)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. Yes X  No 
                                      ---   ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]

As of March 2, 1998, 29,494,224 shares of common stock were outstanding. The
aggregate market value of the voting shares (based on the closing price reported
by the Nasdaq Stock Market on March 2, 1998) of Diamond Multimedia Systems,
Inc., held by nonaffiliates was $411,075,747. For purposes of this disclosure,
shares of common stock held by persons who own 5% or more of the outstanding
common stock and shares of common stock held by each officer and director have
been excluded in that such persons may be deemed to be "affiliates" as that term
is defined under the Rules and Regulations of the Act. This determination of
affiliate status is not necessarily conclusive.

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement to be filed prior to April 30, 1997,
pursuant to Regulation 14A of the Securities and Exchange Act of 1934 are
incorporated by reference into Part III of this Form 10-K.


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<PAGE>   2

PART I

ITEM 1.  BUSINESS

    The discussion and analysis below contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. Actual results could differ materially from
those projected in the forward-looking statements as a result of the risk
factors set forth under "Certain Factors That May Affect Future Performance" in
this report.

DIAMOND PROFILE

    Diamond Multimedia Systems, Inc. ("Diamond" or the "Company") designs,
develops, manufactures and markets multimedia and connectivity products for
IBM-compatible personal computers ("PCs"). The Company is a leading supplier of
graphics and multimedia accelerator subsystems for PCs, and is expanding its
position in the interactive multimedia market by providing advanced solutions
for home, business and professional desktop computer users, enabling them to
create, access and experience compelling new media content from their desktops
and through the Internet. Diamond accelerates multimedia from the Internet to
the hard drive with products that include the Stealth series of media
accelerators, the Monster series of entertainment 3D and audio accelerators, the
Fire series of professional 3D graphics and SCSI accelerators, and the Supra(R)
series of modems.

    The Company has been engaged in expanding its product offerings and
distribution channels through internal development and acquisitions. In
September 1995, the Company acquired Supra Corporation ("Supra"), which designs,
develops, manufactures and markets internal and external fax/modem products. In
November 1995, the Company acquired SPEA Software AG ("Spea"), a German
corporation that designs, develops and markets professional 3D graphics and CAD
accelerators for PCs.

    The Company was incorporated in Delaware in December 1994 as the successor
to Diamond Multimedia Systems, Inc., a California corporation incorporated in
May 1973 ("Diamond CA"). For additional information regarding the
Reorganization, refer to Note 1 in the Notes to Consolidated Financial
Statements. In April 1995, the Company completed an initial public offering of
7,475,000 shares of common stock raising net proceeds of approximately $117
million. Additionally, in November 1995, the Company completed a follow-on
public offering of common stock which raised net proceeds of approximately $94
million. Refer to Liquidity and Capital Resources in Item 7 for discussion of
the use of these proceeds.

STRATEGY

    Diamond's strategy is to identify emerging markets and customers needs, to
use its technological expertise to quickly provide integrated, easy to install
and use, high-performance multimedia solutions for the PC platform, and to use
its worldwide channels to achieve broad distribution and support of its
products. The Company's objectives for the coming year include: capitalizing on
new technologies such as DVD digital video, 3D AGP graphics, 3D PCI audio
acceleration and V.90 56Kbps and dual-line 112Kbps modems; expanding business
with large OEMs, retailers and VARs; expanding international sales; increasing
penetration of the market for audio accelerators and SCSI host adapters; and
strengthening its information technology systems infrastructure to provide
better customer service at lower operating costs.

    Through selective acquisitions, Diamond has been able to add to its
technical expertise and product offerings while further improving its
distribution channels and market presence both domestically and internationally.
In September 1995, Diamond purchased Supra, giving Diamond added expertise in PC
communications and presence in the retail markets. In November 1995, the Company
purchased Spea. The addition of Spea provided Diamond with a key strategic
position in Europe, helping to expand Diamond's presence internationally as a
leading supplier of visual and connectivity systems for the PC, and added
professional 3D graphics and Open GL expertise to the Company. In November 1997,
the Company acquired Binar Graphics, Inc. ("Binar"), adding graphics engineering
capability and certain proprietary intellectual property in graphics
acceleration.


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<PAGE>   3

     A key element of Diamond's strategy is to remain silicon agile, allowing
the Company to incorporate the best semiconductor integrated circuits available
on the open market. By sourcing chips from a variety of semiconductor
developers, the Company believes it is best able to keep pace with the current
rapid advances in multimedia and connectivity technology and bring best-of-breed
products to market. The Company currently has research and development efforts
underway using chipsets from a variety of companies, including but not limited
to Alliance Semiconductor, Aureal, C-Cube, Chromatic Research, Cirrus Logic,
Evans and Sutherland, ESS, Intel, LG Electronics, Lucent, Mitsubishi
Electronics, Motorola, NEC Electronics, nVidea, Rendition, Rockwell
Semiconductor, S3, Symbios Logic, Texas Instruments, Trident Microsystems,
Toshiba Electronics, 3Dlabs and 3Dfx. There can be no assurance, however, that
these efforts will result in actual new product introductions.

    With the increasing incorporation of multimedia, connectivity and visual
computing capabilities into the PC platform, Diamond's objectives are to expand
international sales, serve new OEM and channel assembly customers, and
capitalize on new multimedia and connectivity product categories such as
entertainment 3D animation, professional and workstation 3D graphics, 112Kbps
dual-line V.90 analog modems, digital ADSL (G.Lite) modems, Windows(R)
DirectSound 3D audio accelerators and DVD digital video products.

PRODUCTS

    The Company's products currently include a variety of subsystems that
accelerate multimedia from the Internet to the hard drive on the PC platform and
share certain characteristics such as common customers, common sales channels
and common Company infrastructure requirements.

    GRAPHICS ACCELERATORS. The Company's mainstream graphics accelerators
enhance system performance by increasing the speed at which graphics are
displayed while also improving resolution, image stability and color depth. The
Company's Stealth and Viper series of multimedia accelerators offer mainstream
2D and 3D graphics acceleration with full-screen, full-motion digital video
playback and some products also offer optional TV-In, TV-Out, and/or TV tuner
capabilities.

    SPECIALIZED 3D GRAPHICS. The Company offers two main types of specialized 3D
accelerators. The Company's Monster 3D line of graphics accelerators is aimed at
the interactive entertainment 3D market and accelerates a large and growing
number of 3D games on the PC. The Company's Fire GL series of graphic
accelerators is aimed at the professional workstation 3D market for such
applications as content creation, Open GL acceleration and CAD on the Intel
Architecture/Windows NT platform.

    DVD/DIGITAL VIDEO. The Company shipped its initial DVD decoder and DVD
upgrade kit (including DVD-ROM drive) during 1997. The Company has announced a
second generation DVD kit, which is expected to ship in the first half of 1998
and includes 2D and 3D graphics acceleration, DVD decoding and a second
generation DVD drive.

    3D AUDIO. The Company shipped its first internally developed audio product
in 1997 and now offers a full range of PCI-based 3D audio products. Monster
Sound products offer advanced audio acceleration under Windows 95(R) including
the capabilities for interactive real-time positional 3D audio. Sonic Impact is
an affordable PCI audio product that accelerates audio in Windows 95(R) and also
supports DOS-legacy modes.

    PC COMMUNICATIONS. Under the Supra brand name, the Company markets a line of
analog and digital fax/modems, telephony modems, PC Card modems and video phones
for PCs. The Company also markets modems for Macintosh computers.

    MULTIMEDIA I/O. The Company shipped its first SCSI adaptor in early 1997
under the FirePort brand. The Company now has a line of SCSI products including
20MB/sec, 40MB/sec and dual channel host bus adapters, and plans an 80MB/sec HBA
for production shipment later in 1998.

    See "Certain Factors That May Affect Future Performance - Short Product Life
Cycles; Dependence on New Products," "-New Operating Systems," "-Market
Anticipation of New Products, New Technologies or Lower Prices," "-Migration to
Personal Computer Motherboards" and "-Rapid Technological Change".


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<PAGE>   4

SALES, DISTRIBUTION AND CUSTOMER SUPPORT

    The Company sells its products through independent domestic and
international distributors and directly to larger computer retailers, mass
merchants, system integrators, VAR and OEMs. In addition, the Company sells its
products in the United States through mail-order catalog organizations and
national reseller organizations. The Company is currently seeking to expand its
penetration of the consumer electronics retail/mass merchant and NRO/VAR
channels, including programs to address the large and growing channel assembly
business, and to increase its sales to large PC systems manufacturers. See
"Certain Factors That May Affect Future Performance -OEM Customer Risks,"
"-Product Returns; Price Protection" and "-Distribution Risks."

    The Company has built a customer service and technical support organization
focused on providing value to the Company's customers beyond the purchase of the
Company's products. In this regard, the Company provides customer service and
technical support to customers via email and the Internet, as well as through
facsimile and telephonic communication. In addition, the Company supports a
online community through its presence on the World Wide Web, where technical
support, frequently asked questions and a searchable knowledge base can be
found. More than 80% of customer support contacts are currently handled by
automated systems.

    The Company continues to undertake significant efforts to expand its sales
channels through international penetration. The Company has expanded its sales
and support organizations in Europe, Latin America and Asia-Pacific. The
requirements of these regions are, however, substantially different from one
another and the North American market. Any inability of the Company to
successfully penetrate these new channels or to manage them on a profitable
basis could have a material adverse effect on operating results. See "Certain
Factors That May Affect Future Performance - Risks of International Sales".

    Products sold to OEM customers in bulk-packaged format typically consist of
board-level hardware accompanied by software drivers, multimedia utility
applications and a manual, all frequently implemented on a CD-ROM to reduce cost
and package size. Products sold to computer retailers and mass merchants
typically consist of the hardware, the software and the manuals that are
incorporated into the OEM products plus, in many cases, additional bundled
hardware and software components and installation aids, all in packaging
appropriate for consumer sale. Distributors and NRO's purchase products both
packaged for resale to retail outlets, typically for the installed-base upgrade
market, and bulk packaged for resale to systems integrators and VARs for
incorporation into original-sale PC systems.

RESEARCH AND DEVELOPMENT

    The Company believes that continued investment in research and development
will be critical to the ability of the Company to continue to introduce, on a
timely basis and at competitive prices, new and enhanced products incorporating
the latest technology and addressing emerging market needs. The Company's
research and development staff consisted of 196 employees at December 31, 1997.
The Company's software engineers are engaged in ongoing development of software
and firmware drivers to enhance the performance of graphics, video and audio
accelerators, analog and digital modems, and SCSI host adapters, as well as
upgrades to the Company's proprietary software utility applications. The
Company's engineers are also engaged in the development of new products that
will offer various combinations of 3D graphics, digital video, 3D sound,
fax/modem, telephony, television and other emerging PC multimedia functions.
[Research and development expenses were $24,886,000, $18,824,000, and
$10,665,000 in the years ended December 31, 1997, 1996 and 1995, respectively].
See "Certain Factors That May Affect Future Performance - Short Product Life
Cycles; Dependence on New Products," "-Market Anticipation of New Products, New
Technologies or Lower Prices," "-New Operating Systems" and "-Rapid
Technological Change".

    The Company also endeavors to work closely with third parties that are
strategic to the Company's business. The Company works with suppliers of 3D
graphics, digital video, audio, modem, SCSI, TV and other multimedia chipsets in
an effort to select the appropriate advanced components for the Company's new PC
multimedia products. The Company seeks to develop in a timely manner the
software required to incorporate the chipsets into the Company's products, and
the Company's products into the evolving architecture of the PC. The Company
also works with leading personal computer hardware, operating system 


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<PAGE>   5

and software applications suppliers in order to remain abreast of emerging
opportunities and new standards in the market. There can be no assurance that
the Company's development efforts will be successful, or that the Company will
be able to introduce competitive new products into the marketplace in a timely
manner.

MANUFACTURING

    The Company uses an international network of independent printed circuit
board assembly subcontractors to assemble and test the boards that are the
principal hardware component of the Company's products. The Company generally
procures components and assembles them into kits and provides these kits to its
subcontractors for assembly and board-level testing. In the case of offshore
assembly, the Company also subcontracts certain aspects of the procurement and
materials management functions. The Company performs quality assurance on its
products, but subcontracts certain aspects of its product testing. In 1997, the
Company started to make increased use of full turnkey offshore subcontractors,
and expects to expand the portion of its procurement, manufacturing and test
that is conducted in this manner.

    The Company packages the assembled boards its receives from its
subcontractors with software, manuals and additional hardware components,
placing such materials in retail packaging for the retail/mass merchant channel
and in bulk packaging for the OEM and system integrator channels. While the
Company uses a number of electronics assembly subcontractors to minimize the
risk of business interruption, there can be no assurance that a problem will not
arise with one or more of these suppliers that could adversely affect operating
results. See "Certain Factors That May Affect Future Performance - Component
Shortages; Reliance on Sole or Limited Source Suppliers," and "-Rapid
Technological Change".

PROPRIETARY RIGHTS

    While the Company had 4 issued U.S. Patents and 18 pending U.S. Patent
Applications at December 31, 1997, it nonetheless relies primarily on a
combination of trademark, copyright and trade secret protection together with
licensing arrangements and nondisclosure and confidentiality agreements to
establish and protect its proprietary rights. See "Certain Factors That May
Affect Future Performance - Proprietary Rights."

COMPETITION

    The market for the Company's products is highly competitive. The Company
competes directly against a large number of suppliers of PC add-in visual and
audio subsystems, SCSI host adapters and PC communications products, and
indirectly against OEMs and semiconductor suppliers to the extent they
manufacture their own add-in subsystems or incorporate on their personal
computer motherboards the functionality provided by the Company's products. In
addition, the Company's markets are expected to become increasingly competitive
as multimedia and connectivity functions continue to converge, the price of the
average PC drops and companies that previously supplied products providing
distinct functions (for example, companies in the graphics, video, sound, and
modem markets) emerge as competitors across broader product categories. See
"Certain Factors That May Affect Future Performance - Competition."

EMPLOYEES

    As of December 31, 1997, the Company had 864 full-time employees, 227 of
whom were engaged in manufacturing (including test, quality assurance,
procurement and materials functions), 196 in development engineering, 175 in
marketing, field applications support and sales, 150 in technical support and
customer service, and 116 in finance, IT and administration. The Company's
employees are not represented by any collective bargaining agreements and the
Company has never experienced a work stoppage. The Company believes that its
employee relations are good.


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<PAGE>   6

EXECUTIVE OFFICERS
<TABLE>
<CAPTION>
    The following table sets forth the names, ages and office of all of the
executive officers of the Company:

Name                      Age           Office Held
<S>                       <C>           <C>
William J. Schroeder      53            President and Chief Executive Officer, Director
James M. Walker           49            Senior Vice President and Chief Financial
                                          Officer
Franz Fichtner            45            President, Diamond Europe
C. Scott Holt             56            Senior Vice President, Worldwide Sales
Hyung Hwe Huh             45            Senior Vice President and Chief Technical
                                          Officer
Wade Meyercord            57            Senior Vice President, Management Systems and
                                                    Continuous Improvement
Dennis D. Praske          50            Senior Vice President, Worldwide Operations
</TABLE>


        There are no family relationships between any of the executive officers
and directors.

    Mr. Schroeder has served as President and Chief Executive Officer of the
Company and as a member of the Board of Directors since May 1994. Mr. Schroeder
was employed by Conner Peripherals, Inc. ("Conner") from 1986 to 1994, initially
as President and, from 1989, as Vice Chairman of the Board of Directors. He was
also President of Conner's New Products Group from 1989 to 1990, President of
Archive Corporation (a Conner subsidiary) from January 1993 to November 1993,
and CEO of Arcada Software, Inc. (a Conner subsidiary) from November 1993 to May
1994. Mr. Schroeder is also a director of Xircom, Inc., ShareWave, Inc., and
CNF Transportation, Inc.

    Mr. Walker joined the Company in December 1996 as Senior Vice President and
Chief Financial Officer. Mr. Walker was formerly employed by Global Village
Communication as Vice President and Chief Financial Officer from 1993 to 1996.
Previously, Mr. Walker served as Chief Operating Officer for Fujitsu Computer
Products from 1990 to 1993 and as Vice President of Finance for its parent
company, Fujitsu America, from 1987 to 1990. Mr. Walker is Chairman of the Board
of Alara, Inc, a privately-held medical imaging technology firm.

    Mr. Fichtner joined the Company in October, 1997 as President, Diamond
Europe. Mr. Fichtner was formerly employed by 3Com from 1990 to 1997, most
recently as President Europe, Middle East and Africa from 1995 to 1997, as
Managing Director 3Com Gmbh, Central Europe from 1991 to 1994, and as Technical
Manager for the Central European Sales Region from 1990 to 1991.

    Mr. Holt joined the Company in January 1995 as Senior Vice President,
Worldwide Sales. From 1986 to 1994, Mr. Holt was employed by Conner, most
recently as Executive Vice President, Corporate Accounts and Americas Sales. Mr.
Holt was the Executive Vice President of Sales and Marketing at Conner from 1986
until 1992.

    Mr. Huh joined the Company in 1983 as Engineering Manager and was promoted
to Chief Engineer in 1985, to Vice President of Engineering in 1989, and to the
position of Senior Vice President and Chief Technical Officer in 1994. Mr. Huh
was a member of the Board of Directors of the Company from 1985 to January 1995.

    Mr. Meyercord joined the Company in November, 1997 as Senior Vice President,
Management Systems and Continuous Improvement. Mr. Meyercord was formerly
employed as President of the consulting firm, Meyercord and Associates, from
1987 to 1997. Mr. Meyercord is Chairman of the Board of California Micro Devices
and a director of ADFlex Solutions.

    Mr. Praske joined the Company in October 1995 as Vice President of Worldwide
Operations and was promoted to Senior Vice President in April 1997. Prior to
joining the Company, Mr. Praske was the Vice President of Worldwide Materials
for the Storage Division of International Business Machines (IBM). Previously,
Mr. Praske served as Vice President of Commodity Management at Conner
Peripherals, Inc. from 1988 to 1993.


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<PAGE>   7

ITEM 2. PROPERTIES

    The Company's headquarters facility in San Jose, CA consists of
approximately 80,000 square feet and is leased by the Company for seven years
commencing January 1995. Additionally, the Company has leased 20,000 and 83,000
square foot facilities in Milpitas, California, primarily for manufacturing. The
20,000 square foot facility lease expires in February 1998 and is currently
subleased for the remaining term to an unrelated entity. The 83,000 square foot
facility lease commenced in February 1996 and expires in January 2001. The
Company's facilities in Vancouver, Washington and Albany, Oregon consist of
three buildings comprising approximately 28,700, 21,000 and 35,800 square feet,
respectively. The 28,700 square foot facility expires in November 2000 and the
21,000 square foot facility lease expires June 1999 and is currently subleased
through the remaining term. The Albany property was purchased in 1991. The
Company's facilities in Europe encompass a 26,000 square foot building in
Winnersh, U.K. with a lease commencement date of May 1996. The lease is a
fifteen year term with 3, 5 and 10 year cancellation options. Facilities in
Germany consist primarily of two buildings in Starnberg comprising 22,000 and
14,000 square feet, respectively, and are leased through 2001. The Company also
leases sales or technical support offices in the metropolitan areas of Tokyo,
Japan; Paris, France; Seoul, South Korea, Sydney, Australia; Hong Kong and
Singapore. The Company also leases sales or software development offices in
Atlanta, Georgia; Dallas, Houston and Austin Texas; Chicago, Illinois;
Huntsville, Alabama; Miami and Coral Springs, Florida; San Francisco, CA and
Iselin, New Jersey. The Company believes that its existing facilities are
adequate to meet its facilities requirements for the near term.

ITEM 3. LEGAL PROCEEDINGS

    The Company has been named as a defendant in several putative class action
lawsuits which were filed in June and July, 1996 and June, 1997 in the
California Superior Court for Santa Clara County and the U.S. District Court for
the Northern District of California. Certain executive officers and directors of
the Company are also named as defendants. The plaintiffs purport to represent a
class of all persons who purchased the Company's Common Stock between October
18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege claims
under the federal securities law and California law. The plaintiffs allege that
the Company and the other defendants made various material misrepresentations
and omissions during the Class Period. The complaints do not specify the amount
of damages sought. The Company believes that it has good defenses to the claims
alleged in the lawsuits and will defend itself vigorously against these actions.
No trial date has been set for any of these actions. The ultimate outcome of
these actions cannot be presently determined. Accordingly, no provision for any
liability or loss that may result from adjudication or settlement thereof has
been made in the accompanying consolidated financial statements.

    The Company is also party to other claims and pending legal proceedings that
generally involve employment and trademark issues. These cases are, in the
opinion of management, ordinary and routine matters incidental to the normal
business conducted by the Company. In the opinion of management, the ultimate
disposition of such proceedings will not have a materially adverse effect on the
Company's consolidated financial position or future results of operations.


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

    None.


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<PAGE>   8

PART II

<TABLE>
<CAPTION>
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
                                                             Quarter Ended
                                   Fiscal Year 1996                            Fiscal Year 1997
                     ------------------------------------------     --------------------------------------------
                     March 31   June 30    Sept. 30     Dec. 31     March 31    June 30    Sept. 30     Dec. 31 
----------------------------------------------------------------------------------------------------------------
Closing Price:
<S>                  <C>        <C>        <C>         <C>         <C>        <C>         <C>          <C>
High                 $35-1/2    $21-7/8    $12-7/8     $15-11/16   $17        $9-1/8      $11-3/4      $13-13/16
Low                  $16        $9         $7          $11-1/4     $9-3/4     $6-5/8      $6-15/16     $8-13/16
</TABLE>


      The Company's common stock trades on the Nasdaq Stock Market under the
symbol "DIMD". The price range per share, reflected in the above table is the
highest and lowest closing prices for the Company's stock as reported by the
Nasdaq, during each quarter. The Company's present policy is to retain its
earnings to finance future growth. The Company has never declared or paid cash
dividends and has no present intention to declare or pay cash dividends. At
December 31, 1997 there were approximately 634 stockholders of record including
nominees and brokers holding street accounts.


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<PAGE>   9

ITEM 6. SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
                                                                               YEAR ENDED DECEMBER 31,
                                                           ----------------------------------------------------------------
                                                           1997            1996           1995          1994          1993
                                                           --------       ---------     --------      --------     --------
                                                                        (in thousands, except per share data)
       <S>                                                 <C>            <C>           <C>           <C>          <C>   
       Net sales                                           $443,281       $598,050      $467,635      $203,297     $130,271
       Gross Profit                                          55,795        112,766       108,350        57,983       37,035
       Write-off of in-process technology                        --             --        76,710            --           --
       Income (loss) from operations                        (67,719)        22,708       (19,273)       33,137       20,544
       Net income (loss)                                    (45,605)        16,337       (41,347)       20,116       12,416
       Net income (loss) per share:
             Basic                                            (1.33)          0.48         (1.55)         1.62         1.00
             Diluted                                          (1.33)          0.46         (1.55)         1.12         0.79
       Total assets                                         337,554        332,438       351,729       120,854       41,992
       Current portion of long-term debt                     36,455         18,068        18,077        82,664           --
       Long-term debt, net of current portion                 1,873          2,730        11,705        34,167           --
       Mandatorily redeemable preferred stock                    --             --            --        29,174           --
       Total shareholders' equity (deficit)                 180,521        224,295       208,610      (55,949)       20,967


     SELECTED QUARTERLY FINANCIAL DATA
                                                             First              Second              Third           Fourth
     YEAR ENDED DECEMBER 31, 1997                           Quarter             Quarter            Quarter          Quarter
                                                           ---------           ---------          ---------        ---------
                                                                  (Unaudited & in thousands except per share data)

     Net sales                                             $112,402             $52,982            $92,028         $185,869
     Gross profit                                            19,585             (23,118)            18,178           41,150
     Income (loss)  from operations                          (9,934)            (63,500)            (4,367)          10,082
     Net income (loss)                                       (5,951)            (44,109)            (2,553)           7,008
     Net income (loss) per share:
           Basic                                             $(0.17)             $(1.29)            $(0.07)           $0.20
           Diluted                                           $(0.17)             $(1.29)            $(0.07)           $0.20

                                                           ---------           ---------          ---------        ---------
                                                             First              Second             Third            Fourth
     YEAR ENDED DECEMBER 31, 1996                           Quarter             Quarter           Quarter           Quarter
                                                           ---------           ---------          ---------        ---------
                                                                  (Unaudited & in thousands except per share data)

     Net sales                                             $187,605            $120,219           $123,729         $166,497
     Gross profit                                            40,062              11,167             25,023           36,514
     Income (loss)  from operations                          18,069              (8,502)             2,709           10,432
     Net income (loss)                                       11,194              (4,790)             2,100            7,833
     Net income (loss) per share:
           Basic                                              $0.32              $(0.14)             $0.06            $0.23
           Diluted                                            $0.32              $(0.14)             $0.06            $0.22
</TABLE>


      No dividends have been declared in any of the periods presented. See "Item
5" for a discussion of the Company's dividend history. Data for 1995 includes
acquisitions of Supra and Spea completed during the year that were accounted for
as purchase business combinations. "See Management's Discussion and Analysis of
Financial Condition and Results of Operations".


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<PAGE>   10


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

    The discussion and analysis below contains trend analysis and other
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual
results could differ materially from those projected in the forward-looking
statements as a result of the risk factors set forth under "Certain Factors That
May Affect Future Performance" and elsewhere in this report.

    The following discussion should be read in conjunction with the five-year
summary of selected financial data and the Company's consolidated financial
statements and the notes thereto. All references to years represent fiscal years
unless otherwise noted.

OVERVIEW

    Diamond Multimedia Systems, Inc. ("Diamond" or the "Company") designs,
develops, manufactures and markets multimedia and connectivity products for
IBM-compatible personal computers ("PCs"). The Company is a leading supplier of
graphics and multimedia accelerator subsystems for PCs, and is expanding its
position in the interactive multimedia market by providing advanced solutions
for home, business and professional desktop computer users, enabling them to
create, access and experience compelling new media content from their desktops
and through the Internet. Diamond accelerates multimedia from the Internet to
the hard drive with products that include the Stealth series of media
accelerators, the Monster series of entertainment 3D and audio accelerators, the
Fire series of professional 3D graphics and SCSI accelerators, and the Supra(R)
series of modems and ISDN adapters. Headquartered in San Jose, CA, Diamond has
sales, marketing and technical facilities in several locations including
Vancouver (Wash.), Singapore, Sydney, Hong Kong, Seoul, Tokyo, Starnberg
(Germany), Saarbrecken (Germany), Paris, and Winnersh (U.K.). Diamond's products
are sold through regional, national and international distributors as well as
directly to major computer retailers, VARs and OEMs worldwide. In September
1995, the Company acquired Supra Corporation ("Supra"), which designs, develops,
manufactures and markets internal and external fax/modem products. In November
1995, the Company acquired SPEA Software AG ("Spea"), a German corporation, that
designs, develops and markets professional 3D graphics and CAD accelerators for
PCs. In November 1997, the Company acquired Binar Graphics, Inc., ("Binar") an
engineering services firm specializing in graphics acceleration. All three
acquisitions were accounted for as purchase business combinations.

NET SALES

   Net sales were $443.3 million, $598.1 million, and $467.6 million in 1997,
1996 and 1995, respectively. Net sales decreased in 1997 by $154.8 million, a
26% decrease, compared to 1996 primarily due to significant price erosion and
lower unit demand in the Company's base business of multimedia accelerator
systems and modems, particularly during the first and second quarters of 1997 in
which large price protection charges were triggered. The demand for the
Company's products increased in the latter half of the year as new products such
as the Monster 3D and Viper series of graphics accelerator cards were introduced
and began shipping in volume. Also during the fourth quarter of 1997, there was
strong demand for the Fire GL 1000 and 4000 series of professional 3D graphics
accelerator cards, as well as the 56K modems. Net sales for 1996 increased by
$130.5 million, a 28% increase, compared to 1995 primarily due to the inclusion
of revenues for a full year in 1996 of Supra and Spea and, to a lesser extent,
due to continued growth in revenues from the Stealth series of graphics
accelerator cards. This increase in sales was partially offset by a decrease in
sales in 1996 of multimedia upgrade kits.

    International sales, primarily to Europe and Asia, accounted for 39%, 38%
and 35% of net sales in 1997, 1996 and 1995, respectively. During 1997, as a
percentage of net sales, international sales to Europe increased significantly,
slightly more than offsetting the decrease in the percentage of net sales
relating to Asia and South America. During the 1995 to 1997 period, the Company
acquired Spea, increased its sales to international OEMs and opened offices in
several countries including the United Kingdom, France, Singapore, Hong Kong,
South Korea and Australia. Although the Company's international sales are
primarily denominated in U.S. dollars, these sales are subject to a number of
risks generally associated with international sales, including the effect of
currency fluctuations, state-imposed restrictions on the repatriation of funds,
import and export restrictions, and the logistical difficulties of managing
international operations.


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<PAGE>   11

GROSS PROFIT

    Gross margin (gross profit as a percentage of sales) was 12.6%, 18.9% and
23.2% in 1997, 1996, and 1995, respectively. Gross margin declined to 12.6% of
net sales in 1997 from 18.9% of net sales in 1996 particularly due to absorbing
in the second quarter of 1997 large price protection credits granted to
customers as a result of sales price decreases, inventory write-down charges to
record inventory at lower-of-cost or market value, sales rebate deductions, and
competitive pricing pressures across most product lines. Further, gross margin
was adversely impacted by significantly lower sales volume levels over which
indirect manufacturing costs could be absorbed. Gross margin declined to 18.9%
of net sales in 1996 from 23.2% of net sales in 1995 due to lower unit prices
across most product lines and due to a charge in the second quarter of 1996 of
approximately $10 million, reflecting increased inventory reserves and customer
price protection claims related to the Diamond Edge 3D(R) product.

RESEARCH AND DEVELOPMENT

    Research and development expenses, primarily consisting of personnel
expenses, were $24.9 million, $18.8 million and $10.7 million in 1997, 1996 and
1995, respectively, constituting 5.6%, 3.1% and 2.3% of net sales, respectively.
The increase in research and development expenses for 1997 compared to 1996 was
due primarily to an increase in headcount (from 150 at December 31, 1996 to 196
at December 31, 1997), and increases in material costs and outside service costs
associated with new product development. The increase in research and
development expenses for 1996 compared to 1995 was due primarily to the
acquisitions of Supra and Spea (which were included in operating results for
only a portion of 1995 and all of 1996), higher personnel-related expenses as
headcount increased from 127 to 150 at December 31, 1995 and 1996,
respectively, and to a lesser extent, the material and outside service costs
associated with new product development. For 1997, the increase in expense as a
percentage of net sales was primarily due to a significant decline in net sales
during 1997. For 1996, and to a lesser degree in 1997, the increase in expense
as a percentage of net sales primarily reflected an increase in the Company's
engineering staff and occupancy costs related to its efforts to support the
introduction of new product lines, including those that will offer various
combinations of graphics, digital video, 3D animation, 3D CAD, sound, ISDN
adapter, analog modem, telephony, television, MPEG-2 and other functions
increasingly being implemented on personal computers. The Company anticipates
that its research and development expenses will continue to increase in absolute
dollars and may increase as a percentage of sales. The Company has not
capitalized any software development costs to date.

SELLING, GENERAL AND ADMINISTRATIVE

    Selling, general and administrative expenses were $85.7 million, $66.2
million and $39.3 million in 1997, 1996 and 1995, respectively, and constituted
19.3%, 11.1% and 8.4% of net sales, respectively. The increase in expenses in
1997 compared to 1996 relate to higher sales and marketing promotional programs,
higher depreciation expense and increased personnel-related expenses associated
with increased sales and marketing efforts. The increase in expenses in 1996
compared to 1995 reflected higher level of sales, marketing, technical support
and administrative staffing to support overall increases in sales volume and was
also due to higher costs related to sales incentive and promotion programs,
including channel sales incentive programs that were implemented both in the
third and fourth quarters of 1996, as well as higher outside professional fees
related, in part, to certain ongoing litigation and tax consulting services.
Further, the increases in expenses in 1996 was also attributable to the
acquisitions of Supra and Spea (which operations were included in operating
results only from the date of acquisition at September 20, 1995 and November 15,
1995, respectively).

    Selling, general and administrative costs increased significantly as a
percentage of net sales in 1997 due to higher selling and marketing costs and
also due to the large decline in net sales that occurred in 1997. Selling,
general and administrative costs also increased as a percentage of net sales in
1996 over 1995 due to increased sales incentive program and marketing costs in
1996 and to outside professional services costs.


                                       11
<PAGE>   12

    The Company anticipates that its selling, general and administrative
expenses will continue to increase in absolute dollars as the Company continues
to expand its efforts at penetrating certain sales channels and regions, and
continues to strengthen management information and telecommunications systems to
support its existing and acquired businesses and the anticipated growth in the
scope of its operations.

WRITE-OFFS OF IN-PROCESS TECHNOLOGY AND AMORTIZATION OF INTANGIBLE ASSETS

    The Company incurred two non-cash, non-tax deductible charges to operations
of $38.7 million and $38.0 million for the write-off of in-process technology
related to the acquisition of Supra in the third quarter of 1995 and Spea in the
fourth quarter of 1995, respectively, because the technological feasibility of
the in-process technology acquired had not been established and there was no
alternative future use. Further, the Company wrote-off $9.9 million of
intangible assets in the second quarter of 1997 to reflect a decrease in the
carrying value of goodwill and existing technology associated with the
acquisitions of Supra and Spea. The anticipated cash flows related to those
products indicated that the recoverability of those assets were not reasonably
assured. The Company also incurred amortization expense of $3.0 million and $5.0
million in 1997 and 1996, respectively, related to amortization of purchased
technology and goodwill from the Supra and Spea acquisitions. As a result of the
Company's acquisitions, the Company will incur aggregate amortization expense of
approximately $1.0 million annually for 1998 and the following three years, $0.9
million in 2002 and a remaining $0.5 million in 2003.

NET INTEREST INCOME (EXPENSE)

      Net interest income was $1.7 million and $2.0 million for 1997 and 1996,
respectively, and resulted from cash available for investment, partially offset
by interest expense on debt borrowings. Net interest income declined during 1997
compared to 1996 due to overall lower cash balances and overall higher
outstanding borrowings during 1997. For 1995 there was net interest expense of
$1.3 million due primarily to interest on the debt incurred in connection with
the reorganization of the Company on January 3, 1995. (See Reorganization in
Note 1 of Notes to Consolidated Financial Statements).

OTHER INCOME

    The Company recorded other income of $0.9 million in 1997 due primarily from
a gain on final settlement of a lawsuit. The Company recorded other income in
1996 of $1.2 million primarily related to Value Added Tax (VAT) refunds and
foreign currency translation gains. The Other Income of $1.4 million recorded in
1995 related to a gain pertaining to a lawsuit and foreign currency translation
gains.

PROVISION (BENEFIT) FOR INCOME TAXES

    The Company's effective tax rate was 35.4% in 1997 excluding the impact of
the write-off of $9.9 million of intangibles during 1997 which were not
deductible for income tax purposes. For 1996, the effective tax rate was 37.0%.
For 1995, the tax rate was 38.5% excluding the write-off of $76.7 million of
in-process technology related to the acquisitions of Supra and Spea for which
the write-offs were not deductible for income tax purposes. For 1995 through
1997, differences from the statutory rates consisted principally of the effect
of state income taxes, federal tax-exempt interest income and the research and
development tax credit.


LIQUIDITY AND CAPITAL RESOURCES

     During 1997, the Company used $42.2 million in cash from operating
activities primarily due to a net loss of $45.6 million, an increase in trade
accounts receivables of $14.5 million, an increase in income taxes receivable of
$24.9 million, and an increase in inventories of $26.5 million, partially offset
by an increase in trade accounts payable and other liabilities of $32.2 million,
a decrease in deferred income taxes of $6.4 million, as well as the non-cash
effects of the provision of excess and obsolete inventories of $11.6 million,
the write-off of in-process technology and intangibles of $9.9 million, and
depreciation and amortization expenses of $8.2 million. Net cash used in
investing activities was $11.4 million and consisted primarily of purchases of
property and equipment and purchases of short-term investments. Net cash
provided by financing activities was $19.4 million and was comprised primarily
of proceeds from term loans 


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<PAGE>   13

and revolving credit facilities of $153.4 million, partially offset by payments
and maturities of term loans and revolving credit facilities of $135 million

        At December 31, 1997, the Company had $85.9 million of cash and cash
equivalents. In addition, as of such date, the Company had two domestic bank
credit facilities: a $30 million line of credit permitting borrowings at the
bank's reference rate or a formula Libor based rate (7.52% at December 31, 1997)
and a $15 million line of credit permitting borrowings at the bank reference
rate or a formula Libor based rate (6.75% at December 31, 1997). Borrowings
under these lines at December 31, 1997 were $15 million and $7 million,
respectively. Further, the agreements for these lines of credit expire in May
1998 and February 1999, respectively. The covenants covering these debt
agreements pertain to quarterly profitability, minimum levels of net tangible
worth and minimum levels of liquidity. At December 31, 1997, the Company was in
violation with the ratio relating to a minimum level of liquidity; however, the
Company has obtained the necessary waivers.

    Additionally, the Company has credit facilities under foreign lines of
credit. At December 31, 1997, the Company's Japanese subsidiary had a Japanese
line of credit entitling it to borrow up to approximately $5.2 million. The line
of credit is collaterized by a stand-by letter of credit from the Company and
accrues interest at the bank's variable rate (1.625% at December 31, 1997).
Borrowings were $4.5 million under this facility at December 31, 1997. At
December 31, 1997, the Company's Spea subsidiary had a 5 million DeustcheMark
line of credit (approximately $2.8 million at December 31, 1997) with a German
bank bearing interest at 7.0% at December 31, 1997. Additionally, the Company
had a foreign line of credit of 10 million DeustcheMarks (approximately $5.5
million at December 31, 1997) bearing interest at December 31, 1997 at 7.0% for
borrowings of DeustcheMarks, or 9.25% for borrowings of other currencies, such
as the U.S. dollar. Both these lines were fully utilized at December 31, 1997.
These agreements expire in March 1998. The most restrictive covenant under these
two lines of credit require a minimum annual earnings per share of twenty (20)
cents. At December 31, 1997, the Company was in violation of this covenant.

    The Company expects to spend approximately $12 million for capital equipment
in 1998, principally relating to computer and office equipment, and including,
in particular, an enhanced enterprise-wide business management, resource
planning and decision support application.

    The Company believes that its cash balances and available credit under
existing bank lines will be sufficient to meet anticipated operating and
investing requirements for the short term. There can be no assurance that
additional capital beyond the amounts currently forecasted by the Company will
not be required nor that any such required additional capital will be available
on reasonable terms, if at all, at such time or times as required by the
Company.


RECENT ACCOUNTING PRONOUNCEMENTS

    In June 1997, the Financial Accounting Standards Board issued a Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS
130). SFAS 130 establishes standards for reporting and display of comprehensive
income and its components in a full set of general-purpose financial statements.
Comprehensive income is defined as the "change in equity of a business
enterprise during a period from transactions and other events and circumstances
from nonowner sources. It includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners." SFAS
130 is effective for fiscal years beginning after December 15, 1997, and
reclassification of financial statements for earlier periods provided for
comparative purposes is required. SFAS 130 is not expected to have a material
impact on the Company's financial position, results of operations or cash flows.

    In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information" (SFAS 131). SFAS 131 establishes standards
for the way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to stockholders. SFAS 131 generally supersedes Statement of
Financial Accounting Standards No. 14, "Financial Reporting for Segments of a
Business Enterprise." Under SFAS 131, operating segments are components of an
enterprise about which separate financial information is available that is
evaluated regularly by the chief operating decision maker in deciding how to
allocate resources and in assessing performance. Generally, financial
information is required 


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<PAGE>   14

to be reported on the basis it is used internally. SFAS 131 is effective for
financial statements for periods beginning after December 15, 1997, and
restatement of comparative information for earlier years is required. However,
SFAS 131 is not required to be applied to interim financial statements in the
initial year of application. SFAS 131 will not have a material impact on the
Company's financial position, results of operations or cash flows.


CERTAIN FACTORS THAT MAY AFFECT FUTURE PERFORMANCE

   In addition to other information in this Form 10-K, the following are
important factors that should be considered carefully in evaluating the Company
and its business.

POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS

   The Company's operating results have fluctuated significantly in the past on
a quarterly and an annual basis and is likely to continue to fluctuate
significantly in the future depending on a number of factors. The accompanying
sections explain in greater detail certain important factors that the Company
has identified which may affect the future performance of the Company.

   The Company develops products in the highly competitive multimedia graphics,
video, sound, modem and SCSI adapter markets. These products are very
susceptible to product obsolescence and typically exhibit a high degree of
volatility of shipment volumes over their relatively short product life cycles.
The timing of introductions of new products in one calendar quarter as opposed
to an adjacent quarter can materially affect the relative sales volumes in those
quarters. In addition, product releases by competitors and accompanying pricing
actions can materially and adversely affect the Company's revenues and gross
margins.

   Similarly, the Company sells its products to retail customers (mass
merchandisers and large chains who sell products primarily off-the-shelf
directly to end users) retail distribution customers (distributors which resell
to smaller retail chains and large individual end users) and OEM customers
(customers which use the Company's products in conjunction with other products
to produce complete computer systems for sales through both direct and indirect
distribution channels to end users). Reliance on these customers for almost all
of the Company's sales means that the Company typically has little or no direct
visibility into end user customer demand. OEM customers tend to provide the
Company with forecasts for product requirements but actual order lead times
remain less than 90 days. Retail and retail distribution customers typically do
not forecast product requirements and order lead times are typically very short,
as these customers tend to reorder for stock in quantities that approximate
recent sales volumes. Accordingly, this means that future operating results are
dependent on continued sales to customers where the vast majority of the normal
volume of orders are placed with the Company within the same calendar quarter as
the requested date of shipment by the customer.

   Because the lead times of firm orders are typically short, the Company does
not have the ability to predict with any certainty the future operating results
of the Company. Therefore, sudden changes that are out of the control of the
Company such as general economic conditions, the actions or inaction of
competitors, customers, third party vendors of operating system software,
central processing unit hardware, and independent software application vendors
can have and have had material adverse effects on the Company's performance.

   Other factors which may have a material adverse effect on the Company's
future performance, include the management of growth of the Company, latent
defects that can exist in the Company's products, competition for the available
supply of components, dependence on subcontract manufacturers, dependence on and
development of adequate information technology systems, intellectual property
rights and dependence on key personnel.

   Each of these factors is discussed more thoroughly in the accompanying
sections and all of these sections should be read carefully together to evaluate
the risks associated with the Company's Common Stock. Due to these factors, it
is likely that the operating results of the Company in some future quarter or
quarters will fall below the expectations of securities analysts and investors.
In such an event, the trading price of the Company's Common Stock could be
materially and adversely affected.


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<PAGE>   15

REVENUE VOLATILITY AND DEPENDENCE ON ORDERS RECEIVED AND SHIPPED IN A QUARTER

    The volume and timing of orders received during a quarter are difficult to
forecast. Retail and retail distribution customers generally order without
forecasts on an as-needed basis and, accordingly, the Company has historically
operated with a relatively small backlog. Moreover, the Company has emphasized
its ability to respond quickly to customer orders as part of its competitive
strategy. This strategy, combined with current industry supply and demand
conditions as well as the Company's emphasis on minimizing inventory levels, has
resulted in customers placing orders with relatively short delivery schedules
and increased demand on the Company to carry inventory for its customer base.
This has the effect of increasing such short lead time orders as a portion of
the Company's business and reducing the Company's ability to accurately forecast
net sales. Because retail and retail distribution customers' orders are more
difficult to predict, there can be no assurance that the combination of these
orders, OEM's orders, and backlog in any quarter will be sufficient to achieve
either sequential or year-over-year growth in net sales during that quarter. If
the Company does not achieve a sufficient level of retail and retail
distribution orders in a particular quarter, the Company's revenues and
operating results would be materially adversely affected.

    Also, at any time and with no advance notice, during periods of uncertainty
in the personal computer industry's outlook for future demand or pricing, the
Company's customers may choose to draw down their inventory levels thereby
adversely impacting the Company's revenue during the period of adjustment. The
second and third quarters of 1997 comprised such a period due to the transition
from older slower speed modems and 2D graphics products to new higher speed
modems and 3D graphics products. Also, as is common in the personal computer
industry, a disproportionate percentage of the Company's net sales in any
quarter may be generated in the last month or weeks of a quarter. As a result, a
shortfall in sales in any quarter as compared to expectations may not be
identifiable until at or near the end of the quarter. In addition, from time to
time, a significant portion of the Company's net sales may be derived from a
limited number of customers, the loss of one or more of which could adversely
impact operating results.

    Notwithstanding the difficulty in forecasting future sales and the
relatively small level of backlog at any given time, the Company generally must
plan production, order components and undertake its development, sales and
marketing activities and other commitments months in advance. Accordingly, any
shortfall in net sales in a given quarter may materially impact the Company's
operating results and cash balances in a magnified way due to the Company's
inability to adjust expenses or inventory levels during the quarter to match the
level of net sales for the quarter. Excess inventory could also result in cash
flow difficulties as well as added costs of goods sold and expenses associated
with inventory write-offs or sell-offs. Conversely, in its efforts to adjust
inventory levels to a slower order rate, the Company may overcorrect its
component purchases and inventory levels, thereby experiencing periodic
shortages of inventory and delivery delays, and negatively impacting its net
sales, market share and customer satisfaction levels in the current quarter or
in future quarters. There can be no assurances that such an occurence will not
adversely impact the Company operating results.

DECLINING SELLING PRICES AND OTHER FACTORS AFFECTING GROSS MARGINS

    The Company's markets are characterized by intense ongoing competition and
coupled with a past history and a current trend of declining average selling
prices. A decline in selling prices may cause the net sales in a quarter to be
lower than the revenue of a preceding quarter or corresponding prior year's
quarter even if more units were sold during such quarter than in the preceding
or corresponding prior year's quarter. Accordingly, it is likely that the
Company's average selling prices will decline, and that the Company's net sales
and margins may decline in the future, from the levels experienced to date. The
Company's gross margins may also be adversely affected by shortages of, or
higher prices for, key components for the Company's products, including its
modems, 3D graphics accelerators, SCSI I/O host bus adapters, 3D audio
accelerators and DVD/MPEG-2 video products, some of which have been impacted
from time-to-time by a scarcity in the supply of associated chipsets and other
components. Moreover, the recent agreement by Symbios Logic, the sole supplier
of the Company's SCSI controllers under which Symbios Logic is to be acquired by
Adaptec, the Company's chief competitor in the SCSI host adapter card market
may, if such a merger is consummated result in the unavailability of SCSI
controllers for the Company's SCSI products, or the unavailability of such
controllers or software support under economically reasonable prices, terms,
conditions or timing.


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<PAGE>   16

     In addition, the Company's net sales, average selling prices and gross
margins will be adversely affected if the market prices for certain components
used or expected to be used by the Company, such as DRAM, VRAM, SGRAM or RDRAM
memory, DVD drives, multimedia controller chips or bundled software, decline
more rapidly than the Company is able to process component inventory bought
earlier at higher prices into finished products, book and ship the related
orders, and move such products through third-party distribution channels, some
of which may be price protected, to the final customer. For example, operating
results were negatively impacted in the second and third quarters of 1996 by
declining market prices for the Company's products, caused in part by a sharp
reduction in the market price for DRAMs. Conversely, an increase in the price of
semiconductor components may adversely impact the Company's gross margin due to
higher unit costs, and a decrease in the supply of semiconductor components may
adversely impact the Company's net sales due to lower unit shipments.

SEASONALITY

    The Company believes that, due to industry seasonality, demand for its
products is strongest during the fourth quarter of each year. This seasonality
may become more pronounced and material in the future to the extent that a
greater proportion of the Company's sales consist of sales into the retail/mass
merchant channel, that PCs become more consumer-oriented or entertainment-driven
products, or that the Company's net sales becomes increasingly based on
entertainment-centric products. Also, to the extent the Company is successful in
expanding its European operations, it may experience relatively weak demand in
third calendar quarters due to historically weak summer sales in Europe.

MANAGEMENT OF GROWTH

    In recent years, the Company has experienced a significant expansion in the
overall level of its business and the scope of its operations, including
manufacturing, research and development, marketing, technical support, customer
service, sales and logistics. In addition, through its acquisitions of Supra in
September 1995 and Spea in November 1995, the Company increased the scope of its
product lines and multinational operations. This expansion in scope has resulted
in a need for significant investment in infrastructure, processes and
information systems, as well as the integration of the operations of Supra and
Spea into the Company's infrastructure. This requirement includes, without
limitation: Securing adequate financial resources to successfully integrate and
manage the acquired businesses; retention of key employees; integration of
management information, product data management, control and telecommunications
systems; consolidation of geographically dispersed manufacturing and
distribution facilities; consolidation and coordination of suppliers;
rationalization of distribution channels; establishment and documentation of
business processes; and integration of various functions and groups of
employees. Each of these requirements poses significant, material challenges.
For example, the Company established a restructuring reserve in the second
quarter of 1997 to account for the expected expenses of, among other actions,
integrating customer service and distribution from Supra into Diamond,
transitioning manufacturing from Supra's facility in Oregon to a subcontractor
facility in Mexico, and integrating technical support from Diamond's San Jose,
CA facility to Supra's technical support organization in Oregon. Moreover, Spea
historically has not been profitable and the Company's management took
significant steps to reduce expenses at Spea and integrate its operations with
those of the Company. Accordingly, the Company reorganized Spea to function
principally as follows: a product localization and marketing operation for
Europe; a sales, technical support and customer service operation for Central
Europe; and a product development and launch facility for professional 3D
graphics, including CAD and digital animation, for the Company's worldwide
markets. The Company discontinued manufacturing, test, packaging and logistics
operations at Spea effective October 1, 1996. Prior to its acquisition by the
Company, Spea made certain investments including entering into the shared
ownership (at 49.5%) with Philips Semiconductor (at 50.5%) of a 3D graphics
semiconductor design subsidiary, SP3D. The Company's 49.5% ownership of SP3D is
carried on the Company's balance sheet at approximately $3.4 million. Philips
Semiconductor has full day-to-day operating management control of SP3D and holds
the majority of seats on the SP3D board. There can be no assurance that the
Company will be able to achieve a reasonable return on this asset, or that the
asset will not need to be written down, in whole or in part, during subsequent
accounting periods.

    The Company's future operating results will depend in large measure on its
success in implementing operating, manufacturing and financial procedures and
controls, improving communication and coordination among the different operating
functions, integrating certain functions such as sales, procurement and
operations, strengthening management information and telecommunications systems,
and continuing to hire 


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<PAGE>   17

additional qualified personnel in all areas. Moreover, the Company has selected
and is implementing a new enterprise resource planning (ERP) system to be fully
operational in late 1998 in order to properly manage the increasing complexity
of its international multi-product business and avert potential Year 2000 issues
with its current management information system. There can be no assurance that
the Company will be able to manage these activities and implement these
additional systems, procedures and controls successfully, and any failure to do
so could have a material adverse effect upon the Company's short-term and
long-term operating results.

SHORT PRODUCT LIFE CYCLES; DEPENDENCE ON NEW PRODUCTS

    The market for the Company's products is characterized by frequent new
product introductions and rapid product obsolescence. These factors typically
result in short product life cycles, frequently ranging from six to twelve
months. The Company must develop and introduce new products in a timely manner
that compete effectively on the basis of price and performance and that address
customer needs and meet customer requirements. To do this, the Company must
continually monitor industry trends and make difficult choices regarding the
selection of new technologies and features to incorporate into its new products,
as well as the timing of when to introduce such new products, all of which may
impair the orders for or the prices of the Company's existing products. The
success of new product introductions depends on various factors, some of which
are outside the Company's direct control. Such factors may include: selection of
new products; selection of controller or memory chip architectures; timely
completion and introduction of new product designs; trade-offs between the time
of first customer shipment and the optimization of software for speed, stability
and compatibility; development of supporting content by independent software
application vendors; development and production of collateral product
literature; prompt delivery to OEM accounts of prototypes; support of OEM
prototypes; ability to rapidly ramp manufacturing volumes; and coordination of
advertising, press relations, channel promotion and VAR evaluation programs.

     In the current transition of mainstream PC graphics subsystem architectures
from 2D graphics and the PCI bus to 3D graphics and the accelerated graphics
port (AGP), which began in 1997 and is expected to continue through 1998,
controller and memory chip selection and the timely introduction of new products
have been and will be critical factors. In addition, in the current transition
from the widely accepted V.34 modem protocol (33.6Kbps) through the new higher
speed proprietary K56flex and x2 protocols (56Kbps) to the new international
standard V.90 protocol (56Kbps), the chip selection to implement and deploy such
a standard and the industry alliances to convert such support into revenue and
market share have been and will be critical factors. There can be no assurance
that the Company will select the proper chips to implement and support its
efforts in the various markets or that the Company will execute its strategy in
a timely manner during this transition period.

    Each new product cycle presents new opportunities for current or prospective
competitors of the Company to gain a product advantage or increase their market
share. If the Company does not successfully introduce new products within a
given product cycle, the Company's sales will be adversely affected for that
cycle and possibly for subsequent cycles. Any such failure could also impair the
Company's brand name and ability to command retail shelf space and OEM design
wins in future periods. Moreover, because of the short product life cycles
coupled with the long lead times for procuring many of the components used in
the Company's products, the Company may not be able, in a timely manner, or at
all, to reduce its component procurement commitments, software license
commitments, production rates or inventory levels in response to unexpected
delays in product launch, shortfalls in sales, technological obsolescence or
declines in prices or, conversely, to increase production in response to
unexpected increases in demand, particularly if such demand increases are in a
new product or new technology area where component supply may be hard to secure.
Therefore, changes in actual or expected demand could result in excess
inventory, inventory write downs, price protection and gross margin compression
or, conversely, in lost sales and revenue compression due to product or
component unavailability.

NEW OPERATING SYSTEMS

    The PC industry has been characterized by significant operating system
changes, such as the introduction of Windows 95 in 1995 and Windows NT 4.0 in
1996, and the introduction of significant new operating system components, such
as Microsoft's Direct X and ActiveX for Windows 95. While new operating systems
can provide new market opportunities, such as the growing market for graphical
user interface (GUI) accelerators that occurred with the introduction of Windows
3.0 and the growth in the PC games market with 


                                       17
<PAGE>   18

the introduction of Windows 95, new operating systems and operating system
components also place a significant research and development burden on the
Company. New drivers, applications and user interfaces must be developed for new
operating systems and operating system components in order to maintain net sales
levels and customer satisfaction. Perhaps more significantly, such drivers,
applications and interfaces customarily are ported to the recently shipped
portion of the Company's installed base. This effort involves a substantial
software engineering, compatibility testing and customer technical support
investment with only limited near-term incremental revenue return since these
driver updates are usually provided via electronic distribution at no cost to
the Company's installed customer base. In addition, the installation of this
software may result in technical support calls, thereby generating expenses that
do not have offsetting revenue. Moreover, during the introductory period of a
major new operating system release such as Windows 95, such installed base
support may reduce the research and development and customer technical support
resources available for launching new products. For example, after substantial
investment in porting the Company's software, graphics accelerator and modem
products to Windows 95, the Company was at year-end 1996 still developing for
final release improved, accelerated Windows 95 drivers for the Viper Pro Video
series of accelerator add-in cards. While this product line did not at that time
represent a revenue opportunity for the Company, the Company nevertheless
believed that it was important to make the significant software development
investment represented by this effort in order to maintain relations with its
installed customer base and its reputation for reliable on-going product
support. Furthermore, new operating systems for which the Company prospectively
develops driver support may not be successful, or the drivers themselves may not
be successful or accepted by customers, and a reasonable financial return on the
corollary research and development investment may never be achieved.

DEPENDENCE ON THIRD PARTY SOFTWARE DEVELOPERS

     The Company's business strategy includes developing relationships with
major independent software application vendors that serve the 3D graphics and 3D
audio markets, including the 3D computer games market and the professional 3D
graphics market. The Company believes that the availability of a sufficient
number of high quality, commercially successful entertainment 3D software titles
will be a significant factor in the sale of multimedia hardware to the PC-based
interactive 3D entertainment market. The Company also believes that compelling
professional 3D graphics applications developed for PCs or ported from
traditional workstations, such as those supplied by Silicon Graphics and Sun
Microsystems, to PCs based on advanced Intel microprocessors and the Microsoft
NT operating system will be significant factors in the sale of 3D graphics
hardware to the PC-based NT workstation market. The Company depends on
independent software application developers and publishers to create, produce
and market software entertainment titles and professional graphics applications
that will operate with the Company's 3D products, such as Monster, Stealth,
Viper and Fire GL. Only a limited number of software developers are capable of
creating high quality professional 3D and entertainment 3D software. Competition
for these resources is intense and is expected to increase. There can be no
assurance that the Company will be able to attract the number and quality of
software developers and publishers necessary to develop a sufficient number of
high quality, commercially successful software titles and applications that are
compatible with the Company's 3D products.

     Further, in the case of the Company's entertainment 3D products, there can
be no assurance that third parties will publish a substantial number of
entertainment 3D software titles or, if entertainment 3D software titles are
available, that they will be of high quality or that they will achieve market
acceptance. The development and marketing of game titles that do not fully
demonstrate the technical capabilities of the Company's entertainment 3D
products could create the impression that the Company's products offer less
compelling performance over competing 3D games platforms, such as TV games
console platforms. This may slow or stop any migration from the current
widespread use of TV games consoles to the use of computer games on PCs, or the
enhancement of PCs to operate such games. Further, because the Company has no
control over the content of the entertainment titles produced by software
developers and publishers, the entertainment 3D software titles developed may
represent only a limited number of game categories and are likely to be of
varying quality.

SEMICONDUCTOR OR SOFTWARE DEFECTS

     Product components may contain undetected errors or "bugs" when first
supplied to the Company that, despite testing by the Company, are discovered
only after certain of the Company's products have been installed and used by
customers. There can be no assurance that errors will not be found in the
Company's 


                                       18
<PAGE>   19

products due to errors in such products' components, or that any such
errors will not impair the market acceptance of these products or require
significant product recalls. Problems encountered by customers or product
recalls could materially adversely affect the Company's business, financial
condition and results of operations. Further, the Company continues to upgrade
the firmware, software drivers and software utilities that are incorporated into
or included with its hardware products. The Company's software products, and its
hardware products incorporating such software, are extremely complex due to a
number of factors including the products' advanced functionality, the diverse
operating environments in which the products may be deployed, the need for
interoperability, and the multiple versions of such products that must be
supported for diverse operating platforms, languages and standards. These
products may contain undetected errors or failures when first introduced or as
new versions are released. The Company generally provides a five-year warranty
for its products and, in general, the Company's return policies permit return
within thirty days after receipt of products that do not meet product
specifications. There can be no assurance that, despite testing by the Company,
by its suppliers and by current or potential customers, errors will not be found
in new products after commencement of commercial shipments, resulting in loss of
or delay in market acceptance or product acceptance or in warranty returns. Such
loss or delay would likely have a material adverse effect on the Company's
business, financial condition and results of operations.

     Additionally, new versions or upgrades to operating systems or independent
software vendor titles or applications may require upgrades to the Company's
software products to maintain compatibility with these new versions or upgrades.
There can be no assurance that the Company will be successful in developing new
versions or enhancements to its software or that the Company will not experience
delays in the upgrade of its software products. In the event that the Company
experiences delays or is unable to maintain compatibility with operating systems
and independent software vendor titles or applications, the Company's business,
financial condition and results of operations could be materially adversely
affected.

MARKET ANTICIPATION OF NEW PRODUCTS, NEW TECHNOLOGIES OR LOWER PRICES

    Since the environment in which the Company operates is characterized by
rapid new product and technology introductions and generally declining prices
for existing products, the Company's customers may from time to time postpone
purchases in anticipation of such new product introductions or lower prices. If
such anticipated changes are viewed as significant by the market, such as the
introduction of a new operating system or microprocessor architecture, then this
may have the effect of temporarily slowing overall market demand and negatively
impacting the Company's operating results. For example, the substantial
pre-release publicity surrounding the release of Windows 95 may have contributed
to a slowing of the consumer PC market in the summer of 1995. Moreover, a
similar reaction has likely occurred in the modem market as a result of the
announcements of modems based on 56 Kbps technology which became available in
1997, or in the overall PC market in anticipation of Intel Corporation's
transition to MMX-based microprocessors during 1997. Additionally, the
substantial publicity by Intel Corporation for its MMX technology may have
confused and slowed the market for add-in multimedia accelerators, such as those
sold by the Company, during the first half of 1997. If so, these effects may
continue into future periods for these or similar events. Other anticipated new
product releases that may influence future market growth or the timing of such
growth include Microsoft's release of its "Memphis" upgrade to Windows 95,
currently anticipated to be generally available to the public in the second
quarter of 1998 as Windows 98, Intel's release of its Pentium II CPU and the
associated chipsets supporting the AGP and 2x AGP architectures, and Intel's
release of its "Merced" workstation CPU slated for first customer shipment in
1999.

    The potential negative impact on the Company's operating results as a result
of customer decisions to postpone purchases in favor of new and "publicized"
technology can be further magnified if products or components based on such new
technology are not available in a timely manner or in sufficient supply to meet
the demand caused by the market's shift to the new technology from an older
technology. For example, the Company believes that the PC market may have slowed
in early 1997 in part as customers waited for the availability of Intel's new
MMX-enabled Pentium CPUs. Further, the Company's operating results could be
adversely affected if the Company makes poor selections of chip architectures or
chip suppliers to pursue 3D graphics, AGP or 56Kbps modem market opportunities
and, as a result, is unable to achieve market acceptance of its new products or
is unable to secure enough supply of such components.

    If the Company were to announce a product that the market viewed as having
more desirable features or pricing than the Company's existing products, demand
for the Company's existing products could be curtailed, even though the new
product is not yet available. Similarly, if the Company's customers anticipate


                                       19
<PAGE>   20

that the Company may reduce its prices in the near term, they might postpone
their purchases until such price reductions are effected, reducing the Company's
near-term shipments and revenue. In general, market anticipation of new
products, new technologies or lower prices, even though potentially positive in
the longer term, can negatively impact the Company's operating results in the
short term.

COMPONENT SHORTAGES; RELIANCE ON SOLE OR LIMITED SOURCE SUPPLIERS

   The Company is dependent on sole or limited source suppliers for certain key
components used in its products, particularly chipsets that provide graphics,
digital video, DVD, television (TV), sound or other multimedia functions, random
access memory (including VRAM, DRAM, RDRAM and SGRAM) chips, and speakerphone
modem and fax/modem chipsets. Although the price and availability of many
semiconductor components improved during 1996 and 1997, these components are
periodically in short supply and on allocation by semiconductor manufacturers.
For example, it is expected that the Company may experience substantial
constraints in the supply of high-performance SGRAMs and high-performance 3D
graphics chips for the foreseeable future. There can be no assurances that the
Company can obtain adequate supplies of such components, or that such shortages
or the costs of these components will not adversely affect future operating
results. The Company's dependence on sole or limited source suppliers, and the
risks associated with any delay or shortfall in supply, can be exacerbated by
the short life cycles that characterize multimedia and communications ASIC
chipsets and the Company's products in general. Although the Company maintains
ongoing efforts to obtain required supplies of components, including working
closely with vendors and qualifying alternative components for inclusion in the
Company's products, component shortages continue to exist from time to time, and
there can be no assurances that the Company can continue to obtain adequate
supplies or obtain such supplies at their historical or competitive cost levels.
Conversely, in its attempt to counter actual or perceived component shortages,
the Company may overpurchase certain components, resulting in excess inventory
and reducing the Company's liquidity or, in the event of unexpected inventory
obsolescence or a decline in the market value of such inventory, causing
inventory write-offs or sell-offs that adversely affect the Company's gross
margin and profitability. In addition, such inventory sell-offs by the Company
or its competitors could trigger channel price protection charges, further
reducing the Company's gross margins and profitability.

    As noted above, supply and demand conditions for semiconductor components
are unpredictable and may change from time to time. During periods of
oversupply, prices are likely to fall and certain vendors of such semiconductor
chips may liquidate their inventories in a rapid manner. If such semiconductor
vendors are suppliers to the Company's competitors, then such actions could
enable competitors of the Company to enjoy a cost advantage vis-a-vis the
Company, and any resultant price reduction for such competitors' products could
force the Company to reduce its prices, thereby depressing the Company's net
sales and gross margins in one or more operating periods.

    During periods of component oversupply and associated price deflation,
customers of the Company, particularly those comprising channels that do not
receive price protection from the Company, may seek to draw down the inventory
that they hold since such inventory likely would bear a price deflation risk. As
a consequence, the Company may see its orders, unit shipments and average
selling prices depressed from time to time during such price-deflation and
inventory-reduction periods, which could adversely affect net sales and gross
margin in the related operating period or periods.

    When the PC or PC peripherals markets emerge from a period of oversupply,
such as that experienced in the second quarter of 1997, certain manufacturers,
distributors and resellers may be unprepared for a possible rapid increase in
market demand. Accordingly, the Company may not have sufficient inventory,
scheduled component purchase orders or available manufacturing capacity to meet
any rapid increase in market demand, thereby missing orders and revenue
opportunities, causing customer dissatisfaction and losing market share. The
Company experienced such a situation in the last half of 1997, and is
experiencing a continuation of that situation in the first quarter of 1998 as
the Company continues to experience a shortage of various components restricting
the Company's ability to manufacture quantities of certain products in
sufficient quantities or in a linear fashion during the quarter to meet market
demand. In addition, the Company believes that in the near term the Company will
be subjected to restricted supply and increasing prices on certain semiconductor
components including graphics controllers and memories. The inability of the
Company to obtain product components at their historical cost levels resulting
in the Company being forced to pay higher prices to achieve timely delivery
would directly affect the cost of the Company's products and could materially
and adversely affect the Company's gross margin. There can be no assurance that
the Company 


                                       20
<PAGE>   21

will be able to obtain adequate supplies of components or that such shortages or
the costs of these components will not adversely impact the Company's future
operating results.

DEPENDENCE ON SUBCONTRACTORS

    The Company relies on independent surface mount technology ("SMT") and
printed circuit board ("PCB") subcontractors to manufacture, assemble or test
the Company's products. The Company typically procures its components, assembly
and test services and assembled products through purchase orders and does not
have specific volume purchase agreements with each of its subcontractors. Most
of the Company's subcontractors could cease supplying the services, products or
components at any time with limited or no penalty. In the event that it becomes
necessary for the Company to replace a key subcontractor, the Company could
incur significant manufacturing set-up costs and delays. There can be no
assurance that the Company would be able to find suitable replacement
subcontractors. The Company's emphasis on maintaining low inventory may
exacerbate the effects of any shortage that may result from the use of
sole-source subcontractors during periods of tight supply or rapid order growth.
The Company's ability to respond to greater than anticipated market demand may
be constrained by the availability of SMT or PCB subcontracting services.
Further, various of the Company's subcontractors are located in international
locations that, while offering low labor costs, may present heightened process
control, quality control, political, infrastructure, transportation, tariff,
regulatory, legal, import, export, economic or supply risks.

DEPENDENCE ON GRAPHICS AND MULTIMEDIA ACCELERATOR MARKET

    Sales of graphics and multimedia accelerator subsystems accounted for
approximately 75% of the Company's net sales in 1997, and greater than 75% in
the prior year. Although the Company has introduced DVD and audio subsystems,
ISDN adapters and SCSI host bus adapters, and has entered the modem market
through the acquisition of Supra Corporation, graphics accelerator subsystems
are expected to continue to account for a majority of the Company's sales for
the foreseeable future. A decline in demand or average selling prices for
graphics accelerator subsystems, whether as a result of new competitive product
introductions, price competition, excess supply, widespread cost reduction,
technological change, incorporation of the products' functionality onto personal
computer motherboards or otherwise, would have a material adverse effect on the
Company's sales and operating results.

MIGRATION TO PERSONAL COMPUTER MOTHERBOARDS

    The Company's graphics and multimedia accelerator subsystems are individual
products that function within personal computers to provide additional
multimedia functionality. Historically, as a given functionality becomes
technologically stable and widely accepted by personal computer users, the cost
of providing such functionality is typically reduced by means of large scale
integration into semiconductor chips, which can be subsequently incorporated
onto personal computer motherboards. The Company expects that such migration
will not occur in a substantial way with 3D graphics or Intel's accelerated
graphics port (AGP) in the near term, although the Company recognizes that such
migration could occur with respect to the functionality provided by some of the
Company's current products. While the Company believes that a market will
continue to exist for add-in subsystems that provide advanced or multiple
functions and offer flexibility in systems configuration, such as 3D graphics,
3D audio, MPEG-2 digital video, high-speed I/O and modems, there can be no
assurance that the incorporation of new multimedia functions onto personal
computer motherboards or into CPU microprocessors, such as under Intel's MMX or
AGP technologies, will not adversely affect the future market for the Company's
products. In large part, the continuation of a robust market for add-in graphics
and video subsystems may depend on the timing and market acceptance of 3D
graphics and digital video MPEG-2 acceleration. This, in turn, may depend on the
availability of compelling 3D and MPEG-2 content, including games and
entertainment, broadcast digital video, PC video phones, desktop video
conferencing, and digital video, audio and VRML on the Internet. Similarly, the
robustness of the modem market may depend largely on the widespread adoption of
56Kbps and digital subscriber line (xDSL) technologies in both client-side
modems attached to the PC and server-side modems provided by Internet Service
Providers and telephone network central offices. The timing of major technology
introductions and the market acceptance of these new technologies and standards
are largely out of the control of the Company.


                                       21
<PAGE>   22

COMPETITION

    The market for the Company's products is highly competitive. The Company
competes directly against a large number of suppliers of graphics and multimedia
accelerator products for the PC such as Matrox Graphics Inc., STB Systems Inc.
and ATI Technologies Inc., and indirectly against PC systems OEMs to the extent
that they manufacture their own add-in subsystems or incorporate on PC
motherboards the functionality provided by the Company's products. In certain
markets where the Company is a relatively new entrant, such as modems, sound
cards and SCSI host adapters, the Company may face dominant competitors
including 3Com (modems), Creative Technology (sound cards) and Adaptec (SCSI
host bus adapters). In addition, the Company's markets are expected to become
increasingly competitive as multimedia functions continue to converge and
companies that previously supplied products providing distinct functions (for
example, companies today primarily in the sound, fax/modem, telephony, digital
signal processing, central processing unit or motherboard markets) emerge as
competitors across broader or more integrated product categories.

    In addition, manufacturers of chipsets or other components used in the
Company's products could become future competitors of the Company to the extent
that such manufacturers elect to integrate forward into the add-in subsystem or
value-added software market, or as such multimedia chipset manufacturers provide
increasingly higher quality and more sophisticated software to their chipset
customers, including subsystem suppliers competitive to the Company. Also,
certain of the Company's current and potential competitors have significantly
greater market presence, name recognition and financial and technical resources
relative to the Company, and many have long-standing market positions and
established brand names in their respective markets. In addition, certain of the
Company's current and potential competitors also have a competitive cost
advantage as a result of being located in areas that impose significantly lower
taxes than the United States or offer a substantially lower cost of labor or
provide governmental subsidies, such as research and development and training
funds. Many of the Company's current and potential competitors also design and
manufacture their own graphics acceleration, video, sound, fax/modem or other
multimedia processing chipsets. While the Company believes that its
semiconductor vendor flexibility enables it to select, within certain limits,
from among the most advanced and price competitive chipsets available on the
open market, the captive semiconductor operations of certain of the Company's
current and potential competitors could provide them with significant
advantages, including greater control over semiconductor architecture and
technology, component design, component performance, systems and software
design, availability and cost.

    The Company also believes that the strategy of certain of its current and
potential competitors is to compete largely on the basis of price, which may
result in significant price competition and lead to lower margins for the
Company's products or otherwise adversely affect the market for the Company's
products. To the extent that semiconductor availability is relatively robust and
software drivers and reference hardware designs from multimedia chipset
manufacturers are of high quality and sophistication, then competitors who sell
such reference designs and compete largely on price with little valued added
engineering may have a competitive cost or expense advantage relative to the
Company. There can be no assurance that the Company will be able to continue to
compete successfully in its current and future markets, or will be able to
compete successfully against current and new competitors, as the Company's
technology, markets and products continue to evolve.

DISTRIBUTION RISKS

   The Company sells its products through a network of domestic and
international distributors, and directly to major retailers/mass merchants, VARs
and OEM customers. The Company's future success is dependent on the continued
viability and financial stability of its customer base. The computer
distribution and retail channels historically have been characterized by rapid
change, including periods of widespread financial difficulties and consolidation
and the emergence of alternative sales channels, such as direct mail order,
telephone sales by PC manufacturers and electronic commerce on the World Wide
Web. The loss of, or reduction in, sales to certain of the Company's key
customers as a result of changing market conditions, competition, or customer
credit problems could have a material adverse effect on the Company's operating
results. Likewise, changes in distribution channel patterns, such as increased
commerce on the Internet, increased use of mail-order catalogues, increased use
of consumer-electronics channels for personal computer sales, or increased use
of channel assembly to configure PC systems to fit customers' requirements could
affect the Company in ways not yet known. Moreover, additions to or changes in
the types of products the 


                                       22
<PAGE>   23

Company sells, such as the introduction of professional-grade products or the
migration toward more communications-centric products, may require specialized
value-added reseller channels, relations with which the Company has only begun
to establish.

   Inventory levels of the Company's products in the two-tier distribution
channels used by the Company ("Channel Inventory Levels") generally are
maintained in a range of one to three months of customer demand. These Channel
Inventory Levels tend to be lower when demand is stronger, sales are higher and
products are in short supply. Conversely, when demand is slower, sales are lower
and products are abundant, then Channel Inventory Levels tend to be higher.
Frequently, in such situations, the Company attempts to ensure that distributors
devote their working capital, sales and logistics resources to the Company's
products to a greater degree than to those of competitors. Similarly, the
Company's competitors attempt to ensure that their own products are receiving a
disproportionately higher share of the distributors' working capital and
logistics resources. In an environment of slower demand and abundant supply of
products, price declines are more likely to occur and, should they occur, are
more likely to be severe. Further, in such an event, high Channel Inventory
Levels may result in substantial price protection charges. Such price protection
charges have the effect of reducing net revenue and gross profit. Consequently,
the Company, in taking steps to bring its Channel Inventory Levels down to a
more desirable level, may cause a shortfall in revenue during one or more
accounting periods. This situation may result in future price protection charges
as prices are decreased having an adverse impact on operating results. While the
Company believes that its Channel Inventory Levels for most of its products are
appropriate at this time, there may be certain products which have a Channel
Inventory Level that is higher than desirable. This situation may lead to
significant price protection charges, which would have a material adverse effect
on operating results.

PRODUCT RETURNS; PRICE PROTECTION

    The Company frequently grants limited rights to customers to return certain
unsold inventories of the Company's products in exchange for new purchases
("Stock Rotation"), as well as price protection on unsold inventory. Moreover,
certain of the Company's retail customers will readily accept returned product
from their own retail customers, and these returned products are, in turn,
returned to the Company for credit. The Company estimates returns and accrues
for potential price protection on unsold channel inventory. However, there can
be no assurance that these estimates or accruals will be sufficient, or that any
future returns or price reductions will not have a material adverse effect on
operating results, including through the mechanisms of Stock Rotation or price
protection, particularly in light of the rapid product obsolescence which often
occurs during product transitions. The short product life cycles of the
Company's products, the evolving markets for new multimedia and connectivity
technologies such as the new 56 Kbps modem and 3D graphics technologies, and the
difficulty in predicting future sales through the distribution channels to the
final end customer all increase the risk that new product introductions, price
reductions by the Company or its competitors, or other factors affecting the
personal computer and add-in subsystems industry could result in significant and
unforeseen product returns, with such returns creating a material adverse effect
on the Company's financial performance. In addition, there can be no assurance
that new product introductions by competitors or other market factors, such as
the integration of graphics acceleration or modem connectivity by OEMs onto
system motherboards, will not require the Company to reduce prices in a manner
or at a time that gives rise to significant price protection charges and has a
material adverse impact upon the Company's gross margins.

    Furthermore, the markets that the Company serves include end users who buy
from computer retail and consumer electronics mass merchant outlets to upgrade
their existing PCs. Such customers frequently decide to return products to the
retail outlets from which they earlier purchased the product. Such returns are
made for a variety of reasons, including the customer changing his or her mind
regarding his or her purchase decision, the customer has difficulty with the
installation or use of the product, the product does not offer the features,
functions, or performance that the customer expected or the customer experiences
incompatibilities between the product and his or her existing PC hardware or
software. Since many of the products that the Company sells incorporate advanced
computer technology, the Company expects that end-user customer returns,
including warranty returns, will be a continuing negative attribute of the PC
installed-base upgrade market. There can be no assurance that the Company will
be able to achieve gross margins in the PC installed-base upgrade market that
will be high enough to offset the expenses of end-user customer returns and
still generate an acceptable return on sales to the Company.


                                       23
<PAGE>   24

OEM CUSTOMER RISKS

    The Company currently has a limited number of OEM customers. While the
Company is seeking to increase its sales to OEMs, certain OEMs maintain internal
add-in subsystem design and manufacturing capabilities or have long-standing
relationships with competitors of the Company, and there can be no assurance
that the Company will be successful in its efforts to increase its OEM sales.
Moreover, developing supplier relationships with major PC systems OEMs and
installing the processes, procedures and controls required by such OEMs can be
an expensive and time-consuming process, and there can be no assurance that the
Company will achieve an acceptable financial return on this investment. Further,
to the extent that PC systems OEMs' selection criteria are weighted toward
multimedia subsystem suppliers that have their own captive SMT manufacturing
operations, then the Company's sole reliance on outside SMT subcontract
manufacturers may be a negative factor in winning such PC systems suppliers' OEM
contracts.

    It is expected that OEM revenue will carry a lower gross margin percentage
compared to sales to other channels due to perceived lower expenses to support
such OEM revenue and the buying power exercised by large OEMs. Furthermore, the
Company's products are priced for and generally aimed at the higher performance
and higher quality segment of the market. Therefore, to the extent that OEMs
focus on low-cost solutions rather than high-performance solutions, an increase
in the proportion of the Company's sales to OEMs may result in an increase in
the proportion of the Company's revenue that is generated by lower-selling-price
or lower-gross-margin products, which could adversely affect future gross
margins and operating results of the Company.

RAPID TECHNOLOGICAL CHANGE

    The markets for the Company's products are characterized by rapidly changing
technology, evolving industry standards, frequent new product introductions and
rapid product obsolescence. For example, 3D technology is evolving rapidly in
the graphics and audio markets, and DVD and MPEG-2 decryption techniques and
navigation technologies are still being refined. Product life cycles in the
Company's markets frequently range from six to twelve months. The Company's
success will be substantially dependent upon its ability to continue to develop
and introduce competitive products and technologies on a timely basis with
features and functionalities that meet changing customer requirements in a
cost-effective manner. Further, if the Company is successful in the development
and market introduction of new products, it must still correctly forecast
customer demand for such new products so as to avoid either excessive unsold
inventory or excessive unfilled orders related to the products. The task of
forecasting such customer demand is unusually difficult for new products, for
which there is little sales history, and for indirect channels, where the
Company's customers are not the final end customers. Moreover, whenever the
Company launches new products, it must also successfully manage the corollary
obsolescence and price erosion of those of its older products that are impacted
by such new products, as well as any resulting price protection charges and
Stock Rotations from its distribution channels.

RISKS OF INTERNATIONAL SALES

    The Company's international sales are subject to a number of risks generally
associated with international business operations, including the effect on
demand for the Company's products in international markets as a result of a
strengthening or weakening U.S. dollar, the effect of currency fluctuations on
consolidated multinational financial results, any state-imposed restrictions on
the repatriation of funds, any import and export duties and restrictions,
certain international economic conditions, the expenses, time and technical
resources required to localize the Company's various products and to support
local languages, the logistical difficulties of managing multinational
operations and dispersed product inventory designed or manufactured to meet
specific countries' requirements, and the delays and expenses associated with
homologating the Company's telecommunications products and securing the
necessary governmental approvals for shipment to various countries.

    The Company's international sales can also be affected if inventory sold by
the Company to its international distributors and OEMs and held by them or their
customers does not sell through to final end customers, which may impact
international distributor or OEM orders in the succeeding periods. The Company
believes that at this stage of its development it has generally less information
with respect to the inventory levels held by its international OEMs and
distributors vis-a-vis their domestic counterparts, and 


                                       24
<PAGE>   25

therefore generally less visibility on how this held inventory might affect
future orders to and sales by the Company.

INFORMATION TECHNOLOGY AND TELECOMMUNICATIONS SYSTEMS

    The Company is currently making significant investments in establishing
systems, processes and procedures to more efficiently and effectively manage its
worldwide business and enable communications and data sharing among its
employees and various business units. This effort comprises a significant
investment of expense and capital funds, as well as a drain on management
resources, for the installation of information technology ("IT") and
telecommunications equipment and IT applications. As part of this program to
install IT systems throughout the Company, management has begun installation of
an enhanced enterprise-wide business management, resource planning and decision
support application. Further, in order to more effectively manage the Company's
business and avert Year 2000 issues, the Company is implementing this new ERP
application and the associated IT equipment in order for it to be operational no
later than by early 1999. Such an effort is expected to comprise a further
substantial investment of expenses and management resources by the Company.

CAPITAL NEEDS

    There can be no assurance that additional capital beyond the amounts
currently forecasted by the Company will not be required or that any required
additional capital will be available on reasonable terms, if at all, at such
time or times as required by the Company. Any shortfall in capital resources
compared to the Company's level of operations or any inability to secure
additional capital as needed could impair the Company's ability to finance
inventory, accounts receivable and other operational needs. Such capital
limitations could also impair the Company's ability to invest in research and
development, improve customer service and support, deploy information technology
systems, and expand manufacturing and other operations. Failure to keep pace
with competitive requirements in any of these areas could have a material
adverse effect on the Company's business and operating results. Moreover, any
need to raise additional capital through the issuance of equity securities may
result in additional dilution to earnings per share.

PROPRIETARY RIGHTS

    While the Company had 4 issued U.S. Patents and 18 pending U.S. Patent
Applications at December 31, 1997, it nonetheless relies primarily on a
combination of trademark, copyright and trade secret protection together with
licensing arrangements and nondisclosure and confidentiality agreements to
establish and protect its proprietary rights. There can be no assurance that the
Company's measures to protect its proprietary rights will deter or prevent
unauthorized use of the Company's technology, brand or other proprietary or
intellectual property. In addition, the laws of certain foreign countries may
not protect the Company's proprietary rights to the same extent as do the laws
of the United States or the EC. As is typical in its industry, the Company from
time to time is subject to legal claims asserting that the Company has violated
the proprietary rights of third parties. In the event that a third party was to
sustain a valid claim against the Company, and any required licenses were not
available on commercially reasonable terms, the Company's operating results
could be materially and adversely affected. Litigation, which could result in
substantial cost to and diversion of the resources of the Company, may also be
necessary to enforce proprietary rights of the Company or to defend the Company
against claimed infringement of the proprietary rights of others.

STOCK PRICE VOLATILITY

    The trading price of the Company's Common Stock has been subject to
significant fluctuations to date, and could be subject to wide fluctuations in
the future in response to quarter-to-quarter variations in operating results,
announcements of technological innovations, new products or significant OEM
systems design wins by the Company or its competitors, general conditions in the
markets for the Company's products or the computer industry, the price and
availability of purchased components, general financial market conditions,
market conditions for PC or semiconductor stocks, changes in earnings estimates
by analysts, or other events or factors. In this regard, the Company does not
endorse and accepts no responsibility for the estimates or recommendations
issued by stock research analysts from time to time. In addition, the public
stock markets in general, and technology stocks in particular, have experienced
extreme price and trading volume volatility. This volatility has significantly
affected the market prices of securities of many high technology companies 


                                       25
<PAGE>   26

for reasons frequently unrelated to the operating performance of the specific
companies. These broad market fluctuations may adversely affect the market price
of the Company's Common Stock.

DEPENDENCE ON KEY PERSONNEL

    The Company's future success will depend to a significant extent upon the
efforts and abilities of its senior management and professional, technical,
sales and marketing personnel. The competition for such personnel is intense,
particularly in the San Jose, CA area ("Silicon Valley"). There can be no
assurance that the Company will be successful in retaining its existing key
personnel or in attracting and retaining the additional key personnel that it
requires. The loss of services of one or more of its key personnel or the
inability to add or replace key personnel could have a material adverse effect
on the Company. The salary, performance bonus and stock option packages
necessary to recruit or retain key personnel, particularly in Silicon Valley,
may significantly increase the Company's expense levels or result in dilution to
the Company's earnings per share. The Company does not carry "key person" life
insurance on any of its employees.

LEGAL MATTERS

    The Company has been named as a defendant in several putative class action
lawsuits which were filed in June and July, 1996 and June, 1997 in the
California Superior Court for Santa Clara County and the U.S. District Court for
the Northern District of California. Certain executive officers and directors of
the Company are also named as defendants. The plaintiffs purport to represent a
class of all persons who purchased the Company's Common Stock between October
18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege claims
under the federal securities laws and California law. The plaintiffs allege that
the Company and the other defendants made various material misrepresentations
and omissions during the Class Period. The complaints do not specify the amount
of damages sought. The Company believes that it has good defenses to the claims
alleged in the lawsuits and will defend itself vigorously against these actions.
These cases are in the early stages and no trial date has been set. The ultimate
outcome of these actions cannot be presently determined. Accordingly, no
provision for any liability or loss that may result from adjudication or
settlement thereof has been made in the accompanying consolidated financial
statements.

     The Company is also party to other claims and pending legal proceedings
that generally involve employment and trademark issues. These cases are, in the
opinion of management, ordinary and routine matters incidental to the normal
business conducted by the Company. In the opinion of management, the ultimate
disposition of such proceedings will not have a materially adverse effect on the
Company's consolidated financial position or future results of operations.


                                       26
<PAGE>   27

PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

    Information regarding Registrant's directors will be set forth under the
caption "Election of Directors" in Registrant's proxy statement for use in
connection with the Annual Meeting of Shareholders to be held in May 1998, (the
"Proxy Statement") and is incorporated herein by reference. The Proxy Statement
will be filed with the Securities and Exchange Commission within 120 days after
December 31, 1997.

    Information with respect to the Registrant's executive officers is included
at the end of Part I, Item 1, of this report under the caption "Executive
Officers".

ITEM 11. EXECUTIVE COMPENSATION

    Information regarding remuneration of Registrant's directors and executive
officers will be set forth under the caption "Executive Compensation" in
Registrant's Proxy Statement and is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

    Information regarding security ownership of certain beneficial owners and
management will be set forth under the caption "Share Ownership of Certain
Beneficial Owners and Management" in Registrant's Proxy Statement and is
incorporated herein by reference.


ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

    Information regarding certain relationships and related transactions will be
set forth under the caption "Certain Transactions" in Registrant's Proxy
Statement and is incorporated herein by reference.


                                       27
<PAGE>   28

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
<TABLE>
<CAPTION>
(a)        1.  FINANCIAL STATEMENTS

      The following Consolidated Financial Statements of Diamond Multimedia
Systems, Inc., and its subsidiaries are filed as part of this report on Form
10-K

                                                                                                                  Page
           <S>                                                                                                    <C>
           Report of  Independent Accountants

           Consolidated Balance Sheets as of December 31, 1997 and 1996                                            34

           Consolidated Statements of Operations for the three years ended December 31, 1997                       35

           Consolidated Statements of Shareholders' Equity (Deficit) for the three years ended
           December 31, 1997                                                                                       36

           Consolidated Statements of Cash Flows for the three years ended December 31, 1997                       37

           Notes to Consolidated Financial Statements                                                              38


           2.  CONSOLIDATED FINANCIAL STATEMENT SCHEDULES

           Schedule II-Valuation and Qualifying Accounts                                                           52

           Schedule I through V not listed above have been omitted because the
           matter or conditions are not present or the information required to
           be set forth therein is included in the Consolidated Financial
           Statements hereto.
</TABLE>


                                       28
<PAGE>   29


3.  EXHIBITS

<TABLE>
<CAPTION>
           EXHIBIT
           NUMBER                         DESCRIPTION OF DOCUMENT
           --------                       ---------------------------------------------------------------------

           <S>                            <C>
            3.1(1)                        Certificate of Incorporation

            3.2(1)                        Bylaws of Registrant

            4.1(1)                        Form of Common Stock Certificate

           10.1(1)                        Form of Indemnification Agreement for officers and directors

           10.2(1)                        Form of Indemnification Agreement with certain stockholders

           10.3(1)                        1992 Stock Plan and form of Stock Option Agreement

           10.4(1)                        1994 Stock Plan and form of Stock Option Agreement

           10.5(1)                        1995 Employee Stock Purchase Plan and form of Subscription
                                          Agreement

           10.6(1)                        1995 Director Option Plan and form of Stock Option Agreement.

           10.7(1)                        Stock Purchase Agreement by and among
                                          the Registrant, Diamond Multimedia
                                          Systems, Inc., a California
                                          corporation, and the investors and
                                          shareholders named therein.

           10.8(1)                        Stock and Subordinated Notes Purchase Agreement by and among the
                                          Registrant and the investors name therein.

           10.9(1)                        Shareholders' Agreement by and among
                                          the Registrant and the investors,
                                          management shareholders and
                                          shareholders named therein.

           10.10(1)                       Registration Rights Agreement by and
                                          among the Registrant and the
                                          investors, management shareholders and
                                          shareholders named therein.

           10.11(1)                       Employment Agreement between the Registrant and Mr. Hyung Hwe Huh

           10.12(1)                       Consulting Agreement between the Registrant and Mr. Chong-Moon Lee

           10.13(1)                       Mutual Release among the registrant, Messrs. Lee and Huh, and
                                          certain other parties.

           10.14(1)                       Lease (2880 Junction Avenue, San Jose, CA).

           10.15(1)                       Lease (835  Sinclair Frontage Road Drive, Milpitas, CA).

           10.16(2)                       Agreement and Plan of Reorganization among the Registrant,
                                          Shakespeare Acquisition Corporation and Supra Corporation dated as
                                          of August 7, 1995.

           10.18(4)                       Stock Purchase Agreement by and among the Registrant, SPEA
                                          Software AG and the Stockholders of SPEA Software AG dated as of
                                          October 24, 1995.
</TABLE>

                                       29
<PAGE>   30


<TABLE>
<CAPTION>
           EXHIBIT
           NUMBER                         DESCRIPTION OF DOCUMENT
           --------                       ---------------------------------------------------------------------
           <S>                           <C>   
           10.19(3)                       1993 Stock Incentive Plan

           10.20(4)                       Amendment No. 1 to Stock Purchase
                                          Agreement dated as of November 15,
                                          1995 by and among the Registrant;
                                          Supra (Deutschland) GmbH; SPEA
                                          Software AG; Spea-Beheer C.V.,TVM,
                                          Glenwood and Ulrich Seng for and on
                                          behalf of the Selling Stockholders;
                                          and David Gill.

           10.21(4)                       Line of Credit Agreement between the Registrant and Imperial Bank
                                          dated May 29, 1995.

           10.22(4)                       Amended and Restated Credit Agreement between the Registrant and
                                          Sanwa Bank California dated November 2, 1995.

           10.23(4)                       Line of Credit Agreement between the Registrant and Imperial Bank
                                          dated May 29, 1995.

           10.24*                         Form of Change of Control Severance
                                          Agreement between the Registrant and
                                          the executive officers listed below:

                                          Franz Fichtner
                                          C.    Scott Holt
                                          Wade Meyercord
                                          Dennis D. Praske
                                          James M. Walker


           10.25                          Employment Agreement between the Registrant and Mr. James M. Walker

           10.26                          Line of Credit Agreement between the
                                          Registrant and Sanwa Bank California
                                          dated March 17, 1997

           21.1(4)                        List of Significant Subsidiaries.

           23.1                           Consent of Coopers & Lybrand L.L.P., Independent Accountants

           24.1                           Power of Attorney

           27.1                           Financial Data Schedule
</TABLE>


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

    *   Management contract or compensation plan or arrangement required to be
        filed as an exhibit to this report on Form 10-K pursuant to Item 14 (c)
        of this report.

    (1) Incorporated by reference to the Registration Statement on Form S-1
        (File No. 33- 89386), as amended, filed pursuant to the Securities Act
        of 1933, as amended, relating to the initial public offering of Common
        Stock.

    (2) Incorporated by reference to the Registrant's current report on Form 8-K
        (File No. 0-25580) filed pursuant to the Securities Exchange Act of
        1934, as amended, on October 5, 1995.

    (3) Incorporated by reference to the Registration Statement on Form S-8 (
        File No. 33- 98470) filed pursuant to the Securities Act of 1933, as
        amended, on October 24, 1995.

    (4) Incorporated by reference to Registration Statement on Form S-1 (File
        No. 33-98618), as amended, filed pursuant to the Securities Act of 1933,
        as amended.


                                       30
<PAGE>   31


    (B) REPORTS ON FORM 8-K


        1.     A report on Form 8-K (File No. 0-25580) was filed by the
               Registrant pursuant to the Securities Exchange Act of 1934, as
               amended, on October 28, 1997, relating to a change in fiscal year
               end.

    (C) EXHIBITS

        See (a) above

    (D) FINANCIAL STATEMENT SCHEDULES

        See (a) above


                                       31
<PAGE>   32


                                   SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized on March 20, 1998.

DIAMOND MULTIMEDIA SYSTEMS, INC


        /s/  William J. Schroeder
           ----------------------
By:          William J. Schroeder
President and Chief Executive Officer


                                POWER OF ATTORNEY

KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below
constitutes and appoints William J. Schroeder and James M. Walker, jointly and
severally, his attorneys-in-fact, each with the power of substitution for him in
any and all capacities, to sign any amendments to this report, and to file the
same, with exhibits thereto and other documents in connection therewith, with
the Securities and Exchange Commission, hereby ratifying and confirming that
each of said attorneys-in-fact, or his substitute or substitutes, may do or
cause to be done by virtue hereof.

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

<TABLE>
<CAPTION>
                   Signature                                            Title                             Date
<S>          <C>   <C>                                                  <C>                               <C>

/s/          William J. Schroeder                    Director, Chief Executive Officer and           March 20, 1998
-------------------------------------------------
               William J. Schroeder                  President (Principal Executive Officer)


/s/           James M. Walker                        Chief Financial Officer (Principal              March 20, 1998
-------------------------------------------------
                  James M. Walker                    Financial  and Accounting Officer)


/s/           Jeffrey T. Chambers                    Director                                        March 20, 1998
-------------------------------------------------
                Jeffrey T. Chambers


/s/           Bruce C. Edwards                       Director                                        March 20, 1998
-------------------------------------------------
                Bruce C. Edwards


/s/           Walter G. Kortschak                    Director                                        March 20, 1998
-------------------------------------------------
                 Walter G. Kortschak


/s/           Carl W. Neun                           Director                                        March 20, 1998
-------------------------------------------------
                   Carl W. Neun


/s/           Gregorio Reyes                         Director                                        March 20, 1998
-------------------------------------------------
                   Gregorio Reyes


/s/           Jeffrey D. Saper                       Director                                        March 20, 1998
-------------------------------------------------
                  Jeffrey D. Saper
</TABLE>



                                       32
<PAGE>   33

                        REPORT OF INDEPENDENT ACCOUNTANTS


To the Board of Directors and Shareholders
Diamond Multimedia Systems, Inc.

   We have audited the accompanying consolidated financial statements and
financial statement schedule of Diamond Multimedia Systems, Inc. and its
subsidiaries as of December 31, 1997 and 1996, and for each of the three years
in the period ended December 31, 1997, as listed in Item 14(a) of this Form
10-K. These financial statements and the financial statement schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated 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 consolidated financial position of Diamond Multimedia
Systems, Inc. and its subsidiaries as of December 31, 1997 and 1996, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1997, in conformity with generally
accepted accounting principles. In addition, in our opinion, the financial
statement schedule referred to above, when considered in relation to the basic
financial statements taken as a whole, presents fairly, in all material
respects, the information required to be included therein.


                                                   COOPERS & LYBRAND L.L.P.


San Jose, California
January 23, 1998


                                       33
<PAGE>   34

<TABLE>
<CAPTION>
                                      DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
                                                 CONSOLIDATED BALANCE SHEETS
                                           (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


                                                                                         DECEMBER 31,
                                                                                     --------------------
                                                                                       1997       1996
                                                                                     ---------    -------

                                          ASSETS
         <S>                              <C>                                          <C>       <C>
         Current assets:
           Cash and cash equivalents                                                   $85,929   $120,147
           Short-term investments                                                        4,136        ---
           Trade accounts receivable, net of allowance for doubtful accounts
             of  $2,440 and $1,943 in 1997 and 1996                                     98,777     85,268
           Inventories                                                                  78,647     63,704
           Prepaid expenses and other current assets                                     6,350      9,043
           Income taxes receivable                                                      24,929        ---
           Deferred income taxes                                                        14,679     21,944
                                                                                       -------    -------
             Total current assets                                                      313,447    300,106
           Property, plant and equipment, net                                           15,216     12,883
           Other assets                                                                  3,616      3,222
           Goodwill and other intangibles, net                                           5,275     16,227
                                                                                       -------    -------
                  Total assets                                                        $337,554   $332,438
                                                                                      ========   ========

                                        LIABILITIES
         Current liabilities:
           Current portion of long-term debt                                           $36,455    $18,068
           Trade accounts payable                                                       98,764     68,770
           Accrued liabilities                                                          17,667     14,483
           Income taxes payable                                                          2,274      3,257
                                                                                       -------    -------
                  Total current liabilities                                            155,160    104,578
         Long-term debt, net of current portion                                          1,873      2,730
         Deferred income taxes                                                             ---        835
                                                                                       -------    -------
                  Total liabilities                                                    157,033    108,143
                                                                                       -------    -------

         Commitments and contingencies (Notes 4, 5 and 10)

                                   SHAREHOLDERS' EQUITY
         Preferred stock, par value $.001; Authorized - 8,000 shares
           in 1997 and 1996, none issued and outstanding                                    --         --
         Common stock, par value $.001; Authorized - 75,000 in 1997
           and 1996; issued and outstanding - 34,491 in 1997 and
            34,163  in 1996                                                                 34         34
         Additional paid-in capital                                                    307,877    306,046
         Distributions in excess of net book value (Note 1)                           (56,775)   (56,775)
         Accumulated deficit                                                          (70,615)   (25,010)
                                                                                       -------    -------
         Total shareholders' equity                                                    180,521    224,295
                                                                                       -------    -------
                Total liabilities and shareholders' equity                            $337,554   $332,438
                                                                                      ========   ========
</TABLE>


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


                                       34
<PAGE>   35

<TABLE>
<CAPTION>
                                      DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
                                            CONSOLIDATED STATEMENTS OF OPERATIONS
                                            (IN THOUSANDS, EXCEPT PER SHARE DATA)



                                                                                    YEARS ENDED DECEMBER 31,
                                                                            --------------------------------------
                                                                            1997             1996             1995
                                                                            ----             ----             ----
    <S>                                                                     <C>              <C>            <C>     
    Net sales                                                               $443,281         $598,050       $467,635
    Cost of sales                                                            387,486          485,284       359,285
                                                                             -------          -------  -    -------
      Gross profit                                                            55,795          112,766        108,350
                                                                              ------          -------  -     -------
    Operating expenses:
      Research and development                                                24,886           18,824         10,665
      Selling, general and administrative                                     85,684           66,209         39,311
      Amortization of intangibles                                              3,006            5,025            937
      Write-off of intangibles                                                 9,938
      Write-off of in-process technology                                                                      76,710
                                                                           ---------          -------      ---------
              Total operating expenses                                       123,514           90,058        127,623
                                                                           ---------          -------      ---------
    Income (loss) from operations                                           (67,719)           22,708       (19,273)
    Interest income (expense), net                                             1,696            1,979        (1,291)
    Other income, net                                                            873            1,245          1,357
                                                                           ---------          -------      ---------
    Income (loss) before provision (benefit) for income                     (65,150)           25,932       (19,207)
            taxes
    Provision (benefit) for income taxes                                    (19,545)            9,595         22,140
                                                                           ---------          -------      ---------
    Net income (loss)                                                      $(45,605)          $16,337      $(41,347)
                                                                           =========          =======      =========
    Net income (loss) per share:
           Basic                                                             $(1.33)            $0.48        $(1.55)
                                                                           =========          =======      =========
           Diluted                                                           $(1.33)            $0.46        $(1.55)
                                                                           =========          =======      =========
                                                  
    Shares used in per share calculations:
            Basic                                                             34,322           34,351         26,724
            Diluted                                                           34,322           35,194         26,724
</TABLE>

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


                                       35
<PAGE>   36


<TABLE>
<CAPTION>
                                      DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
                                  CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
                                                        (IN THOUSANDS)


                                                                             DISTRIBUTIONS     RETAINED
                                        COMMON STOCK          ADDITIONAL       IN EXCESS       EARNINGS
                                      -----------------        PAID-IN          OF NET       (ACCUMULATED
                                      SHARES     AMOUNT        CAPITAL        BOOK VALUE       DEFICIT)        TOTAL
                                      ------     ------       ----------     -------------   ------------      -----
<S>                                   <C>        <C>          <C>            <C>            <C>                <C>
BALANCES, JANUARY 1, 1995             12,396         $12           $814         ($56,775)              --   ($55,949)
  Stock options exercised              5,558           6            484                                           490
  Issuance of common stock             2,615           3            171                                           174
  Repurchase of common stock           (270)                       (18)                                          (18)
  Common stock issued in                                                                                             
    public offerings                  10,625          10        210,672                                       210,682
  Common stock issued
    to purchase Supra                                                                                          
    Corporation                        2,073           2         53,731                                        53,733
  Common stock issued to
    purchase SPEA Software AG          1,623           2         38,924                                        38,926
    
  Sale of shares under
    Employee Stock Purchase Plan          53                        765                                           765

  Tax benefit from stock options                                  1,154                                         1,154
  Net loss                                                                                       (41,347)    (41,347)
                                      ------      ------        -------          --------        --------    --------
BALANCES, DECEMBER 31, 1995           34,673          35        306,697          (56,775)        (41,347)     208,610
  Stock options exercised                273                        969                                           969
  Repurchase of common stock            (702)         (1)           (34)                                          (35)
  Payment of note receivable
   from Shareholder                     (109)                    (3,196)                                       (3,196)
  Sale of shares under
   Employee Stock Purchase Plan           28                      1,167                                         1,167
  Tax benefit of stock options                                      443                                           443
  Net income                                                                                       16,337      16,337
                                      ------      ------        -------          --------        --------    --------
BALANCES, DECEMBER 31, 1996           34,163          34        306,046          (56,775)        (25,010)     224,295
  Stock options exercised                339                      1,232                                         1,232
  Repurchase of common stock           (115)                        (7)                                           (7)
  Sale of shares under
   Employee Stock Purchase Plan         104                        606                                           606
   Net loss                                                                                      (45,605)    (45,605)
                                      ------     -------       --------          --------        --------    --------
BALANCES, DECEMBER 31, 1997           34,491         $34       $307,877         ($56,775)       ($70,615)    $180,521
                                      ======     =======       ========         =========       =========    ========
</TABLE>

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



                                       36
<PAGE>   37

<TABLE>
<CAPTION>
                                      DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES
                                            CONSOLIDATED STATEMENTS OF CASH FLOWS
                                                        (IN THOUSANDS)


                                                                                        YEARS ENDED DECEMBER 31,
                                                                                ----------------------------------------
                                                                                   1997             1996          1995
                                                                                --------          --------     ---------

<S>                                                                             <C>                <C>         <C>      
Cash flows from operating activities:
   Net income (loss)                                                            ($45,605)          $16,337     ($41,347)
   Adjustments to reconcile net income (loss)
     to net cash provided by (used in) operating activities:
   Write-off of in-process technology and intangibles                               9,938                         76,710
   Depreciation and amortization                                                    8,224            8,371         2,603
   Provision for doubtful accounts                                                    952            1,026           710
   Provision for excess and obsolete inventories                                   11,580           14,249         1,000
   Deferred income taxes                                                            6,430          (5,415)          (49)
   Loss on disposal of property and equipment                                         332
   Changes in assets and liabilities:
   Trade accounts                                                                (14,461)           17,475      (58,870)
   Income taxes receivable                                                       (24,929)
   Inventories                                                                   (26,523)            2,981      (49,340)
   Trade accounts payable and other liabilities                                    32,195         (24,524)        38,385
   Prepaid expenses and other assets                                                (357)          (3,596)       (6,273)
                                                                                 --------         --------      --------
Net cash provided by (used in) operating activities                              (42,224)           26,904      (36,471)
                                                                                 --------           ------      --------

Cash flows from investing activities:
   Cash acquired in acquisition of Supra Corporation and Spea Software AG                                            952
   Purchases of property and equipment                                            (7,219)          (6,077)       (5,236)
   Purchases of short-term investments                                            (4,136)                       (14,234)
   Proceeds from sales of short-term investments                                                                  17,760
   Proceeds from maturities of short-term investments                                               12,232              
                                                                                 --------         --------      --------
Net cash provided by (used in) investing activities                              (11,355)            6,155         (758)
                                                                                 --------         --------      --------

Cash flows from financing activities:
   Repayments of mandatorily redeemable preferred stock                                                         (29,174)
   Proceeds from issuance of common stock                                           1,838            2,136         1,429
   Repayments of subordinated promissory notes payable                                                          (34,167)
   Repayment of short-term notes payable in Reorganization                                                      (82,664)
   Proceeds from public offerings, less related expenses                                                         210,682
   Proceeds from term loans and revolving credit facilities                       153,415           46,778        31,757
   Payments of term loans and revolving credit facilities                       (101,159)         (55,177)      (25,993)
   Maturities of term loans and revolving credit facilities                      (33,900)
   Proceeds from capital lease financing                                                               197         2,494
   Repayments of capital lease financing                                            (826)            (782)         (310)
   Repurchases of common stock                                                        (7)             (35)          (18)
                                                                                 --------         --------      --------
Net cash provided by (used in) financing activities                                19,361          (6,883)        74,036
                                                                                 --------         --------      --------

Net increase (decrease) in cash and cash equivalents:                            (34,218)           26,176        36,807
Cash and cash equivalents at beginning of period                                  120,147           93,971        57,164
                                                                                 --------         --------      --------
Cash and cash equivalents at end of period                                        $85,929         $120,147       $93,971
                                                                                  =======         ========       =======
</TABLE>

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


                                       37
<PAGE>   38


DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

1.  BASIS OF PRESENTATION; REORGANIZATION; PUBLIC OFFERINGS;
     ACQUISITION OF SUPRA AND SPEA

    Diamond Multimedia Systems, Inc. a Delaware Corporation, (the "Company")
designs, develops, manufacturers and markets multimedia add-in subsystems for
IBM-compatible personal computers and fax/modem products for the PC and
Macintosh markets.

   The Company was formed in December 1994 and acquired substantially all of the
outstanding common stock of Diamond Multimedia Systems, Inc., a California
Corporation ("Diamond CA"), on January 1, 1995, the last day of the 1994 fiscal
year (the "Reorganization"). The total acquisition price was approximately
$99,192,000 which consisted of $82,664,000 of cash paid after the end of fiscal
1994 on January 3, 1995, $8,800,000 of subordinated promissory notes, $7,517,000
of mandatorily-redeemable preferred stock and $211,000 of common stock. In
connection with this transaction, the Company issued $34,167,000 of subordinated
promissory notes (including the $8,800,000 issued to the Diamond CA
shareholders); $29,174,000 of mandatorily redeemable preferred stock (including,
$7,517,000 issued to the Diamond CA shareholders) and $826,000 of common stock
(including $211,000 issued to the Diamond CA shareholders). On January 3, 1995,
Diamond CA was merged into the Company.

   The transaction has been accounted for as a recapitalization, and
accordingly, no change in the accounting basis of Diamond CA's assets has been
made in the accompanying consolidated financial statements. The amount of cash
paid and securities issued to the shareholders of Diamond CA of $99,192,000
exceeded Diamond CA's net assets of approximately $42,417,000 on the date of the
transaction by $56,775,000. This amount has been recorded in the equity section
as distributions in excess of net book value.

   On April 19, 1995, the Company completed an initial public offering of
7,475,000 shares of common stock at a price of $17.00 per share, all of which
shares were sold by the Company. The net proceeds realized by the Company from
this offering were approximately $117,188,000 which were used by the Company to
repay all of the Company's senior debt and subordinated promissory notes payable
and to redeem the Company's mandatorily redeemable preferred stock.

   The Company acquired all of the outstanding common stock of Supra Corporation
("Supra") and SPEA Software AG ("Spea") on September 20, 1995 and November 15,
1995, respectively, in two purchase business combination transactions.

   In November, 1995, the Company sold 3,150,000 shares of common stock in a
Public Offering at a price of $31.25 per share raising net proceeds of
approximately $93,494,000.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF CONSOLIDATION

   The accompanying consolidated financial statements include the accounts of
the Company, Diamond CA (which was subsequently merged into the Company) and its
wholly owned subsidiaries. The accounts of the Company's wholly owned
subsidiaries, Supra and SPEA, have been included in the accompanying
consolidated financial statements as of the date of acquisition, September 20,
1995 and November 15, 1995, respectively. All intercompany transactions and
balances have been eliminated in consolidation.


                                       38
<PAGE>   39

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

FISCAL YEAR-END

   During 1996 and prior years, the Company operated under a 52-53 week fiscal
year which ended on the Sunday closest to December 31. As a result, the fiscal
year may not have ended as of the same day as the calendar year. Fiscal 1996 and
1995 were 52 week years. For convenience of presentation, the accompanying
consolidated financial statements of the Company for 1996 and 1995 have been
shown as ending on December 31 of each year. During 1997, the Company changed
its fiscal year end to a calendar year. Net sales for 1997 include approximately
$29,000,000 due to the change in year end.

STOCK SPLITS

   During 1995, the Company's Board of Directors approved a 3-for-2 stock split.
All share and per share data in the accompanying consolidated financial
statements have been retroactively restated to reflect these stock splits.

CASH AND CASH EQUIVALENTS

   All highly liquid investments with an original maturity of three months or
less from the date of purchase and money market funds are considered cash
equivalents. Cash and cash equivalents consist primarily of municipal bonds held
by investment banks in the U.S. along with a lesser amount of cash deposits in
banks in the U.S., Japan, Germany and the United Kingdom.

SHORT-TERM INVESTMENTS

   At December 31, 1997, short-term investments consisted of debt securities
with a remaining maturity of more than three months when purchased. The Company
had determined that all of its debt securities should be classified as
available-for-sale. The difference between the cost basis and the market value
of the Company's investments was not material at December 31, 1997. The
Company's investments at December 31, 1997 consisted of municipal bonds with
maturities of less than one year.

ACCOUNTS RECEIVABLE

   The Company participates in cooperative advertising and similar programs with
certain distributors. These programs generally permit distributors credits up to
a specified percentage of purchases for certain forms of advertising and
promotional activities. The Company offers limited price protection to its
customers. Accruals based on estimated costs of future claims are reflected in
the accompanying consolidated financial statements.

INVENTORIES

    Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market. Inventories are summarized as follows (in
thousands):
<TABLE>
<CAPTION>

                                     DECEMBER 31,
                                  ------------------
                                    1997      1996
                                  -------    -------
           <S>                    <C>        <C>
           Raw material           $29,876    $22,080
           Work in process         40,286     20,847
           Finished goods           8,485     20,777
                                  -------    -------
                                  $78,647    $63,704
                                  =======    =======
</TABLE>

                                       39
<PAGE>   40

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

   The Company is currently dependent on sole or limited suppliers for certain
key components used in its products, particularly VRAM and DRAM memory and other
chipsets, which may cause shortages that limit production capacity. There can be
no assurance that such shortages will not adversely affect future operating
results. Conversely, in its attempt to counter actual or perceived component
shortages, the Company may overpurchase certain components, resulting in excess
inventory and reducing the Company's liquidity or, in the event of inventory
obsolescence or a decline in the market value of such inventory, causing
inventory write-offs against the Company's operating results.

   The Company has approximately $3 million of inventory in excess of its normal
short-term needs for certain product lines at December 31, 1997. Management has
developed a program to reduce this inventory to desired levels over the near
term; however, it is reasonably possible that the program will not be wholly
successful and a material loss could ultimately result on the disposal of this
inventory. No estimate can be made of the range of amounts of such loss.

PROPERTY, PLANT AND EQUIPMENT

   Property, plant and equipment are stated at cost and are depreciated using
the straight-line and double declining balance methods over their estimated
useful lives ranging from three to thirty and one-half years. Upon disposal, the
assets and related accumulated depreciation are removed from the Company's
accounts, and the resulting gains or losses are reflected in operations.
Property, plant and equipment consisted of the following (in thousands):

<TABLE>
<CAPTION>

                                                              DECEMBER 31,
                                                           -----------------
                                                             1997     1996
                                                           -------   -------
                <S>                                        <C>       <C>    
                Furniture and equipment                    $20,732   $15,284
                Building, land and leasehold                                
                  improvements                               3,912     3,242
                                                           -------   -------
                                                            24,644    18,526
                Less accumulated depreciation                9,428     5,643
                                                           -------   -------
                                                           $15,216   $12,883
                                                           =======   =======
</TABLE>

NON CASH FINANCING ACTIVITIES

      Non cash financing activities in the cash flows consisted of the following
(in thousands):

<TABLE>
<CAPTION>
                                                                                       1997           1996         1995
                                                                                       ------        -------     -------
          <S>                                                                          <C>           <C>         <C>    
          Income taxes paid                                                            $1,825        $11,583     $21,169
                                                                                       ======        =======     =======
          Interest paid                                                                $1,472         $1,675      $2,957
                                                                                       ======        =======     =======
          Issuance of common stock and options for Supra Corporation                   $   --        $    --     $53,733
                                                                                       ======        =======     =======
          Issuance of common stock  for Spea Software AG                               $   --        $    --     $38,926
                                                                                       ======        =======     =======
</TABLE>


                                       40
<PAGE>   41

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

GOODWILL AND OTHER INTANGIBLE ASSETS

   Goodwill and other intangible assets arose primarily from the Company's
acquisitions of Supra and Spea on September 20, 1995 and November 15, 1995,
respectively. Additionally, approximately $2 million of goodwill arose from the
acquisition of Binar Graphics, Inc. which occurred on November 15, 1997.
Goodwill is being amortized on a straight line basis over seven years. Other
intangible assets consisted of purchased technology, which was amortized on a
straight-line basis over its estimated useful life of two years. The Company
assesses the recoverability of intangible assets by determining whether the
amortization of the asset's net book value over its remaining life can be
recovered through projected undiscounted future cash flows. Accordingly, the
Company wrote-off $9.9 million of intangible assets in the second quarter of
1997 to reflect a decrease in the carrying value of goodwill and existing
technology associated with the acquisitions of Supra and Spea. The anticipated
cash flows related to those products indicated that the recoverability of those
assets were not reasonably assured.

   Intangible assets consist of the following at December 31, 1997 and 1996,
respectively (in thousands):
<TABLE>
<CAPTION>
                                                          1997            1996
                                                        --------        --------
               <S>                                      <C>             <C> 
               Goodwill                                 $ 18,328        $ 16,339
               Purchased Technology                           --           5,850
                                                        --------        --------
                                                          18,328          22,189
               Less accumulated amortization              13,053           5,962
                                                        --------        --------
                                                        $  5,275        $ 16,227
                                                        ========        ========
</TABLE>

WARRANTIES

   The Company's products are generally warranted for one to five years.
Estimated future costs of repair, replacement, or customer accommodations are
reflected in the accompanying consolidated financial statements.

REVENUE RECOGNITION

   Revenue is recognized upon shipment of the product to the customer. Certain
of the Company's sales are subject to a limited right of return. The Company
estimates product returns and reduces sales to reflect anticipated product
returns.

RESEARCH AND DEVELOPMENT

   Research and development expenditures are charged to operations as incurred.

ADVERTISING COSTS

   Advertising costs are charged to operations as incurred. Advertising costs
were $11,233,000, $11,555,000 and $9,306,000 in 1997, 1996 and 1995
respectively.

INCOME TAXES

   The Company uses the liability method to calculate deferred income taxes. The
realization of deferred tax assets is based on historical tax positions and
expectations about future taxable income.


                                       41
<PAGE>   42

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

FAIR VALUE OF FINANCIAL INSTRUMENTS

   Carrying amounts of certain of the Company's financial instruments including
cash and cash equivalents, accounts receivable, accounts payable and other
accrued liabilities approximate fair value due to their short maturities. Based
on borrowing rates currently available to the Company for loans with similar
terms, the carrying value of its debt obligations approximates fair value.
Estimated fair values for marketable securities which are separately disclosed
elsewhere, are based on quoted market prices for the same or similar instruments
(see Short-Term Investments above).

CONCENTRATIONS OF CREDIT RISK

   Financial instruments which potentially subject the Company to concentration
of credit risk are primarily accounts receivables and cash equivalents.

   The Company sells its products through distributors, OEMs and retail/mass
merchant outlets primarily in the regions of North America, Europe and Asia. The
Company performs ongoing credit evaluations of its customers and, generally,
does not require collateral for its receivables and maintains an allowance for
potential credit losses. The allowance for non-collection of accounts
receivables is maintained for potential credit losses and is based upon the
expected collectibility of accounts receivables. The Company places its cash
equivalents in investment grade, short-term debt instruments and limits its
amount of credit exposure to any one issuer.

   Cash and cash equivalents are invested primarily in deposits with several
banks in the United States, United Kingdom, Germany and Japan. Deposits in these
banks may exceed the amount of insurance, if any, provided on such deposits. The
Company has not experienced any losses on its cash and cash equivalents.

FOREIGN CURRENCY ACCOUNTING

   Substantially all of the Company's sales are denominated in U.S. dollars and
the U.S. dollar is the functional currency for all foreign operations. Foreign
exchange gains and losses, which result from the process of remeasuring foreign
currency financial statements into U.S. dollars are included in the statement of
operations. The Company recorded net foreign currency translation gains in other
income of $93,000, $609,000 and $750,000 during 1997, 1996 and 1995,
respectively.

COMPUTATION OF NET INCOME (LOSS) PER SHARE

   The Company adopted Financial Accounting Standards Board No. 128 "Earnings
Per Share" (EPS) and accordingly all prior periods have been restated. Basic EPS
is computed as net income (loss) divided by the weighted average number of
common shares outstanding for the period. Diluted EPS reflects the potential
dilution that could occur from common shares issuable through stock options,
warrants and other convertible securities. Common equivalent shares are excluded
from the computation of net loss per share as their effect is antidilutive.


                                       42
<PAGE>   43

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

   The following is a reconciliation of the numerator (net income) and
denominator (number of shares) used in the basic and diluted EPS calculation:

(Dollar amounts, in thousands)
<TABLE>
<CAPTION>
                                                Year Ended December 31
                                        ---------------------------------------
                                          1997            1996           1995
                                        --------        --------       --------
<S>                                     <C>             <C>            <C>      
Basic EPS:
Net income (loss)                       $(45,605)       $ 16,337       $(41,347)
Average Common
   Shares Outstanding                     34,322          34,351         26,724
                                        --------        --------       --------
Basic EPS                               $  (1.33)       $   0.48       $  (1.55)
                                        ========        ========       ========
Diluted EPS:
Net income (loss)                       $(45,605)       $ 16,337       $(41,347)
Average Common
   Shares Outstanding                     34,322          34,351         26,724
Stock options                                 --             843             --
Total Shares                              34,322          35,194         26,724
                                        --------        --------       --------
Diluted EPS                             $  (1.33)       $   0.46       $  (1.55)
                                        ========        ========       ========
</TABLE>


USE OF ESTIMATES

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

FOURTH QUARTER CHARGES

   The Company incurred in 1995 a fourth quarter charge to cost of sales
associated with a book to physical inventory adjustment of approximately $3
million.

RECENT ACCOUNTING PRONOUNCEMENTS

    In June 1997, the Financial Accounting Standards Board issued a Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS
130). SFAS 130 establishes standards for reporting and display of comprehensive
income and its components in a full set of general-purpose financial statements.
Comprehensive income is defined as the "change in equity of a business
enterprise during a period from transactions and other events and circumstances
from nonowner sources. It includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners." SFAS
130 is effective for fiscal years beginning after December 15, 1997, and
reclassification of financial statements for earlier periods provided for
comparative purposes is required. SFAS 130 is not expected to have a material
impact on the Company's financial position, results of operations or cash flows.

        In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information" (SFAS 131). SFAS 131 establishes standards
for the way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected


                                       43
<PAGE>   44

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

information about operating segments in interim financial reports issued to
stockholders. SFAS 131 generally supersedes Statement of Financial Accounting
Standards No. 14, "Financial Reporting for Segments of a Business Enterprise."
Under SFAS 131, operating segments are components of an enterprise about which
separate financial information is available that is evaluated regularly by the
chief operating decision maker in deciding how to allocate resources and in
assessing performance. Generally, financial information is required to be
reported on the basis it is used internally. SFAS 131 is effective for financial
statements for periods beginning after December 15, 1997, and restatement of
comparative information for earlier years is required. However, SFAS 131 is not
required to be applied to interim financial statements in the initial year of
application. SFAS 131 will not have a material impact on the Company's financial
position, results of operations or cash flows.

3.  ACCRUED LIABILITIES

   Accrued liabilities consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                    DECEMBER 31,
                                                  -----------------
                                                    1997      1996
                                                  -------    ------
         <S>                                      <C>       <C>    
         Warranty                                 $ 4,110   $ 4,684
         Accrued payroll and employee related       
         costs                                      7,405     4,019
         Accrued royalties                          3,542     2,194
         Other                                      2,610     3,586
                                                  -------   -------
                                                  $17,667   $14,483
                                                  =======   =======
</TABLE>

4.  DEBT AGREEMENTS

   The following represents the Company's debt at December 31 (in thousands):

<TABLE>
<CAPTION>

                                                    1997       1996
                                                  -------     ------
                  <S>                             <C>         <C>  
                  Domestic Lines of Credit        $22,000        $--
                  Japanese Bank Line of             4,536      1,365
                  Credit
                  European Lines of Credit          8,338     15,783
                  Capital Lease Obligations         1,070      1,896
                  Other                             2,384      1,754
                                                   ------     ------
                                                   38,328     20,798
                  Less current portion             36,455     18,068
                                                   ------     ------
                                                   $1,873     $2,730
                                                  =======     ======
</TABLE>



    At December 31, 1997, the Company had two domestic bank credit facilities: a
$30 million line of credit permitting borrowings at the bank's reference rate or
a formula Libor based rate (7.52% at December 31, 1997) and a $15 million line
of credit permitting borrowings at the bank reference rate or a formula Libor
based rate (6.75% at December 31, 1997). Borrowings under these lines at
December 31, 1997 were $15 million and $7 million, respectively. Further, the
agreements for these lines of credit expire in May 1998 and February 1999,
respectively. The covenants covering these debt agreements pertain to quarterly
profitability, minimum levels of net tangible worth and minimum levels of
liquidity. At December 31, 1997, the Company was in violation with the ratio
relating to a minimum level of liquidity; however, the Company has obtained the
necessary waivers.


                                       44
<PAGE>   45

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

   Additionally, the Company has credit facilities under foreign lines of
credit. At December 31, 1997, the Company's Japanese subsidiary had a Japanese
line of credit entitling it to borrow up to approximately $5.2 million. The line
of credit is collaterized by a stand-by letter of credit from the Company and
accrues interest at the bank's variable rate (1.625% at December 31, 1997).
Borrowings were $4.5 million under this facility at December 31, 1997. At
December 31, 1997, the Company's Spea subsidiary had a 5 million DeustcheMark
line of credit (approximately $2.8 million at December 31, 1997) with a German
bank bearing interest at 7.0% at December 31, 1997. Additionally, the Company
had a foreign line of credit of 10 million DeustcheMarks (approximately $5.5
million at December 31, 1997) bearing interest at December 31, 1997 at 7.0% for
borrowings of DeustcheMarks, or 9.25% for borrowings of other currencies, such
as the U.S. dollar. Both these lines were fully utilized at December 31, 1997.
These agreements expire in March, 1998. The most restrictive covenant under
these two lines of credit require a minimum annual earnings per share of twenty
(20) cents. At December 31, 1997, the Company was in violation of this covenant.

   At December 31, 1997, the Company's weighted average interest rate on short
term borrowings was 7.8%.

   The Company has various capital lease obligations payable through 2000.

   As of December 31, 1997, the Company's future payments on debt related to
notes payable, lines of credit and capital lease obligations are $36,455,000,
$333,000, $199,000, $581,000, $61,000 and $699,000 in fiscal years 1998, 1999,
2000, 2001, 2002 and thereafter, respectively.

5.  COMMITMENTS

   The Company occupies facilities in several countries including the U.S.,
England, France, Germany, Japan, and Singapore and is obligated under several
leases expiring through 2001. Under the leases, the Company is responsible for
insurance, maintenance and property taxes. The Company's headquarters facility
lease agreement includes an option to extend the lease for one five year period.
During the extension period, all terms and conditions under the agreement would
remain the same, except that the monthly rental payments for the option period
shall be the fair market value of the facility.

    Future annual minimum payments under the Company's operating leases are as
follows at December 31, 1997 (in thousands):

<TABLE>
                               <S>             <C>   
                               1998            $2,937
                               1999             2,248
                               2000             2,027
                               2001             1,257
                               2002                31
                                                   14
                               Thereafter      ------
                               Total           $8,514
                                               ======
</TABLE>


   Rent expense charged to operations was $3,005,000, $2,508,000 and $1,021,000
for 1997, 1996 and 1995, respectively.

6.  SHAREHOLDERS' EQUITY

PREFERRED STOCK

   Under the Company's Articles of Incorporation, the Board of Directors may
determine the rights, preferences and terms of the Company's undesignated
preferred stock.


                                       45
<PAGE>   46

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

STOCK OPTION PLANS

    The Company has four fixed stock option plans. Under the Company's stock
option plans, options generally vest over a four year period and they expire
five to ten years from the date of grant. Options may be granted to directors,
officers, consultants and employees at prices not less than the fair market
value at the date of grant. At December 31, 1997, approximately 627,000 shares
were available for future grants.

    On January 19, 1996, the Board of Directors approved the repricing of all
employee stock options, except those for executive officers, granted with
exercise prices higher than $17.875 per share. Approximately 1,316,000 shares
were repriced to $17.875 per share. The Board of Directors approved the
repricing with the condition that all employees would give up three months of
vesting on such repriced options.

    On July 17, 1996, the Board of Directors approved the further repricing of
all employee stock options, except those for executive officers, granted with
exercise prices higher than $7.625 per share. Approximately 1,883,000 shares
were repriced to $7.625 per share. The Board of Directors approved the repricing
with the general condition that these options cannot be exercised at the new
price of $7.625 until after June 30, 1997; however, the options are exercisable
at the original higher price if exercised prior to July 1, 1997.

    On April 16, 1997, the Board of Directors approved the further repricing of
all employee stock options granted with exercise prices higher than $7.625 per
share. Approximately 568,000 shares were repriced to $7.625 per share. The Board
of Directors approved the repricing with the general condition that these
options cannot be exercised at the new price of $7.625 until April 1, 1998.

    In January 1995, the 1995 Director Option Plan (the "Director Plan") was
adopted by the Board of Directors. The Director Plan provides for the grant of
options to purchase the Company's common stock to directors who are not
employees of the Company. A total of 175,000 shares of common stock have been
authorized for issuance under the Director Plan. Each nonemployee director who
joins the board will automatically be granted an option to purchase 30,000
shares of common stock at a price equal to the fair market value on the date of
grant and upon each reelection to the Board will be granted an additional option
to purchase 7,500 shares of common stock at a price equal to the fair market
value on the date of grant. The 30,000 share grants vest at the rate of 25% of
the option shares upon the first anniversary of the date of grant and 1/48th of
the option shares per month thereafter, and the 7,500 share grants vest four
years after grant, in each case unless terminated sooner upon the termination of
the optionee's status as a director or otherwise pursuant to the Director Plan.
In the event of a merger of the Company with or into another corporation or a
consolidation, acquisition of assets or other change in control transaction
involving the Company, each option becomes exercisable in full or will be
assumed for an equivalent option substituted by the successor corporation. The
Director Plan expires in 2005, unless terminated earlier by the Board of
Directors. As of December 31, 1997, approximately 45,000 shares have been issued
under the Director Plan.

    In connection with the acquisition of Supra, the Company assumed the Supra
1993 Stock Incentive Plan. Under the Plan the equivalent of 381,000 shares of
the Company's common stock were granted to employees of Supra upon the
acquisition of Supra by the Company at an exercise price determined pursuant to
a calculation described in the Plan document. These stock options generally vest
over three years from the date of grant. Such options are included in the
activity for the Company's stock options described above.

    The Company has also issued options outside of the four fixed plans
amounting to 280,000, 225,000 and 2,545,000 shares in 1997, 1996 and 1995,
respectively. These options vest under various periods up to a maximum vesting
period of 4 years.


                                       46
<PAGE>   47

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

    The fair value of each option grant is estimated at the date of grant using
the Black-Scholes pricing model with the following weighted average assumptions
for grants in 1997 and 1996: 

<TABLE>
                                                    1997          1996
                                                   -------       -------
                   <S>                             <C>           <C>  
                   Risk-free Interest Rate         6.36%         5.57%
                   Expected life                   4 years       2 years
                   Volatility                      61.0          50.8
                   Dividend Yield                  -------       -------
</TABLE>


   A summary of the Company's option activity as of December 31, 1997, 1996, and
1995 and changes during the year ending on those dates are as follows:

(amounts in thousands, except share data)

<TABLE>
<CAPTION>
                                                          Outstanding Options
                                                     ------------------------------
                                                      Number          Weighted Avg.
                                                     of Shares       Exercise Price
                                                     ---------      ---------------
<S>                                                  <C>            <C> 
Balance, December 31, 1994                              5,940          $   0.07
  Options granted                                       2,134             21.81
  Options exercised                                    (5,558)             0.09
  Options canceled                                       (140)             8.78
                                                     --------          
Balance, December 31, 1995                              2,376             19.03
  Options granted                                       1,695             11.84
  Options exercised                                      (117)             3.21
  Options canceled                                       (511)            20.41
                                                     --------
Balance, December 31, 1996                              3,443              7.90
  Options granted                                       3,386              8.83
  Options exercised                                      (293)            (4.37)
  Options canceled                                     (1,539)            10.92
                                                     --------
Balance, December 31, 1997                              4,997              7.89
                                                     ========          ========
</TABLE>

    At December 31, 1997 and 1996 vested options to purchase 1,232,000 and
590,000 shares respectively were unexercised. The weighted average fair value of
those options granted in 1997 and 1996 was $4.76 and $3.78, respectively.

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

<TABLE>
<CAPTION>
                                                   Options Outstanding                             Options Exercisable      
                               ---------------------------------------------------------     --------------------------------
                                  Number            Weighted Average     Weighted Average       Number       Weighted Average
Range of                       Outstanding              Remaining           Exercise          Exercisable        Exercise
Exercise Prices                at 12/31/97          Contractual Life          Price           at 12/31/97         Price
---------------                -----------          ----------------     ----------------    -------------  -----------------
<S>                            <C>                  <C>                  <C>                 <C>            <C>    
$ 0.07 - $ 3.14                   186,000              5.65 years             $1.93              147,000         $  2.28
$ 7.00 - $ 9.88                 4,462,000              8.80 years              7.83            1,061,000            7.63
$10.44 - $19.06                   349,000              9.50 years             11.76               24,000           16.08
</TABLE>


      At December 31, 1997, the Board of Directors has reserved 8,012,500 under
the 1994 and 1992 Stock Option Plans and 175,000 shares under the Director Plan.


                                       47
<PAGE>   48


DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

EMPLOYEE STOCK PURCHASE PLAN

    During 1995, the 1995 Employee Stock Purchase Plan (the "Purchase Plan") was
adopted by the Board of Directors. As of December 31, 1997, a total of 450,000
shares of common stock have been authorized for issuance under the Purchase Plan
of which 200,000 shares are authorized and available for issuance subject to
Shareholder approval at the Annual Meeting on May 22, 1998. The Purchase Plan
provides for eligible employees to purchase common stock at a price equal to 85%
of the fair market value at certain specified dates. During 1997 and 1996, the
Company issued 104,000 and 93,000 shares of common stock, respectively, under
this plan.

    Fair value for the purchase rights issued under the Company's Employee Stock
Purchase Plan, described above, is determined under the Black-Scholes valuation
model using the following assumptions for 1997 and 1996:

<TABLE>
<CAPTION>
                                    1997           1996
                                    --------       --------
        <S>                         <C>            <C>  
        Risk-free Interest Rates    5.12%          5.44%
        Expected Life               6 months       6 months
        Volatility                  61.0%          50.8%
        Dividend Yield              --------       --------
</TABLE>

    The weighted average fair market value of those purchase rights granted in
1997 and 1996 was $3.89 and $13.17 respectively.

    The Company has adopted the disclosure-only provisions of the Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-based
Compensation." Accordingly, no compensation cost has been recognized for the
Company's Stock Plans. Had compensation cost for the Stock Plans been determined
based on the fair market value at the grant date for awards in 1997 and 1996,
consistent with the provisions of SFAS No. 123, the Company's net income and net
income per share for the years ended December 31, 1997 and 1996 would have been
reduced as follows:

     (amounts in thousands except per share data)

<TABLE>
<CAPTION>
                                                           1997           1996
                                                       ----------     ----------
<S>                                                    <C>            <C>  
Net income (loss) - as reported                        $(45,605)        $16,337

Net income (loss) - proforma                           $(54,420)        $11,307

Net income (loss) per share - as reported              $  (1.33)        $  0.46

Net income (loss) per share - proforma                 $  (1.59)        $  0.33
</TABLE>


    REORGANIZATION AND STOCK REPURCHASE AGREEMENT

    Effective with the Reorganization described in Note 1, all of the
outstanding unexercised options of Diamond CA were canceled and new options were
issued at $.07 per share, the fair market value of the Company's common stock
immediately after the Reorganization. During the year ended December 31, 1995,
certain option holders exercised their option to purchase 5,430,000 shares of
the Company's common stock pursuant to restricted stock purchase agreements.
Under the terms of the restricted stock purchase agreements, the Company's right
to repurchase the stock expires monthly over four years from the date of grant
of the original stock options. In addition to the exercise of stock options
described above, on January 3, 1995, the Company issued 2,615,000 shares of
common stock to certain employees, officers, board members, and consultants
under restricted stock purchase agreements. Under the terms of the restricted
stock repurchase agreements, the right to repurchase this stock expires monthly
over four years from the


                                       48
<PAGE>   49

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

original date of grant as determined by the Board of Directors. Shares subject
to repurchase may be repurchased by the Company at the end of each individual's
association with the Company. As of December 31, 1997, 567,000 shares of common
stock were subject to repurchase by the Company.

COMMON STOCK DIVIDENDS

    The Company has never declared or paid cash dividends on its common stock.
The Company's bank loan agreement prohibits the payment of cash dividends on the
common stock without prior approval.


7.  GEOGRAPHIC REGION INFORMATION

<TABLE>
<CAPTION>
Net Sales to Geographic Region:          1997           1996           1995
<S>                                <C>            <C>            <C>       
                                   ----------------------------------------
United States                      $  271,311     $  369,367     $  303,064
Europe                                116,844        132,971        131,045
Far East and other                     55,126         95,712         33,526
                                   ----------------------------------------
Net Sales                          $  443,281     $  598,050     $  467,635
                                   ========================================
Export sales:
Europe                             $  116,844     $  104,473     $  113,954
Far East and other                     45,054         84,184         23,098
                                   ----------------------------------------
Total Export Sales                 $  161,898     $  188,657     $  137,052
                                   ========================================
Operating Income (loss):
United States                      $  (64,606)    $   22,840     $   13,348
International                          (3,113)          (132)       (32,621)
                                   ----------------------------------------
Total Operating Income (loss):     $  (67,719)    $   22,708     $  (19,273)
                                   ========================================

Identifiable Assets:
United States                      $  313,006     $  257,449     $  298,347
International                          24,548         74,989         53,382
                                   ----------------------------------------
Total Assets                       $  337,554     $  332,438     $  351,729
                                   ========================================
Transfers between Affiliates
(Eliminated in Consolidation)
by Geographic Region:
United States                      $    9,483     $   67,882     $   26,819
International                              --         14,816            850
                                   ----------------------------------------
Total transfers                    $    9,483     $   82,698     $   27,669
                                   ========================================
</TABLE>


   The Company's foreign operations consist principally of its foreign
subsidiaries in Germany, the United Kingdom and Japan. The identifiable assets
and operating income (loss) of the Company's consolidated foreign subsidiaries
are shown above.

   In 1997, 1996 and 1995, no one customer accounted for greater than 10% of net
sales.


                                       49
<PAGE>   50

DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

8.  INCOME TAXES:

   The provision (benefit) for income taxes consists of the following (in
thousands):
<TABLE>
<CAPTION>
                                         1997            1996            1995
                                       --------        --------        --------
<S>                                    <C>             <C>             <C>
Current:
  Federal                              $(18,873)       $ 12,779        $ 16,930
  State                                      73           2,231           4,525
                                       --------        --------        --------
                                        (18,800)         15,010          21,455
                                       --------        --------        --------

Deferred:
  Federal                                   138         (14,568)           (494)
  State                                    (883)           (458)            486
  Foreign                                    --           9,611             693
                                       --------        --------        --------
                                           (745)         (5,415)            685
                                       --------        --------        --------
                                       $(19,545)       $  9,595        $ 22,140
                                       ========        ========        ========
</TABLE>

   The Company's effective tax rate differs from the statutory federal income
tax rate as shown in the following schedule:

<TABLE>
<CAPTION>
                                                 1997        1996        1995
                                                ------      ------      ------

<S>                                              <C>          <C>        <C>    
Tax provision at federal statutory rate          (35.0)%      35.0%      (35.0%)
State taxes, net of federal tax benefit           (1.6)        3.4        (5.5)
Research and development tax credit               (0.3)       (0.7)       (0.9)
Foreign sales corporation benefit                   --          --        (1.2)
Amortization of intangibles                        6.0         1.7          --
Write-off of in-process technology                  --          --       158.5
Other                                              0.9        (2.4)       (0.6)
                                                ------      ------      ------
                                                 (30.0%)      37.0%      115.3%
                                                ======      ======      ======
</TABLE>

The components of the deferred tax asset are as follows (in thousands):

<TABLE>
<CAPTION>
                                                        DECEMBER 31,
                                              --------------------------------
                                                1997        1996        1995
                                              --------    --------    --------
<S>                                           <C>         <C>         <C>   
Deferred tax assets:
  Net operating loss carryforwards            $    756          --    $  9,611
  Sales returns and receivables allowances          --    $  4,145       3,225
  Inventory valuation allowances                 7,060       6,307       1,438
  Warranty accruals                              1,465       1,718       1,127
  Compensation                                     455         644         318
  State taxes                                       --       1,019       1,281
  Software amortization                          4,695       7,350          --
  All other                                        248         761         554
                                              --------    --------    --------
                                                                           
          Total deferred tax assets           $ 14,679    $ 21,944    $ 17,554
                                              ========    ========    ========
</TABLE>

   Management has determined that no valuation allowance is necessary as the
Company has sufficient taxable income in carryback years to absorb net operating
losses and future items deductible for federal tax purposes, and expects that
its future taxable income will allow the deferred tax asset for state tax
purposes to be fully realized in future years.

9.  EMPLOYEE BENEFIT PLAN

   During 1993, the Company established a 401(k) tax-deferred savings plan under
which all employees meeting certain age and service requirements may contribute
up to 15% of their eligible compensation (up to a maximum allowed under IRS
rules). Contributions may be made by the Company at the discretion of


                                       50
<PAGE>   51


DIAMOND MULTIMEDIA SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

the Board of Directors. Contributions by the Company amounted to $671,000,
$616,000 and $265,000 in 1997, 1996, and 1995, respectively.

10.  LITIGATION

    The Company has been named as a defendant in several putative class action
lawsuits which were filed in June and July, 1996 and June, 1997 in the
California Superior Court for Santa Clara County and the U.S. District Court for
the Northern District of California. Certain executive officers and directors of
the Company are also named as defendants. The plaintiffs purport to represent a
class of all persons who purchased the Company's Common Stock between October
18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege claims
under the federal securities law and California law. The plaintiffs allege that
the Company and the other defendants made various material misrepresentations
and omissions during the Class Period. The complaints do not specify the amount
of damages sought. The Company believes that it has good defenses to the claims
alleged in the lawsuits and will defend itself vigorously against these actions.
No trial date has been set for any of these actions. The ultimate outcome of
these actions cannot be presently determined. Accordingly, no provision for any
liability or loss that may result from adjudication or settlement thereof has
been made in the accompanying consolidated financial statements.

    The Company is also party to other claims and pending legal proceedings that
generally involve employment and trademark issues. These cases are, in the
opinion of management, ordinary and routine matters incidental to the normal
business conducted by the Company. In the opinion of management, the ultimate
disposition of such proceedings will not have a materially adverse effect on the
Company's consolidated financial position or future results of operations.


                                       51
<PAGE>   52

DIAMOND MULTIMEDIA SYSTEMS, INC.
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                 Additions
                                     Balance at    Charged to   Deductions                       Balance
                                   Beginning of       Costs &         from                        at End
                                        Periods      Expenses     Reserves   Adjustments (1)   of Period
                                    ----------     -----------  -----------  ---------------   ---------
<S>                                <C>             <C>          <C>          <C>               <C>
(In thousands)

YEAR ENDED DECEMBER 31, 1997
Accounts Receivable Allowances            1,943           952          455                         2,440
Inventory Allowances                     13,755        11,580        8,828                        16,507

YEAR ENDED DECEMBER 29, 1996

Accounts Receivable Allowances            1,959         1,026        1,042                         1,943
Inventory Allowances                      5,063        14,249        5,557                        13,755

YEAR ENDED DECEMBER 31, 1995

Accounts Receivable Allowances            1,500           710        1,573            1,322        1,959
Inventory Allowances                      2,500         1,000        5,047            6,610        5,063
</TABLE>

(1) Adjustments consist of opening balance allowances related to the
    acquisitions of Supra and Spea.


                                       52
<PAGE>   53

DIAMOND MULTIMEDIA SYSTEMS, INC.
LIST OF EXHIBITS
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
Exhibit No.          Description                                                          Page No.
----------           -----------                                                          --------
<S>                  <C>                                                                  <C>     
10.24                Form of Change of Control Severance Agreement
                     between the Registrant and the executive officers
                     listed below:                                                           54

                               Franz Fichtner
                               C.    Scott Holt
                               Wade Meyercord
                               Dennis D. Praske
                               James M. Walker

23.1                 Consent of Coopers & Lybrand L.L.P.
                     Independent Accountants                                                 60

24.1                 Power of Attorney                                                       32

27.1                 Financial Data Schedule                                                 61
</TABLE>


                                       53